We are requesting survey input from CEO’s and Directors of Mergers and Acquisitions across a broad cross section of software, IT services, and Information Technology, (Approximately 6,000 are being asked to participate).
We will send the survey results out to all respondents. The 7 questions will take 2 minutes to complete. Please cut and paste this link into your browser to take the survey http://www.surveymonkey.com/s/X5SWMPK
Thank you in advance for your participation.
Dave
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
Wednesday, February 24, 2010
Tuesday, February 16, 2010
Thursday, February 4, 2010
Selling Your Software Company- The Number One Value Driver
When helping our clients sell their software companies, we get to witness buyer behavior first hand. The most important behavior is their economic vote - how much they are willing to pay for a business. Many factors go into their assessment of value, but a contractually recurring revenue stream is consistently the number one value driver.
Why is contractually recurring revenue so important? The first answer is risk. Buying a business is risky. Any factor that reduces this risk is rewarded with transaction value. Forecasted sales, for example, are at the high end of the risk scale and are heavily discounted in value. Historical time and materials revenues that are "most likely to be at about the same level" next year are somewhere in the middle of the risk scale and are valued accordingly.The owner and key employees may leave after the acquisition and may take their customer relationships and accounts with them.
Those customers locked into contracts are less likely to leave. The acquisition can temporarily inject uncertainty into the marketplace and cause disruption or delays in pending sales situations. The integration efforts will introduce execution risk into previously routine revenue generating activities.The acquiring company wants the existing customers to stay put long enough to get comfortable with the new company. Contracts with plenty of time remaining are their security.How can you use this knowledge to your advantage?
Go on a mission to convert every time and materials revenue source you can to an annual contract. If you are a software company, for example, and you have customers that are not on an 18% - 20% annual maintenance contract, get those customers converted. A strategy might be a one time "get current sale" in return for signing an annual maintenance contract. Services companies should review their T&M records with their regular customers and devise programs that convert those to annual fixed price programs. Equipment dealers come up with your own extended warranty programs. Services firms devise a concept where you provide departmental or functional outsourcing for your clients.
Financials are important so we have to acknowledge this aspect of buyer valuation as well. We generally like to build in a baseline value (before we start adding the strategic value components) of 2 X contractually recurring revenue during the current year. So, for example, if the company has monthly maintenance contracts of $100,000 times 12 months = $1.2 million X 2 = $2.4 million as a baseline company value component. Another component we add is for any contracts that extend beyond one year.
We take an estimate of the gross margin produced in the firm contract years beyond year one and assign a 5 X multiple to that and discount it to present value. Let's use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final three years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2 X recurring year one revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.
On a value scale, contractually recurring revenue is a 10, expected historical revenue is a 6 and a sales pipeline is a 3. Move your 3's and 6's to 10's and recognize a big boost in your business selling price.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
Selling Your Software Company- Why Use a Merger and Acquisitions Advisor?
Business valuations for software companies are at best a mathematical estimate. If you are selling your software company, the only way to be certain that you have gotten a fair price is to conduct a soft auction process where competing companies establish the market value.
Perhaps the most important business transaction you will ever pursue is the sale of your software company. Many business owners attempt to do it themselves and when asked if they got a good deal, many respond with "I think so," or "I got my asking price," or "I really don't know," or "It was a disaster." Often times these very capable business people approach the sale of their business with less formality than in the sale of a home.
The purpose of this post is to answer the questions - Why would I use a Merger and Acquisitions Advisor and what am I getting for the fees I will pay?
1. Confidentiality. If an owner tries to sell his own software business, that process alone reveals to the world that his business is for sale. Employees, customers, suppliers, and bankers all get nervous and competitors get predatory. The Merger and Acquisitions Advisor protects the identity of the company he represents for sale with a process designed to contact only owner approved buyers with a blind profile- a document describing the company without revealing its identity. In order for the buyer to gain access to any sensitive information he must sign a confidentiality agreement. That generally eliminates the tire kickers and deters behaviors detrimental to the seller's business.
2. Business Continuity. Selling a software company is a full time job. The business owner is already performing multiple functions instrumental to the success of his company. By taking on the load of selling his business, many of those essential functions will get less attention, sometimes causing irreparable damage to the business. The owner must maintain focus on running his business at its full potential while it is being sold.
