Do You Understand the Financial Health of Your MSP

Guys, welcome to this month's MSPs in Conversation. This is our final one for the year, so we won't be doing one in December, and I think the next one is in February. We're going to let everyone have a bit of a break, ourselves included. But today we are here to talk about financial metrics, questioning and challenging you: do you understand the financial health of your MSP? And giving you some tips and stories of the things that our panelists Ryan and James have seen in the industry.

Please make sure that you ask lots of questions. If you've got a question today around financial metrics or something that you've got an issue with, jump into the chat and please feel free to jump in. As always, this is recorded. So we cut this up into a webinar, or sorry, we cut the webinar into a podcast. It goes on to Spotify, Apple Podcasts, Vimeo, YouTube, etc. So if you'd like to share it around, please do. It is a great resource to share with your team as well.

Quickly, a little bit about Hosted Network. I know we're not here to talk about Hosted Network, but we are a wholesale cloud and Telco provider for Australian MSPs. We started as an MSP way back when, and our differentiator is that unlike most of the ISPs out there, we don't think like one, we think like an MSP. We love to get things done, and we support over 250 MSPs across Australia. As an organization, everything that we've built is entirely feedback driven, and our differentiator for you guys is that we help you fundamentally be more profitable, not because of the services that we provide, but how we operate. Because we think like an MSP, your techs can talk to techs that understand the problems that they're having, and we can prioritize them accordingly. Everything all the way through, from how you troubleshoot all the way through to billing, we make sure it's as efficient as possible. So simple, easy, with no margin then, right? I think that's the longest pitch I've done on one of these in a long time, so let us move on and introduce our panelists.

Meet the Panelists: MSP Finance and M&A Experts

I'm up there today. I would introduce myself, but Ryan, aka Fuzzy, and James, can I get you to do an intro?

Yeah, certainly. Well, for those that don't know me or are on the recordings or whatnot, I ran an MSP for 25 years, and have been through a lot of the trials and tribulations and the hard knocks, etc., of learning all those mistakes and what to do and what not to do. And now, in 360 Consulting for the last few years, we actually consult with MSPs and our customers on anything from general ledger work, profitability, mergers and acquisitions, appraisals, everything that the MSP needs to actually start making more money, reduce stress, and enjoy a lot more of their business. So that's probably a very quick summation of what we do.

All right, and Mr. Davis himself. Thank you. I'm from Pax8, head of the Academy, which is basically the enablement arm for partners or MSPs out there to create better businesses and make it more sustainable through growth and profitability. I've been in and around this industry the last 13 years, and I've been coaching, consulting, advising technology companies for the last seven years. Now it feels a lot longer but a lot shorter at the same time, but excited to be back.

Ben, it's been a while. It's been a while. For those of you that saw our very first one, I think James is one of our very first few. So both Fuzzy and James have been our guests many times, and guys, thank you for coming back. Your insights have always been absolutely amazing, and I personally consider you guys industry experts around financial metrics. I know I've quizzed you both many times and we've had many deep conversations around this topic, so I'm excited to get into it today. So with that in mind, let me stop sharing and let's jump into it.

I'll just remind everyone in the chat, if you do have any problems or things, challenges, stories that you'd like to share, please feel free to drop it into the chat and we will try and answer them as we go today. So I'm going to just throw a big one out there, and we'll see whoever answers first. Guys, within an MSP, what is the single key financial metric that you think the audience today should be focusing on? Go.

Gross margin dollars. James? Net profit. Net profit, it's all that matters.

Gross Margin vs. Net Profit: The Key MSP Metric

All right, care to explain and argue? I'd like to see some punches thrown. All right, so Fuzzy, please explain, as you went first.

Look, I totally agree with James, to be clear on this one, in that, yes, well, look, net profit. I would actually say if you want to go that far, James, I'd say free cash flow is actually better again, but we'll come to that in a minute. But yeah, look, at the end of the day, gross margin dollars is what actually pays the bills. So what do we talk about when we're talking about gross margin dollars? It's the profit that comes on any product you sell, so that's your gross profit. Same thing, it's like the margin you make on your managed services after you take away all the costs for delivering those managed services, your tech wages, all of those things. So the gross margin dollars is what actually pays the bills inside your business.

So that's the money spent on everything else, right? Exactly, well, it's what actually pays the bills at the moment. And then from there it's then what are your expenses in the business? So the sales team, your marketing team, administration, the rent, the light, the power, the internet connections you're getting from Hosted Network for their office, all of those types of things for the office.

I was going to say, everything else should be above the line. Yeah, that's right. Exactly, that's right. That's why I put in there the office. So yes, that then obviously goes down to what your expenses are, which then gives you, as James said, your net profit. So yes, totally agree. Look, the profit at the end of the day is what matters, and everyone says the old saying that revenue is vanity and profit is sanity, and then for years I've just added cash flow is king, because it's the cash that comes out of the business that actually matters. And then obviously, as we'll get to throughout the hour, ultimately how much cash goes into you as the owner's pocket at the end of the day as well, and how you get that out.

