Most MSPs have two options to grow: finding more customers, or finding other MSPs to acquire. Or, "organic growth" vs "inorganic growth."

Inorganic growth is today’s hotness. MSPs are in love with the idea of growing via acquisition.

But I think M&A is a fast, painful way to lose money. Here’s how you can avoid the most common M&A mistakes.

Why are MSPs excited to buy other MSPs?

Organic growth is an unsolved puzzle for all but the top MSPs. Most MSPs have a book of clients that came from referrals in their network; very few MSPs have a repeatable sales pipeline.

Since building your own sales pipeline is hard, MSP sales & marketing agencies emerged to help MSPs without pipelines get new clients. These agencies promise to deliver X new leads per month. But each MSP tempted to hire such an agency has seen a horror story from another MSP who wasted $X0,000 on these agencies, only to close zero new clients.

Sometimes you actually do manage to get some meetings with prospects from these agencies. But managed IT services are difficult for non-technical business owners to understand, let alone buy. It's not surprising when an MSP fails to close any of these leads.

Money that went to these sales & marketing agencies could have just gone into your own pocket. How frustrating to lose money on these agencies!

Discouraged with organic growth, most MSPs turn to inorganic growth. They seek to grow by acquiring smaller MSPs. They seek to become a "strategic buyer" in the M&A market, competing against private equity groups and other strategics to bolt on other MSPs to their core business.

These newly minted strategic buyers find themselves hooked on inorganic growth. Turns out most business owners find M&A fun! Switching from operating to investing makes us feel like fancy business people! A lot of people in business have big egos. M&A has a way of validating big egos that simple organic growth can’t.

Here's the catch. Most MSPs are competing for limited acquisition opportunities. The demand for small MSP acquisitions outpaces the supply, so the price to acquire MSPs goes up. Furthermore, 70-90% of acquisitions fail, according to Harvard Business Review. So you're paying inflated prices for an acquisition that's only 10-30% likely to pay off its own cost. That doesn't sound like good investing to me.

There are a lot of "strategic buyers" in the M&A market who will only lose money by acquiring MSPs. I've met founders who want to acquire smaller businesses, but these guys don't even understand EBITDA or their own business's working capital… and they want to acquire another business? I guess everyone is entitled to losing their own money however they choose.

If organic growth is difficult, inorganic growth is not a magic bullet to help you reach your growth goals. Inorganic growth is difficult too.

Strategic buyers are making poor decisions with debt

The urgency to correct our view toward inorganic growth has never been higher than today, because most MSPs aspiring to be strategic buyers are making bad choices with debt.

Many strategic buyers are financing their acquisitions with SBA loans. While I won't debate the pros and cons of SBA loans here, the notable consequence of SBA loans is that the borrower must personally guarantee that they'll pay off the loan, even for the 70-90% of acquisitions that fail.

Can you imagine buying a company, levering up to 90% with an SBA loan, having a 70-90% chance of the acquisition failing, and then still having to pay off the loan anyway? You’re not just losing money. What about all the time to find this acquisition, run the deal process, and try to integrate it? What about all the frustration from watching your core business slip up since you’ve been off focusing on M&A? This insanity is what many strategic buyers are doing.

Don't be insane. Don't find more excruciating ways to lose money.

Loan officers are actually sales people, paid to find new customers to buy their product. Most loan officers will actually call their borrowers "customers." They have quotas and commissions just like any ordinary salesperson. Most loan officers don't want their customers to default on their loans, so they'll do some basic underwriting, but lenders make money by putting themselves in can't-lose deals. If you default on your loan, the lender will be ok, but you will not.

Being good at M&A means being a good capital allocator

The difference between a) strategic buyers above who lose money in new silly ways, and b) strategics who are actually making money and growing with M&A, is their understanding of capital allocation.

The former doesn't understand how to measure their performance as capital allocators. The latter embraces the good and bad that comes with being a capital allocator.

What is capital allocation? It's the flipside of capital generation. One of the ways to simplify business is the cycle between generating capital and allocating capital. Most of your team will be focused on capital generation: running the machine that creates extra cash for you to manage. The extra cash is when we switch to capital allocation: deciding how to put that extra cash to work.

Capital allocation is important because it's a learnable skill that makes you more money when you bother to learn it, or loses you money if you think you're too smart for it.

The north star metric for capital allocators is ROIC

How do you measure your success as a capital allocator, as a strategic buyer, as an MSP owner?

Most people would start with revenue, so their goal as capital allocators is to make revenue go up. Not the worst place to start. I've argued that revenue is vanity, profit is sanity, and cashflow is reality, so you should use cashflow instead. Capital generation is optimizing your cashflow.

Some people measure their success at M&A by enterprise value, so their goal as capital allocators is to make enterprise value go up. These people are almost always strategic buyer MSPs with no corporate finance background, not actual private equity groups. This is the most unprofessional mistake that an MSP capital allocator can make. Haven’t we evolved past believing bigger is always better?

