Art of the Possible – M&A Roll-ups in Tech and Software (2/2)

February 2024

Value Creation in Roll-up

Creating value through a roll-up strategy presents a significant opportunity in the software/msp/tech sector as they face challenges related to infrastructure and client servicing capabilities. By consolidating these entities, a platform or aggregator can effectively leverage its own infrastructure, which includes comprehensive sales and marketing models, a diverse range of product offerings, and scalable operations. This synergy allows for the bridging of existing gaps in these smaller companies.

The value created through this process can be realized in several key ways. First, there are enhanced cross-selling and upselling opportunities, allowing companies to expand their service offerings to existing clients. Additionally, improved client retention can be achieved by enhancing customer satisfaction through robust support and innovation. Furthermore, the realization of economies of scale streamlines operations and enables investments in cutting-edge technology. By addressing the various challenges faced by smaller MSPs, this strategic approach empowers them to overcome barriers to investment and scalability, fostering a mutually beneficial relationship for all parties involved.

The fragmentation of the software and services market also provides a fertile ground for roll-up strategies. By identifying companies that share similar cultural and operational values, aggregators position themselves as ideal partners. Unlike the approach of targeting a limited number of large firms, the lower mid-market offers a vast pool of potential candidates. This broad market perspective facilitates the effective execution of a roll-up strategy, creating growth opportunities while simultaneously consolidating the market.

In addition to operational synergies, roll-ups also benefit from the principle of multiple arbitrage. By acquiring smaller companies at lower EBITDA multiples, integrating them, and expanding the combined business, the resulting entity can achieve higher valuation multiples, ultimately delivering substantial value to shareholders. The successful execution of this strategy relies on several critical factors, including strong client and employee retention, organic growth alongside acquisitions, and a commitment to vertical market expertise and technological leadership.

Evaluating Roll-up Targets

When evaluating potential acquisitions, there are several key metrics to gauge the viability and long-term potential of target companies. A primary consideration is growth trends; businesses that demonstrate steady, organic growth signal a strong foundation for future success. Next is to look into the client mix of the company, recognizing that a diversified client base is crucial for risk reduction; any overreliance on a single client raises concerns and can pose significant challenges.

Another important factor in software related acquisition is the quality of recurring revenue - ideally companies that derive half or more of their revenue from recurring sources, as such businesses can command premium valuations due to the predictability and scalability of their revenue streams. Also to verify are risks associated with customer concentration, especially when a substantial portion of a target's revenue comes from a single client. To address these risks, they encourage diversification prior to acquisition and may adjust deal structures to protect both parties. For instance, permitting sellers to roll over equity into the larger organization can foster a more resilient business model.

Valuation of Targets

Valuation is recognized as one of the most complex yet essential elements of roll-up strategies within the business landscape.

EBITDA as the Core Metric - Most valuations prioritize EBITDA as a proxy for cash flow. However, it is often necessary to make adjustments to account for inaccuracies in reported figures.

EBITDA Multipliers and Arbitrage - The differential between acquisition and exit multipliers must be substantial to effectively mitigate risks. Consolidation within this framework can facilitate multiple arbitrage, ultimately amplifying returns.

Unique Challenges in Valuation - Legacy businesses frequently lack contemporary accounting practices, which complicates due diligence efforts. Additionally, careful adjustments need to be made for owner-specific expenses and informal financial management practices.

Premiums and Integration - Care should be taken to avoid overpaying for businesses that require considerable integration efforts, especially those with outdated systems or poorly maintained records. Premiums should only be considered when they are justified by ease of integration and operational readiness.

Complexities and Challenges in Roll-Up

The roll-up strategy in business acquisitions presents a range of complexities and challenges, mainly related to operational systems, financial transparency, management transitions, legal complexities, and deal structuring. However, a disciplined and strategic approach can help mitigate these obstacles and unlocking value. Private equity firms and aggregators that focus on the lower middle market often encounter significant information asymmetry challenges when targeting small businesses.

One of the primary challenges arises from the lack of available information on smaller companies compared to larger enterprises or various industries. Buyers often face considerable effort in gathering relevant data on potential acquisition targets. However, by conducting thorough groundwork, they can take advantage of the opportunity to acquire these businesses at lower costs.

Typically, small businesses fall at the lower end of the industry valuation multiple spectrum. When executed effectively—by acquiring two or three businesses at low multiples and streamlining their operations—buyers have the potential to enhance profitability and create a more robust platform. Often, these small businesses lack comprehensive accounting systems, which adds uncertainty to their financial performance. Addressing this gap, along with other operational challenges, can position these businesses for future sales at higher multiples, creating significant arbitrage opportunities.

