Valuing The Growth Rate in the Sale of a Technology Company

In the sale of privately held businesses there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple. Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), the purpose of this article is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.

Experienced business buyers are masters of setting the rules for how they calculate the value of a business they are attempting to acquire. You may think that a 5 X multiple of EBITDA or 1 X Sales would be pretty cut and dried, but in practice it is open for creative interpretation. For example, if you just had your best year ever and your EBITDA was $2 million and the market valuation was 5 X, then you would expect a $10 million offer. Not so fast. The buyer may counter with, "That last year was an anomaly and we should normalize EBITDA performance as an average of the last three years." That average turns out to be $1.5 million and like magic your purchase offer evaporates to $7.5 million. On the flip side, if you just had your worst year at $1 million EBITDA, you can bet the buyer will use that as your metric for value.

The three owners paid themselves $100,000 each in salary, but the buyer asserts that the fair market value salary for a replacement for each senior manager is really $150,000. They apply this total $150,000 EBITDA adjustment and your valuation drops by another $750,000. If the family owns the building separately and rents it to the business for an annual rent of $200,000 when the FMV rental rate is $300,000, the resulting adjustment costs the seller another $500,000 in lost value.

Another valuation trap for a seller is that they want to hire additional sales resources to pump up their sales just prior to the sale. This is almost always a bad move. Most technology sales reps take a year or longer to ramp up to productivity. In the interim, with salary and some draw or guarantee, they actually become a drain on earnings. The buyers do not care about the explanation, they just care about the numbers and will whack you with a value downgrade.

The least understood valuation trap, however, is there seems to be no mechanism and certainly no attempt on the part of buyers to account for the selling company's growth rate. In the public market this factor is widely recognized and is accounted for with an improvement on the PE multiple, the PEG or Price Earnings Growth multiple. The rule of thumb is that if the stock is valued with a PEG of less than 1 then it is a good value and if it is over 1 it is not as good.

Because there is no exact translation between EBITDA multiple (the primary valuation metric for privately held companies) and Earnings Per Share and PE multiple (the primary valuation metric for publicly traded stocks), please allow me a measure of imprecision in my analysis. My purpose is to try to calculate an adjustment factor that can be applied against the EBITDA valuation metric in order to present a more accurate accounting for differences in growth rate for the valuation of privately held companies.

I have chosen two stocks for my analysis, Google and Facebook. The reason I choose these two is that they are widely known, very successful, in the same general market niche, and are at different stages of their growth cycle. Google sells at a PE multiple of 33.37 while Facebook sells for a PE multiple of 113.71. The PEG of Google which = PE Multiple/5 year growth rate is 33.37/16.85 for a PEG of 1.98. I actually backed into the growth rate using the readily available PE multiple and the PEG from my Fidelity account.

Facebook sells at a PE multiple of 113.71 and has a PEG ratio of 3.62 (may be some irrational exuberance here), which translates into a 5 year growth rate of 31.41%. For our comparison we should also include the average PE multiple for the S&P 500 of about 15. Let's make the assumption that on average, this assumes that these companies will grow at the growth rate of the U.S. Economy, say 3%.

So to calculate a normalized PE ratio for these two companies, we are going to create an adjustment factor by dividing the 5 year compound growth rate of Google and Facebook versus the anticipated 5 year compound growth rate of the S&P 500. For Google the 16.85% growth rate over 5 years creates a factor or 2.178 or a total of 217.8% total growth over the next 5 years. The S&P factor is 1.16. So if you divide the Google factor by the S&P factor you get 1.878. If you multiple the market PE multiple of 15 by the Google factor, the result is a PE of 28.2. Not too far off from the current PE multiple of 33.37

Facebook is a little off using this method resulting in a normalized calculated PE of 50.65 versus their current rate of 113.71. This will appropriately seek a level over time and settle into a more rational range. My point here is that the public markets absolutely account for growth rates in the value of stocks in a very significant way.

