Many
entrepreneurs seek venture capital or private equity as a way to take
their company to the next level. Consider the smart equity alternative
of having a large information technology company take an equity stake in
your company. This article discusses why that is a superior
alternative.
If you are an entrepreneur with a small
information technology based company looking to take it to the next
level, this article should be of particular interest to you. Your
natural inclination may be to seek venture capital or private equity to
fund your growth. According to Jim Casparie, founder and CEO of the
Venture Alliance, the odds of getting Venture funding remain below 3%.
Given those odds, the six to nine month process, the heavy, often
punishing valuations, the expense of the process, this might not be the
best path for you to take.
We have created a smart
equity model designed to bring the appropriate capital resources to you
entrepreneurs. It allows the entrepreneur to bring in smart money and to
maintain control. We have taken the experiences of several technology
entrepreneurs and combined that with our traditional investment banking
merger and acquisition approach and crafted a model that both large
industry players and the high tech business owners are embracing.
Our
experiences in the technology space led us to the conclusion that new
product introductions were most efficiently and cost effectively the
purview of the smaller, nimble, low overhead companies and not the
technology giants. Most of the recent blockbuster products have been the
result of an entrepreneurial effort from an early stage company
bootstrapping its growth in a very cost conscious lean environment. The
big companies, with all their seeming advantages experienced a high
failure rate in new product introductions and the losses resulting from
attempting to internally develop the next hot technology were
substantial.
Don't get us wrong. There were hundreds
of failures from the start-ups as well. However, the failure for the
edgy little start-up resulted in losses in the $1 - $5 million range.
The same result from an industry giant was often in the $100 million to
$250 million range.
For every Google, EBay,
Salesforce, or Twitter there are literally hundreds of companies that
either flame out or never reach a critical mass beyond a loyal early
adapter market. It seems like the mentality of these smaller business
owners is, using the example of the popular TV show, Deal or No Deal, to
hold out for the $1 million briefcase. What about that logical
contestant that objectively weighs the facts and the odds and cashes out
for $280,000?
As we discussed the dynamics of this
market, we were drawn to a private equity investment model commonly used
by technology bell weather, Cisco Systems, that we felt could also be
applied to a broad cross section of companies in the high tech niche.
Cisco Systems is a serial acquirer of companies. They do a tremendous
amount of R&D and organic product development. They recognize,
however, that they cannot possibly capture all the new developments in
this rapidly changing field through internal development alone.
Cisco
seeks out investments in promising, small, technology companies and
this approach has been a key element in their market dominance. They
bring what we refer to as smart equity to the high tech entrepreneur.
They purchase a minority stake in the early stage company with a call
option on acquiring the remainder at a later date with an agreed-upon
valuation multiple. This structure is a brilliantly elegant method to
dramatically enhance the risk reward profile of new product
introduction. Here is why:
For the Entrepreneur: (Just substitute in your technology industry giants name that is in your category for Cisco below)
1.
The involvement of Cisco - resources, market presence, brand,
distribution capability is a self fulfilling prophecy to your products
success.
2. For the same level of dilution that an
entrepreneur would get from a VC, angel investor or private equity
group, the entrepreneur gets the performance leverage of "smart money."
See #1.
3. The entrepreneur gets to grow his
business with Cisco's support at a far more rapid pace than he could
alone. He is more likely to establish the critical mass needed for
market leadership within his industry's brief window of opportunity.
4. He gets an exit strategy with an established valuation metric while the buyer helps him make his exit much more lucrative.
5.
As an old Wharton professor used to ask, "What would you rather have,
all of a grape or part of a watermelon?" That sums it up pretty well.
The involvement of Cisco gives the product a much better probability of
growing significantly. The entrepreneur will own a meaningful portion of
a far bigger asset.
For the Large Company Investor:
1. Create access to a large funnel of developing technology and products.
2. Creates a very nimble, market sensitive, product development or R&D arm.
3. Minor resource allocation to the autonomous operator during his "skunk works" market proving development stage.
4.
