Build Enterprise Value Now for the Next Round of M&A
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Entering the summer of 2022, the future seems a bit cloudy. The rapid rise in inflation, the war in Ukraine, and political unrest resulting from the January 6th Commission hearings and the Supreme Court’s overturning of Roe v. Wade will undoubtedly impact the midterm elections this fall. As a result, consumers and businesses alike will likely tamp down their spending and err on the side of caution in the near term, while keeping a watchful eye on economic indicators and consumer sentiment. Yet, it is worth noting that the underpinnings of the economy — employment, manufacturing, savings rates and consumer demand — remain incredibly strong. As such, one can reasonably presume that the pullback, and even a recession, should one occur, will likely be short and shallow.
The Good Times Will Return
This backdrop sets the stage for those of you who noticed the flurry of M&A activity over the past couple of years and who are concerned that you might have missed the opportunity to participate. Fear not! The good times will return (as they always do), and it’ll likely be before you know it. So, in the meantime, what can you do to prepare and be optimally positioned for the next wave of mergers and acquisitions?
As most service businesses are, electronic systems contractors are typically valued on a multiple of earnings, or EBITDA. Those businesses that have wisely built up a noteworthy recurring-revenue base (i.e., >10% of total revenues) will likely be rewarded by seeing that revenue stream carved out and valued at a multiple of revenues. Although some investors may place a premium on a company’s transferrable value (i.e., the ease of absorption into the parent), increasing a business’ enterprise value will come down, for the most part, to recurring revenue and EBITDA growth.
Sources of recurring revenue — system monitoring, service contracts, software subscriptions and AVaaS (or similar) — are fairly well known, and systems contractors pursue them with varying degrees of vigor. The most attractive features of these agreements are auto-pay; auto-renewal; annual term (or longer); and well-structured, non-recourse contract agreements. For most electronic systems integrators, growing their recurring-revenue base comes down to 1) making a strategic decision to actively pursue it; 2) developing a plan to productize and aggressively promote these services; and 3) executing on that plan.
Successfully building a strong recurring-revenue base is the most direct path to increasing enterprise value and, thus, being viewed as a more attractive acquisition target.
Levers to Pull
A slower, but perhaps more comfortable, path to increasing enterprise value is to increase net profit, or EBITDA. A systems integration firm can pull several levers to try to strengthen their bottom line. Many of these might seem obvious, but a reminder never hurts.
- Raise Prices: You might have missed the recent M&A frenzy, but, hopefully, you didn’t also miss the opportunity to raise prices when everyone else was doing it. From an impact perspective, raising prices is the simplest and most effective way to drop more dollars into the bottom line. It requires little work (i.e., simply changing labor rates and multipliers in your proposal and accounting software), and there is no direct correlation or impact on the cost of goods (such as labor and materials) or overhead expenses.
- Sell More: Considering that corporations, institutions and consumers are proceeding with more caution in this slowing economy, it might seem like an unrealistic objective to increase top-line sales, but some dynamics of this changing economic environment can play in your favor. Employment is softening, so there is an increased likelihood of being able to find another salesperson or two to source more leads, generate more proposals and close more business. Additionally, it is well known that the “smart money” (i.e., the deep-pocketed corporations and consumers) invests in capital improvements in down economies because there is less competition for service providers and, often, they can negotiate better prices. The margins might be a little tighter, but the business is out there.
Trimming the Fat
- Cut Costs: You’ve undoubtedly noticed that the large (and smart) tech companies acted quickly to trim the fat that they’d accumulated during “the good times” as soon as they saw the economy beginning to soften. Following their lead, this is a good time to assess which team members may be underperforming, may not be completely engaged or may not be fully utilized. In addition, and as appropriate, scrutinize and eliminate (or reduce) other costs that crept in during the post-pandemic run up.
- Renegotiate with Suppliers: Most systems integrators have seen product costs increase — in some cases, substantially — over the past year. Suppliers blame the price increases on everything from the increased cost of raw materials, labor and/or overseas freight to being required to pay a premium to gain access to products that are in short supply. Regardless, many of these cost inputs will revert to the norm over time, giving suppliers more flexibility to adjust prices downward. That said, I anticipate that many will play the inflation card and leave their prices jacked up. The larger and more prudent integrators will force their suppliers to revisit their dealer cost and carve out a few additional points of margin by doing so.
- Improve Operating Efficiencies: In the post-pandemic run up, it has been “all hands on deck.” Team members have had little choice but to spend every available minute focused on signing and fulfilling contracts; this has left little time to “work on the business.” As project work starts to subside, which will be a welcome shift for many, it is imperative to assess current workflows and productivity tools to identify where operational improvements can be made. Throughput enhancements will help to boost the bottom line, and, ultimately, your enterprise value.
Moving the Needle
Of course, there are other levers to pull, as well, when seeking to increase enterprise value; however, those cited here will likely move the needle most noticeably. If you’re at the age or stage of your career when exiting your systems integration business is on your mind, now is the time to prepare for the next hot M&A market. I maintain it will be upon us before you know it.
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