A Business Valuation May Not Accurately Reflect a Software Company's Value

I can't tell you  the number of times I have talked with owners of software companies that are very disappointed with a valuation performed by a qualified valuation professional. The purpose of this article is not to disparage this fine profession, but to point out the limitations of a process based on quantifiable metrics. Those metrics, industry comparables or Comps, and discounted cash flow are excellent valuation approaches for most traditional businesses. In addition to these metrics, many industries  have established rules of thumb for valuations like 4 X EBITDA or 70% of the trailing twelve months' revenue. 

If these metrics accurately function universally over a broad range of businesses, why don't they work for software companies? The most compelling difference is the exponential nature of the leverage of technology.  In its most basic form, if you are making Widgets, to make your next Widget, you need the same amount of material, labor and capital. Yes, you can achieve some economies of scale, but those improvements are linear. This limitation naturally results in a narrow range of potential business valuation multiples.

Let's compare this with the exponential scalability of software assets. Once the software is written and stress tested by a core group of users, the cost for the next unit sold is almost $0 for a digitally duplicated copy that is downloaded. To go from 100 users to 1 million users will require more staff, but it is not even close to the additional resources required for the same scaling in the manufacturing, distribution, services or retailing environment. 

Software company owners that are approached by strategic buyers generally do not do a very good job of positioning their company to drive this strategic value. They will usually start with the argument that  IBM or Microsoft or Google bought XYZ Competitor with $300 million in revenues for $1.2 billion. My company that is in the same space with sales of $3 million should sell for $12 million. The valuation of a large, brand name competitor  is not translatable into a valuation for a small unknown company that provides a similar software. The buyers all know this and can immediately dismiss this potential seller as unrealistic.  

Another limiting factor in the valuation puzzle is that finding relevant comps is very difficult with unique, small private companies. Privately held business owners do not want the public to know what they sold their company for and do not authorize the publication of that information. Unless the transaction is an acquisition by a public company and the deal value is large enough to be material and is required to be reported, no information about the transaction will be publicly available. So you can get the information on the $1.2 billion transaction but generally will not get the metrics on a $10 million deal. We are now back to the problem of the large company metrics that are not applicable to the very small company valuation.

In the discounted cash flow model, the analyst must project the cash flows out for five years and longer. To see the classic hockey stick growth actually captured in a financial model is an outlier for a typical valuation model. When a buyer analyzes this model they are generally resistant to accepting the high double digit or triple digit growth rates required to get the valuation that the owner deems appropriate.

Software company owners often put me on the spot and ask me for my opinion of value. I almost feel like the two realtors competing for a listing where the ethical guy says your house is worth $925 K and the other guy says he can get $1 million. The seller picks the $1 million realtor and then the overpriced house sits on the market for eight months before being sold for $880 K. The ethical guy could have sold it in three months for $925 K.

A software business is way more complex. Even though I am flattered that the business owner is inviting my opinion, my answer is not supportable from a classic valuation metrics standpoint. I will rely on my experience with selling similar types of companies, the level of acquisition activity happening in the space, the value of the contractually recurring revenue, the availability of similar companies that could be substituted, the uniqueness of the solution, the sales resource required to scale, the time and cost to develop the solution internally, etc. We create a teaser and a memorandum where we package and highlight the strategic value drivers to the potential buyers.

When you see these high profile technology acquisitions and see that a relative start up with no profits and limited sales was acquired for $250 million by Tech Giant A, do you think they just picked that number out and said to the seller, here you go? It looks easy and glamorous, but if the acquirer could have paid $5 million, they sure would have.  What was going on behind the scenes was the equivalent of a championship boxing match of M&A. Two or more qualified firms each saw tremendous value, growth, strategic fit and potential in this prize and did whatever they could to buy it as cheaply as the market would allow.

Here are a few examples of buyer negotiation approaches to help illustrate their every attempt to make an acquisition at the lowest price possible. Well, last year your sales were unusually high. I am just going to use the average of the last three years as my number. They recognize all of their software revenue when they make the sale. I am going to adjust my bid downward by the unearned income amount. I disagree with the amount you used for the owner's replacement salary in your EBITDA analysis. I am going to put in a fair market value number to come up with this reduced EBITDA number.

If the owner is trying to sell the business himself, he can usually only process one buyer at a time and thus these buyer negotiation tactics can be very effective. Likewise, if we only have one qualified buyer, it is very difficult to negotiate off these buyer positions.

However, in a professional M&A process, we design it to process several buyer pursuits in parallel. So when a buyer tells me they are going to just normalize the last 3 years' performance to lower their bid, I do not argue with them. My response is, you are certainly entitled to whatever methodology you want to employ to come up with your offer. Unfortunately your offer is no longer competitive with the marketplace. I will present this offer to my client, but I am pretty sure he will not counter sign your Letter of Intent. So in the example above, there were several very knowledgeable and talented representatives trying to buy as cheaply as possible and the market drove the valuation to a level that no valuation model in the world could have predicted.