Diversify their product development portfolio - because this approach
provides for a relatively small investment in a greater number of
opportunities fueled by the entrepreneurial spirit, they greatly improve
the probability of creating a winner.
5. By
investing early and getting an equity position in a small company and
favorable valuation metrics on the call option, they pay a fraction of
the market price to what they would have to pay if they acquired the
company once the product had proven successful.
Let's
use two hypothetical companies to demonstrate this model, Big Green
Technologies, and Mobile CRM Systems. Big Green Technologies utilized
this model successfully with their investment in Mobile CRM Systems. Big
Green Technologies acquired a 25% equity stake in Mobile CRM Systems in
1999 for $4 million. While allowing this entrepreneurial firm to
operate autonomously, they backed them with leverage and a modest level
of capital resources. Sales exploded and Big Green Technologies
exercised their call option on the remaining 75% equity in Mobile CRM
Systems in 2004 for $224 million. Sales for Mobile CRM Systems were
projected to hit $420 million in 2005.
Given today's
valuation metrics for a company with Mobile CRM Systems growth rate and
profitability, their market cap is about $1.26 Billion, or 3 times
trailing 12 months revenue. Big Green Technologies invested $5 million
initially, gave them access to their leverage, and exercised their call
option for $224 million. Their effective acquisition price totaling $229
million represents an 82% discount to Mobile CRM Systems 2005 market
cap.
Big Green Technologies is reaping additional
benefits. This acquisition was the catalyst for several additional
investments in the mobile computing and content end of the tech
industry. These acquisitions have transformed Big Green Technologies
from a low growth legacy provider into a Wall Street standout with a
growing stable of high margin, high growth brands.
Big
Green Technologies profits have tripled in four years and the stock
price has doubled since 2000, far outpacing the tech industry average.
This success has triggered the aggressive introduction of new products
and new markets. Not bad for a $5 million bet on a new product in 1999.
Wait, let's not forget about our entrepreneur. His total proceeds of
$229 million are a fantastic 5- year result for a little company with
1999 sales of under $20 million.
MidMarket Capital
Advisors has borrowed this model combining the Cisco smart equity
investment experience with our investment banking experience to offer
this unique Investment Banking service. MMCA can either represent the
small entrepreneurial firm looking for the "smart equity" investment
with the appropriate growth partner or the large industry player looking
to enhance their new product strategy with this creative approach. This
model has successfully served the technology industry through periods
of outstanding growth and market value creation. Many of the same
dynamics are present today in the information technology and software
industries and these same transaction structures can be similarly
employed to create 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
Thursday, January 30, 2014
Wednesday, January 29, 2014
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
Monday, April 29, 2013
Seeking Board Seat with a $10-$50 million in Revenue Software or IT Services Company
David M. Kauppi, Managing Director
Transactions The Transition Companies
I am seeking a board of directors position with a
growing software or IT services firm. I
am still actively involved in technology company M&A and would like to
share my perspectives on driving enterprise value and maximizing business
development effectiveness. Please review my qualifications below. I welcome contact from any CEOs who would like to discuss this.
Thanks,
Dave
Based
on my broad and varied background in sales, business development and executive
management in the technology industry and my last 13 years representing
technology companies in the Merger & Acquisition process, I bring valuable
insights to company leadership teams.
Current Position Managing Director
Transactions for M&A Firm The Transition Companies (recent merger)
2002-
2/28/2013 President and Managing Director MidMarket Capital Advisors - a
technology focused M&A Firm
Prior Professional
Experience
- Dave began his high tech Merger and Acquisition practice after a twenty-year
career within the information technology industry. His varied background includes positions in
hardware (Storage Technology Corporation), IT Services (IBM's Service Bureau
Corp. and Comdisco Disaster Recovery), Software (Metaphor Computer Systems),
computer leasing (Bell Atlantic Systems Leasing), datacom (Paradyne Corp.), and
Internet (DigitalCars.com).
