You risked everything by leaving your comfortable, well paying position with the large corporation to start your own software company. You devoted all of your energy, worked for low pay, and probably reinvested your profits back into product development.
So the question you have now is "what is my company worth?" It is a question we frequently get from our software company clients, and it can be a difficult one to answer given the dynamics of the industry. The following information provides multiple valuation techniques and the factors that go into determing the value.
2012 Valuation Multiples
Valuation multiples for software companies remain steady in 2012 in comparison to the prior period ranging from 2.6 X to 3.8 X gross revenues.
To more accurately determine a software company's true value, it takes experience and expertise, and is almost science, and can be based on:
* Global IT spending and forecasts (Gartner and IDC reports)
* Market economy (Wall Street Journal, Dow and S&P Index)
* Specific software product category, technology, and market
* Delivery model (SaaS, Software on Demand, perpetual License)
* Revenue performance
* EBITDA performance
* Reacurring revenues
* Gross and net margins
* Short and long term debt
* Legal risks
* Size of company; quantity of employees and customers
* Quantity of customers representing 10% of revenues
* Executive and mid-management experience; tenure of employees
To learn more about what valuation multiples you might expect to see for your business, contact us at email@example.com.
Financial valuations start with a baseline value (before we start adding the strategic value components) of 2X for 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 5X multiple to that and discount it to present value.
Let's use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final three years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2X recurring year 1 revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.
We try to assign values for miscellaneous assets that the seller is providing to the buyer. Don't overlook the strategic value of Blue Chip accounts. Those accounts become a platform for the buyer's entire product suite being sold post acquisition into an installed account. It is far easier to sell add-on applications and products into an existing account than it is to open up that new account. These strategic accounts can provide a have huge value to a buyer.
The buyers are smart and experienced in the M&A process, and quite frankly, they try to deflect these strategic values in favor of pure financial analysis. But make no mistake, these other values are very important to most buyers.
The best leverage point we have is the buyers know that we are presenting the same analysis to their competitors, and they don't know which components of value will resonate with their competition.
In the final analysis, we are providing the buyers some reasonable explanation for their board of directors to justify paying 4X revenues for an acquisition.
General Valuations Methods and Dynamics of the Software Industry
There are nine generally recognized ways to value a software business, although all may not be appropriate for your particular business. The professionals at 2Merge.com can help determine which methods should be used. Each of these methods is briefly described below:
1) Similar Company Transactions A very logical way to examine the value of a company is to base the value upon what someone is willing to pay for a like company. When public companies buy privately held companies, they must reveal the amount and terms paid in their 10-Q and 10-K forms for public scrutiny. Private companies who purchase other private companies are not obligated to report purchase price.
2) Discounted Cash Flow (or DCF) This approach describes a method to value a company using the concepts of the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the appropriate cost of capital, and incorporates judgments of the uncertainty (risk) of the future cash flows. The problem with software companies is that many of them do not have a stable history to calculate or rely in the numbers with confidence, therefore we typically use a five year period and employ a discount factor of 20% or higher.
3) Free Cash Flow This method is often used to value privately held software companies with a range of five to eight times the cash available to spend after operating expenses being the usual method of calculation. Free cash flow is important when the Buyer intends to finance the purchase using the revenue from the purchased company itself. Free cash flow is the net income plus interest expense, income taxes, depreciation and amortization, minus software development costs capitalized in the current year and current year fixed asset purchases.
4)Price Earnings Ratio (P/E) This transitional method of valuation has been applied to companies in all industries, and is the most often quoted method of valuation for public companies. P/E multiples ranging from 5 to 50 are possible in the software industry, with growth of the company and the growth of the industry determining the selection of the multiple. A reasonable multiple is generally around 10 times net income.
5) Sales Multiple A quick and easy way to estimate the value of a software company is by applying a multiple to your annual revenue. For companies with a significant direct sales costs of sale such as purchased hardware, applying the ultiple to gross profit is more appriate. There is some latitude in valuations based on the growth of thecompany, using trailing (last 12 months), actual (fiscal year projections) and forecasted (next 12 months or fiscal year) revenue. The sales multiple method is not often used when revenues are highly volatile or declining. Sales of software companies typically occur in the 1 to 5 times revenues, although valuations of higher and lower multiples do occur.