3. Time to Close. Since the function of a software business broker is to sell a software company, he has a much better chance of closing a transaction faster than the owner. The faster the sale, the lower the risk of business erosion, customer defection, employee problems and predatory competition.
4. Large Universe of Buyers. Software business brokers subscribe to databases of software companies that enable them to screen for buyers that are in a certain SIC Code and have revenues that would support the potential acquisition. In addition, they maintain databases of high net worth individual buyers and have access to private equity groups' databases that outline their buying criteria.
5. Marketing. A business broker can help present the software company in its best light to maximize selling price. He understands how to recast financials to recognize the EBITDA potential post acquisition. Higher EBITDA = higher selling price. He understands the key value drivers for buyers and can help the owner identify changes that translate into enhanced selling price.
6. Valuation Knowledge. The value of a business is far more difficult to ascertain than the value of a house. Every software company is unique and has hundreds of variables that effect value. Business brokers have access to business transaction databases, but those should be used as guidelines or reference points. The best way for a business owner to truly feel comfortable that he got the best deal is to have several financially viable parties bidding for his business. An industry database may indicate the value of your software company based on certain valuation multiples, but the market provides the real answer. An industry database, for example, cannot put a value to a particular buyer on a key customer relationship or a proprietary technology. Most business owners that act as their own business broker get only one buyer involved- either another business that approaches him with an unsolicited offer or a referral from his banker, accountant, or outside attorney. Just look at the additional billion plus dollars of value created for MCI shareholders because of the competitive bidding between Verizon and Quest Communications.
7. Balance of Experience. Most corporate buyers have acquired multiple businesses while sellers usually have only one sale. In one situation we represented a first-time seller being pursued by a buyer with 26 previous acquisitions. Buyers want the lowest price and the most favorable terms. The inexperienced seller will be negotiating in the dark. To every term and condition in the buyer's favor the buyer will respond with, "that is standard practice" or "that is the market" or "this is how we did it in ten other deals." By engaging a business broker, the seller has an advocate with a similar experience base to help preserve the seller's transaction value and structure.
8. Maximize the Value of Seller's Outside Professionals. Business brokers can save the seller significantly on professional hourly fees by managing several important functions leading up to contract. His compensation is usually comprised of a reasonable monthly fee plus a success fee that is a percentage of the transaction value. The business broker and seller negotiate with the buyer the business terms of the transaction (sale price, down payment, seller financing, etc.) prior to turning the purchase agreement over to outside counsel for legal review. In the absence of the business broker that sometimes-exhaustive negotiation process would default to the outside attorney. It is not his area of expertise and could result in significant hourly fees.
9. Maintain Buyer-Seller Relationship. The sale of a software company is an emotional process and can become contentious. The business broker acts as a buffer between the buyer and seller. This not only improves the likelihood of the transaction closing, but helps preserve a healthy buyer- seller relationship post closing. Often buyers want sellers to have a portion of their transaction value contingent on the successful performance of the company post closing. Buyer and seller need to be on the same team after closing.
Our experiences with businesses that engaged our firm as a result of an unsolicited offer from a buyer have been quite instructive. The eventual selling price averaged over 20% higher than the first offer. In no case was the business sold at the initial price. To conclude, the business broker helps reduce the risk of business erosion with improved confidentiality while allowing the owner to focus on running the business. The business broker led sale helps maximize sales proceeds by involving a large universe of buyers in a competitive bidding process. Finally, the business broker can improve the likelihood that the sale closes by buffering buyer-seller negotiations and by balancing the experience scales.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
Perhaps the most important business transaction you will ever pursue is the sale of your software company. Many business owners attempt to do it themselves and when asked if they got a good deal, many respond with "I think so," or "I got my asking price," or "I really don't know," or "It was a disaster." Often times these very capable business people approach the sale of their business with less formality than in the sale of a home.
The purpose of this post is to answer the questions - Why would I use a Merger and Acquisitions Advisor and what am I getting for the fees I will pay?
1. Confidentiality. If an owner tries to sell his own software business, that process alone reveals to the world that his business is for sale. Employees, customers, suppliers, and bankers all get nervous and competitors get predatory. The Merger and Acquisitions Advisor protects the identity of the company he represents for sale with a process designed to contact only owner approved buyers with a blind profile- a document describing the company without revealing its identity. In order for the buyer to gain access to any sensitive information he must sign a confidentiality agreement. That generally eliminates the tire kickers and deters behaviors detrimental to the seller's business.