James, would you like to add anything? Disagree? No, pretty well agree. I think we'll disagree when we start getting into the details, but how you frame that up I think is the important thing. Not enough of us view that end-to-end process, and you mentioned the whole above the line, below the line stuff. I'll give people a really simple breakdown of a small MSP. Basically, if you're generating a million dollars worth of revenue, you should be generating about 50% gross profit, including what Fuzz said around your technical wages and stuff as part of those costs to delivering the revenue. And then that operating expenses, the below the line stuff, your occupancy, your sales, your marketing, your general administration costs, should be 32% or less. So basically we're talking about generating a 500K gross profit, then we're going to spend 320K on sales and marketing and administration and all that fun stuff, leaving us 180K in EBIT or net profit. Most of the time, for most MSPs, it's going to be basically the same because of the way that we run a service business, and that's best-in-class performance. That's a high-performing company.

Defining EBITDA and Best-in-Class Benchmarks

We've thrown out already some great terms, so let's pull out the dictionary and actually do some definitions for everyone. So we just talked about best-in-class, so I sort of want to understand more, how do we find and what is that? And then EBITDA, what is it, and why is it important? So let's start with E, because that was the first one, and Fuzzy, I'm going to throw that to you, given you're the resident M&A guru. Can you please explain what EBITDA is and why it is important?

Okay, the acronym. Let's start with what EBITDA actually means, and what it says is earnings before interest, tax, depreciation, and amortization. So look, the easiest way for most businesses, they don't actually have a huge interest bill, or they shouldn't. The tax is not your net profit tax, or your company tax, after its other taxes within the business. The biggest thing that most Australian small businesses and MSPs would have was depreciation. So that is the reduction in value of assets that you have bought, so computers, cars, phones, all of those types of things, the TV for the office that sits at your house and things like that. All of those types of things which all get depreciated by your accountants normally, or if you have your accounting system set up properly, then it will depreciate a certain amount of that every single month for you.

And then A is amortization. We rarely use that in Australia. It is definitely used, but if you're buying or building out a big piece of software or a big project or whatnot, you can amortise the cost of that project over multiple years, and basically take it from your profitability and your profit and loss into your balance sheet. So again, rarely in smaller MSPs or smaller business done, but quite a bit, or used I should say, quite effectively in larger businesses on very large projects, like million dollar and 100 million, billion dollar projects often get amortized, etc.

So in short, the horrible way and the dirty way of thinking about it is basically your net profit, and then add back your depreciation, is an easy way of coming up with what your EBITDA is. So it's a good way, and we use EBITDA as a way of how can you evaluate different MSPs, but then how could you evaluate an MSP versus a fruit shop or against a cafe, those types of things? EBITDA does that for you. It's a way of normalizing financials and whatnot across industries, across sectors and things like that. It often can be seen a little bit in a bit of a negative light, because depreciation is an expense to the business, and you can have a great EBITDA but still have no net profit. Again, we can get deeper into that later if needed, but yes, in simple forms, your net profit plus your depreciation back in, and that helps give you a good balance between, and again, a way of comparing to other businesses.

Cool, okay, so that's a good leading into the next one. So comparing to other businesses, and obviously the value of your business for EBITDA. We talked about best-in-class a second ago, because this is going to be important as we go through best-in-class. James, who makes up these best-in-class numbers? Is it guys like you that just, you know...

Yeah, that's what I'm good at, so I might as well. Get bored on a Friday night after a couple at the pub, just make stuff up. That's the name of the game. James is a numbers man. Best, best financials, C11, E8, yep.

So best-in-class, it's a term that Service Leadership use. Service Leadership are actually owned by ConnectWise these days, but they're a financial benchmarking company for not just MSPs but technology businesses around the world. And what they defined as best-in-class is basically, out of the data that they gather from their quarterly financial surveys, they take the bottom of the top 25% is what classes as best-in-class. So when I spoke about EBIT and talking about 18%, that means 18% is best-in-class, which is the bottom of the top 25%. So it's basically a way to normalize it, get rid of some of the extremes, and set a benchmark to aim for.

And from my experience as well, not just in that Service Leadership report, but out in my real-world experience as well, typically 18 to 20% is high-performing businesses in this space. And they also report on industry average, because obviously they have a significant number reporting in on this survey. The industry average has been 6% EBIT for a long time. There's been some flips in the data in more recent times, but that's more likely because the US is doing a whole lot of consolidation. The types of people that do that kind of survey are often more mature than the average, but from my anecdotal experience of seeing hundreds of technology companies around the globe, 6% is pretty average. And at any one time, 25% of the industry is losing money every quarter. They're not even breaking even, they're actually losing, and that's what this webinar today is all about, trying to give you guys some help.

So hopefully we've given a bit of a baseline there. So we've talked about your GP, your net profit, your EBITDA, and best-in-class. So there are some terms that we're going to be throwing around today. I have also popped in the chat the link to the Service Leadership website. It does cost to subscribe to that, but if you are interested, I'm going to do a little bit of a shout out to the Pax8 Academy, and James and Pax8, and all the likes of IT Nation, Evolve, they take you through this modeling as well to help you understand where you sit. There are other coaches out there as well, so if you're looking for someone, feel free to reach out to your Hosted Network account manager and we can point you in the right direction as well.

