How to Drive Value in Your Healthcare Information Technology Company Sale

One of the most demanding aspects of selling a Healthcare Software Company  is coming up with a business valuation. Sometimes the valuations provided by the marketplace defy the valuation judgment that commonly dictates a selling price for a bricks and mortar company, for example. This article covers how an investment banker can correctly position your Healthcare Information Technology Company  to the right buyer in order to accomplish a attractive transaction price.

One of the most demanding factors of selling a Healthcare Software Company  is coming up with a business valuation. Sometimes the valuations provided by the market (translation - a concluded transaction) defy all logic. In other business segments there are some pretty helpful rules of thumb for valuation metrics. In one line of business it may be 1 X Revenue, in another it could be 5 X EBITDA or cash flow.

Since it is essential to our business to aid our Healthcare Information Technology Company clients raise their business selling value, I have given this considerable thought. Why are some of these Healthcare Software Company valuations so elevated?

It is because of the profitability leverage a Healthcare Software Company  can generate. A clear-cut case in point is; what is Microsoft's incremental expense to supply the next copy of Office Professional? It is most likely $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 materialize in manufacturing or services or retail or most other industries.

One drawback in selling a small Healthcare Information Technology Company  is that they do not have any of the brand recognition, distribution, or standards leverage that the big companies own. So, on their own, they cannot produce this profitability leverage. The buying company, however, does not aim 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 rationalize 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 positioning our Healthcare Information Technology Company  for maximum selling price:

Cost for the buyer to develop the product 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 comprehensive 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 build it internally so that he starts his own build versus buy analysis.

Most acquirers could write the code themselves, but we put forward 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 getting your product today. We were able to convince one buyer that they would be able to defend our seller's entire purchase price predicated on the amount of client defections their acquisition would avert.

Another arrow in our valuation driving quiver for our sellers is we restate historical financials using the pricing premium of the brand name acquirer. We had one client that was a small IT company that had developed a superior piece of software that compared favorably with a sizable, publicly traded company's solution. Our product had the same functionality, ease of use, and open systems platform, but there was one very significant difference. The buyer's perception of risk was far greater with the little IT company that could be "out of business tomorrow."

We were literally able to increase twofold the financial performance of our client on paper and put forward a compelling line of reasoning to the big company buyer that those results would be immediately obtainable to him post acquisition. It certainly was not GAP Accounting, but it was helpful as a tool to direct transaction value.

Financials are of great consequence 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 factors) 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 complete product suite being offered post acquisition into an "installed account." It is a lot easier to market add-on applications and products into an loyal account than it is to close that new account. These strategic accounts can possess huge importance to a purchaser.

Lastly, we use a customer acquisition cost model to propel value in the eyes of a prospective buyer. Let's say that your sales professional 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 calculation would be $2,550,000.

After reading this you may be saying to yourself, come on, this is a little far-fetched. These factors do have real value, but that value is open to a varied interpretation by the marketplace. We are trying to assign metrics to a very subjective set of components. The buyers are intelligent, and practiced in the Merger and Acquisition process and quite frankly, they try to repel these inventive approaches to driving up their economic outlay. The greatest leverage point we have is that those buyers recognize that we are presenting the same analysis to their competitors and they don't know which component or components of value that we have presented will resonate with their competition. In the final analysis, we are just trying 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

 


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

Before You Sell Your Software Company- Focus on Recurring Revenue

This article discusses some actions the owners should take in anticipation of selling a software business or an IT Services business. Many of these actions would be implemented by the acquirer post acquisition. If, you implement them prior to the sale, the buyers will reflect that in an enhanced purchase price. If the buyer implements them post acquisition, they certainly will not pay you for the improvements.

Review all long-term maintenance contracts and implement price increases that are covered by your annual increase limits. Send your sales team out to all accounts that are not on your latest version. Bring those accounts current with the appropriate license and maintenance level increase.

Identify all accounts that use your software, but are not currently covered by an annual maintenance contract, but by a T&M contract. Offer them a one-time fee to get the latest software version if they agree to execute an annual maintenance agreement.

Do you have any Add-on modules that your customers base has been slow to adopt? Offer a 2 year price freeze on their currently installed software if they buy the add-on module and sign a maintenance agreement. The principal theme of these actions is to increase your company's level of contractually recurring revenue. That is your most important financial driver of the value of your software company.

