Tuesday, June 28, 2011

Selling Your Software Company May be the Best Path to Product Success

Owners of software companies with a great new product are often frustrated by their inability to gain broader market acceptance. The problem isn't the product; the issue is risk adverse buyers. This post explores how a business sale may be the best way to unlock your product's potential.

In our investment banking practice, we are often approached by software companies that have a leading edge new software product that is not producing the desired sales results. Many times they are what we affectionately term, accidental software companies - an Information Technology consulting firm that has developed a solid application in conjunction with their demanding blue-chip client. They strike a deal with the client to reduce their development fees in return for ownership of the intellectual property.

Just like that, they become a software company. Not so fast Mr. Optimist. You can't just say you are a software company and expect the product to garner mass market acceptance. They generally do not have a sales force that can now transition from selling projects to now selling a software product. Many go down the path of hiring a salesperson that has an impressive large company sales resume. He promises to bring his large client database with him and achieve impressive sales levels. He is going to take this small company to the next level.

Nine months later, with a substantial base and draw, the sales star is far below quota and is either fired or quits to find a much easier sale. It is one thing to sell with Oracle, SAP, Microsoft or IBM on your business card. It is an entirely different proposition representing Acme Software Products. It is a rare sales person that can make that transition and achieve success for the new company.

The primary deterrent to sales success is that the perceived risk for the large company software purchaser is far greater with the unproven newcomer than with the established software giant. This dramatically lengthens the sales cycle with much more testing, software code escrow requirements, references, proof steps, trials, etc.

So how does this small company scale? How about the VAR channel? Again, the inexperience can be costly. You can't just recruit some VARs and expect sales to multiply. It is a big commitment of resources to manage the channel. You are competing for mind share with many other strong products and services. The revenue split with a VAR is generally about 50%.

Strategic alliances have been employed successfully in earlier times. This approach has been tried by a large percentage of emerging software companies to the point where this channel is extremely crowded and diminishing in its effectiveness. Larger companies are becoming very selective and demanding in lending their brand, sales resources, and mind share to anything but their own products. If they do agree to partner, the terms are not favorable for the small guy and often there is some ownership equity requirement.

Step back from the ledge. All is not lost. Often the best approach is to seek to be acquired by a larger software or information technology company that has the client base and sales resources to leverage with your hot new product. It is important that I manage your expectations, however. If you are below $50 million in revenue, Microsoft, Google, IBM, Oracle and the other multi billion dollar software firms are not going to buy you. There is the occasional outlier that defies this rule, but their corporate development people do not even blink unless you are big enough to move their needle. So if you are a $3 to $25 million in revenue firm, your buyer is most likely a $25 million to $300 million software or IT services firm.

I must include one final reality check. Buyers of software companies are reluctant to pay for potential, projections, pipelines or any other seller perceived hockey stick revenue explosions with cash at closing. They have heard it all before and will not be persuaded to part with their cash until those orders actually come in. The good news is that if they are convinced that there is potential and this product is a good fit with their sales team and clients, they often will make a generous earn out offer based on future revenues or profits.

This can be very attractive to the seller because now his effective sales force, installed base of customers, brand name recognition, and marketing budgets have all been expanded exponentially. The risk in the marketplace has been reduced and the sales cycle compresses. So if the selling company with 2 sales people and 30 installed accounts gets acquired by a larger company with 1,000 installed accounts and 30 sales people and gets a 15% of revenues earn out deal over four years, he can recognize considerably more value when compared to slugging it out on his own over the next 15 years.

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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Tuesday, June 21, 2011

The Art of Software Company 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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Saturday, March 19, 2011

Selling Your Software Company - How Important is the Sale Process

It is common knowledge that timing is very important when selling a software company in determining the value the owner receives. This article discusses what actually is a far more powerful determinant in selling price - the process employed in selling your software company.

As a general rule, there is a greater variance in company valuations for software and information technology companies than for brick and mortar type companies. If you took a manufacturer of bottle caps out to ten different private equity groups (the most disciplined group of financial buyers), the purchase price offers would be within 10% of each other at around 4.5 X EBITDA.

If you took a software company out to that same group of buyers, their purchase price would still be within 10% of each other at 5.5 X EBITDA. If you located ten software companies that were actively making acquisitions and took the same software company out to them, the offers could vary by over 100%.