2. Business Continuity. Selling a software company is a full time job. The business owner is already performing multiple functions instrumental to the success of his company. By taking on the load of selling his business, many of those essential functions will get less attention, sometimes causing irreparable damage to the business. The owner must maintain focus on running his business at its full potential while it is being sold.
3. Time to Close. Since the function of a software business broker is to sell a software company, he has a much better chance of closing a transaction faster than the owner. The faster the sale, the lower the risk of business erosion, customer defection, employee problems and predatory competition.
4. Large Universe of Buyers. Software business brokers subscribe to databases of software companies that enable them to screen for buyers that are in a certain SIC Code and have revenues that would support the potential acquisition. In addition, they maintain databases of high net worth individual buyers and have access to private equity groups' databases that outline their buying criteria.
5. Marketing. A business broker can help present the software company in its best light to maximize selling price. He understands how to recast financials to recognize the EBITDA potential post acquisition. Higher EBITDA = higher selling price. He understands the key value drivers for buyers and can help the owner identify changes that translate into enhanced selling price.
6. Valuation Knowledge. The value of a business is far more difficult to ascertain than the value of a house. Every software company is unique and has hundreds of variables that effect value. Business brokers have access to business transaction databases, but those should be used as guidelines or reference points. The best way for a business owner to truly feel comfortable that he got the best deal is to have several financially viable parties bidding for his business. An industry database may indicate the value of your software company based on certain valuation multiples, but the market provides the real answer. An industry database, for example, cannot put a value to a particular buyer on a key customer relationship or a proprietary technology. Most business owners that act as their own business broker get only one buyer involved- either another business that approaches him with an unsolicited offer or a referral from his banker, accountant, or outside attorney. Just look at the additional billion plus dollars of value created for MCI shareholders because of the competitive bidding between Verizon and Quest Communications.
7. Balance of Experience. Most corporate buyers have acquired multiple businesses while sellers usually have only one sale. In one situation we represented a first-time seller being pursued by a buyer with 26 previous acquisitions. Buyers want the lowest price and the most favorable terms. The inexperienced seller will be negotiating in the dark. To every term and condition in the buyer's favor the buyer will respond with, "that is standard practice" or "that is the market" or "this is how we did it in ten other deals." By engaging a business broker, the seller has an advocate with a similar experience base to help preserve the seller's transaction value and structure.
8. Maximize the Value of Seller's Outside Professionals. Business brokers can save the seller significantly on professional hourly fees by managing several important functions leading up to contract. His compensation is usually comprised of a reasonable monthly fee plus a success fee that is a percentage of the transaction value. The business broker and seller negotiate with the buyer the business terms of the transaction (sale price, down payment, seller financing, etc.) prior to turning the purchase agreement over to outside counsel for legal review. In the absence of the business broker that sometimes-exhaustive negotiation process would default to the outside attorney. It is not his area of expertise and could result in significant hourly fees.
9. Maintain Buyer-Seller Relationship. The sale of a software company is an emotional process and can become contentious. The business broker acts as a buffer between the buyer and seller. This not only improves the likelihood of the transaction closing, but helps preserve a healthy buyer- seller relationship post closing. Often buyers want sellers to have a portion of their transaction value contingent on the successful performance of the company post closing. Buyer and seller need to be on the same team after closing.
Our experiences with businesses that engaged our firm as a result of an unsolicited offer from a buyer have been quite instructive. The eventual selling price averaged over 20% higher than the first offer. In no case was the business sold at the initial price. To conclude, the business broker helps reduce the risk of business erosion with improved confidentiality while allowing the owner to focus on running the business. The business broker led sale helps maximize sales proceeds by involving a large universe of buyers in a competitive bidding process. Finally, the business broker can improve the likelihood that the sale closes by buffering buyer-seller negotiations and by balancing the experience scales.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
Selling Your Technology Company - Why Earn Outs Make Sense Today
Sellers have historically viewed earn outs with suspicion as a way for buyers to get control of their companies cheaply. Earn outs are a variable pricing mechanism designed to tie final sale price to future performance of the acquired entity and are tied to measurable economic milestones such as revenues, gross profit, net income and EBITDA. An intelligently structured earn out not only can facilitate the closing of a deal, but can be a win for both buyer and seller. Below are ten reasons earn outs should be considered as part of your selling transaction structure.