Tie these actions directly to your sales team's commission plan. The commission plan should tell your sales reps exactly what you value. A higher commission rate should be applied to recurring revenue contracts. If you have poor performers, immediately put them on notice. You may tie their future employment to meeting some short term goals in these strategic areas. If they continue to under perform, let them go. A buyer that is looking at your business will rightfully question your management capability when they find in due diligence that you have allowed a poor performer to drain profits from your company.

If you are concerned that firing the sales rep would be disruptive to your customer base, offer to allow him to stay on a commission only plan. Remove his fixed salary portion and replace that with a higher commission rate that would equal his previous expected compensation level at 100% of quota. Let's think of it this way. If a salesman's lack of performance is costing you $50,000 in EBITDA and your company will sell at a 7 X multiple, this laggard will cost you $350,000 in transaction value.

Your key short-term strategy in maximizing your company's value in the marketplace is to increase the level of contractually recurring revenue. As an acquiring company looks at you as a potential acquisition target they place a value of, for example, 1 X on projected new sales supported by historical performance. They will place a value of 2 X on the revenue that is covered by contracts they acquire with the purchase of your information technology company.

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 - Using  an Earn Out to Maximize Value
 
Sellers have historically viewed earn outs with suspicion as a way for buyers to get control of their companies cheaply. Earn outs are a variable pricing mechanism designed to tie final sale price to future performance of the acquired entity and are tied to measurable economic milestones such as revenues, gross profit, net income and EBITDA. An intelligently structured earn out not only can facilitate the closing of a deal, but can be a win for both buyer and seller. Below are ten reasons earn outs should be considered as part of your strategy to maximize your selling price and transaction value.

Sellers have historically viewed earn outs with suspicion as a way for buyers to get control of their companies cheaply. Earn outs are a variable pricing mechanism designed to tie final sale price to future performance of the acquired entity and are tied to measurable economic milestones such as revenues, gross profit, net income and EBITDA. An intelligently structured earn out not only can facilitate the closing of a deal, but can be a win for both buyer and seller. Below are ten reasons earn outs should be considered as part of your selling transaction structure.

1. Buyers acquisition multiples are at pre 1992 levels. Strategic corporate buyers, private equity groups, and venture capital firms got burned on valuations. Between 1995 and 2001 the premiums paid by corporate buyers in 61% of transactions were greater than the economic gains. In other words, the buyer suffered from dilution. During 2012 multiples paid by financial buyers were almost equal to strategic buyers multiples. This is not a favorable pricing environment for tech companies looking for strategic pricing.

2. Based on the bubble, there is a great deal of investor skepticism. They no longer take for granted integration synergies and are wary about cultural clashes, unexpected costs, logistical problems and when their investment becomes accretive. If the seller is willing to take on some of that risk in the form of an earn out based on integrated performance, he will be offered a more attractive package (only if realistic targets are set and met).

3. Many tech companies are struggling and valuing them based on income will produce some pretty unspectacular results. A buyer will be far more willing to look at an acquisition candidate using strategic multiples if the seller is willing to take on a portion of the post closing performance risk. As a starting point, consider the cash at closing component of the transaction at 5 X EBIT with an earn out component based on post acquisition performance that would capture the strategic value component. The key stakeholders of the seller have an incentive to stay on to make their earn out come to fruition, a situation all buyers desire.

4. An old business professor once asked, “What would you rather have, all of a grape or part of a watermelon?” The spirit of the entrepreneur causes many tech company owners to go it alone. The odds are against them achieving critical mass with current resources. They could grow organically and become a grape or they could integrate with a strategic acquirer and achieve their current distribution times 100 or 1000. Six % of this new revenue stream will far surpass 100% of the old one.

5. How many of you have heard of the thrill of victory and the agony of defeat of stock purchases at dizzying multiples? It went something like this - Public Company A with a stock price of $50 per share buys Private Company B for a 15 x EBITDA multiple in an all stock deal with a one-year restriction on sale of the stock. Let's say that the resultant sales proceeds were 160,000 shares totaling $8 million in value. Company A’s stock goes on a steady decline and by the time you can sell, the price is $2.50. Now the effective sale price of your company becomes $400,000. Your 15 x EBITDA multiple evaporated to a multiple of less than one. Compare that result to $5 million cash at close and an earn out that totals $5 million over the next 3 years if revenue targets for your division are met. Your minimum guaranteed multiple is 9.38 X with an upside of 18.75 X.