6) Replacement Value This is one of the best ways to create some minimum value especially for young software companies or where the investment in technology has been heavy and the projected life span of the technology is long. Replacement value goes up where there is a high barrier to entry due to proprietary tools or patents or new technologies. The replacement value assigned to the software is determined by calculating the time and costs which would be saved in the re-write of the company's products. The value of the installed base may generally be figured at around 4 times the recurring revenues.
7) Book Value Method Book value is the amount of assets on the books in excess of liabilities on the books. While an important accounting concept and important in managing the business, it is generally not very relevant in determining the true value of most software companies, since the value of the user base, recurring revenue stream, and cost to recreate the technology are largely ignored using this method. Also, book value for a software company may be heavily influenced by the company's policy with respect to capitalizing software development costs. Book value is often multiplied by a multiple of 2 or 3, then used as a sanity check against other more creditable valuation methods.
8) Liquidity Value This value, in the software business especially, is only used as a minimum floor value below which no offer should ever fall. Software companies have very little in the way of hard assets, and the most valuable assets are intangible.
9) Dunn-Rankin Formula This formula can be adjusted for unusual swings in sales or earnings. A rapidly growing company may use next year's numbers with a present value discount. Since this is the "public" price, you need to adjust by 20% - 50% downward to reflect the normal discount for stock of privately held companies. Obviously, if you use your current data, then this formula values your company as currently operated by you. So to determine the likely value of your company in a strategic acquisition, you would need to adjust your profit margin, growth rate and revenue to the numbers that could be generated by the Buyer, and then apply the formula.
[(net profit margin / 5%) + (growth rate / 10%)] divided by 2 = multiple of revenue valuation
multiple of revenue valuation X annual revenue = value of the Company
The higher valuations typically come from a sale to a strategic Buyer who is able to generate much higher earnings out of the business. A strategic buyer is generally a larger company in your same or related industry which will be able to eliminate portions of your expenses or able to generate additional revenue by layering your products with products they are already selling. A strategic Buyer may be able to eliminate an entire layer of overhead, or may substantially increase sales of your products by selling it through their existing sales channels, or increase sales of its other products by selling them through your existing sales channels.
The key to determining the value of your company in a strategic acquisition, is to look not to what your company is worth the way you are operating today, but instead to what it will be worth to the Buyer, taking into account the changes the Buyer will make. To do this, 2Merge.com Professionals will help you make a rough estimate of the future revenue that the Buyer will be able to generate from your business, and a rough estimate of what the related expenses will be. If the Buyer is a publicly traded company, then its stock probably trades on a multiple of earnings. Apply this multiple to the amount by which your business will increase its net earnings and you can have a good feel for how much your business could increase the value of the Buyer's company.
If the Buyer is primarily interested in your technology, then the best way to determine the value of the your company may be to determine how much it would cost the Buyer to develop your technology products. If what the Buyer is primarily interested in is your customer base, then estimate how much it would cost the Buyer to develop this level of market share. This same approach can be taken with any other possible benefit of your business to a prospective Buyer. The point is that even if your business has always operated at a loss, there may be significant value to a strategic Buyer.
Rules of Thumb
The value of your specific company will depend on a number of factors which will include financial factors such as revenue, net earnings, cash flows and balance sheet, but also the sales or earnings growth or the lack of growth. Additional factors include the potential market for your products/services, your company's market share, competition, your customer base and related agreements, your product's differences and advantages, sales channels, the skills and geographic coverage of your sales force, and a host of othr factors. There are some general rules of thumb you can use as a quick guide.
Software companies are worth somewhere between 1 and 5 times annual revenues, with valuations of 2 times annual revenue as the general rule. If your company is unprofitable, not growing, has a small market share and obsolete technology, then it is probably worth less than 1 times annual revenue. At the other extreme, if your company has a leading edge technology, is profitable, is growing rapidly and is the dominant player in your niche, then it may be worth much more than 2 times annual revenue.
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