Adjusted EBITDA and Normalising Owner Compensation

All right, so before we go to the next one, Ben, I'm going to throw one more in there, one more curveball. Not a curveball, I'm going to throw another term in that's actually really important as well, is your adjusted EBITDA or a normalized EBITDA. Normally we say it's adjusted, that's the normal term. But then yes, it builds on top of the EBITDA, and the EBITDA doesn't take into account how much you as the owner takes out of the business. Your salary is already in the EBITDA figure, but if you're comparing two businesses, let's say James's example before with that business doing a million dollars worth of revenue and 50% gross profit, which is the same as gross margin in that case, but if you're taking a $100,000 salary and you're still making that $180,000 profit that he talked about, but if you compare that to another MSP that might be taking a $200,000 salary but still putting the same amount to the bottom line, those businesses are worth very different amounts. And how do you actually, what we call normalize that, and that's through the adjusted EBITDA.

So the adjusted EBITDA, which is what I spend a lot of time working on, especially for valuing businesses or buying and selling MSPs, is how do you actually understand what the business is really making? So the way we do that is we look at how much a manager would be paid to do your job inside that business. So yes, they might get a car, but they're not going to get their partner's car, they're not going to get their kids' school fees paid through the business, they're not going to have the home internet connection or any of those things, or a random racehorse or something like that that gets run through the business. That's perfect examples of the differences between when we and why we look for an adjusted EBITDA, and what that actually looks like. So yes, most people aren't paying themselves enough, that's what we normally find, that the adjusted EBITDA goes down compared to the EBITDA. But there are good businesses out there that are paying themselves well and paying themselves a lot of money, and in that case then their adjusted EBITDA actually goes up quite a bit.

All right, so if there's anyone with a racehorse that's through the business, you're clearly doing the right thing, you're going to jump on as the next panelist next time. And for those of you, and I'm not part of the ATO, and anyone from any listening to this... That's right, exactly. We should have done a disclaimer at the beginning, but everyone knows not to take us too seriously, so that's good.

All right, so they are some really good baseline pieces of that, and again, if anyone struggles with understanding those pieces, feel free to reach out, we can always point you to some great resources as well. And I know that these two lovely gentlemen are always happy to help as well.

Pricing: The Most Common MSP Mistake

But the next question I have for you is around the drivers of those numbers within an MSP. Obviously some of these are going to be generic business drivers, but what levers or metrics, I guess depending on how you want to look at it, are the most high priority for an MSP? Or which ones do they get wrong the most? Because that's probably more relevant. And that's two different questions, I guess, we'll start with what do we get wrong, and then what are the most important. So James, I can see you shaking your head, and I know that we've had this conversation many times.

The easiest thing that we get wrong the most is pricing, straight up. What I mean by that is the levers behind it. We've already spoken around gross margin, our managing our operating expenses. We can be super efficient on those, but if we're not charging enough, we're just not going to win, no matter what we do. And that's what most MSPs are stuck in, they just do not charge enough for what they do. And that comes down to our hourly rate prices. So the simple old-school way of just going three times hourly burden rate, most of us don't do that, so we're already charging a lot less per hour when we do that, to actually how much our people are costing us in our available time to actually build our managed services. We randomly look at the market and go, what's the market charging, without understanding any nuance to pricing methodology and the way that we're packaging things up.

So you'll hear someone go, we're charging $100 an hour, $100 a seat, but they've included the M365 license, they've included a bunch of EDR and sort of baseline products. So what they're actually charging for their managed service is actually quite low per seat. So people aren't understanding that nuance for those kinds of things. And often as well, we're not delivering projects fixed fees, because we're just charging by the hour. So we miss out on all this opportunity to streamline efficiencies around, you know, we'll do an M365 migration, or we'll do an Intune, or we'll do this or that. We're not actually giving ourselves the opportunity to charge decent prices for our IP and make it repeatable, we're just charging by the hour. And then we're often not charging enough, and then we're not charging for things like project management and administration in those sort of projects.

Documentation. Yep, exactly. So pricing is number one for me.

So I'm going to raise you. I agree with that. I'm also going to throw you a question in a second, James, because you threw another term out there that I'm not sure if Ben picked up on, we'll see in a second. But I would also say definitely pricing, no doubt, but I'd also say people don't understand their costs. They don't understand what each person's costing them, how effective those people are. Like, we look, okay, there's what, 1960 hours a year, or about 1750 really, and then it's how many of those are actually productive, etc. So yes, everyone thinks, okay, everyone's going to bill 40 hours a week or track 40 hours a week, but yeah, at most MSPs it's probably about 32 hours at best. So that's 6 hours a day, or just over 6 hours a day. So yes, there's a lot of waste of time that you're not actually billing for or getting anything out of. So it costs to have extra people.

So I'm going to challenge or ask the question back to you, James. You mentioned there something called burden costs. Can you give us what that is, please? We're asking all the hard questions.

So burden and hourly rate is attributing more than just the base salary cost that we often do. So it's adding additional costs for that employee, and that would include, and it should include by minimum, superannuation, payroll tax, and any other direct labor costs. You can go to the Nth degree of attributing things like uniforms and specific other costs like their license costs and stuff per hour if you want to go and do that. And basically what you're doing is understanding how much it's costing you to have them in that seat delivering the services. And what you mentioned there around the amount of hours, like that 1960 hours per year, everyone defaults, they go, oh, we've got all this time, when you actually break it down in Australia and New Zealand, and you touched on it, we've only got X amount of productive utilized time. And typically, realistically, we're only going to get about 82% of productive utilization time when someone is actually there working.