A competitive M&A process will provide the ultimate company valuation. The decision now becomes, is it enough for me to sell?

 


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

Acquisition Opportunity - Established On-demand Training Platform Provider

We represent this client. If you would like to review the Profile/Confidentiality Agreement please Click the link:  https://dl.dropboxusercontent.com/u/12507505/%23151109%20Profile%20and%20CA%20Combined.pdf

• 66 client companies, Several Fortune 500,  90% retention rate of accounts.
 

• This battle tested platform - original product released in 1998 the software is now on Version 6.4, incorporating countless client requested upgrades and a vision toward future needs. not only delivers the latest technology, but could also be considered an accurate proxy for best practices in e-Learning.

• 2015 Proj Revenue: $572 K 2015 Proj EBITDA: $215 K

The Company has continuously upgraded the toolset to create the most flexible comprehensive and cost effective e-Learning platform available today.  The Company’s Total E-Learning Solution  includes features like a web-based configuration wizard, quick course-building and authoring, learner self-enrollment, batch  registration, reporting and analysis, test results graphing, streaming video support, automated  testing, virtual student  menus, virtual grade book, and  much  more. We take traditional E-Learning to the  next  level, with a simplicity and  powerful feature set that can  be found nowhere else. For planning, customizing,  delivering, and managing online learning, nothing else even comes close.

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

Experience Trumps Smarts in the Sale of Your Information Technology Company

People who start software and information technology companies are generally very smart people. When it comes to representing yourself in the sale of your business, the key issue is not smarts, but experience. The purpose of this post is to highlight the intelligence versus experience issue and give examples where experience trumps intelligence.

The greater the complexity of the task, the more the advantage goes to the one who has prior experience with that task. Ask anyone who has sold their business and they will tell you it is a surprisingly complex undertaking.

Some very well-known examples were the experiences of the great author, George Plimpton as he stepped into the boxing ring against Joe Louis, put on the goalie pads for the Boston Bruins or barked out signals as the quarterback for the Detroit Lions in a pre-season football game.

These experiences resulted in some great reading. The competitive outcome for the inexperienced combatant, however, was not a happy ending. Curious George was totally outmatched. Admittedly, I had earlier written self-serving articles and Blog posts on the benefits of business seller representation by a Merger and Acquisition Advisor or Business Broker. There are hundreds of similar articles out there from our competitors. The message is pretty much the same:

1. They know the market and the valuations.

2. They have an active database of identified buyers.

3. By representing yourself, you alert the market, your customers, your competitors, and your employees that you are for sale.

4. Running a business is a full-time job. Selling a business is also a full-time job.

5. A business owner normally conducts a serial process (one buyer at a time) which dramatically reduces his market feedback and negotiating position.

6. It is complex, you may only sell one business in your lifetime and the buyers are much more experienced than the sellers.

I really want to dissect point number 6 because I don't believe most business owners fully embrace either the complexity or the consequences of the disparity in experience. First of all, as a generalization, successful business owners are really smart people and have solved myriad complex problems over the years to make their businesses prosper. To many of them, selling their business is just another of those complex problems that they have routinely solved to their advantage. Well, I am a pretty smart guy (my kids might differ), but if my doctor presented me with my lab test results from my physical and asked me to prescribe my treatment, I would refer him to a mental health professional. The point here is not my intelligence, but my level of experience.

Joe Louis spent 10,000 hours perfecting his craft under extreme conditions of competition and pressure. George Plimpton worked in a gym for a couple of weeks with a boxing trainer. If you asked Joe Louis to write a Pulitzer Prize winning novel, you might have to duck a right cross. Both Joe Louis and George Plimpton were geniuses at their craft. They were inexperienced in other areas and were at a distinct disadvantage when trying to compete in another field against the experts in that field. 
As I retrieve my third golf ball from the water hazard, I rationalize to myself, "Well at least Tiger Woods can't run an HP 12C present value calculator like I can. Knowing Tiger Woods, he actually probably can.

Let me try another example of the value of experience to illustrate my point. Have you ever tried mounting a new door? The first time I did it, it took me several hours - getting the special hole drill for the knob and internal mechanism, measuring for hinges, chiseling the slots for the hinges, propping the door and securing it for mounting, etc. Each one of these steps was something new to me and I wasn't very good at any of them. By my third door mounting, I was starting to become pretty competent. For a business owner, your business sale is your first door. By the way, that is one very important door.