Representative
Transactions
M&A
Advisor for The Systems House (ERP Software Company) in their sale to Hicks
Muse Tate and Furst
M&A
Advisor for Van Slyck & Assc. (Healthcare IT Company) in their sale to Eclipsys
M&A
Advisor for Brightstar Partners (IBM Business Partner, Software and IT Services
Company) in their sale to Avnet
M&A
Advisor for Profund Systems (a pension administration software company) in
their company sale
M&A
Advisor for MedLink (a cost accounting software company) in their company sale
M&A
Advisor for Flexistaff (a SaaS staffing and shift bidding system for nurses) in
their sale to Per-Se Technologies
Education - Dave graduated from The Wharton School of
Business, University of Pennsylvania with a BS in Economics with a
concentration in Finance. He received an MBA with a concentration in marketing
from DePaul University.
Other Dave Kauppi is the editor of The Exit
Strategist Newsletter rated by New York Times Small Business as "Best
newsletter for deal terms and strategy.
Wednesday, February 6, 2013
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
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
Wednesday, January 30, 2013
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
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
Wednesday, January 2, 2013
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
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
Tuesday, January 1, 2013
Selling Your Company - Avoid These Ten Mistakes
Selling your business is the most important business transaction you will ever make. Mistakes in this process can greatly erode your transaction proceeds. Do not spend twenty years of your toil and skill building your business like a pro only to exit like an amateur. This article discusses ten common mistakes to avoid in selling your business.
Successful business owners are smart and competent people. They are fiercely independent, trust their instincts, and take pride in calling the shots. When it comes to selling their business, however, this attitude can be very costly. They have no problem relying on their doctor or lawyer for their professional expertise. For some reason, when it comes to the sale of their business, they want to rely on their personal strengths and direct the process. This can be a very costly mistake. Below are ten common mistakes that business owners make when attempting to represent themselves in the sale of their company.
1. Selling because of an unsolicited offer to buy - One of the most common reasons owners tell us they sold their business was they got an offer from a competitor. If they previously were not considering this business sale, the owner has probably not taken some important personal and business steps to exit on his terms. The business may have some easily correctable issues that could detract from its value. The owner may not have prepared for an identity and lifestyle to replace the void caused by his separation from his company. If you are prepared, you are more likely to exit on your own terms.
2. Poor books and records - Business owners wear many hats. Sometimes they become so focused on running the business that they are lax in financial record keeping. A buyer is going to do a comprehensive look into your financial records. If they are done poorly, the buyer loses confidence in what he is buying and his perception of risk increases. If he finds some negative surprises late in the process, the purchase price adjustments can be harsh. The transaction value is often attacked well beyond the economic impact of the surprise. Get a good accountant to do your books.
3. Going it alone - The business owner may be the foremost expert in his business, but it is likely that his business sale will be a once in a lifetime occurrence. Mistakes at this juncture have a huge impact. Do you understand the difference in after tax proceeds between an asset sale and a stock sale? Your everyday bookkeeper may not, but a tax accountant surely does. Is your business attorney familiar with business sales legal work? Would he advise you properly on Reps and Warranties that will be in the purchase agreement? Your buyer’s team will have this experience. Your team should match that experience of it will cost you way more than their fees.
4. Skeletons in the closet - If your company has any, the due diligence process will surely reveal them. Before your firm is turned inside out and the buyer spends thousands in this process and before the other interested buyers are put on hold - reveal that problem up-front. We sold a company that had an outstanding CFO. In the first meeting with us, he told us of his company’s under funded pension liability. We were able to bring the appropriate legal and actuarial resources to the table and give the buyer and his advisors plenty of notice to get their arms around the issue. If this had come up late in the process, the buyer might have blown up the deal or attacked transaction value for an amount far in excess of the potential liability.