Now let's try to apply this same logic to the EBITDA multiple for valuing a privately held technology company. If the rule-of-thumb multiple for your company's valuation is 5 X EBITDA but you are growing at 10% compounded, shouldn't you receive a premium for your company. Using the logic from above we assign a 3% compound growth rate as the norm in the 5 X EBITDA metric. So the 10% grower gets a factor of 1.61 versus the norm of 1.16. Dividing the target company factor by the normalized factor results in a multiple acceleration factor of 1.39. Multiply that by the Standard 5 X EBITDA multiple and you get a valuation metric of 6.95 X EBITDA.

A little sobering news, however, you will have a real challenge convincing a financial buyer or a Private Equity Group to veer to far away from their rule of thumb multiples. You will have a better chance of moving a strategic technology company buyer with this approach.  A discounted cash flow valuation technique is superior to the rule of thumb multiple approach because it accounts for this compound growth rate in earnings. If the technique produces a higher value for the seller, the buyer will keep that valuation tool in his toolbox.

Perhaps the best way to negotiate a projected high growth rate and translate that into transaction value is with a hybrid deal structure. You might agree to a cash at close valuation of 5 X EBITDA and then create an upside kicker based on hitting your growth targets.

 So for example, your EBITDA is $2 million and your standard industry metric is 5X EBITDA. You believe that your 10% growth rate (clearly above the industry average) should provide you a premium value of 6 X.  So the value differential is $10 million versus $12 million. You set a target of a 10% compounded growth in Gross Profit over the next 4 years and you calculate an earn out payment methodology that would provide an additional $2 million in transaction value if you hit the targets. It is a contingent payment based on actual post closing performance, so if you fall short of targets you fall correspondingly short on your earn out. If you exceed target you could earn more.

Successful buyers do not remain as successful buyers if they over pay for an acquisition. Therefore, the lower the price they pay, the greater their odds of chalking up a win. This is a zero sum game in that each dollar that stays in their pocket is one less dollar in your pocket. They will utilize every tool at their disposal to convince the seller that "this is market" or this is "how every industry buyer values similar companies."  It is to your advantage to help move them toward your value expectations. That is a very hard thing to accomplish unless you have other buyers and can walk away from a low offer. Believe me, if they are looking at you, they are doing the same dance with at least a couple of others. You must match their negotiation leverage by having your own options.

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. Please visit our Web Site MidMarket Capital

Sell Your Information Technology Company -Why Pay an Investment Banker?

Perhaps the most important transaction you will ever pursue is the sale of your business. Many owners of information technology companies attempt to do it themselves and 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 article is to answer the questions - Why would I use an investment banker and what am I getting for the fees I will pay?

More than any other type of business sale, the intellectual property based business is the most complex and difficult. The primary reason is that the seller is not interested in selling their company for a financial multiple like 5 X EBITDA. They almost always want that amount plus a premium for strategic value. Another very important factor is that most smaller information technology companies run their financials on a cash basis and the buyers usually employ the accrual method. The adjustments in transaction value that often occur during the due diligence process are often surprising and expensive. Below are several reasons why a seller of an IT business should seek a firm that specializes in this type of business sale.

1. Confidentiality. If an owner tries to sell his own 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 investment banker 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 business is a full time job. The business owner is already performing multiple functions instrumental to the success of his business. 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 investment banker's function is to sell the business, 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. The investment banking firm that specializes in information technology and software companies already has a developed list of target companies with contact information for the individual that runs the merger and acquisition process. They recognize that information technology companies with the same SIC Code 5734-01 can be vastly different and need a further categorization like document management software, SaaS CRM Systems, or healthcare financial software.

5. Marketing. A merger and acquisition advisor can help present the business in its best light to maximize selling price. He understands how to recast financials to recognize the EBITDA potential post acquisition.  He understands the key value drivers for buyers and can position the selling company to enhance its strategic value in the eyes of the buyer.

