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