5. Letting the word out - Confidentiality in the business sale process is crucial. If your competitors find out, they can cause a lot of damage to your customers and prospects. It can be a big drain on employee morale and productivity. Your suppliers and bankers get nervous. Nothing good happens when the work gets out that your company is for sale.
6. Poor Contracts - Here we mean the day-to-day contracts that are in place with employees, customers, contractors, and suppliers. Do your employees have non-competes, for example? If your company has intellectual property, do you have very clear ownership rights defined in your employee and contractor agreements. If not, you could be looking at meaningful escrow holdbacks post closing. Are your customer agreements assignable without consent? If they are not, customers could cancel post transaction. Your buyer will make you pay for this one way or another.
7. Bad employee behavior - You need to make sure you have agreements in place so that employees cannot hold you hostage on a pending transaction. Key employees are key to transaction value. If you suspect there are issues, you may want to implement stay on bonuses. If you have a bad actor, firing him or her during a transaction could cause issues. You may want to be pre-emptive with your buyer and minimize any damage your employee might cause.
8. No understanding of your company’s value - Business valuations are complex. A good business broker or M & A advisor that has experience in your industry is your best bet. Business valuation firms are great for business valuations for gift and estate tax situations, divorce, etc. They tend to be very conservative and their results could vary significantly from your results from three strategic buyers in a battle to acquire your firm. When it comes to selling your company, let the competitive market provide a value.
9. Getting into an auction of one - This is a silly visual, but imagine a big auction hall at Sotheby’s occupied by an auctioneer and one guy with an auction paddle. “Do I hear $5 million? Anybody $5.5 million?’ The guy is sitting on his paddle. Pretty silly, right? And yet we hear countless stories about a competitor coming in with an unsolicited offer and after a little light negotiating the owner sells. Another common story is the owner tells his banker, lawyer, or accountant that he is considering selling. His well-meaning professional says, “I have another client that is in your business. I will introduce you.” The next thing you know the business is sold. Believe me, these folks are buying you business at a big discount. That’s not silly at all!
10. Giving away value in negotiations and due diligence - When selling your business, your objective is to get the best terms and conditions. I know this is a shocker, but the buyer is trying to pay as little as possible and he is trying to get contractual terms favorable to him. These goals are not compatible with yours. The buyer is going to fight hard on issues like total price, cash at close, earn outs, seller notes, reps and warranties, escrow and holdbacks, post closing adjustments, etc. If you get into a meet in the middle compromise negotiation, before you know it, your Big Mac is a Junior Cheeseburger. Due diligence has a dual purpose. The first is obviously to insure that the buyer knows exactly what he is paying for. The second is to attack transaction value with adjustments. Of course this happens after their LOI has sent the other bidders away for 30 to 60 days of exclusivity. If you don’t have a good team of advisors, this can get expensive
As my dad used to say, there is no replacement for experience. Another saying is that when a man with money and no experience meets a man with experience, the man with the experience walks away with the money and the man with the money walks away with some experience. Keep this in mind when contemplating the sale of your business. It will likely be your first and only experience. Avoid these mistakes and make that experience a profitable one.
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 business is the most important business transaction you will ever make. Mistakes in this process can greatly erode your transaction proceeds. Do not spend twenty years of your toil and skill building your business like a pro only to exit like an amateur. This article discusses ten common mistakes to avoid in selling your business.
Successful business owners are smart and competent people. They are fiercely independent, trust their instincts, and take pride in calling the shots. When it comes to selling their business, however, this attitude can be very costly. They have no problem relying on their doctor or lawyer for their professional expertise. For some reason, when it comes to the sale of their business, they want to rely on their personal strengths and direct the process. This can be a very costly mistake. Below are ten common mistakes that business owners make when attempting to represent themselves in the sale of their company.
1. Selling because of an unsolicited offer to buy - One of the most common reasons owners tell us they sold their business was they got an offer from a competitor. If they previously were not considering this business sale, the owner has probably not taken some important personal and business steps to exit on his terms. The business may have some easily correctable issues that could detract from its value. The owner may not have prepared for an identity and lifestyle to replace the void caused by his separation from his company. If you are prepared, you are more likely to exit on your own terms.