6. Valuation Knowledge. The value of a business is far more difficult to ascertain than the value of a house. Every business is unique and has hundreds of variables that effect value. This is especially true with companies with a strong component of intellectual property. Investment Bankers 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 strategic industry buyers bidding for his business. An industry database may indicate the value of your business based on certain valuation multiples, but the market provides the real answer.

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.”  Our firm has saved our clients transaction value greater than our total fees during the due diligence and closing adjustments process.  By engaging an investment banker that specializes in information technology companies, the seller has an advocate with an experience base to help preserve the seller’s transaction value and deal structure.

8. Maximize the Value of Seller’s Outside Professionals. Experienced investment bankers 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 M&A advisor 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 investment banker, that sometimes-exhaustive negotiation process would default to the outside attorney. The economics of the deal are not your attorney's area of expertise and could result in significant hourly fees or even a breakdown of the transaction.

9. Maintain Buyer - Seller Relationship. The sale of a business is an emotional process and can become contentious. The investment banker 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 information technology companies that engaged our firm as a result of an unsolicited offer from a buyer have been quite instructive. The eventual selling price averaged over 30% higher than the first offer. In no case was the business sold at the initial price.

The technology focused investment banker helps reduce the risk of business erosion with improved confidentiality while allowing the owner to focus on running the business. The advisor- led sale helps maximize sales proceeds by involving a large universe of qualified and targeted buyers in a competitive bidding process. Finally, the investment banker 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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Selling Your Software Company - Important Factors in Determining Its Valuation

I just posted my first unscripted video on YouTube. Nothing like expanding your horizons. Not bad, if I do say so myself, for this ship's maiden voyage. I may have a future doing this.

http://youtu.be/zz8Qe636J1s

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

I Want to Sell my Social Mobile Software Company Once I Close That Next Big Sale

You have made the decision to sell your Social Media technology company. Maybe it was because your prospects are selecting the inferior product but superior safety of your brand name competitor. It could be that one of the industry giants recently acquired one of your small but worthy competitors and has removed the risk component of a buyer's decision. You may think that you have a limited window of opportunity for your Cloud-Based or Mobile Enabled technology solution and you should sell it while it still enjoys a competitive advantage.

These are all good reasons to set your business sale process in motion. A critical element here is time. Good technology not achieving meaningful market penetration is vulnerable to competition. Given this scenario, the more rapidly you can get your acquisition opportunity in front of the viable buyers, the better your chance for more favorable sale terms and conditions.

All systems go, right? But wait. We have a major proposal out to that international advertising agency and when we get that deal our sale price will sky rocket. So we are just going to wait for that deal to close and then put our company up for sale.

Let me give you a gem here. We will call it the Moving Sales Pipeline Theorem. It states that the sales pipeline always moves to the right. This is based on over 20 years in technology sales and sales management experience and many years of selling companies with sales pipelines. The sales either take much longer than projected or do not materialize at all.

Given this, the time critical nature of your pending emerging technology business sale, and your desire to ring the bell from your advertising agency deal, what do you do?
You engage a great M&A firm that specializes in Information Technology companies (I know of one if you are interested) to sell your business. Let them focus on selling your business and you focus on running your business and closing that big sale.

 Get several buyers interested and negotiate for your best deal. There will be a lot of give and take here. At the right moment, as a counter to one of the buyer's points, you ask for a 6-month window, post acquisition to close that deal. You then ask, for example, for an earn out incentive of 50% of the contracted first year revenues of the advertising agency deal as "additional transaction value" payable 30 days after the one year purchase anniversary date.

There are lots of moving parts here so let me elaborate. The first element is you do not delay your business sale process. We already established that it was time critical. Secondly, I very carefully chose the language "additional transaction value".  We want to make sure that this payment is not confused with ordinary income at double the long term capital gains tax rate. Third, you have a way better chance of closing the big advertising agency as a division of Google, SalesForce.com, or LinkedIn, for example, than as XYZ Mobile Media Software, Inc. Finally, what a great way to kick off a relationship than a big collaborative sales win that makes the buyer look really smart. Your earn out check will be the most enjoyable payment they can make.