6. Strategic corporate buyers are reluctant to use their devalued stock as the currency of choice for acquisitions. Their preferred currency is cash. By agreeing to an earn out, you give the buyer’s cash more velocity (ability to make more acquisitions with their cash) and therefore become a more attractive candidate with the ability to ask for greater compensation in the future.

7. The market is starting to turn positive which reawakens sellers’ dreams of bubble type multiples. The buyers are looking back to the historical norm or pre-bubble pricing. The seller believes that this market deserves a premium and the buyers have raised their standards thus hindering negotiations. An earn out is a way to break this impasse. The seller moves the total selling price up. The buyer stays within their guidelines while potentially paying for the earn out premium with dollars that are the result of additional earnings from the new acquisition.

8. The improving market provides both the seller and the buyer growth leverage. When negotiating the earn out component, buyers will be very generous in future compensation if the acquired company exceeds their projections. Projections that look very aggressive for the seller with their pre-merger resources, suddenly become quite attainable as part of a new company entering a period of growth. An example might look like this: Oracle acquires a small software Company B that has developed Oracle conversion and integration software tools. Last year Company B had sales of $8 million and EBITDA of $1 million. Company B had grown by 20% per year. The purchase transaction was structured to provide Company B $8 million of Oracle stock and $2 million cash at close plus an earn out that would pay Company B a % of $1 million a year for the next 3 years based on their achieving a 30% compound growth rate in sales. If Company B hit sales of $10.4, $13.52, and $17.58 million respectively for the next 3 years, they would collect another $3 million in transaction value. The seller now expands his client base from 200 to 100,000 installed accounts and his sales force from 4 to 5,000. Those targets should be very easy to hit. If these targets are met, the buyer easily finances the earn out with extra profit.

9. The window of opportunity in the technology area opens and closes very quickly. An earn out structure can allow both the buyer and seller to benefit. If the smaller company has developed a winning technology, they usually have a short period of time to establish a lead in the market. If they are addressing a compelling technology gap, the odds are that companies both large and small are developing their own solution simultaneously. The seller wants to develop the potential of the product and achieve sales numbers to drive up the company’s selling price. They do not have the distribution channels, the resources, or time to compete with a larger company with a similar solution looking to establish the industry standard.

A larger acquiring company recognizes this first mover advantage and is willing to pay a buy versus build premium to reduce their time to market. The seller wants a large premium while the buyer is not willing to pay full value for projections with stock and cash at close. The solution: an earn out for the seller that handsomely rewards him for meeting those projections. He gets the resources and distribution capability of the buyer so the product can reach standard setting critical mass before another large company can knock it off. The buyer gets to market quicker and achieves first mover advantage while incurring only a portion of the risk of new product development and introduction.

10. You never can forget about taxes. Earn outs provide a vehicle to defer and reduce the seller’s tax liability. Be sure to discuss your potential deal structure and tax consequences with your advisors before final negotiations begin. A properly structured earn out could save you significant tax dollars.

Smaller technology companies have many characteristics that make them good candidates for earn outs in sale transactions: 1. High growth rates, 2. Earnings not supportive of maximum valuations, 3. Limited window of opportunity to achieve meaningful market penetration, 4. Buyers less willing to pay for future potential entirely at the sale closing and 5. A valuation expectation far greater than those supported by the buyers. It really comes down to how confident the seller is in the performance of his company in the post sale environment. If the earn out targets are reasonably attainable and the earn out compensates him for the at risk portion of transaction value, a seller can significantly improve the likelihood of a sale closing and maximizing the transaction value.


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

Maximizing Valuation Multiples in the Sale of a Software Company

One of the most challenging aspects of selling a software or information technology company is coming up with a business valuation. Sometimes the valuations provided by the market defy the valuation logic that typically dictates a selling price for a manufacturing company, for example. This article discusses how an investment banker can properly position your company to the right buyer in order to achieve a strategic transaction value.
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 5 X EBITDA or cash flow.

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 a technology company can generate. 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 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 positioning our software business for maximum selling price:

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. 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.

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.

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. 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. The buyers are smart, and experienced in the M&A process and quite frankly, they 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 that we have presented will resonate with their competition. In the final analysis, we are just trying 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 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