2. Poor books and records - Business owners wear many hats. Sometimes they become so focused on running the business that they are lax in financial record keeping. A buyer is going to do a comprehensive look into your financial records. If they are done poorly, the buyer loses confidence in what he is buying and his perception of risk increases. If he finds some negative surprises late in the process, the purchase price adjustments can be harsh. The transaction value is often attacked well beyond the economic impact of the surprise. Get a good accountant to do your books.
3. Going it alone - The business owner may be the foremost expert in his business, but it is likely that his business sale will be a once in a lifetime occurrence. Mistakes at this juncture have a huge impact. Do you understand the difference in after tax proceeds between an asset sale and a stock sale? Your everyday bookkeeper may not, but a tax accountant surely does. Is your business attorney familiar with business sales legal work? Would he advise you properly on Reps and Warranties that will be in the purchase agreement? Your buyer’s team will have this experience. Your team should match that experience of it will cost you way more than their fees.
4. Skeletons in the closet - If your company has any, the due diligence process will surely reveal them. Before your firm is turned inside out and the buyer spends thousands in this process and before the other interested buyers are put on hold - reveal that problem up-front. We sold a company that had an outstanding CFO. In the first meeting with us, he told us of his company’s under funded pension liability. We were able to bring the appropriate legal and actuarial resources to the table and give the buyer and his advisors plenty of notice to get their arms around the issue. If this had come up late in the process, the buyer might have blown up the deal or attacked transaction value for an amount far in excess of the potential liability.
5. Letting the word out - Confidentiality in the business sale process is crucial. If your competitors find out, they can cause a lot of damage to your customers and prospects. It can be a big drain on employee morale and productivity. Your suppliers and bankers get nervous. Nothing good happens when the work gets out that your company is for sale.
6. Poor Contracts - Here we mean the day-to-day contracts that are in place with employees, customers, contractors, and suppliers. Do your employees have non-competes, for example? If your company has intellectual property, do you have very clear ownership rights defined in your employee and contractor agreements. If not, you could be looking at meaningful escrow holdbacks post closing. Are your customer agreements assignable without consent? If they are not, customers could cancel post transaction. Your buyer will make you pay for this one way or another.
7. Bad employee behavior - You need to make sure you have agreements in place so that employees cannot hold you hostage on a pending transaction. Key employees are key to transaction value. If you suspect there are issues, you may want to implement stay on bonuses. If you have a bad actor, firing him or her during a transaction could cause issues. You may want to be pre-emptive with your buyer and minimize any damage your employee might cause.
8. No understanding of your company’s value - Business valuations are complex. A good business broker or M & A advisor that has experience in your industry is your best bet. Business valuation firms are great for business valuations for gift and estate tax situations, divorce, etc. They tend to be very conservative and their results could vary significantly from your results from three strategic buyers in a battle to acquire your firm. When it comes to selling your company, let the competitive market provide a value.
9. Getting into an auction of one - This is a silly visual, but imagine a big auction hall at Sotheby’s occupied by an auctioneer and one guy with an auction paddle. “Do I hear $5 million? Anybody $5.5 million?’ The guy is sitting on his paddle. Pretty silly, right? And yet we hear countless stories about a competitor coming in with an unsolicited offer and after a little light negotiating the owner sells. Another common story is the owner tells his banker, lawyer, or accountant that he is considering selling. His well-meaning professional says, “I have another client that is in your business. I will introduce you.” The next thing you know the business is sold. Believe me, these folks are buying you business at a big discount. That’s not silly at all!
