Wednesday, October 24, 2018

The Art of Getting Strategic Value for Software Companies

Takeaway: If you want to get top dollar for your software company, you need to think strategically and entice the right buyer with the right information. Below is our latest published article on Divestopedia.

One of the most challenging aspects of selling a software or information technology company is coming up with a business valuation. Sometimes the selling prices of these technology companies are far higher in terms of valuation metrics (i.e., EBITDA multiple or price to sales) than those for a manufacturing company, for example. This article discusses how information technology business sellers can properly position their company to the right buyers in order to achieve a strategic transaction value.

Why are some of these software company valuations so high?

It is because of the profitability leverage a technology company can generate. Here's a simple example to illustrate. What is Microsoft's incremental cost to produce the next copy of Office Professional? It is probably $1.20 for three CDs and 80 cents for packaging. Let's say the license cost is $400. The gross margin is north of 99%. The same goes for Google with their Ad Words platform that is "self service" for the businesses buying the paid search placement. The majority of content on Facebook is provided by users, making that business model very profitable. That does not happen in manufacturing or services or retail or most other industries.

Fill the Valuation Gap

One problem in selling a small technology company is that they are a relatively unproven commodity compared to their large, brand name competitors. 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. The potential is there, but the battle is about what percentage of future results gets allocated to the seller and what percentage gets allocated to the buyer.

The business seller wants to artfully help the buyer justify paying a much higher price than a pre-acquisition financial valuation of the target company. In other words, the seller wants to get strategic value from the buyer. An important thing to keep in mind is that the effectiveness of this strategy goes up exponentially based on the number of qualified buyers that are vying for the acquisition when it is time to submit letters of intent. The reason for this is that some of the acquisition benefits we present will resonate with some and not with others. The more buyers involved, the greater the chances of one or more of the benefits creating a favorable impression of post-acquisition business value creation.

Tips on Positioning Your Software Business for Maximum Price:

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. 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.

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. Think of the difference today between first-mover Gatorade and the distant number two, Powerade.

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 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 GAAP accounting, but it was effective as a tool to drive transaction value.

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. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.

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. Value that can be created for the buyer is important when the selling company has developed a superior sales system or highly effective business model that could be implemented in the buying company.

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 five 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.

You think this is a little far-fetched. However, these components do have real value — that value is just 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. They'll 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 will resonate with their competition. You need to provide the buyers some reasonable explanation for their board of directors to justify paying far more than a financial multiple for our client's company.

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology, software, and other technology based companies. Dave is also the editor of the Exit Strategist Newsletter and author of the Book Selling your Software Company - An Insider's Guide to Achieving Strategic Value

Wednesday, October 17, 2018

Letting the Market Bridge the Valuation Gap in Your Business Sale

Below is our latest Article Dave Kauppi Article on Divestopedia

Takeaway: Using fair market value to help business owners bridge the gap between the valuation they feel they deserve and that which they're likely to receive increases the likelihood of a transaction.

Statistics show that a surprisingly low percentage of businesses for sale actually sell on the first attempt. The major reason for the lack of sales is the valuation gapbetween the buyers and the seller. This article discusses how that gap can be breached, resulting in completed business sale transactions.
In a survey that we conducted with business brokers and merger and acquisition professionals, 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 three years of going to market. That is a 90% failure rate!

Setting Value Expectations for Business Owners

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 fee, 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.

To give our clients an idea of the kind of offers they would receive for their business as-is, we prepared a mock letter of intent for them after analyzing their business. This mock LOI included not only transaction value, but also the amount of cash at closingearnoutsseller notes and other factors we felt would be components of a real market offer.

If you can believe it, that mock LOI was generally not well received! Clients couldn't believe the value they gave their company wasn't reflected in our analysis. 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 earnout payment. Our client was adamant that this structure would be a non-starter. Fast forward nine months and 30 buyers that had signed confidentiality agreementsand reviewed the confidential information memorandum withdrew from the buying process. It was only after that level of market feedback was the client was willing to consider the message of the market.
We decided to eliminate this approach because it 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 Consulting sold for 1x revenues" or "We invested $3 million in developing this product, so we should get at least $4.5 million."
Unfortunately, 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. We often hear examples like "IBM bought XYZ Software Company for 2X revenues so we should get 2X revenues." However, 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; 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 companies carry a valuation premium compared to smaller companies.

The Price and Terms of a Sale Are Based On Several Key Business Characteristics

1. Contractually Recurring Revenue — by far the most powerful factor for driving favorable price and terms. You just need to look at Microsoft's stock price since the new CEO changed their business model from a one-time software license sale to a subscription model. Revenues went down short-term, but over the longer term, revenues have accelerated and the stock price has responded beautifully.
This characteristic is why all of the major software firms are converting to the SaaS (Software as a Service) Model.
For a business buyer, this significantly de-risks the transaction. The longer the contracts, the better. It is predictable revenue and the risk of large customer defections post-acquisition is greatly reduced. This is much more highly valued than a business that is driven by having to sell new business as the bulk of their revenue. So, the greater the percentage of revenue that is contractually recurring revenue, the higher the selling price for your business. The greater the contractually recurring revenue, the greater percentage of transaction value that will be payable in cash at closing. The lower the contractually recurring revenue, the greater the transaction value that will be shifted to a seller earnout, seller financing or both.

Also, the greater the percentage of contractually recurring revenue, generally the term of owner involvement in the business will be reduced. So if you have very little recurring revenue and you want to exit shortly after sale, good luck. The new owners will want you around to help transition the business and the customers.
2. Durable Competitive Advantage — There is a reason Warren Buffett is such a successful investor. He looks for businesses that have a competitive moat around them and that are not commodities. They have pricing power. This is a powerful driver of selling price and a meaningful factor in risk reduction.
3. Growth Rate — This is an area where the current EBITDA valuation model falls short. A firm growing revenue at 30% per year should be valued far higher than another firm with the same EBITDA growing at only 10% per year. Wall Street has accounted for this with their price/earnings/growth multiple. Growth rate is valued by business buyers, but they will try to use the EBITDA model to justify their price if you let them.
4. Customer Concentration — This is a value killer and a terms killer. If you have 40% of your business with one client and that client goes away, you do not have a business. That is exactly how a buyer looks at it and it normally scares them away. But if there is a transaction, it will be characterized with a very large percentage of the deal as an earnout and a much smaller percentage in cash at closing. The buyer will want the owner be involved for a long period of time to ensure these necessary customers stay.

The Valuation Challenge of Intellectual Property and Software Businesses

This issue becomes even more difficult when the business is heavily based on intellectual property, such as a software or information technology firm. These companies face a much broader interpretation by the market than more traditional brick-and-mortar firms. With asset-based businesses we can present comparables 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, proprietary intellectual property, unusual profitability, rapid growth, significant barriers to entry or something that is not easily duplicated.

For an information technology, computer technology or healthcare company, comparables 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 value by the market, it is essential to conduct the right process to unlock all of the value.

Letting the Market Decide Value

How do we handle value expectations in these technology based company situations? M&A professionals are not the right authority on our client’s value, the market is. 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 or she can see the reality of the situation. The likelihood of a completed transaction increases dramatically after this.
The client is now faced with a very difficult decision and a test of reasonableness. Can he or she interpret the market feedback, balance that against the potential disappointment resulting from his or her preconceived value expectations and complete a transaction?
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology, software, and other technology based companies. Dave is also the editor of the Exit Strategist Newsletter and author of the Book Selling your Software Company - An Insider's Guide to Achieving Strategic Value