1. Buyers acquisition multiples are at pre 1992 levels. Strategic corporate buyers, private equity groups, and venture capital firms got burned on valuations. Between 1995 and 2001 the premiums paid by corporate buyers in 61% of transactions were greater than the economic gains. In other words, the buyer suffered from dilution. During 2002 multiples paid by financial buyers were almost equal to strategic buyers multiples. This is not a favorable pricing environment for tech companies looking for strategic pricing.
2. Based on the bubble, there is a great deal of investor skepticism. They no longer take for granted integration synergies and are wary about cultural clashes, unexpected costs, logistical problems and when their investment becomes accretive. If the seller is willing to take on some of that risk in the form of an earnout based on integrated performance, he will be offered a more attractive package (only if realistic targets are set and met).
3. Many tech companies are struggling and valuing them based on income will produce some pretty unspectacular results. A buyer will be far more willing to look at an acquisition candidate using strategic multiples if the seller is willing to take on a portion of the post closing performance risk. The key stakeholders of the seller have an incentive to stay on to make their earnout come to fruition, a situation all buyers desire.
4. An old business professor once asked, "What would you rather have, all of a grape or part of a watermelon?" The spirit of the entrepreneur causes many tech company owners to go it alone. The odds are against them achieving critical mass with current resources. They could grow organically and become a grape or they could integrate with a strategic acquirer and achieve their current distribution times 100 or 1000. Six % of this new revenue stream will far surpass 100% of the old one.
5. How many of you have heard of the thrill of victory and the agony of defeat of stock purchases at dizzying multiples? It went something like this – Public Company A with a stock price of $50 per share buys Private Company B for a 15 x EBITDA multiple in an all stock deal with a one-year restriction on sale of the stock. Lets say that the resultant sales proceeds were 160,000 shares totaling $8 million in value. Company A’s stock goes on a steady decline and by the time you can sell, the price is $2.50. Now the effective sale price of your company becomes $400,000. Your 15 x EBITDA multiple evaporated to a multiple of less than one. Compare that result to $5 million cash at close and an earnout that totals $5 million over the next 3 years if revenue targets for your division are met. Your minimum guaranteed multiple is 9.38 x with an upside of 18.75x.
6. Strategic corporate buyers are reluctant to use their devalued stock as the currency of choice for acquisitions. Their preferred currency is cash. By agreeing to an earnout, you give the buyer’s cash more velocity (ability to make more acquisitions with their cash) and therefore become a more attractive candidate with the ability to ask for greater compensation in the future.
7. The market is starting to turn positive which reawakens sellers’ dreams of bubble type multiples. The buyers are looking back to the historical norm or pre-bubble pricing. The seller believes that this market deserves a premium and the buyers have raised their standards thus hindering negotiations. An earnout is a way to break this impasse. The seller moves the total selling price up. The buyer stays within their guidelines while potentially paying for the earnout premium with dollars that are the result of additional earnings from the new acquisition.
8. The improving market provides both the seller and the buyer growth leverage. When negotiating the earnout component, buyers will be very generous in future compensation if the acquired company exceeds their projections. Projections that look very aggressive for the seller with their pre-merger resources, suddenly become quite attainable as part of a new company entering a period of growth. An example might look like this: Oracle acquires a small software Company B that has developed Oracle conversion and integration software tools. Last year Company B had sales of $8 million and EBITDA of $1 million. Company B had grown by 20% per year. The purchase transaction was structured to provide Company B $8 million of Oracle stock and $2 million cash at close plus an earnout that would pay Company B a % of $1 million a year for the next 3 years based on their achieving a 30% compound growth rate in sales. If Company B hit sales of $10.4, $13.52, and $17.58 million respectively for the next 3 years, they would collect another $3 million in transaction value. The seller now expands his client base from 200 to 100,000 installed accounts and his sales force from 4 to 5,000. Those targets should be very easy to hit. If these targets are met, the buyer easily finances the earnout with extra profit.