10. Giving away value in negotiations and due diligence - When selling your business, your objective is to get the best terms and conditions. I know this is a shocker, but the buyer is trying to pay as little as possible and he is trying to get contractual terms favorable to him. These goals are not compatible with yours. The buyer is going to fight hard on issues like total price, cash at close, earn outs, seller notes, reps and warranties, escrow and holdbacks, post closing adjustments, etc. If you get into a meet in the middle compromise negotiation, before you know it, your Big Mac is a Junior Cheeseburger. Due diligence has a dual purpose. The first is obviously to insure that the buyer knows exactly what he is paying for. The second is to attack transaction value with adjustments. Of course this happens after their LOI has sent the other bidders away for 30 to 60 days of exclusivity. If you don’t have a good team of advisors, this can get expensive
As my dad used to say, there is no replacement for experience. Another saying is that when a man with money and no experience meets a man with experience, the man with the experience walks away with the money and the man with the money walks away with some experience. Keep this in mind when contemplating the sale of your business. It will likely be your first and only experience. Avoid these mistakes and make that experience a profitable one.
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
Tuesday, June 28, 2011
Selling Your Software Company May be the Best Path to Product Success
Owners of software companies with a great new product are often frustrated by their inability to gain broader market acceptance. The problem isn't the product; the issue is risk adverse buyers. This post explores how a business sale may be the best way to unlock your product's potential.
In our investment banking practice, we are often approached by software companies that have a leading edge new software product that is not producing the desired sales results. Many times they are what we affectionately term, accidental software companies - an Information Technology consulting firm that has developed a solid application in conjunction with their demanding blue-chip client. They strike a deal with the client to reduce their development fees in return for ownership of the intellectual property.
Just like that, they become a software company. Not so fast Mr. Optimist. You can't just say you are a software company and expect the product to garner mass market acceptance. They generally do not have a sales force that can now transition from selling projects to now selling a software product. Many go down the path of hiring a salesperson that has an impressive large company sales resume. He promises to bring his large client database with him and achieve impressive sales levels. He is going to take this small company to the next level.
Nine months later, with a substantial base and draw, the sales star is far below quota and is either fired or quits to find a much easier sale. It is one thing to sell with Oracle, SAP, Microsoft or IBM on your business card. It is an entirely different proposition representing Acme Software Products. It is a rare sales person that can make that transition and achieve success for the new company.
The primary deterrent to sales success is that the perceived risk for the large company software purchaser is far greater with the unproven newcomer than with the established software giant. This dramatically lengthens the sales cycle with much more testing, software code escrow requirements, references, proof steps, trials, etc.
So how does this small company scale? How about the VAR channel? Again, the inexperience can be costly. You can't just recruit some VARs and expect sales to multiply. It is a big commitment of resources to manage the channel. You are competing for mind share with many other strong products and services. The revenue split with a VAR is generally about 50%.
Strategic alliances have been employed successfully in earlier times. This approach has been tried by a large percentage of emerging software companies to the point where this channel is extremely crowded and diminishing in its effectiveness. Larger companies are becoming very selective and demanding in lending their brand, sales resources, and mind share to anything but their own products. If they do agree to partner, the terms are not favorable for the small guy and often there is some ownership equity requirement.
Step back from the ledge. All is not lost. Often the best approach is to seek to be acquired by a larger software or information technology company that has the client base and sales resources to leverage with your hot new product. It is important that I manage your expectations, however. If you are below $50 million in revenue, Microsoft, Google, IBM, Oracle and the other multi billion dollar software firms are not going to buy you. There is the occasional outlier that defies this rule, but their corporate development people do not even blink unless you are big enough to move their needle. So if you are a $3 to $25 million in revenue firm, your buyer is most likely a $25 million to $300 million software or IT services firm.
I must include one final reality check. Buyers of software companies are reluctant to pay for potential, projections, pipelines or any other seller perceived hockey stick revenue explosions with cash at closing. They have heard it all before and will not be persuaded to part with their cash until those orders actually come in. The good news is that if they are convinced that there is potential and this product is a good fit with their sales team and clients, they often will make a generous earn out offer based on future revenues or profits.