Now let's look at the buyers. The first category is the Private Equity Investor. They buy businesses for a living. Ask an average PEG (Private Equity Group) how many deals they look at for every one they actually acquire. They will tell you it is well over 200 different companies. Most of these 200 are dismissed at the start of the process with the teaser or blind profile. They can judge whether the target meets their broad criteria of revenue, EBITDA, profit margins, industry segment, and others.

Many businesses pass their initial screen and they enter the excruciating process of conference calls, detailed data requests on customers, vendors, gross profit by product/customer/vendor, sales by product/customer, top ten customers, top 10 suppliers, percentage of business in the top ten, and on-and on. Many more companies are eliminated in this process. We then proceed to the indication of interest letter (broad statement of the economics of their proposed deal) followed by corporate visits. Once through that process, the surviving targets get additional data requests and follow-up questions.

This is not always a one-way elimination. Sometimes the PEG IOI letter is not high enough to make the seller's cut and they will be eliminated from the process.

The home stretch is submitting a Letter of Intent with a much tighter presentation of the final deal value and structure. This is a competitive process and the seller winnows the suitors down to 1 finalist through back and forth negotiations. Once the highest and best LOI is countersigned by the seller, there is an exclusive period for due diligence. Often the deal blows up in due diligence when a material issue is uncovered and the buyer attempts to alter their original offer in response to this new data. Often times the seller will simply blow up the deal. So the process starts all over.

The point here is that these Private Equity Groups have vast experience, not only in closing deals, but vast experience with every stage of the deal process. So for every deal completed they originally look at 200 teasers that result in the execution of 50 confidentiality agreements and the review of 50 memoranda. 20 of those deals warrant a conference call with the owners and follow up questions. 8 companies survive that process and result in 8 indications of interest letters and 5 corporate visits. 3 companies survive to due diligence and 1 makes it to the finish line. This is a continual moving pipeline of deep deal experience.

As a business owner, by the time you connect with a PEG, they have pretty much seen every twist and turn a deal can take. Their approach resembles an apartment owner's rental agreement - tremendously one-sided in their favor. For a PEG, a deal that blows up in the eleventh hour becomes an expensive lesson learned and war story. For a business owner, it can dramatically negatively impact their future business performance.

Wait, you say. I am a software company with the next big thing. My buyer is not a private equity group, but one of the strategic buyers - IBM, Google, Facebook, Adobe, and Microsoft (pick your giant). Let me give you a humbling dose of reality. We have represented some world class technology companies and just getting one of these blue chippers to take a look at them is a monumental task. The primary objective of the M&A department of the giants is to protect the mother ship. They want to prevent entrepreneurs from getting into any potential legal claim on the Blue Chip's intellectual property.

Therefore they institute a screening process designed to surround the company with a corporate moat around the castle. That moat has different names at each company. At one it is called the "Opportunity Management System". At another it is the "Partnership Management Department".

Here is how it works. The individuals in this department are very hard to find and very seldom answer their phone. You are directed to a Website and are required to fill out an exhaustive 16 page submission form. You are then issued a submission number. You then go into the black hole and may be reviewed by a junior level screener that does not have the breadth of experience to judge an Uber versus a Pets.com.

It gets worse. Every day 100 more "Opportunities" get submitted and piled on top of your number. The only way to get attention is from the Division Manager who owns the functional area where your product fits. Convince him to go rescue your number and to get your form to a senior opportunity manager to process and vet the idea. 
Just like with the PEGs, this is a relentless process of deal flow for these company buyers. Sellers in this environment are on their heels right from the start and struggle to garner any negotiating leverage. If your technology is strong enough to be rescued for a more comprehensive look, the guys on the other side of the table are the heavyweight champions of M&A deals. They have seen it all.

Not to minimize the first 5 benefits identified earlier in this article, but balancing the experience of the buyer's team with the experience of the seller's team is critical to enhance, protect and preserve the value of your transaction.

In its purest form, a letter of intent is a document designed to define the economic parameters of a transaction that, pending completion of due diligence, will be memorialized in a definitive purchase agreement and a deal closing. In its practical use, a letter of intent is like an apartment renter's agreement with every subtle advantage benefitting the author of the document. An inexperienced seller will agree to a seemingly innocuous clause about working capital adjusted at closing according to GAAP accounting rules. If you are the seller of a software company with annual software licenses or prepaid maintenance contracts, that could be a $ million mistake. It is a rare attorney that would ever catch that. Well, not actually. They are all representing the experienced buyers.

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

ACHIEVING STRATEGIC VALUE IN A SOFTWARE COMPANY SALE

One of the most challenging aspects of selling an information technology 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 .Net. 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 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 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. This discipline allows us to help bring buyer and seller together in productive dialogue to bridge the valuation gap and create a winning 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