That's a key thing, because we have a lot of time off. We've got two weeks leave, we've got four weeks of annual leave, and then we've got two weeks of public holidays throughout the year. So when you actually start breaking that down, we've actually only got 1440 hours worth of time that we could possibly bill at most per person. That's our absolute maximum. So when you start calculating, most people go, they're earning 100,000, let's divide that by 52 and let's divide that by 40, that's my hourly rate. Well, that's way off. When you start adding in the additional labor expenses, let alone when you start going, actually, we can only do 30 hours per week and we're only doing at most 46 weeks per year, that hourly rate actually shifts quite significantly. And then when you do that exercise, and then you do the multiple of three times the hourly cost, this is a huge difference of per hourly rate very quickly when you do this.

So it's a great call out for us. That's a great one. I actually, twice this week I've had different partners ask me on the back of other conversations just that, how much should I charge? And I think that's a great example of kind of go, well, let's figure out your cost first. We then, at Hosted Network, we actually call it a CTC, cost to company, as well. So when we include everything, we try and look at, I mean, we don't build an hourly rate, so it's a bit different for ours, so don't take everything that I'm saying for an MSP, but it is important that you include everything in that. Another way of doing it. Yep, right, so your Office 365 licensing, your payroll system, Autotask, yep, all those things. That's right. So yeah, that's a good call out, a good point out.

Protecting Gross Margins Without Competing on Price

We've got Cindy, our partner enablement team leader, we should say, we should get that right, sorry, Cindy, has thrown a great question: what's your recommendation for MSPs to maintain healthy gross margins during tough times or when competing on price? Probably more competing on price particularly these days.

Try not to. That's a short and easy one. But that's right, exactly, it's just that simple, isn't it? So okay, now let's delve into it. Again, rare are we ever competing apples with apples, even in this industry. Your managed service is different to someone else's managed service. So how do you actually get the end buyer to understand those differences? And I've got a statement I've said for many, many years, and I'll say it now: we're selling a sophisticated product to an unsophisticated buyer. If you think of your end customers out there who are buying managed services or any of those things from you, most times they're a finance person or accountant or whatnot, and technology is just under their remit. It's rare that you're dealing with an IT manager who understands what you do and understands all the nuances, etc. It's so rare for that to happen.

So if someone says they've got a cyber plan and it costs $80, and someone says they've got a cyber plan that costs $50, well hey, it's still cyber, it's got the word cyber, and it's got to be good, so I'm going to go with the $50 one. So you've got to then start showing what's the differences. And again, if you are competing, then a lot of times you've got to show value, you've got to show where you're taking pain away or helping the business in a different way compared to what the competition are. So you try not to, wherever possible you don't try and compete on price, because to be honest it's a race to the bottom. Let's be honest, everyone wants everything for nothing. You don't want to pay, and we do the same thing as MSPs, we do it with the vendors and disties as well. Hang on, we're going to commit to two and a half thousand of these licenses even though we're using only 1,500 or 1,800 of them, because we're going to grow and sell these extra 700 because we're going to get a better price. So we do that. So it's no different than exactly that.

Understanding through economic times, it's okay, well, where can you be efficient with the customers, have that conversation sometimes with the customer before they ask. Ask them how are they going, how is their business going, are they finding it challenging or anything like that? And if they say yes, then okay, we'll say okay, look, can we spend some time trying to optimize your spend or whatnot, those types of things. You can take the high road, you can take the position that you're actually there to help them, rather than them having to come to you and say, oh, we need to cut costs or something like that.

A lot of times as well, and I've said this a number of times over the years when I owned an MSP, is it doesn't almost matter what the economic times are, you have a story to explain why customers should be investing in the technology. And it's literally three or four words different when the economy is booming or growing really fast and people can't keep up. It's like, you need to invest in your technology to get the most out of your people, to take advantage of all these opportunities you've got out there, you can take on extra clients because your systems are working well. And it's hilarious, it's the same thing when things are not going so well economically. You can say, hey, yes, it would be logical to start cutting costs in these areas, but your technology underpins the people, and all the people that are doing these services and delivering the services for your customer to their end customers, the last thing you want to do, the biggest cost you have to that organization and to your own organization is the people, so why actually let them use older technology or inefficient technology when they could be doing so much more while the times are tough?

So again, it's almost the same statement, it's just a couple of words that are different. And look, it's valid, it's not rubbish, and I'll just say it on a recording, I believe it, because again, the highest cost to pretty much 99% of businesses out there are their people. So why let them sit on old equipment and old slow things that means they can't get as much productivity out of them?

I'm going to jump in myself, because James, I know you're about to add something, but I'm going to add something for once. We talked quite heavily over previous conversations around understanding your customer, right? I think that is fundamental for proving value. If you understand their business, then you can have a business conversation. I've been talking to a bunch of different people, particularly recently, around the fact that IT business owners or MSP owners, they are no longer the IT guy. They have an understanding of HR, they have an understanding of finance, they have an understanding of all these different areas, your concept of business, that's value. You can have a much deeper level of conversation. If you understand that, you can show a lot greater value. So I think that's an important piece of it, because that versus someone else that might be slightly cheaper with no understanding, that's vastly different. James, back to you.

Commoditisation and Shifting to Advisory Services

We're going to compete more and more on price, like we always have as an industry, because people haven't been confident in what they do, so they weren't winning business, so the easiest way to win business was, well, we'll just make it cheaper than the other guy. That's a very different play to what's actually happening in the market and what's going to increase. And what's actually going to happen is traditional end-user support and infrastructure management is very fast becoming a commodity. You can't really compete on a commodity basis in general, but if you look at electricity and you look at ISP, those kinds of things, commodity, you go for cheap unless you need a very niche or very specialized or very specific reason to spend higher. That's just human nature. And so if we're not understanding that and not knowing that that's happening, it's very hard to compete, because we will traditionally go to the "we add value," but that's actually murking the water with what we're doing.

