Most organisations in today’s world require IT equipment, software and support services – which can be provided by MSPs. MSPs service a range of customers in terms of size, sector and geography. These factors can often influence a MSP’s revenue and working capital model.
This article, however, focuses on a typical mid-market MSP, serving a range of SMEs and mid-sized enterprise customers.
Typical MSP financial model
Revenue and costs
MSPs’ revenue streams typically include: product sales, maintenance support revenue and project revenue.
An MSP’s cost base largely comprises delivery personnel but also the costs associated with third party channel providers / partners (hardware, software and outsourced or product specific support).
Working capital and cashflow
The working capital model of an MSP, can typically include the following key characteristics:
- Revenue invoiced and cash received in advance of services provided. The timing of cash received can sometimes be concentrated to certain points of a year
- Cash received in arrears for project work, which can me “lumpy”
- Cash paid in advance to vendors
- Monthly payment of staff and other costs
Typical areas to look out for in financial and tax due diligence of MSPs
This financial model therefore creates some specific areas to look out for in financial due diligence, as follows:
Revenue recognition
Revenue for support services and software licenses should be recognised over the contract duration. We often see MSPs incorrectly recognising multi-period support revenue at the point of invoice, where the performance obligations are yet to be fulfilled. In a growing business, a consequent adjustment to defer revenue is likely to reduce EBITDA. Furthermore, we would expect to see a deferred revenue balance, which may impact equity value adjustments.
Cost recognition
Similarly, vendor costs which cover a specified period of time should be recognised over that duration.
Run-rate EBITDA
Given the recurring nature of support services and SaaS revenue, sale particulars of MSPs will often present a “run-rate” EBITDA, often based on an annualisation of a short time period. The calculation of these run-rates requires careful due diligence to understand the basis of assumptions and their validity/sustainability.
Revenue visibility
MSPs often have good revenue visibility. We would typically analyse (a) the “run-off” of contracted revenue; (b) historical rate of contract and sales pipeline.
Customer concentration
MSPs serving enterprise customers can often have one or several large accounts, which if lost could have significant detrimental impact on revenue.
Gross margin development
Product, Projects and Support Services revenue can have very different gross profit margins. It is important to ensure correct cost allocation to each revenue stream (including direct staff costs) and to understand the mix of revenue and profit from each of these sources. The blended gross margin may be altered by the timing and quantum of large “one-off” Project or Product sales.
Go to market proposition
Understanding how the business drives new sales; and the cost of customer acquisition is important in order to quantify the expected costs that are required to drive projected new sales.
Capitalisation of development costs
Do the costs incurred in developing proprietary software meet the accounting standards criteria for capitalising; or are they really a recurring EBITDA cost.
Lease accounting (IFRS16)
If the business has adopted IFRS16, it may be recognising the value of future operating leases costs (such as data centres) as a liability on the balance sheet, with rental payments being treated as a repayment of that liability. Such costs are typically recurring and should normally be included in EBITDA for enterprise valuation purposes.
Restructuring and “growth” costs
In MSPs, we often see positive EBITDA adjustments which add back the cost of redundant staff (and their redundancy cost) or the cost of staff that have been recruited ahead of sales growth. Both of these areas need investigating to ensure they are valid EBITDA adjustments; and to calculate any related liabilities.
Working capital
Monthly working capital can be influenced by the timing of invoicing/cash collection of support services invoices and/or large project/product sales. It is important to understand the impact of these factors on the working capital profile for the purposes of setting a working capital target.
These are just some of the specific areas that are common to MSPs and these can obviously vary depending on the specifics of the business in question.
If we can be of assistance or if you would like to discuss any of the above in more detail, please do not hesitate to get in touch.
