Technology Business Sales - Animal Spirits Create Strategic Value

There is no more effective approach to driving up your tech company selling price than to get buying companies in a competitive bidding process. In this short video we discuss how we were able to do this for one of our information technology clients to drive her strategic value in her company sale.


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 learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital

Clients Represented Software and information Technology

We got our start after working for a very fine "Generic" Merger and Acquisition Advisory firm. I do not mean this to be a dig, but just a way to describe that our former firm was industry agnostic in engaging with all types of companies. Generally they did an excellent job relying on a proven M&A process. One area that they struggled with, however, was in representing software and information technology companies. In analyzing the competitive landscape, we found this to be the case with the vast majority of lower market M&A firms and business brokers. They did not speak the language and felt uncomfortable in pursuing transaction values that were not based on rules of thumb or a multiple of EBITDA. They struggled with unlocking strategic value for their clients.

MidMarket Capital was originally founded based on our deep roots in technology in our prior business experience. Our ideal client is one that has a significant part of their company value contained in their technology and intellectual property. We have chosen to focus on representing businesses in this space and our value proposition is to drive strategic transaction value for our clients.

For buyers of technology companies, it is important that the seller's representatives "speak the language" and if you are a technology, software, information technology, or healthcare information technology company, odds are that we have represented a similar company to yours during the past fifteen years. Please see below for a list describing companies we have represented:

MidMarket Capital Clients

An IBM Cognos Partner - Performance Management, Professional Services, and Software Development Firm

A Distribution ERP Systems Software Company

Web Enabled Supply Chain Management System

eCommerce Company

Document Imaging & Management Software Company

Textbook Content Service Provider

Managed Information Security Services Company

Information Technology Consulting Company

IT Services Provider SMB

Affiliate Marketing Management Firm

Digital Communications Company

Pension Administration Software Company

CRM and Integrated Product Performance Management Software Company

Live Virtual Computer Training Company

Telecom Alliance Channel Partner

Rich Media & Interactive Marketing Software and Services Company

Wireless Electronic Monitoring Company Hardware, Software, Firmware, Software as a Service

Third-party Provider of Software for Bentley’s MicroStation

Mobile, On-Demand Data Collection, Management & Reporting

IT and telephony system design and support SMB

Publishing Management Software and Services

Network Integrity and Switch Provisioning Software Company

Advanced Networking Technology Development Contractor

ECommerce software-as-a-service (SaaS) Company

PRINT MANAGEMENT AND DISTRIBUTION COMPANY

Smart Grid Software and Engineering Company

Web Content Distribution and Compliance Management Software Company

Recreational Team Management and Group Management Portal

.Net - SaaS Based Sales Collateral Management Software and IT Services Company

Pool and Spa Service Management and Store Software Systems

Systems integrator and reseller of IT products to Federal Government clients

Mobile Field Merchandising & Data Collection Software

The BI Life Cycle Management Company - IBM/Cognos Enhancement Software Solutions

Security Solutions Value Added Distributor

A Pathology Laboratory Information Systems Company

A Cost Analysis and Control Software Company for Healthcare Facilities

An Evidence Based Patient Acuity Measurement and Nurse Staffing Systems and Services Company

A Web-Based Staffing, Scheduling and Nurse Shift Bidding Software Company

HOSPITAL INTEGRATION SOFTWARE COMPANY

Ophthalmology Information System (OIS) Company

Healthcare Revenue Cycle Management Company

Cloud-Based Vendor Neutral Archiving & PACS Software Company

Hospital Services & Software Company

Electronic Health Record and Personal Identification Wristband Company

Big Data Analysis Engine for Repositioning Drug Discovery

Smart Pharma Cap for Medication Adherence and Compliance Recording
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

Selling Your Information Technology Company - A Do It Yourself Job - NOT

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 article is to highlight the intelligence versus experience issue and give examples where experience trumps intelligence. 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 a Twitter 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