And so apart from understanding what the clients actually need and want that we can deliver, we need to start realizing that we're either just that sort of IT support and infrastructure management company, and we're going to have to embrace being a commodity and have to actually scale, which most people listening to this are never going to do, which is okay, so we need to actually start segmenting out our actual value. Like, to Fuzz's point and to what you were just saying, Ben, around we need to have business conversations, we need to provide advisory, we need to provide other cyber compliance or other higher-value offerings, rather than leading with our traditional support and infrastructure management. While that's still needed, it's a commodity.

And this is where, I'll go on a little rant for a second, this is where the traditional advice of trying to bundle everything into one mythical price, or doing the good, better, best model, doesn't actually apply, because it is exactly what you said, Fuzz, we're selling very sophisticated things to unsophisticated buyers. So if you over-productize this thing, make it super vague, you're forcing it into a commodity even though it's not, and you're going to compete on price by default. So we need to start getting used to going back to probably what we were maybe 15, 20 years ago in the industry, more consultative-led engagements, and need to reshape what we're actually doing.

And I'm already seeing the technology solution partners that are leading with that more business-level advice, business technology advisory, whatever you want to call it, they're winning, and they're winning with making more money, because they're coming in and having the conversations around how does your business operate, what compliance needs do you have, etc., and then tailoring services to what they need. There's still a solutions catalog behind the scenes of what they can do and the deliverables, but it's going a lot more to, let's lead and engage with that advisory practice first, and then bolt on the other things, rather than trying to do the traditional, you need to buy my full managed services and force you onto this stack, because that's just not what clients need and what they'll buy anymore. So very much a transformation of how you go to market on top of this, which is a lot more difficult, but it's what's necessary, because you're just not going to compete with the commodity, because the big guys are going to deliver that much better at a cost-effective price, and they're going to deliver it with margin.

Well, it's rare for a customer to come out and basically say, hey, I've got 60 users and I need a managed service provider to replace another managed service provider. It happens, but it's rare. Normally they actually have a challenge or a pain point, and that is the wedge or the door that gets opened, and you want a wedge opened, and that's how you get in there, is by solving a pain point. Is it AI at the moment? Is it cloud in the past? Is it optimization, is it digital transformation? It's all the buzzword bingo we've had for the last 10 years, all of those things were all door openers, and then you go and sell your managed services after it. It's rare for someone to come out and say, we need a new managed service provider for blah blah blah. Yes, that happens, but they're really looking for something else, and that's the byproduct of the change, is they're looking for something else.

Pain, right, they're going to have that pain, they're going to have a problem that you have a business conversation around, that allows you to have a consultative approach, right? Throwing a random thing out there for you, Ben, I'm going to let you host. Just, okay, we could go down that path in a minute.

Growth Rates, Stickiness, and Avoiding Complacency

No, I was at a conference two weeks ago, and it was interesting actually that they said as an industry we're growing at 13.6%. And it was like, okay, I thought back and I thought, yeah, that's probably pretty accurate, I would say it wouldn't be far off, the technology industry as a whole. Now that's across the whole gamut of everything. So the way I looked at that then is, for businesses not growing at 15%, or not growing at least 13.6% a year, they're ultimately going backwards. So if you're only growing at 5 or 6% or 10% a year, you're slowly going backwards, and that's where you're seeing that now. And even what James was saying, with some of the commoditization and the bigger players and whatnot, that can deliver that commoditization a lot more efficiently, they can't deliver the high level of service and the high level engagement, because they can't scale that. No one can scale that well at this stage. Yet to see anyone do it well at that stage. So yeah, I think it was interesting to look at that, it's like, yeah, if you're not growing at a decent rate at the moment, then yeah, you are going backwards.

And I see this from a consulting perspective, and again, James, the pre-day you and I did at SMB professionals a couple months ago now, it's exactly that. There's a lot of people, some are on this webinar at the moment, where it was eye-opening for them, opening their eyes of, no, you can't just stay in what you're doing, the world is moving, things are shifting. And while a lot of customers are happy with what they've got, at some point they're going to get to a point where they're not happy with what they've got, and there's going to be someone else who's going to open that door with a random wedge, a random webinar, a random lunch and learn, a random golf game with someone else on the weekend, and they say, hey, we've got this problem, how are you solving it? Oh yeah, our technology provider or our MSP or our IT company, they came with an idea, and we're doing a project with them on this, and that's how they open the door. It's something I think we need to be aware of.

The Hosted Network wedge, I mean, that's often something that we talk about quite often, is that the services Hosted Network provides is very much about increasing stickiness, right? And it's also keeping the fox out of the henhouse, right? If you've got, there's a lot, unfortunately there's a lot of ISPs out there that are trying to do MSP now, and I think anyone that's seen them knows that they're doing a terrible job of it, but they're persistent, right? And that's something, I'm not going to name names, but I think everyone on the call will know, would have seen those before, right? And so it's important that you do control that customer relationship in that sense, right? So that it's worth that 13% growth.