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

Looking to Sell a Software Company - Consider an Merger and Acquisition Advisor

Perhaps the most important business transaction you will ever pursue is the sale of your business. Many information technology 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 high-tech business with less formality than in the sale of a home. The purpose of this article is to answer the questions – Why would I use an M&A Advisor and what am I getting for the fees I will pay?

Confidentiality.  If an owner tries to sell his own 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 M&A 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

Business Continuity.  Selling a business is a full time job. The healthcare business owner is already performing multiple functions instrumental to the success of his business. 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.

Time to Close. Since an M&A Advisor's function is to sell the business, 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.

Large Universe of Buyers. M&A Advisors subscribe to databases of the various information technology business categories 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  custom software company databases of  the various categories refined even further like CRM, ERP, document management, mobility management, security, vertical industry, SaaS, and many more, to hone in on only the best potential buyers for your business. A good M&A Advisor also has access to private equity groups databases that outline their buying criteria.

Marketing. An M&A Advisor can help present the business 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 in a particular software segment and can help the owner identify changes that translate into enhanced selling price.

Valuation Knowledge. The value of a software business is far more difficult to ascertain than the value of a house or even the value of a "bricks and mortar" type business. Every business is unique and has hundreds of variables that effect value.  M&A Advisors 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 information technology industry transaction database may indicate the value of your business based on certain valuation multiples, but the market provides the real answer. An industry database, for example, can not put a value to a particular buyer on a key customer relationship or a proprietary technology. Most business owners that act as their own M&A Advisor 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 Verison and Quest Communications.

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 an M&A Advisor the seller has an advocate with a similar experience base to help preserve the seller's transaction value and structure.

Maximize the Value of Seller's Outside Professionals. An M&A Advisor 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 M&A Advisor 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 M&A Advisor, 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.

Maintain Buyer – Seller Relationship. The sale of a business is an emotional process and can become contentious. The M&A Advisor 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. Many times the seller will become an integral part of the management team of the buyer's company after the sale. 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.

A model that is becoming quite popular in the software industry is for the big players to identify good technologies in smaller companies and to forge partnerships or strategic alliances with them. The larger company will have the smaller company spend a great deal of their resources and attention in educating the bigger player on their product and market. The smaller partner will often work very hard to integrate their offering into the broad product set of the bigger partner. Finally, the smaller company will put all their eggs into this one basket of opportunity. After the larger company has effectively removed most of the integration risk on the smaller company's nickel, they then make an unsolicited offer to buy. The smaller company is often less profitable during this "try it before you buy it period."  The bigger player then predicates their offer on the latest period financials.

A good M&A Advisor can help the smaller company navigate and recover from this situation.  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, an M&A Advisor helps reduce the risk of business erosion with improved confidentiality while allowing the owner to focus on running the business. The M&A Advisor led sale helps maximize sales proceeds by involving a large universe of buyers in a competitive bidding process. Finally, the M&A Advisor 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. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Selling a Security Software Company - Bridging the Valuation Gap between Business Seller and Business Buyer

In an earlier article we discussed a survey that we did with the Business Broker and the Merger and Acquisition profession.  68.9% of respondents felt that their top challenge was dealing with their seller client's valuation expectations. This is the number one reason that, as one national Investment Banking firm estimates only 10% of businesses that are for sale will actually close within 3 years of going to market. That is a 90% failure rate.

As we look to improve the performance of our practice, we looked for ways to judge the valuation expectations and reasonableness of our potential client. An M&A firm that fails to complete the sale of a client, even if they charged an up-front or monthly fees, suffers a financial loss along with their client. Those fees are not enough to cover the amount of work devoted to these projects. We determined that having clients with reasonable value expectations was a key success factor.

We explored a number of options including preparing a mock letter of intent to present to the client after analyzing his business. This mock LOI included not only transaction value, but also the amount of cash at closing, earn outs, seller notes and any other factors we felt would be components of a market buyer offer. If you can believe it, that mock LOI was generally not well received. For example, one client was a service business and had no recurring revenue contracts in place. In other words, their next year's revenues had to be sold and delivered next year. Their assets were their people and their people walked out the door every night.

