Digital Agency M&A: Buy-side Assignment, Valuation and Liquidity
I have been assisting individuals and CEOs acquire, divest and value Internet service companies since the days of the dial-up modem, so to witness the “Digital Agency” industry evolve from basic website design and old school advertising to where it is today has been a fascinating journey for many of us.
My 2018 six-month buyside consulting assignment
In mid 2018 I was approached by the CEO of a software development agency in the northeast US. He wanted to entertain acquiring a few digital agencies to both scale up and diversify his company’s offerings. My role was to assist with the strategy, identify the pool of target companies, contact then educate each target, schedule and participate in conference calls, collect initial due diligence info, and help pro/con each target.
I am approached with this type of assignment at least 2-3 times per month and only end up accepting about 2-3 per year. Why do I only accept 2-3 of these assignments per year? … because
· I end up spending an enormous amount of time with each buyside client, so the personality match has to be close to perfect.
· I need to be impressed with the CEO, their company and their acquisition strategy.
· it is far more financially lucrative for me to only represent sellers.
· many buyers never end up acquiring a single company.
So why did I take on this assignment?
· I was and still am very impressed with this CEO and his company.
· because sometimes during the evolution of specific industries, they explode with regards to the speed of strategic change of the industry participants. This has certainly been the case with the “Digital Agency Space” … and there is no better way to learn exactly what is happening than to have conference calls and 100’s of due diligence information exchanges with CEOs who are entertaining selling their Digital Agencies.
The History of Digital Agencies
How did we get to this point? There were several industries which were growing and evolving by themselves … think
· Websites: design and hosting (established in the mid 1990’s)
· Advertising: branding, package/product design, print, PR, media planning & buying (established 100+ years ago)
· Technical infrastructure: data centers, fiber, wireless, satellite (established in the mid 1900’s)
· Cell phones (established around 1990+-)
· Software Development: mobile app, wearables, IoT, AI, BI, custom software, blockchain, application testing-management-support, etc.
· Visuals: UX/UI, AR/VR, graphic design, audio-video production
· Marketing: Social media, mobile ad, email, PPC, SEO/SEM, content
· Managed Services Providers: Cloud services, IaaS, PaaS, cyber security, IAM, network (design-maintenance-monitoring), SaaS (101 flavors) etc.
· The massive eCommerce Universe
· Financial: Cryptocurrencies and the explosion of fintech
(Did you notice how I blended MSPs into the new school of Digital Agencies … or should it have been the other way around? … I was surprised at how many digital agencies offer many MSP type services … and why not.)
What happened over the last 5-15 years is, the old school industries evolved and added many of the new school services mentioned above.
What is the urgent rush now?
To get as much of the Fortune 1000 company’s technology spend as possible because these client commitments can last for many years and can be extremely profitable. Once an IT business development person has their client’s decision maker’s attention, it is smart to lock them into as many services as possible. As we know, once mutually beneficial business relationships get traction, it is hard for an outsider to break in.
The Next School:
Of course, the “next school” will always provide us with new products and services to develop and market, but the class which every IT Company CEO is always attending is … which services, more importantly which blend of services should their company offer. Which services should they develop and manage in-house and which should they outsource or white label from 3rdparty providers … OR should they stay focused on being experts in 1-2 closely related services and be the provider that other digital agencies and MSPs reach out to.
Back to my six-month buyside assignment and the “discovery” questions we asked many CEOs:
The five core questions we used to get conversations flowing are as follows.
“Which of the listed 30 digital agency services accounts for most of your annual revenue? And which service accounts for #2 and #3 of total annual revenue?”
· Most of the time, the answer quickly and clearly defined their company.
· Sometimes this discussion led to who they want to be, what steps they are taking to become that type of agency and the hurdles they are facing to finish the strategy pivot.
· From a business buyer’s perspective, it is always comforting to hear CEOs confidently discuss their laser focused strategy … but this is not always what we heard. We heard many flavors of bad news from quite a few of them. And we actually heard the truth from a few CEOs that this is not what they want to do with their life. Of course, these CEOs who want to leave the digital agency space all together are hoping for a business buyer who wants the CEO to leave post-closing … and that is not what we wanted.
“How much of your client work is performed by your in-house fulltime employees vs. how much do you out-source to 3rdparty providers or contractors”?
· A few CEOs told us that they perform close to 100% of the work in-house, but most CEOs told us they outsource a percent of the work … some more than others.
· The perception from many business buyers is that if the target company outsources 50%+ of their client’s work to a third-party development company, then why not acquire the third-party development company … unless the original goal is to acquire the sales and project management talent at the target company.
· Some CEOs told us they only outsource when they are overloaded with client projects, while other CEOs told us that they always outsource specific services for which they do not have an expert in-house.
· Over the months of asking this question many times and listening to the answers, I think we heard every single pro and con to the “in-house vs. outsource” debate.
“What year was the company established, what was the annual revenue for the last year, and in what year did your annual revenue peak?”