9. The window of opportunity in the technology area opens and closes very quickly. An earnout structure can allow both the buyer and seller to benefit. If the smaller company has developed a winning technology, they usually have a short period of time to establish a lead in the market. If they are addressing a compelling technology gap, the odds are that companies both large and small are developing their own solution simultaneously. The seller wants to develop the potential of the product and achieve sales numbers to drive up the company’s selling price. They do not have the distribution channels, the resources, or time to compete with a larger company with a similar solution looking to establish the industry standard. A larger acquiring company recognizes this first mover advantage and is willing to pay a buy versus build premium to reduce their time to market. The seller wants a large premium while the buyer is not willing to pay full value for projections with stock and cash at close. The solution: an earnout for the seller that handsomely rewards him for meeting those projections. He gets the resources and distribution capability of the buyer so the product can reach standard setting critical mass before another large company can knock it off. The buyer gets to market quicker and achieves first mover advantage while incurring only a portion of the risk of new product development and introduction.
10. You never can forget about taxes. Earnouts provide a vehicle to defer and reduce the seller’s tax liability. Be sure to discuss your potential deal structure and tax consequences with your advisors before final negotiations begin. A properly structured earnout could save you significant tax dollars.
Smaller technology companies have many characteristics that make them good candidates for earnouts in sale transactions: 1. High growth rates, 2. Earnings not supportive of maximum valuations, 3. Limited window of opportunity to achieve meaningful market penetration, 4. Buyers less willing to pay for future potential entirely at the sale closing and 5. A valuation expectation far greater than those supported by the buyers. It really comes down to how confident the seller is in the performance of his company in the post sale environment. If the earnout targets are reasonably attainable and the earnout compensates him for the at risk portion of transaction value, a seller can significantly improve the likelihood of a sale closing and the transaction value.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
Time to Sell Your Software Company - Look for These Ten Signs
A business owner's toughest decision is deciding to sell. In many cases, he ignores some market dynamics that foretell difficult times ahead. Those difficult times often result in a significant drop in the value of the business. This post will help you identify some of those signs.
For the past 20 years you have built your software business. Your company has become part of your identity. Even when you are not at work, you are working, thinking, planning. You never stop. If you sell, you are leaving behind much more than a job. In this post, we will discuss some signs that might indicate that it is time to exit your business.
1. Late in your working life you are faced with a major capital requirement in order for your software company to maintain its competitive position.
2. A large competitor is taking market share away from you at an accelerating pace.
3. Your legacy systems, production capabilities, or competitive advantage has been "leap frogged" by a smaller, nimble, entrepreneurial firm.
4. A major company in a related industry just acquired a direct competitor.
5. Your fire to compete at your top level is not burning as brightly as it once did.
6. Your kids are not interested or are not capable of running the software business.
7. You have had a health scare and have decided to smell the flowers.
8. You have lost a major client or a key employee.
9. The market is hot and you decide to take some chips off the table for asset diversification.
10. You exit in an orderly fashion and from a position of strength as you intended.
Let's look at these in a little more detail:Major Capital Investment Required - You are supposed to be diversifying your assets, not concentrating them even further. Think about a simple payback analysis. Does that extend beyond your retirement date? You want to be able to defend that investment with the energy and intensity you devoted when you were originally growing your business. Maybe it is time to bring in an equity partner with smart money, an industry buyer with the management depth, infrastructure, or distribution network to protect that investment.
You might consider selling not with a three year employment contract. Let the new owner defend the required capital investment.
A Large Competitor is Taking Market Share Away from You - Believe me, the news is not going to get better. As an investor you would probably sell the stock in a company you owned if Microsoft or GE decided to assume a presence in that market. Business owners often struggle with objectivity when a similar event takes place in their own company's industry.
Your Legacy Systems have been "Leap Frogged" by a Nimble Entrepreneurial Firm - This happens all the time and can cause an erosion of your customer base. Your inertia will sustain you for a while, but eventually you will begin to experience customer defections. You can either re-write, acquire or sell. If you decide to sell, do so before losing too many clients.
A giant company in a related industry just acquired one of your major competitors- Watch out, they did not make this acquisition to maintain status quo. They want to grow their market share. They will be coming after your clients. The good news is that as a defensive measure, one or more of their competitors will be compelled to make a similar acquisition. It is best to be aggressively ahead of the curve and get acquired while the market is hot and prices are being bid upwards.