This can be very attractive to the seller because now his effective sales force, installed base of customers, brand name recognition, and marketing budgets have all been expanded exponentially. The risk in the marketplace has been reduced and the sales cycle compresses. So if the selling company with 2 sales people and 30 installed accounts gets acquired by a larger company with 1,000 installed accounts and 30 sales people and gets a 15% of revenues earn out deal over four years, he can recognize considerably more value when compared to slugging it out on his own over the next 15 years.
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
In our investment banking practice, we are often approached by software companies that have a leading edge new software product that is not producing the desired sales results. Many times they are what we affectionately term, accidental software companies - an Information Technology consulting firm that has developed a solid application in conjunction with their demanding blue-chip client. They strike a deal with the client to reduce their development fees in return for ownership of the intellectual property.
Just like that, they become a software company. Not so fast Mr. Optimist. You can't just say you are a software company and expect the product to garner mass market acceptance. They generally do not have a sales force that can now transition from selling projects to now selling a software product. Many go down the path of hiring a salesperson that has an impressive large company sales resume. He promises to bring his large client database with him and achieve impressive sales levels. He is going to take this small company to the next level.
Nine months later, with a substantial base and draw, the sales star is far below quota and is either fired or quits to find a much easier sale. It is one thing to sell with Oracle, SAP, Microsoft or IBM on your business card. It is an entirely different proposition representing Acme Software Products. It is a rare sales person that can make that transition and achieve success for the new company.
The primary deterrent to sales success is that the perceived risk for the large company software purchaser is far greater with the unproven newcomer than with the established software giant. This dramatically lengthens the sales cycle with much more testing, software code escrow requirements, references, proof steps, trials, etc.
So how does this small company scale? How about the VAR channel? Again, the inexperience can be costly. You can't just recruit some VARs and expect sales to multiply. It is a big commitment of resources to manage the channel. You are competing for mind share with many other strong products and services. The revenue split with a VAR is generally about 50%.
Strategic alliances have been employed successfully in earlier times. This approach has been tried by a large percentage of emerging software companies to the point where this channel is extremely crowded and diminishing in its effectiveness. Larger companies are becoming very selective and demanding in lending their brand, sales resources, and mind share to anything but their own products. If they do agree to partner, the terms are not favorable for the small guy and often there is some ownership equity requirement.
Step back from the ledge. All is not lost. Often the best approach is to seek to be acquired by a larger software or information technology company that has the client base and sales resources to leverage with your hot new product. It is important that I manage your expectations, however. If you are below $50 million in revenue, Microsoft, Google, IBM, Oracle and the other multi billion dollar software firms are not going to buy you. There is the occasional outlier that defies this rule, but their corporate development people do not even blink unless you are big enough to move their needle. So if you are a $3 to $25 million in revenue firm, your buyer is most likely a $25 million to $300 million software or IT services firm.
I must include one final reality check. Buyers of software companies are reluctant to pay for potential, projections, pipelines or any other seller perceived hockey stick revenue explosions with cash at closing. They have heard it all before and will not be persuaded to part with their cash until those orders actually come in. The good news is that if they are convinced that there is potential and this product is a good fit with their sales team and clients, they often will make a generous earn out offer based on future revenues or profits.
This can be very attractive to the seller because now his effective sales force, installed base of customers, brand name recognition, and marketing budgets have all been expanded exponentially. The risk in the marketplace has been reduced and the sales cycle compresses. So if the selling company with 2 sales people and 30 installed accounts gets acquired by a larger company with 1,000 installed accounts and 30 sales people and gets a 15% of revenues earn out deal over four years, he can recognize considerably more value when compared to slugging it out on his own over the next 15 years.
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
Tuesday, June 21, 2011
The Art of Software Company Business Valuation
One of the most challenging aspects of selling a software 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's latest platform. 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 tree 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. 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 8 X revenues for an acquisition.
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
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's latest platform. 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 tree 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. 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 8 X revenues for an acquisition.
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
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