Business
valuations of software companies use proven methodologies to arrive at
an indication of value. If the technology is one in demand, however, the
valuations provided by the markets can be off the charts. This article
discusses how the pros value software companies and the limitations to
their approach.
Software company owners looking to sell
their companies are often inspired to start the process after reading
about the latest high profile, stratospheric acquisition price paid by a
large tech bell weather company. The transaction metrics, i.e.
transaction value to sales or transaction value to EBIT sometimes defy
all logic.
The new, would-be seller applies these
metrics to his company's sales and EBIT and determines that IBM,
Microsoft, Google, Oracle, Cisco, etc. should be ready to get into a
bidding war over his $5 million in revenue, game changing, best in breed
software company for a value of 8 X revenue.
Let's
break down the methodology that professional business valuation firms
use as their standard in arriving at a company's indicated value. Their
approach calls for a triangulation of three valuation methodologies.
The
first is a comparison to publicly traded companies in the same
category. It is very interesting to look at the lists that the valuators
come up with. Technically they are all software companies with SIC Code
5734-01, but they are as alike as apples, coconuts, watermelons, and
blueberries. True, they are all fruit, but that is where the similarity
ends.
Next, they take the valuation metrics of these
publicly traded companies. The most commonly used are sales to
enterprise value and EBIT to enterprise value. Next they come up with
the median value (one half of the companies are above the value and one
half are below). They then apply what I can best describe as an
arbitrary discount factor to account for the value differential between
public companies and small, closely held companies. They come up with
their adjusted metrics then apply them to the target company and voila,
you have one of the valuation legs completed.
The
valuation analyst next applies the same approach to actual completed
transactions. If the buyer was a public company then the metrics are
publicly available. If the transaction is between two privately held
companies, the metrics are only available on a voluntary basis. Maybe
10% of these participants release information about these transactions.
These unreported deals are probably the best fit in terms of
comparables.
In order to get a meaningful number of
transactions, the analyst often is forced to use transactions from a
5-10 year period. Do you know how to say Tech Bubble/Tech Meltdown? Wow,
this isn't sounding quite as scientific as I originally thought.
Wait,
maybe we can add some needed precision with the third valuation
technique, the discounted cash flow method. My Wharton Finance Professor
would be so proud. First they calculate a risk adjusted discount rate.
After three pages of explanation, they usually arrive at a discount rate
of between 24-30%. They next project the after tax cash flow for the
next five years and discount it to present value.
They
then calculate the terminal value of the company (five years of year
five cash flow discounted by the risk adjusted rate less the projected
growth rate). They discount that number to present value and add that to
the discounted cash flow to create the third leg of the valuation
stool.
How many software companies are not projecting
hockey stick growth during the valuation period in question? Not only
are these projections very aggressive, but cash flow margins are
projected to improve by a factor of three times during this same period.
Now
our seller is armed and dangerous with his company's value. That
becomes his minimal acceptable offer and it must all be in cash at
closing. To use a Wall Street term - this company is priced for
perfection. We often discover during a sell-side engagement that these
projections are not just missed, but they are missed by a large margin.
In spite of this, the seller's valuation expectations remain the same.
All
is not lost, however. One of the unique aspects of selling a software
company is that if the technology is fresh (think SaaS, Mobile Apps,
Virtualization, Cloud Computing) financial multiples are often not the
driving force in the buyer's valuation equation.
One
thing that we have learned in the representation of software companies
for sale is that the value is subject to broad interpretation by the
market. We find that strategic buyers in this space are driven by such
considerations as first mover advantage, time to market, development
costs, customer acquisition costs, customer defections, and enhancing an
existing product suite.
The better the target company
addresses these issues, the greater the post acquisition value creation
potential. If the right buyer is located and recognizes the seller's
potential when integrated with the new owner's distribution channel and
customer base, we may find an even bigger hockey stick then our very
optimistic sellers. If two or three buyers recognize a similar dynamic,
then the valuations can become very exciting.
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
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