By Lori Gross, Senior Financial Analyst, and Jacky Kwan, Senior Financial Analyst
If you own an MSP and are thinking about selling, the first thing you should do is review your books. Adhering to best practices will help your buyer see the value of your company, and the more straightforward your financials are, the faster your transaction can close. Books that require reallocations not only confuse buyers, but it may also dilute the value of your operation and extend the time it takes to conclude the deal.
From an income statement perspective, we recommend MSPs employ accrual-based accounting. This approach provides a more accurate view of your MSP’s performance and a more detailed long-term picture of revenue and expenses. While cash basis accounting is easier to manage, the difference between the two methods comes down to when you recognize revenue. In this case, timing really is everything – especially for MSPs that want to show revenue predictability. Keep in mind that you can use one method for day-to-day accounting and a second approach for tax purposes.
Revenue and Cost of Goods Sold
When it comes to capturing revenue and the cost of goods sold, a more detailed view of this key financial activity can help minimize buyer confusion. For example, margin calculations are a key indicator of a company’s financial health. Recording revenue and the associated cost of goods sold in the applicable month improves the accuracy of your margin calculation. This is consistent with accrual-based bookkeeping. Misalignment may question the accuracy of the company’s financial results.
Knowing how much profit is coming from each billing cycle is crucial because many potential buyers will compare this number to the industry average when evaluating your MSP.
Clarity of Granular Revenue
It is essential that sellers separate revenue into two categories: recurring and non-recurring. The more granular a seller is with reflecting revenue, the more confidence the buyer will have in the accuracy of the financials. For example, classifying revenue into a minimum of four general ledger (GL) accounts, such as recurring labor, recurring resale (product), nonrecurring hardware and software sales, and project work will construct a more accurate view of revenue sources rather than a single general ledger account. In this example, revenue related to out-of-scope work, time and materials, and break-fix activity, is recorded in the project work GL account or its own.
Owners’ and Executives’ Benefits
To easily arrive at an adjusted EBITDA, clearly identify and separate owners’ and executives’ personal costs from the day-to-day costs of running the business. While every MSP has its own bookkeeper, accountant or CPA who has their preferred way of managing the books, it is recommended that owner benefits be sequestered for easy identification. Blending these benefits into the financials can cause potential buyers to doubt the accuracy of your MSP’s financials. This practice will help assure that your MSP’s revenue picture puts the bottom line in the best financial light.
Owners that are active with day-to-day operations and not taking a salary may skew the financial picture. It is much cleaner if the owner takes a salary, preferably at fair market value. If the seller assumes the new owner will choose not to have a hands-on role with the company, the new CEO’s fair market value salary will come off the bottom line. For example, if the current owner has 100% of his or her expenses reimbursed by the company at an annual cost of $150,000 and the market value of the position is $100,000, the company has a $50,000 difference between current and fair market value compensation to make up.
Labor Burden Estimation
The income statement should also include a detailed accounting of outsourced payroll, including wages, payroll taxes and benefits. Putting all of the payroll details into a single GL account, lump sum category will risk the accuracy of your estimated labor burden. Potential buyers will want to see how your MSP compares to the industry averages, which favors taking a more granular approach to detailing payroll expenses. For example, some MSPs pay the insurance costs of an employee’s entire family. Because this benefit will likely be expected to continue post-acquisition, it is critical that the potential buyer see this liability in advance.
Balance Sheet Recommendations
Moving on to the balance sheet, instituting a standard process to reconcile cash and checking accounts on a monthly basis is a best practice. Cash balances should also be reconciled to credit card accounts and accounted for in the books. Expenses need to be allocated to budgetary line items, not simply grouped into an “Expense” category.
Deferred Revenue, PTO Liability
Recognizing deferred revenue comes into play if your MSP has adopted accrual-based accounting. Deferred revenue is a liability and the seller will be expected to account for the revenue received but not yet serviced in a transaction. Keep in mind that if working on a cash basis and receiving payments before performing services, such as for monthly managed services, that collected cash has not been “earned” by the company and would need to be transferred to a buyer who is taking on the liability of performing the services after a deal closes. This same reconciliation guideline should be applied to loan payments and balances. As each payment is made, the principal amount should be deducted from the loan balance and the interest should be reflected as an expense.
In addition to deferred revenue, MSPs frequently overlook another liability: paid time off (PTO). Vacation time and sick leave, even if available on an annual “use it or lose it” basis, can be a sizeable liability for MSPs when the employee leaves or a buyer assumes this balance. While company policy governs how PTO time is earned, tracking the balance for liability purposes is recommended.
Distribution Schedule Details
Owner distributions should be reflected in the equity section of the balance sheet. W-2 wages associated with the owner’s salary should be included in the company’s operating expenses. If the owner takes some or all of the profits in a distribution, typically made at the end of the year, those transactions should be included in the Equity section of the Balance Sheet.
Periodic financial review allows a buyer to see if the seller is consistent with its accounting practices. Repeatable performance in this key area of evaluation can calm the concerns of many potential buyers.
During the evaluation process, potential buyers will spend considerable time reviewing an MSP’s income statement and balance sheet. These two documents, when properly created and updated, give buyers significant insight into how an MSP is run, how profitable it is and how much liability, if any, they will be taking on. Following best practices will help MSP owners and executives demonstrate the true value of their operations to potential buyers.