Eric Pritchard is a partner in Kleinbard Bell & Brecker LLP, Philadelphia. The firm focuses on acquisition and succession strategies.
Recurring revenue (recurring monthly revenue or RMR) is the most important asset your company has when it comes to determining market value on exit. Generally speaking, the more RMR and the better or more qualified the RMR, the more your company is worth to an acquirer. In the electronic security industry, purchase price is determined primarily as the product of a multiple times the amount of a particular category of RMR. Acquirers generally distinguish between RMR that is included in the calculation of purchase price and RMR that is excluded from that calculation. (Thus, seller sells excluded RMR to buyer but receives nothing in return.)
Buyers do not treat all RMR the same. RMR included in the purchase price calculation is referred to as “eligible RMR,” “performing RMR” or some similar term. The buyer’s definition is driven by buyer’s lenders since most buyers borrow some of the purchase price and must maintain purchased RMR within parameters of the lender’s definition of eligible RMR.
From the seller’s perspective, the definition of performing RMR is the most important provisions in the purchase agreement because it governs what the seller gets paid for. Part of every seller’s challenge is to make all RMR “performing” as of closing. Occasionally, buyers give sellers a short period of time post-closing to qualify accounts as “performing” in order to receive payment for them after closing.
A number of factors determine if RMR is “performing,” including the following:
1. Scope of Service Alarm monitoring RMR generally has the highest profit margin given the efficiencies and minimal labor requirements. It’s also the RMR buyers associate with the highest multiple. RMR related to services at a subscriber’s premises tends to be valued at a lower multiple because the associated labor costs results in a lower gross profit margin. (This would include repair services and testing and inspections.) RMR associated with equipment leases is valued differently among buyers. If the seller has paid for the leased equipment, the RMR is profitable. If the equipment is old or needs to be replaced, RMR is less profitable. No buyer will purchase lease RMR where the subscriber has the right to buy out the lease for a nominal amount at the end of the lease.
2. Contracts A good contract doesn’t mean a single-minded focus on limitation of liability or indemnity. One important factor is automatic renewal, which provides buyers some degree of certainty. Most buyers require a seller to produce original signed contracts to qualify as “performing.” Another issue is whether the contract, by its terms, permits assignment by seller. Not all contracts do. Don’t miss these issues in diligence.
3. Payment Buyers (and buyer’s lenders) require subscribers to pay their bill within a certain period of time as of closing, usually 60 or 90 days. Sellers often have to spend time and effort getting subscribers to pay open invoices in order to qualify their RMR as performing as of closing. Some buyers limit the payment requirement to RMR-related invoices, excluding invoices for non-recurring amounts such as repairs. Occasionally, a buyer is willing to pay something for “historically late paying accounts” but the seller must demonstrate the accounts continually paid late to qualify them. Finally, buyers will not pay for accounts where the subscriber has provided any form of notice (written or oral) that the subscriber intends to cancel or not renew the account at some point in time, including notices that are not legally effective.
4. Communication Paths Buyers want the right to control the communications paths/systems used to transmit and receive signals. The right to control POTS lines means having “billing responsibility” for the lines, i.e., paying the monthly bill for the POTS lines. Often, the monitoring facility has billing responsibility for the communication paths. Under those circumstances, buyer and seller need to make arrangements with the monitoring facility for the eventual transfer of billing responsibility. Another possible requirement is that the systems must be remotely programmable.
5. Residential Accounts Some buyers place limits on residential accounts. Virtually all buyers require a residential subscriber to own their home. Some buyers require minimum credit scores or that the subscriber have satisfied a minimum upfront payment. In other cases, buyers will forgo these requirements for well-seasoned accounts.
This list is not exhaustive. If you’re selling your company, consider these issues and retain someone who understands the nuances in these requirements to limit surprises at the time of closing.
Eric Pritchard is a partner in Kleinbard Bell & Brecker LLP, based in Philadelphia. The firm focuses on acquisition and succession strategies. This column does not constitute legal advice; contact an attorney well-versed in the field with specific questions. To be considered for the “Catch of the Week,” or for more information on the program, contact Eric Pritchard at: EPritchard@Kleinbard.com, or firstname.lastname@example.org.