Fuzz, it's a good call out, because it should happen by default. Most generic business advice is you should be growing by about 10% by default by just existing. And for most of us out there that have been around for quite a significant time, that's what we've been doing really, is that 10 to 15% year-on-year growth. A lot of it hasn't been purposely driven, that's why it's only 10 to 15%, but it brings up the point of, when you break that down, it's not a lot. Like, when you look at a million dollar business, we're talking about adding 130 grand a year extra, so we're talking about 11 grand a month just for simplicity's sake. It's not a lot of additional sales. It's also very easily achieved with a price rise that most people don't do. Like, over the past probably five years, we probably should have been doing 5% price rises each and every year on our managed services, that would have given us basically this growth as well.

So what's happening is that complacency, like you call out, everyone's just sort of assuming we can stay static and clients will magically turn up, but that's not how growth works. And the danger here is not just the commoditization and the people going out to price shop that way, it's also that complacency seeping into client churn. So while a lot of that average of 13%, most people aren't even growing at 13%, they're typically a lot less or they're a lot more. There's not many at 5 to 6%. Yeah, yep. Or they're usually 20 to 30%. There's very few that I come across that are probably doing around that 10 to 15% at the moment.

Levers for Growth: Evolving Products and Hardware Margins

So can we talk about some of the things that, going back to that lever conversation, we talked a little bit about what people are doing wrong, right, but what can we do to accelerate, right? If we're struggling to get up to that average of 13%, you said 13.6%, there we go, I wrote it down, what levers do we have? You mentioned price increases obviously, what other things? 5% price increase year on year, CPI increase, what other things do you see that a healthy MSP is doing? Cutting back. Evolution. Yeah, both. You had ideas, sorry, I should have done my job and directed the question to someone. Fuzzy, Fuzz can go first.

Evolution of their products, evolution of the managed services agreements. Again, we started out with managed services was just patching and putting an RMM agent on it, then we added antivirus in, rather than a separate line item it got added into the monthly amount, and then we did DNS filtering and all that. Nowadays we're adding in cybersecurity tools, EDR, XDR, SIEM, SOC. It's again buzzword bingo, but it's like all these things that customers now need. Like how do you get your customers to Essential Eight level one, or Essential Eight level two, or SMB1001 silver or gold level, or CIS controls, whichever, pick your flavor. But how do you, are you building your own cybersecurity requirements of your clients and telling them that they need to be at that level or above? That there costs money, that there is revenue growth for you, both on the monthly basis, but also a lot of times the projects to deliver those.

In the next 12 months, you've got Windows 11, like all the rollout, Windows 10 stopping to be used. Realistically, what, 25% of the existing Windows 10 fleet can be upgraded to Windows, all the chips and requirements that are needed to go to Windows 11 properly. So again, do you think the manufacturers are producing enough equipment to handle that? Start the process now with clients, start getting it budgeted. If you are going on a little tirade or a little rant for a second, the last time most equipment got changed was Covid. We sold everything at that point in time, laptops and all of that. If you think about it, we're about to come up to the 5-year refresh of all that cycle. A lot of it is still there, there is a lot of equipment that needs to be replaced in the next 12 months, or really under 12 months, I think it's about 10 months, isn't it, before Windows 10 dies? So like, what are you doing about that? How many, again, every single customer, you need to replace three machines every month, or 30 machines every month if they're that size, or is it in the budget now? And if it isn't, they need to have a project and be ready to buy that. Have you spoken to a finance company to see if they can finance it for your clients and things like that, to take away the sticker shock and the capex hit or any of those things? It's like, how can you make it easier for your customers to say yes? And that ultimately feeds into growth and a higher increase in revenue. Your rates should go up every year. All of those things will slowly get you to at least 8 or 10% pretty easy. Then it's again, as I said, like all the extra value adds, the extra bits on top, can get you further than that.

That's a great call out, because not only do you generate project revenue and hardware revenue, it actually improves your managed services margin by having everyone up to scratch. Paul's asked the question, yeah, it is, it's reducing the amount of issues that come in, it's easy to manage all of that kind of stuff. To answer your question, Paul, on the chat, minimum 25% gross margin on hardware. If you're doing any less, you're doing something wrong, unless you're in the big scale.

Is there a best-in-class number for that? It's 25%. 25%. Industry average is somewhere around like 16 to 18%, that's been dropping, I guess people are getting caught up in the wrong things. But I know people that have been doing 30, 35% margins for many, many years and can continue to do it. Depends on the size, yeah, depends on the size of MSP. Smaller MSPs with smaller clients will generally get that 25 to 30% margin, because the buyer is happy with the relationship and happy to pay 5 or 6% or 10% above RRP, because they're dealing with someone they trust, and it's like, okay, you need to make some money too, and that's okay. If you're dealing with, and you're selling 200 laptops or 500 laptops or 10,000 devices at a time, then unfortunately, I'll be honest, you're at 4%, 5% margin, and that's just the size of things, and you pick it up through rebates, and that's what it is. You see even some big deals nowadays where they're going in at cost because they're picking it up in the rebate. So that's silly, you don't ever want to play in that field, it doesn't work really well.

But yeah, look, for us we were at about 11% on hardware, and we over a little bit of time inched that up to about 16 to 17%, but we were also doing two and a half, three million dollars in hardware a year, so that's why over time, it takes, you got to be competitive in some places, other places you can add an extra percent or two in, and then it all adds up. But definitely agree with James again, if you could aim for that 20 to 25%, that would be great. That's where you really want to see if you can.