· While many companies have grown revenue a bit each year since the company was established, I was actually surprised at how many company’s annual revenue peaked in prior years. If the answer was simply that they lost their largest client yet have picked up growth since then … great. However, if the answer was something else, we dug in a bit more.
“How many employees do you currently have”?
· This seems like a simple question with a simple answer … but the implications are huge. The answer was many times the foundation of who the CEO is. If a business buyer is looking at making acquisitions in the digital agency space, the CEO is the largest variable of a sub 50 employee agency.
· If the answer was 40-50+ employees, this told me that this CEO/owner probably knows how to properly manage people and client projects … and equally as important, wants to and is willing to manage people. This is not an easy skill set to master and maintain year after year. The reality is many business owners can’t do it, hence one of the reasons why small businesses stay small.
· Having said that, there are many digital agency owners and owners of 101 other types of businesses who choose to stay the size they are. The business owner enjoys client interaction and the creative side of client projects … and much prefer this over spending 100% of their time managing their employees and performing the same company administrative duties over and over while their employees enjoy client interaction and the creative side. I actually totally understand this. I have worked for myself with no employees since 1996. I would much rather do the client work myself than manage employees.
· The downside of staying small is, these small digital agencies with less than 25+- employees are harder to sell. Why? Because the CEO knows many if not all of the clients. If the CEO leaves the company post acquisition, so will some of the best clients and some of the best employees. This is not just a company acquisition risk, this could also happen with a “merger of equals” causing similar damage to the remaining equity partners and the company’s reputation and stability.
· The smaller agencies are considered “lifestyle businesses”, and unless they have a notable portion of their annual revenue which is recurring, they are hard to sell with traditional deal structures. Many times in order to complete an acquisition, the deal structure includes much less of the total deal value paid at closing, and more is paid over time based on revenue targets, AKA “earn-outs”, or revenue shares.
“How many employees work in the main office, how many are in offices across the US and how many work remote?”
· We heard it all, but from an M&A perspective, most buyers would prefer a cohesive team working from one or two offices.
· We also heard all the valid arguments for remote employees, but it is just not what we were looking for.
Digital Agency Valuation and Liquidity Bullet Points:
· I am not aware of any digital agency “industry standard” valuation formulas, rather it is every buyer for themselves, and it is their responsibility to customize each offer according to the value that the specific deal will bring to their organization. Of course, this sounds like it should be the proper strategy within every industry, but it is not. In other industries, the “valuation gods”, dictate that valuation is a certain dollar per subscriber, or for example within 6-8 times annualized EBITDA … but in the Digital Agency space, valuations are all over the map, but from what I have heard and seen, rarely over 1.5 times annual revenue, unless there is a notable SaaS component or proprietary IP.
· So, should the offers be based on a multiple of operating profit (EBITDA)? Sure, that is one of the variables I use … however it can be a bit counter intuitive. Since most digital agencies are primarily one-time revenue businesses, their EBITDA ebbs and flows with the size and frequency of client projects. It is simply the nature of the beast.
- Are all 5% EBITDA margin target companies in bad shape, deserving of a low valuation? No … I want to hear the story. They might be growing so fast that every dollar which comes in is going to increased head count. Maybe the digital agency is 100% focused on ecommerce and most of their work is from May to November ramping up for Christmas … then almost dead from Jan to April, but the CEO keeps everyone on the payroll waiting for the May-Nov ecommerce season. There are plenty of examples of this.
- Are all 30% EBITDA margin target companies in great shape, deserving of a high valuation? Well, they are in great shape as far as the CEO/owner paying the bills for the next few months, but I am not sure what the 30% margin tells me about the future of the company. Is the CEO/owner intentionally “passing” and not bidding on prospective client projects which would result in a profit margin of less than 30%? OR, has this target company’s revenue remained at $4mm per year for many years, and the operation is lean and mean with consistent client work, and the CEO/owner wants to keep his agency at about this $4mm per year level.
· Side note regarding recurring revenue business models: In other Internet service industries focused more on the infrastructure side, the industry participating companies are more alike. They are all trying to scale up each month by adding recurring revenue customers. After these companies grow for a few years, there are logical company to company valuation metrics.
· The greater the recurring revenue as a percent of the total annual revenue, the more valuable and liquid the digital agency will be.
· The more services which are developed and managed in house, the more valuable and liquid the digital agency will be.
· If a new client is going to end up being 25%+ of the total annual revenue, yet very profitable … of course the CEO should sign them up. Yet of course this well affect the company valuation and liquidity, but not as much as one would think. This single client risk can be offset by a slightly strung out acquisition deal structure addressing the longevity of the big client.
· Ending on a positive note: Keep in mind digital agencies and consulting shops can pivot quickly without substantial cost. This is in contrast to the infrastructure players who are married to their initial technology commitments for long periods.
In conclusion, is there a perfect blend of digital agency services to offer, is there a perfect headcount, is there a perfect inhouse vs. outsource model? I don’t think so. These depend upon the founder, the partners and the team members … what they are the good at, what they want to do every day for years, and if they can develop and sustain a sales pipeline to make it work.
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