I was talking with a financial advisor who related the following story to me about one of his clients that was the owner of a software company. One day the software company owner was approached by a private equity group with an unsolicited offer to buy his company. The two parties executed a confidentiality agreement and exchanged financial statements. Within a very short time the private equity group submitted a qualified letter of intent. The owner was thrilled and told his financial advisor that he was about to sell his company for $10 million.

His financial advisor's alarms sounded and he encouraged his client to engage a mergers and acquisitions firm that specialized in selling software companies. The owner resisted, evidently thinking that the process would be a breeze and that he could avoid the fees of the investment banker. His advisor persisted, however, and after a great deal of persuasion, finally agreed to hire a mergers and acquisitions firm that specialized in software company business sales.

The first concern of the owner was that hiring an investment banker would somehow upset the buyer and jeopardize this lucrative offer. The investment banker explained to the seller that he should contact the buyer and explain that since this was his first experience at selling a business so he was going to engage an advisor that could help him with the process. The owner instructed the buyer to work through his investment banker from this point forward.

The software investment banker included this identified buyer in his mix of other private equity groups and a large list of software company strategic buyers. This software was in a niche that was getting a lot of play lately as big legacy providers were being supplanted by smaller, more nimble new comers that were delivering their SaaS solution through the cloud.

As a result of the mergers and acquisitions Advisor's efforts, thirty potential buyers executed confidentiality agreements and reviewed the memorandum. From that group, twenty firms dropped out of the process after reviewing the memorandum, but ten interested buyers remained. Those ten then had conference calls with the owners and three completed a buyer visit.

After the company visits, all three companies started working on qualified Letters of Intent. This is a non-binding letter that basically says that if we complete our due diligence process and do not uncover any negative surprises, we are willing to pay XX amount for your company under the following terms (define an earn out, seller notes, owner continuing obligations, etc.). The serious negotiations come at the letter of intent stage because once the owner counter signs the LOI, the buyer is granted a quiet period in order to perform his due diligence. This means that the investment banker is precluded from soliciting any other offers during this period.

The seller and his software investment banker were able to be more demanding in the negotiations because they knew that they had the original unsolicited offer in hand as well as three very qualified strategic buyers that were willing to negotiate a letter of intent. Fast forward thirty days and the seller countersigned the LOI from one of the strategic buyers with a total transaction value of $120 million.
This was 12 times the original unsolicited offer. Quick disclaimer here like on the TV diet commercials, your results may differ.

This is an extreme example, but we have seen it play out many times. Our firm has been engaged to consult with several software companies that have been approached with an unsolicited offer. Maybe offer is not the right word, so let's say they were approached with interest from a buyer. We were brought in because the business owner could not get the potential suitor to actually make an offer.

They were circling, asking numerous questions, kicking the tires, and maintaining a dialogue with the would-be seller, but were not coming up with any terms and conditions for a potential offer. This is no man's land for the seller. We have been engaged to move the process forward or to stop this endless brain drain. We advise the owners to let us be the bad cop and not to take on that role themselves because it is important to preserve their relationship with the suitor as a potential reseller, channel partner or business development resource.

When we force the issue with the potential buyer, more often than not we find out that their intentions all along were to buy this high growth, cutting edge software company for an EBITDA multiple. Needless to say, our client is disappointed because he was already sizing his yacht. He was envisioning the lofty valuations that he had read about in a recent acquisition by a marquee industry player.

There is absolutely no reason for the single buyer to offer anything other than a "justifiable" EBITDA multiple offer as long as he has no competition in the process.

Compare this to HP or Dell making an unsolicited offer for a publicly traded, cloud enabled, virtualization software company as they did recently. They started out at a 30% premium to the current stock price and know that the target company will hire a Wall Street investment banker to maximize their transaction value. This public company buying process is, by law, a very public and transparent process. In an offer for a private company, however, it is a very private process. The seller does not want his customers, employees, or his competition to know that his company is in play.

Opportunistic buyers understand this dynamic and try to exploit it. We tell our clients that they should not feel so special because these buyers are doing the same dance with multiple target companies simultaneously. It is like the real estate guru who wrote the book and gives the classes to buyers to go out to 100 home sellers and offer a really low price and maybe one will take it.

We recently experienced this phenomenon directly. We were brought in to flesh out an unsolicited approach on an IBM iSeries partner software company who had been approached by a private equity consolidator in that space. When our client provided the buyer contact information, we recognized it immediately because we had completed an engagement with a similar target company six months earlier. They circled but did not offer. When we forced their hand, lo and behold it was an EBITDA financial offer. This dance was ended quickly and our client returned to managing and growing their business.

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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital