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.

Conclusion

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