Your interest and competitive fire is eroding- Let's face it, if you are not growing, you most likely are contracting. Your competition was tough when you were on your game. Your family's net worth is under attack if you are no longer fully committed.
Your original plan was to turn your software business over to your children- They may not be interested or capable of competing at this level. Perhaps the greatest legacy you can leave to your kids is to convert your company into a diversified portfolio of financial assets that are far less risky than turning the company over to inexperienced managers.
You have a health scare- All of a sudden you start thinking of all the sacrifices you made and all the things you want to do before it is too late. Your list of goals is immediately changed from financial in nature to family, friends, travel, experiences, philanthropy, etc. You might want to listen to your heart this time.
You have lost a major client or a key employee- That can be a real blow to a business. The owner, by nature, is optimistic and believes that the lost business will soon be replaced and does not ratchet down the expense level to match this new sales level. If he does cut, inevitably, it is not fast enough and not deep enough. Maybe it is time to seek a buyer that could replace that business before your company's value is severely impaired as your profits erode.
The market is hot and you decide to take some chips off the table for diversification- You may be thinking of retiring in four years, but a consolidation is occurring in your industry and valuations are up 20%. Sell at the top and sign a four year employment or consulting contract. The odds are that if you exit on your original schedule, valuations will have settled back down to the norm.
You ring the bell and exit on your own terms, from a position of strength, exactly like you planned- You are well aware of the competitive forces in the market and the relative strength or weakness in valuation multiples. You have prepared your software business to be attractive to a strategic buyer. Everything is going your way. You hire a good M&A advisory firm to present you confidentially to the most likely buyers. Several recognize your value and show interest. You are able to get a little competitive bidding going. Your transaction value rises and your terms improve. You pull the trigger and complete the sale. Mission Accomplished.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
Sell Your Software Company - The Art of Business Valuation
One of the most challenging aspects of selling a software company is coming up with a business valuation. Sometimes the valuations provided by the market (translation - a completed transaction) defy all logic. In other industry segments there are some pretty handy rules of thumb for valuation metrics. In one industry it may be 1 X Revenue, in another it could be 7.5 X EBITDA.
Since it is critical to our business to help our information technology clients maximize their business selling price, I have given this considerable thought. Why are some of these software company valuations so high? It is because of the profitability leverage of technology?
A simple example is what is Microsoft's incremental cost to produce the next copy of Office Professional? It is probably $1.20 for three CD's and 80 cents for packaging. Let's say the license cost is $400. The gross margin is north of 99%. That does not happen in manufacturing or services or retail or most other industries.
One problem in selling a small technology company is that they do not have any of the brand name, distribution, or standards leverage that the big companies possess. So, on their own, they cannot create this profitability leverage. The acquiring company, however, does not want to compensate the small seller for the post acquisition results that are directly attributable to the buyer's market presence. This is what we refer to as the valuation gap.
What we attempt to do is to help the buyer justify paying a much higher price than a pre-acquisition financial valuation of the target company. In other words, we want to get strategic value for our seller. Below are the factors that we use in our analysis:
1. Cost for the buyer to write the code internally - Many years ago, Barry Boehm, in his book, Software Engineering Economics, developed a constructive cost model for projecting the programming costs for writing computer code. He called it the COCOMO model. It was quite detailed and complex, but I have boiled it down and simplified it for our purposes.
We have the advantage of estimating the projects retrospectively because we already know the number of lines of code comprising our client's products. In general terms he projected that it takes 3.6 person months to write one thousand SLOC (source lines of code). So if you looked at a senior software engineer at a $70,000 fully loaded compensation package writing a program with 15,000 SLOC, your calculation is as follows - 15 X 3.6 = 54 person months X $5,800 per month = $313,200 divided by 15,000 = $20.88/SLOC.
Before you guys with 1,000,000 million lines of code get too excited about your $20.88 million business value, there are several caveats. Unfortunately the market does not care and will not pay for what it cost you to develop your product.