I think it's probably one of those things that, like the price rise email, right, there's a lot of fear in doing it for the first time, and once you realize that most people don't even question it, it's the same thing, right? You can probably increase that here and there, a little lever that you can pull. Yeah, it's not as hard as what people think, it's just a strategy, and then going and educating your client, this is why we do what we do, and I won't go down that rabbit hole, but it is a way to increase your margins, which increases your profitability, and it is one area that is quite neglected. Most partners out there are probably doing 15 to 20% of their revenue is in product, so that in itself is quite a significant amount.

But to your point before, Fuzz, around where we've got opportunities to keep increasing the available services that we've got to our clients, we can increase offerings through subscriptions or different hardware, like we can go broad. And I'll flip it on the other side, the problem is a lot of us are getting stuck on adding it, because we actually suck at selling, we suck at go to market. And so, think about this, cyber is a great example, the majority of partners still don't have cyber out there of any type or form, outside of, we've sold EDR, we've sold a modern email security, we're just doing what we've always done as an MSP and add some bolt-ons. So that's one other area to really improve.

Where I'll go with this is, even if you start getting this right in terms of adding offerings, the big thing around that is actually managing your cost, because we're all of a sudden managing, you know, back in the day, 10 years ago, we're probably only managing like four different vendor products that we had to reconcile, now we're probably up to 15 to 20, and it's only going to keep growing. So straight away, I know from experience, I know from people like Cloudlive and that, typically we're bleeding 7% of revenue from not on-billing the stuff that we're actually paying for. So right there and then, there's a huge amount that comes into our profitability. And making sure that we're standardizing on those products, reviewing and consolidating when we can. We shouldn't be spinning our tires year after year going, what RMM is the best RMM, that's just wasting our time and burning energy on something that probably isn't going to move the needle. But if we've got multiple different kinds of email security, or we've got the opportunity to move product set to make it more efficient and things like that, there's a huge way to improve our margins very quickly based on managing those things properly.

Agree, definitely. I think, I mean James, you mentioned that it's not as hard, but I think that emotional hurdle, that once you get over that, you do it a first few times, it becomes, you get comfortable with it. And I know back in the day, doing our first price increase for our MSP back when we ran it, it was hard, we were scared shitless, but it helps. And most people, you know, and sure, you might lose a couple.

Good Customers vs. Bad Customers and Pricing Confidence

We don't have a huge amount of time, but I want to talk about, I guess, a good customer versus a bad customer, and how it can impact profitability. It's a bit of a broad one as a lever, because we've only got through about four or five of my questions out of about 25, but that's okay. We can always turn this into a series, kind of, we kind of always do, we follow the bouncing ball. But this came from a question I got yesterday. The partner had a particular customer that was their lifeblood, right? So I'm actually putting it to you guys, because I know that they're on the call, so I'm going to ask on their behalf. They had a particular customer, they're right, a pain in the ass, they were their lifeblood, they're struggling to put prices up and things like that because they just say outrightly no. When you do get those, it is a big risk, if they said no or if they moved on, how do you navigate that?

You've got to understand why, why are they saying no, what are they pushing back against? I would say that we are far too nice in this industry. We care about our customers a lot more than they sometimes care about themselves. We're worried about, oh, hang on, if we put the price up an extra dollar or this, that and the other. It's business, it is life, just do it. James and I work with a common customer that was so scared about putting their prices up, but I think this was only, what, two months, eight months now or something ago, James, and they finally did it, and that equaled just under $20,000 a month of extra billing just by doing their price increase. They had four customers come back and question, two of them had no problems whatsoever, two actually just needed to ask questions about it, and no problems. So they just added 250K or 240K worth of billing for sending an email. And in the end we just put it on the bottom of their ConnectWise invoice saying, in two months' time and then one month's time, your rates are going up, and just did it. And it was, like, stop, get over yourself, get over what we do.

I will come back around to what you said, Ben, there was a big one that I think we need to, I'm throwing it out there recently, and I'll be doing it a lot more. Professional organizations like lawyers, accountants and whatnot, they make 25 to 40% EBITDA, or 25 to 40% net profit, why is us as an industry, we're making 7% or 6% as an average, and the best ones are at 17 and 18%? Suck it up and get over it, and let's just stop being afraid to make money. There's nothing wrong with it, it's not a bad word, charge what you're worth.

And look, not all customers are good. As wrapping it back around, there are some customers that are an absolute pain in the ass, they call too much, they don't listen to your advice, they don't take any of those things, and yes, they can become a large customer for an MSP, which then becomes that lifeblood. I can tell you now what happens when that customer leaves at some point anyway, you're going to go through it. The best way of doing it is saying, okay, we're going to put our rates up, because that's the cost. If you look at it, it's funny, because the rate of salary increases generally is what, 3, 4, 5% over the last couple of years, but in the IT space we're talking 5, 8, 10% a year, our costs are going up much higher than the rest of the economy in what it costs us to employ technology people and techs. So we should be putting those rates up. And if the customer has a problem, to be honest with you, I know it's scary, but it'll be one of the best things you ever did. You'll either put the price up and they'll stay, or you'll put the price up and they'll leave, but at that point in time you'll actually have more time to look after the customers that will listen to you, that will take your advice, and that call you a lot less because they're actually taking your advice.