The best way to measure your success as a capital allocator is return on invested capital, or ROIC. This is a ratio. So to increase ROIC, either increase return or decrease invested capital.

Let's illustrate ROIC to measure the performance of two different capital allocators, each acquiring an MSP.

The first capital allocator spent $5 million to acquire an MSP doing $1 million in cashflow a year, or a 5x multiple. Their ROIC is ($1 million cash return) / ($5 million invested capital) = 20%.

The second capital allocator spent $2 million to acquire an MSP doing $400k in cashflow a year, also a 5x multiple. But through hard work and smart sales & marketing, they grew it to $1 million cashflow. Your ROIC is ($1 million cash return) / ($2 million invested capital) = 50%.

In both cases, enterprise value is the same. Both cases have the same cashflow, and we'll make the fair assumption that enterprise value is a function of applying a market multiple to cashflow, so the same cashflow will create the same enterprise value in the same market.

The reason why I don't like enterprise value as a north star metric is that you can build enterprise value efficiently or inefficiently. The inefficient builders of enterprise value are actually bad capital allocators. If I'm investing in these two example MSPs, I'm much happier with getting 50% return on my invested capital in the second example, rather than 20% in the first, even though both have the same cashflow, and thus the same enterprise value.

A capital allocator's goal should be to increase ROIC. Not enterprise value, not revenue, not even cashflow.

There are similar metrics to ROIC that get the job done. The main point is to measure your capital allocation decisions with a ratio between some cash return metric that you care about, over some cash equity injection metric that you care about. Other metrics capturing this spirit that I've seen include free cash flow on net assets, and EBITDA on equity.

When you measure your capital allocation decisions with ROIC, you realize that growth is not free. Inorganic growth is still growth, but at what cost?

How MSPs can make acquisitions that increase ROIC

By this point, we've established that MSPs wanting to acquire other MSPs are strategic buyers, strategic buyers are capital allocators, and capital allocation is measured with ROIC. That means ROIC is the way to evaluate your acquisitions for other MSPs.

But that also means ROIC is how you choose M&A over other ways to allocate your capital. Every dollar you spend acquiring a company is a dollar not spent on growing sales. Or paying down debt. Or even putting into your own pocket as the owner.

Each capital allocation option has its own impact on ROIC.

The best way to make acquisitions that increase ROIC is to evaluate all of your capital allocation options together, and then choose the ones that will maximize ROIC. Sometimes your most accretive capital allocations will be M&A, but oftentimes it will be something else, even organic growth.

When I was a finance student at Wharton, they taught us that the five options for allocating capital are:

1. Organic growth

2. Inorganic growth, i.e. M&A

3. Paying down debt

4. Paying dividends to shareholders

5. Buying back shares from shareholders

We can simplify this further. In my judgment, there are really three options for allocating capital:

1. Invest in your capital generator, so it can generate even more capital

2. Strengthen your balance sheet

3. Return money to shareholders

Each opportunity to allocate your capital should have a business case for how it affects your ROIC. When you can compare these cases against one another, now you can evaluate capital allocation trade-offs, such as:

• Hire more technicians, or hire more sales executives?

• Double down on our SEO, or cold outreach?

• Buy a competitor MSP, or buy out one of your cofounders' equity?

• Pay down a loan, or hire a marketing consultant?

• Paying a dividend to shareholders, or investing in organic growth?

Some of these decisions don't have an objective correct answer. You need to have a strategy to govern all these trade-offs. All shareholders should be onboard with your strategy, otherwise they'll get mad at you for managing capital in ways that they don't agree with. For instance:

• Do we maximize upside during bull markets without a care for performance during bear markets, or do we aim for consistent performance across all market cycles?

• Are we issuing regular dividend payments to shareholders, or no dividends and reinvesting each extra dollar into the business instead?

• Are we being averse to leverage and avoiding debt, or seeking upside and levering up?

• Will we raise money from institutional investors who want an exit in 10 years, or syndicate with smaller investors who are more ok with you calling the shots on a potential exit?

Since capital allocation is an exercise in comparing all your options together so you can maximize ROIC, capital allocation must be a centralized decision by either the CEO, or the most senior shareholders. After all, another way to consider ROIC is the return on a shareholder’s cash contribution to your business, and most people invest in businesses to earn a return on their investment.

I do not recommend decentralizing capital allocation decisions. For instance, while you probably pushed most capital generation decisions further down your org chart, you should keep capital allocation decisions at the top of your org chart. Decentralization is great for capital generation, but not for capital allocation.

This post has been high-level, but M&A requires lots of low-level considerations too. If you'd like to chat more, email me [email protected].

Summary

1. Acquiring MSPs is hot because organic growth is hard, while inorganic growth are fun and sexy.

2. Strategic buyers are making poor decisions with debt, increasing the cost of a bad acquisition.

3. Success at M&A requires learning how to be a capital allocator.

4. Measure your capital allocation decisions with ROIC.

5. Any MSP that considers itself a capital allocator needs to weigh all the different ways to invest capital, not just M&A, to maximize ROIC.