Secondly, this information is designed to help us understand what it might cost the buyer to develop it internally so that he starts his own build versus buy analysis. Thirdly, we have to apply discounts to this analysis if the software is three generations old legacy code, for example. In that case, it is discounted by 90%. You are no longer a technology sale with high profitability leverage. They are essentially acquiring your customer base and the valuation will not be that exciting.
If, however, your application is a brand new application that has legs, start sizing your yacht. Examples of this might be a click fraud application, Pay Pal, or Internet Telephony. The second high value platform would be where your software technology "leap frogs" a popular legacy application.
An example of this is when we sold a company that had completely rewritten their legacy distribution management platform for a new vertical market in Microsoft's latest platform. They leap frogged the dominant player in that space that was supporting multiple green screen solutions. Our client became a compelling strategic acquisition. Fast forward one year and I hear the acquirer is selling one of these $100,000 systems per week. Now that's leverage!
2. Most acquirers could write the code themselves, but we suggest they analyze the cost of their time to market delay. Believe me, with first mover advantage from a competitor or, worse, customer defections, there is a very real cost of not having your product today.
We were able to convince one buyer that they would be able to justify our seller's entire purchase price based on the number of client defections their acquisition would prevent. As it turned out, the buyer had a huge install base and through multiple prior acquisitions was maintaining six disparate software platforms to deliver essentially the same functionality.
This was very expensive to maintain and they passed those costs on to their disgruntled install base. The buyer had been promising upgrades for a few years, but nothing was delivered. Customers were beginning to sign on with their major competitor.
Our pitch to the buyer was to make this acquisition, demonstrate to your client base that you are really providing an upgrade path and give notice of support withdrawal for 4 or 5 of the other platforms. The acquisition was completed and, even though their customers that were contemplating leaving did not immediately upgrade, they did not defect either. Apparently the devil that you know is better than the devil you don't in the world of information technology.
3. Another arrow in our valuation driving quiver for our sellers is we restate historical financials using the pricing power of the brand name acquirer. We had one client that was a small IT company that had developed a fine piece of software that compared favorably with a large, publicly traded company's solution. Our product had the same functionality, ease of use, and open systems platform, but there was one very important difference.
The end-user customer's perception of risk was far greater with the little IT company that could be "out of business tomorrow." We were literally able to double the financial performance of our client on paper and present a compelling argument to the big company buyer that those economics would be immediately available to him post acquisition. It certainly was not GAP Accounting, but it was effective as a tool to drive transaction value.
4. Financials are important so we have to acknowledge this aspect of buyer valuation as well. We generally like to build in a baseline value (before we start adding the strategic value components) of 2 X contractually recurring revenue during the current year.
So, for example, if the company has monthly maintenance contracts of $100,000 times 12 months = $1.2 million X 2 = $2.4 million as a baseline company value component. Another component we add is for any contracts that extend beyond one year. We take an estimate of the gross margin produced in the firm contract years beyond year one and assign a 5 X multiple to that and discount it to present value.
Let's use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final tree years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2 X recurring year 1 revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.
5. We try to assign values for miscellaneous assets that the seller is providing to the buyer. Don't overlook the strategic value of Blue Chip Accounts. Those accounts become a platform for the buyer's entire product suite being sold post acquisition into an installed account. It is far easier to sell add-on applications and products into an existing account than it is to open up that new account. These strategic accounts can have huge value to a buyer.
6. Finally, we use a customer acquisition cost model to drive value in the eyes of a potential buyer. Let's say that your sales person at 100% of Quota earns total salary and commissions of $125,000 and sells 5 net new accounts. That would mean that your base customer acquisition cost per account was $25,000. Add a 20% company overhead for the 85 accounts, for example, and the company value, using this methodology would be $2,550,000.
After reading this you may be saying to yourself, come on, this is a little far fetched. These components do have real value, but that value is open to a broad interpretation by the marketplace. We are attempting to assign metrics to a very subjective set of components. The buyers are smart, and experienced in the M&A process and quite frankly, they try to deflect these artistic approaches to driving up their financial outlay.
The best leverage point we have is that those buyers know that we are presenting the same analysis to their competitors and they don't know which component or components of value that we have presented will resonate with their competition. In the final analysis, we are just trying to provide the buyers some reasonable explanation for their board of directors to justify paying 8 X revenues for an acquisition.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. For more information about exit planning and selling a business, click to visit our Web Site MidMarket Capital
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