Have a look at, again, we've not even got to gross profit reporting and agreement profit reporting and whatnot. You want your managed services profits to be between 40 and 60%, 40 at the bottom and 60 is where it should be. Go and look at that on that particular customer for whoever it is, and go and look at how much time is going into those customers on your tickets alone. Hopefully you've got a good enough ticketing engine that will tell you some of that financial reporting, but look at how much, and then look and then consider, you're probably going to have a really low margin on that customer as it is, and then look into how much account management time, how many brain cycles you as the owner of the business is actually spending thinking about that customer you're probably losing money on.

I know I did an engagement probably about 10 years ago now where there was an MSP that was in trouble, and I went and actually spent some time with them and helped turn the business around, and I openly got approval to slap them, as such, proverbially, sorry. And I actually made a comment to them, they actually had this lovely analyzer of all the profit on all their customers, and inside that it was amazing what they had, but I actually told them, the first bit of advice I gave them is, these bottom 15 customers, I want you to pay them $500 a month to go and use another IT provider, because you would lose less money on those clients than doing all the over-servicing they were doing. So I told them, pay those customers to go elsewhere, and pay them every single month, and you'll be more profitable. And that's how I kind of shocked them into listening, but they actually started fixing their rates.

Again, how many things are you including in your managed services and giving your customers for free even though it's not included in your managed services? Go and start adjusting these things little bit by little bit, and just don't Sledgehammer it immediately, then customers will definitely notice it, but start pushing back gently, then start pushing back harder, and that should start bringing the profitability on those clients around. And if the customer bucks and goes too far against it, you've got to then really ask, are they a right fit for you?

And I think, James, you only touched on it briefly, but you mentioned 7% on average of revenue that you're not actually billing, right? So if you're going to go do these things, fix the hole that you've got now, and make sure that as you do increase those prices and things like that, or if you are adding in bits and pieces, yeah, please make sure that they're billed, and there are tools out there that will do that for you, or help you do that. So if you need any of those, feel free to reach out and we can tee them up.

Pricing on Value, Not Averages, and Turning Client Loss into Opportunity

We've got only a couple minutes, but we've got a question from TRB, and again, I got this question yesterday actually as well, so what is the industry average for a general services technician? And James, I did see that you sent round a link, so check out the article, because I'll answer this, and I want to answer the whole big client leaving thing, because I think that's actually quite critical.

Don't base your prices on averages. If we're a small business, you do not want to be average pricing, especially when we talk about the average EBIT at 6%. What does that tell you? Just to throw that out there, if we're adding that value, being that premium white glove service, well, that's what comes with the premium, premium costs. So don't, stop comparing to market and start understanding your costs, your value, the outcomes that you're delivering to clients, and reframe things, and your differentiators.

Yep, and on this big client thing, I'll just throw another perspective of, let's assume that we can't have a friendly conversation with them and they're going to leave. Actually, it can be one of the best things for your business as well. Like, we're worried about losing all this revenue, let's, even if they are profitable, right, let's just assume we're going to lose this and it's going to have a significant impact to the business. I've seen this time and time again with partners that I've worked with, it's actually a good catalyst for change, because we've gotten a whole bunch of complacency around this whale of a client. We're not actually leveraging the advantages of having this whale client, we're getting sucked into it, we're not looking after the rest of our clients, we're probably carrying a bunch of techs that are fairly mediocre, or account managers that are fairly mediocre. So can we turn this into a positive? If we're losing all this revenue, the cost needs to follow, so this is the time that you reshape your business as well. And there's nothing wrong with consolidating. Some of the most successful businesses that I see in the technology services industry at the moment have gone through this consolidation phase, they grew, they realized there's some things wrong, they got rid of some clients, they got rid of some staff, came backwards, and then they've grown way past where they were before, but even more profitably. So, as long as it's deliberate and you're making these decisions and you're being planned about it, it's actually a positive thing.

Well guys, oh, there's a good rabbit hole there, but we don't have the time. Yeah, and we do have another question. So Fuzz, Rod's got a question, is that Rod's question? Yeah, look, Rod, you can put it as, it depends, if you're doing a straight CPI, then just say it's a CPI, or we're putting the rates up by 4.2% or whatever, or if you're just changing one rate, or let's say you've got a user price and it's going from $65 to $73, you can put that there, that's not a problem. Again, right now there's nothing stopping you. We know Microsoft on the 1st of April are putting their NCE pricing up by 5%, put it on the bottom now, have something in there that every single month on the bottom of your invoice, or start putting it even in the signature of your accounts mailbox or something like that, that this is happening. Again, it's another way of informing people of what's happening.

All right, well guys, we covered a lot, we didn't get through all the questions, but we threw out a lot of numbers and things like that today. So again, I just want to remind everyone this is recorded, we will send it out, so if you want to refer back, please feel free to check out the recording. The video of that will be available in the next couple of days, the podcast takes a little bit longer. But if you would like to refer to any of our previous sessions, and just to pop up a quick slide, we now have a dedicated website, mspsinconversation.com, where you can see all of our previous episodes, so please check that out.

Fuzzy, James, thank you very, very much, that was absolutely fantastic. And to everyone on the call today and all listening to this at a later date, hopefully today gives you a few light bulb moments that you can take away to improve your profitability. Again, thank you guys, and thank you everyone. Thanks everyone, have a good afternoon.