How to maximise the exit value of an IT Services firm

Michael Gordon – Gordon Tartan Ltd

 

Developing a plan to maximise the firm’s value at exit

It’s the time of year when many IT Services firms are kicking-off a process to review and update their strategy as input to the 2016 Business Plan. A key question to address in doing this is: how can the shareholders and management of the firm maximise the firm’s enterprise value? A good way to start answering this question is to consider who would assess the value of the firm and how they would do it.

Ask an analyst for the methodology that he or she would use to value a services firm, and there will typically be reference to financial metrics extracted from the accounts (sales, revenue, EBIT, EBITDA,  discounted free cash flow, capitalisation of earnings, etc.), along with benchmark multiples. However, the limitation of these valuation methods is apparent when you consider that the true market value of a firm is quite simply the price an acquirer is willing to pay. Value, like beauty, is in the eye of the beholder, and that value (being the price that can be achieved) will be determined by a range of factors beyond pure financial metrics. These other considerations will be based on factors such as:

  • the attractiveness to the acquirer of the market in which the acquisition target operates;
  • the nature of the assets of the target firm that promise to sustain and/or accelerate future earnings;
  • the perceived threats to the target firm’s future earnings; and
  • the synergies that the acquirer can derive through acquisition of the target.

If the goal of the management of an IT Services firm is to maximise shareholder value by a date targeted for an exit, then the above four bullet points provide a good reference for the development and execution of the firm’s strategy.

So, taking each of the points in turn, what should management do to ensure that they are working to maximise enterprise value?

1. Ensure that the firm is focussed on markets that are likely to be attractive to a buyer

Within the development of strategy, and subsequent decision-making in relation to sales, marketing, proposition development and opportunity qualification, the following need to be considered in assessing the attractiveness of a market, and the associated actions to be taken:

  • CONSIDERATION – Market size and growth. ACTION – Ensure that there is a focus on markets that are big enough to sustain targeted future growth in sales and revenue.
  • CONSIDERATION – Sector risk in the target market. ACTION – Avoid too great a focus on a market that has a very high exposure to political, economic, social or technological risk events that are outside the control of the firm.
  • CONSIDERATION – Pricing trends. ACTION – Shift focus away from markets in which margins will be threatened by reduced “willingness to pay”.
  • CONSIDERATION – Nature and intensity of current and emerging competition. ACTION – Monitor competitive threats in the market and shift focus if those threats will lead to either (i) a significant increase in cost of sale or (ii) achievable margins on delivery.
  • CONSIDERATION – Opportunity to differentiate products and services. ACTION – Ensure that the markets upon which the firm focusses are those in which the firm’s offerings have demonstrable differentiated value.

2. Invest in the development of assets that promise to accelerate future earnings

Key considerations and actions here are:

  • investing in intellectual property (“IP”) and related assets, to establish differentiation, gain access to new accounts and secure high margin sales;
  • being rigorous in the application of contractual terms, including licensing, copyright and confidentiality, to ensure that IP is protected;
  • recognising that IP can be used not just to generate high margin license revenue, but also to leverage services revenue, which can be won with all the advantages of being the sole potential provider; and
  • investing in people, process and technology, to ensure that controlled growth can be maintained.

3. Manage risks that threaten future earnings

A potential buyer will be very sensitive to the following types of risk, and a target firm therefore needs to be able to demonstrate (during the due diligence process) that the risks are being effectively managed:

  • CONSIDERATION – The risk that the firm will not meet its forecasts. ACTION – The firm needs to be able to demonstrate that it has a good record of meeting or beating its annual budget/target forecasts and this needs to be carefully considered in setting budgets and forecasts;
  • CONSIDERATION – The risk of a past or ongoing engagement leading to a liability or other related financial claim. ACTION – The firm needs to be able to demonstrate effective quality management procedures in service delivery with evidence of a strong delivery track record, as well as prudence and consistency in contracting with clients to limit potential liabilities;
  • CONSIDERATION – Client concentration risk. ACTION – Many IT Services firms have a very high concentration on one or two major accounts. A risk event within the control of the firm (such as poor quality in delivery of a project) or totally outside the control of the firm (such as a change in Procurement strategy within the account) could put all that revenue at risk and seriously threaten the viability of the firm and hence its attractiveness to an acquirer. An IT Services firm therefore needs to avoid excessive concentration on a small number of accounts;
  • CONSIDERATION – The risk presented by a “rolling cliff edge”. ACTION – Many services engagements have short duration, and as a result the “order book” for contracted business can appear alarming in respect of size and duration. A potential acquirer’s concerns in this regards can be mitigated by investing effort in securing long term contracts (such as those for the provision of outsourcing under a Service Level Agreement); and
  • CONSIDERATION – The risk that key staff will leave post-acquisition. ACTION – This is a risk primarily for the acquirer to manage.  However management within a target firm can address potential acquirer concerns (and consequential bid price reduction) by avoiding key man dependency and including relevant protective terms in employment agreements.

4. Create synergies that an acquirer can derive following the transaction

The synergies that an acquirer could derive from post-merger integration will be highly dependent on how the assets and strategy of the acquirer match up to those of the acquisition target. Typically the potential synergies fall into two categories:

  • Revenue enhancement by selling and/or delivering either: (i) the acquirer’s products and services through the target firm’s channels or (ii) the target firm’s products and services through the acquirer’s channels.
  • Cost reduction through operational integration; at best driving the business volumes of both the acquired and the acquiring firms’ through just one of the firm’s “back offices”.

There are limitations on the ability of an IT Services firm to take steps to build synergistic value in advance of an acquisition unless it is able to take a view on which firm (or types of firm) are likely to want to acquire it. However:

  • in relation to creating opportunities for revenue enhancement synergy, the management of a target firm can take a view on the type of acquirer that is likely to view it as an attractive acquisition target, and the would-be target can then align its strategy accordingly; whilst
  • in relation to cost reduction synergies, the development of scalable cost-effective operational infrastructure will always help to enhance enterprise value.

 Stand back and assess the strategy: will it achieve the objective?

All the points outlined above contribute to making an IT Services firm more attractive to an acquirer. In doing so, they can clearly drive up the price that can be achieved in an exit.

So – how does your strategy and its execution match-up to these guidelines?

  

© Gordon Tartan Limited

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