Our mock LOI included a deal structure that proposed 70% of transaction value would be based on a percentage of the next four years of revenue performance as an earn out payment. Our client was adamant that this structure would be a non-starter. Fast forward 9 months and 30 buyers that had signed Confidentiality Agreements and reviewed the Memorandum withdrew from the buying process. It was only after that level of market feedback was he willing to consider the message of the market.

We decided to eliminate this approach because the effect was to put us sideways with our client early in the M&A process. The clients viewed our attempted dose of reality as not being on their side. No one likes to hear that you have an ugly baby. We found the reaction from our clients almost that pronounced.

We tried probing into our clients' rationale for their valuation expectations and we would hear such comments as, "This is how much we need in order to retire and maintain our lifestyle," or, "I heard that Acme Security Software sold for 1 X revenues," or, "We invested $3 million in developing this software, so we should get at least $4.5 million."

My unspoken reaction to these comments is that the market doesn't care what you need to retire. It doesn't care how much you invested in the product. The market does care about valuation multiples, but timing, company characteristics and circumstances are all unique and different. When our client brings us an example of IBM bought XYZ  Enterprise Security Software Company for 2 X revenues so we should get 2X revenues.  It is simply not appropriate to draw a conclusion about your value when compared to an IBM acquired company.  You have revenues of $6 million and they had $300 million in revenue, were in business for 28 years, had 2,000 installed customers, were cash flowing $85 million annually and are a recognized brand name. Larger information technology companies carry a valuation premium compared to small companies.

When I say my unspoken reaction, please refer to my success with the mock LOI discussed earlier. So now we are on to Plan C in how to deal with this valuation gap between our seller clients and the buyers that we present. Plan C turned out to be a bust also. Our clients did not respond very favorable when in response to their statement of value expectations we asked, "Are you kidding me?" or "What are you smoking?"

This issue becomes even more difficult when the business is heavily based on intellectual property such as a software or information technology firm or in a hot area like Security, Mobility Management, SaaS or Cloud Services.  There is much broader interpretation by the market than for more traditional bricks and mortar firms. With the asset based businesses we can present Industry Comps that provide us and our clients a range of possibilities. If a business is to sell outside of the usual parameters, there must be some compelling value creator like a coveted customer list, a new SaaS or Cloud Based offering, a new mobile application, proprietary intellectual property, unusual profitability, rapid growth, significant barriers to entry, or something that is not easily duplicated.
For an information technology, computer technology, security software or healthcare company, Comps are helpful and are appropriate for gift and estate valuations, key man insurance, and for a starting point for a company sale. However, because the market often values these kinds of companies very generously in a competitive bid process, we recommend -just that, when trying to determine value in a company sale.  The value is significantly impacted by the professional M&A process. In these companies where there can be broad interpretation of its value by the market it is essential to conduct the right process to unlock all of the value.

So you might be thinking, how do we handle value expectations in these technology based company situations? Now we are on to Plan D and I must admit it is a big improvement over Plan C (are you kidding)? The good news is that Plan D has the highest success rate. The bad news is that Plan D is the most difficult. We have determined that we as M&A professionals are not the right authority on our client's value, the market is.

After years of what are some of the most emotionally charged events in a business owner's life, we have determined that we must earn our credibility to fully gain his trust. If the client feels like his broker or investment banker is just trying to get him to accept the first deal so that the representative can earn his success fee, there will be no trust and probably no deal.

If the client sees his representatives bring multiple, qualified buyers to the table, present the opportunity intelligently and strategically, fight for value creation, and provide buyer feedback, that  process creates credibility and trust.  The client may not be totally satisfied with the value the market is communicating, but he should be totally satisfied that we have brought him the market. If we can get to that point, the likelihood of a completed transaction increases dramatically.