A critical element of this strategy involves understanding the vital verticals prevalent in any given industry. As industries evolve, the necessity for effective accounting systems becomes apparent. Yet, it’s essential to identify the specific needs unique to each sector; a thorough understanding and addressing of industry-specific requirements are crucial for success. Navigating this landscape demands a keen awareness of the current market environment and the foresight to anticipate future changes. Conducting comprehensive market research and possessing future intelligence are integral components of this approach.

Financial discrepancies and varying accounting standards are significant hurdles. Many small businesses lack compliance with standards such as IFRS/GAAP, leading to inconsistencies in EBITDA calculations. Adjustments from non-GAAP to GAAP accounting can result in notable swings in valuation, complicating price negotiations. Additionally, discrepancies in working capital tracking can pose further issues, as sellers often do not monitor normalized working capital accurately, creating risks of unexpected capital requirements post-acquisition.

To bridge valuation gaps and align seller incentives with long-term goals, buyers frequently utilize rollover equity and earnouts. Yet, these tools can spark disputes if performance metrics are unclear or if financial dynamics shift after the acquisition. Furthermore, sellers may manipulate financial statements by accelerating revenue collection or delaying payables, inflating cash flow before the sale. Such practices often go undetected until post-closing audits unveil inventory deficits or receivable discrepancies, which can jeopardize compliance with lender covenants.

Management transitions also present challenges, particularly in service-oriented businesses where retaining owner-managers is crucial. Scaling management capabilities from a smaller enterprise to a larger organization often necessitates incentivizing owners through future payouts tied to the business's success.

Finally, the legal complexities associated with roll-up strategies cannot be overlooked. Negotiating purchase price adjustments, indemnification, and tax structures within the Letter of Intent requires careful planning. Poorly structured agreements can lead to disputes or tax inefficiencies, underscoring the need for thorough preparation and strategic foresight in navigating these intricate waters.

Risk Management in Roll-ups

To effectively mitigate risks in business transactions, it’s essential to adopt a well-rounded approach. This begins with thorough financial diligence, where conducting comprehensive quality-of-earnings analyses is crucial to uncover any anomalies. It’s important to avoid quick assessments that might overlook vital elements such as revenue recognition and working capital adjustments.

Establishing clear earnout agreements is another significant factor. These agreements should explicitly define performance metrics and payout structures, incorporating pro-rata thresholds and necessary adjustments for any changes in the business structure. It’s also wise to include provisions that address unforeseen events, such as breaches of credit covenants or potential business sales.

A strategic management transition is vital for ensuring ongoing success. This involves crafting tailored retention plans for key managers, which blend reduced roles with long-term incentives. Gradual transitions help maintain continuity without overly relying on departing owners.

Disciplined deal structuring is essential as well. Prioritize obtaining accurate working capital figures and ensure that the purchase price aligns with realistic financial expectations. If reliable working capital figures cannot be established, it’s often best to reconsider the deal altogether.

When negotiating the Letter of Intent (LOI), tackle key terms such as indemnification, management roles, and tax implications early in the process. Incorporating exclusivity periods with extensions for diligent buyers or establishing tight timelines for sellers can help streamline negotiations.

It’s critical to avoid common pitfalls by steering clear of rushed deals characterized by unrealistic timelines or insufficient financial diligence. Focus your negotiations on the most important aspects of the deal to foster mutual trust and minimize the potential for future conflicts.

Additionally, when considering deal structures, distribution of risk plays a vital role. In lower-middle-market transactions, employing a mix of seller financing, rollover equity, and earnouts effectively bridges valuation gaps. In contrast, larger transactions should prioritize minimizing risks associated with financing fluctuations, potentially using breakup fees or equity guarantees.

Lastly, tailored financing approaches are important in optimizing deal structures. Combining senior debt with equity contributions while considering industry-specific lending multiples—typically around 2 to 3 times EBITDA for smaller deals—can be advantageous. During periods of high interest rates, focusing on cash-flowing add-ons to portfolio companies and financing these primarily through debt provides opportunities to exploit potential arbitrage benefits.

Deal Structures and Potential Red Flags

Before signing a Letter of Intent (LOI), several red flags can indicate potential challenges. A sudden surge in profitability, for instance, might reflect unsustainable cost-cutting measures implemented to inflate the business's appeal ahead of a sale. High turnover among employees or customers often signals deeper instability within the organization. Similarly, evasive or overly polished communication from the seller could point to misalignment or hidden issues. Another significant concern arises when discrepancies emerge between the financial information initially presented and the details disclosed after the LOI. Identifying and addressing these issues early in the process can save buyers from costly surprises during due diligence.

