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

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