The client is now faced with a very difficult decision and a test of reasonableness.  Can he interpret  the market feedback, balance that against the potential disappointment  resulting from his preconceived value expectations and complete a transaction?

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

Sell a Cloud-Based Software Company - Ten Costly Mistakes That Reduce Your Transaction Proceeds

Selling your Cloud-Based Software Company is the most important transaction you will ever make. Mistakes in this process can greatly erode your transaction proceeds. Do not spend twenty years of your toil and skill building your business like a pro only to exit like an amateur.  Below are ten common mistakes to avoid:

Selling because of an unsolicited offer to buy – One of the most common reasons owners tell us they sold their business was they got an offer from another Software as a Service (SaaS) Company, or more often these days, an overseas company looking to buy a customer base in the United States.  If you previously were not considering this business sale, you probably have not taken some important personal and business steps to exit on your terms. The business may have some easily correctable issues that could detract from its value.  You may not have prepared for an identity and lifestyle to replace the void caused by the separation from your company.  If you are prepared, you are more likely to exit on your own terms.

Poor books and records – Business owners wear many hats. Sometimes they become so focused on the next SaaS, Cloud Based, or Mobile version release that they are lax in financial record keeping. A buyer is going to do a comprehensive look into your financial records. If they are done poorly, the buyer loses confidence in what he is buying and his perception of risk increases. If he finds some negative surprises late in the process, the purchase price adjustments can be harsh. The transaction value is often attacked well beyond the economic impact of the surprise. Get a good accountant to do your books.

Going it alone – The business owner may be the foremost expert in ERP, CRM, Security, or Mobility Management Software, but it is likely that his business sale will be a once in a lifetime occurrence. Mistakes at this juncture have a huge impact. It is especially critical to have a good M&A advisor if you are selling a Web- Based information technology company because these companies do not fit traditional company valuation metrics. If an owner does not get the right representation and have several qualified buyers that covet his technology, he possibly can leave a lot of money on the table. Selling a software company is complex. Is it a better deal to structure some of the transaction value as an earn out based on post acquisition sales performance? Do you understand the difference in after tax proceeds between an asset sale and a stock sale? Your everyday bookkeeper may not, but a tax accountant surely does. Is your business attorney familiar with business sales legal work?  Would he advise you properly on Reps and Warranties that will be in the purchase agreement?  Your buyer's team will have this experience. Your team should match that experience of it will cost you way more than their fees.

Skeletons in the closet - If your company has any, the due diligence process will surely reveal them. One of the key issues in software companies is the clear title to intellectual property. Are your employee agreements well written? If you hired outside programmers, was their agreement specific in ownership of their output? The concern of the buyer is that once it becomes public that the deep pockets company is owner, previous disgruntled employees or contractors may resurface looking to bring legal action. Before your firm is turned inside out and the buyer spends thousands in this process and before the other interested buyers are put on hold – reveal that problem up-front.  We sold a company that had an outstanding CFO. In the first meeting with us, he told us of his company's under funded pension liability. We were able to bring the appropriate legal and actuarial resources to the table and give the buyer and his advisors plenty of notice to get their arms around the issue. If this had come up late in the process, the buyer might have blown up the deal or attacked transaction value for an amount far in excess of the potential liability.

Letting the word out - Confidentiality in the business sale process is crucial. If your larger legacy software competitors or hard-charging new competitors find out, they can cause a lot of damage to your customers and prospects. It can be a big drain on employee morale and productivity. What if your head of systems development gets skittish and entertains offers from other companies and leaves while you are selling? The buyer wants your top people and they represent a significant portion of your future transaction value. If word you are for sale gets out, your suppliers and bankers get nervous. Nothing good happens when the work gets out that your company is for sale.

Poor Contracts – Here we mean the day-to-day contracts that are in place with employees, customers, contractors, and suppliers.  Do your employees have non-competes, for example?  If your company has intellectual property, do you have very clear ownership rights defined in your employee and contractor agreements. If not, you could be looking at meaningful escrow holdbacks post closing. Are your customer agreements assignable without consent?  If they are not, customers could cancel post transaction. Your buyer will make you pay for this one way or another. If you are tempted to sign that big deal at bargain rates to pump up your business selling price, think again. Locking in a contract at below market rates could actually cause a discount to your selling price.