When structuring deals, simplicity is crucial. A straightforward model typically involves a majority cash payout upfront—usually 60–80%—with the remainder in rollover equity. This approach aligns the seller’s interests with the long-term success of the acquiring company while avoiding the complications associated with earnouts. Although earnouts can seem attractive in theory, they frequently lead to administrative challenges and integration hurdles. A streamlined structure accelerates the transition and helps the combined entity generate value faster. Flexibility in deal structures remains important, enabling buyers to accommodate sellers’ preferences without compromising organizational goals or alignment.

Standard Operating Procedures for Roll-Ups

Building and maintaining customer trust is essential in service-oriented businesses, as losing this trust can significantly impact operations. To foster customer loyalty, companies must focus on delivering new value through enhanced convenience, advanced technology, and unparalleled service.

In addition to refining back-office operations, it is crucial to prioritize revenue growth and margin expansion. Developing a versatile playbook enables businesses to adapt to changing industry trends, competitive environments, and technological advancements.

Implementing innovative tools and services can set a company apart from its competitors while greatly improving the customer experience.

When engaging with capital providers, the execution of strategies often takes precedence over financial modeling. Investors typically place a greater emphasis on a company’s ability to execute plans rather than on theoretical financial projections. Therefore, it’s important to mitigate execution risks by presenting robust operational plans and demonstrating a successful track record.

Securing equity commitments upfront is a vital step, as debt providers often evaluate cash flow and equity support. While offering a combination of cash and equity to sellers may be an option, caution is necessary regarding earnouts. Despite their appealing nature, earnouts can lead to disputes due to varying accounting interpretations and structural disagreements. Reducing dependence on earnouts can facilitate smoother post-acquisition integration and decrease the likelihood of conflicts.

Case-in-point: Constellation Software Playbook

Constellation Software (CSU) is a remarkable Canadian success story that exemplifies effective business roll-up strategies. Established in 1995 and listed publicly in 2006, CSU has transformed into a $40 billion enterprise, primarily through its concentrated focus on acquiring and managing Vertical Market Software (VMS) businesses—specialized software solutions tailored to specific industries.

With a remarkable track record of over 800 acquisitions spanning more than 100 verticals, CSU has developed a scalable and disciplined approach to mergers and acquisitions (M&A). In 2021, the company achieved revenues of $5.1 billion, reflecting a 29% year-over-year growth, and recorded $1.1 billion in EBITDA, resulting in a 22% margin.

The success of Constellation Software (CSU) is built upon three foundational pillars. First, the company employs a decentralized structure in which autonomous Operating Groups (OGs) oversee multiple Business Units (BUs). Each BU operates independently, maintaining its own strategic direction and profit-and-loss management, while receiving mentorship and access to operational best practices and extensive data benchmarks. This meritocratic environment incentivizes employees with stock options, minimizing bureaucracy and promoting long-term career growth.

Second, CSU adopts a scalable and disciplined approach to mergers and acquisitions, focusing on the perpetual ownership of VMS businesses characterized by strong fundamentals, founder-led leadership, and financial metrics that ensure a return on investment greater than 20%. The company prioritizes smaller acquisitions valued at less than $5 million with attractive valuations, having allocated $6.6 billion across over 780 deals since 2005, empowering OGs and BUs to identify suitable targets while adhering to stringent internal guidelines.

Lastly, CSU targets high-quality VMS businesses, which are ideal for acquisition due to their mission-critical nature, impressive customer retention rates of approximately 95%, low competition, and efficient capital structures. These businesses provide specialized solutions that foster high switching costs, ensuring market leadership and long-term profitability.

CSU's systematic approach to roll-ups incorporates several key elements:

Market Selection: The company targets fragmented markets with more than 500 suitable candidates.

Acquisition Criteria: It seeks businesses generating over $0.5 million in EBITDA at low multiples (below 5x unlevered free cash flow).

Sustainability: CSU prioritizes asset-light companies with EBITDA margins exceeding 30% and free cash flow conversion rates above 70%.

Pricing Power: By leveraging high customer switching costs, CSU maintains stable and predictable earnings.

The Playbook

Buy Quality Assets at Attractive Multiples: Seek out businesses with solid fundamentals and favorable market conditions.

Leverage Debt Judiciously: Employ debt strategically to finance acquisitions without succumbing to overleveraging in uncertain economic climates.

Adopt a Long-Term View: Build strong relationships with target companies, respect their pricing power, and avoid rushed integrations.

Execution Excellence: Ensure each acquisition aligns with the broader strategic vision, promoting sustainable growth.

Repeat ...