Bad employee behavior – You need to make sure you have agreements in place so that employees cannot hold you hostage on a pending transaction.  Key employees are key to transaction value. If you suspect there are issues, you may want to implement stay on bonuses. If you have a bad actor, firing him or her during a transaction could cause issues. You may want to be pre-emptive with your buyer and minimize any damage your employee might cause.

No understanding of your company's value – Business valuations are complex especially in a hot area like Web-Based software, Business Intelligence software, Cloud Based analytics solutions or Mobility Management. A good business broker or M & A advisor that has experience in the software industry is your best bet. Business valuation firms are great for business valuations for gift and estate tax situations, divorce, etc.  They tend to be very conservative and their results could vary significantly from your results from three strategic buyers in a battle to acquire your firm. Where a services business may sell for between 75% and 100% of last years sales, for example, SaaS  companies are all over the map. One of our clients had a coveted piece of software technology and was able to get 8 X last year's sales as his purchase price. We certainly could not have and would not have predicted that at the start of the engagement, but what a nice surprise.  When it comes to selling your information technology company, let the competitive market provide a value.

Getting into an auction of one – This is a silly visual, but imagine a big auction hall at Sotheby's occupied by an auctioneer and one guy with an auction paddle. "Do I hear $5 million?  Anybody $5.5 million?' The guy is sitting on his paddle. Pretty silly, right?  And yet we hear countless stories about a competitor coming in with an unsolicited offer and after a little light negotiating the owner sells.  Another common story is the owner tells his banker, lawyer, or accountant that he is considering selling. His well-meaning professional says,  "I have another client that is an information technology company. I will introduce you."  The next thing you know the business is sold. Believe me, these folks are buying your business at a big discount. That's not silly at all!

Giving away value in negotiations and due diligence – When selling your business, your objective is to get the best terms and conditions. I know this is a shocker, but the buyer is trying to pay as little as possible and he is trying to get contractual terms favorable to him. These goals are not compatible with yours. The buyer is going to fight hard on issues like total price, cash at close, earn outs, seller notes, reps and warranties, escrow and holdbacks, post closing adjustments, etc. If you get into a meet in the middle compromise negotiation, before you know it, your Big Mac is a Junior Cheeseburger.  Due diligence has a dual purpose. The first is obviously to insure that the buyer knows exactly what he is paying for. The second is to attack transaction value with adjustments. Of course this happens after their LOI has sent the other bidders away for 30 to 60 days of exclusivity. If you don't have a good team of advisors, this can get expensive.

Not understanding post-closing adjustments in working capital. This point is especially critical for smaller software companies that are being acquired by larger public companies. Savvy buyers (most of them are because they have done multiple prior software company acquisitions) will include language in the LOI (letter of intent) that sets a net working capital level at closing. Any overage will be paid to the seller as additional transaction proceeds. Any shortage will be deducted from the purchase price. The LOI also stipulates that this calculation will be made using GAAP or generally accepted accounting principles. GAAP is an accrual based accounting system while most smaller companies operate under a cash accounting system. So for example, if you collect your annual software maintenance or license fees up-front on the anniversary date, you likely have recognized the entire amount as revenue. Under accrual accounting you actually get to recognize 1/12 of the amount each month and you have a liability of undelivered services. This can destroy the net working capital level and cause a huge net working capital adjustment at closing. We advise our clients to require very precise language in the letter of intent about the level of net working calculation and the method of calculation, including examples and formulas.

As my dad used to say, there is no replacement for experience. Another saying is that when a man with money and no experience meets a man with experience, the man with the experience walks away with the money and the man with the money walks away with some experience. Keep this in mind when contemplating the sale of your software as a service company. It will likely be your first and only experience. Avoid these mistakes and make that experience a profitable one.

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