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The Number One Driver of Business Valuation in a Software Company Sale

Apr 2, 2008
We get to witness buyer behavior first hand in our software investment banking practice. The most important behavior is their economic vote - how much they are willing to pay for an information technology business. Many factors go into their assessment of value, but a contractually recurring revenue stream is consistently the number one value driver.

Why is this so important? The first answer is risk. Buying a business is risky. Any factor that reduces this risk is rewarded with transaction value. Forecasted sales, for example, are at the high end of the risk scale and are heavily discounted in value. Historical time and materials revenues that are "most likely to be at about the same level" next year are somewhere in the middle of the risk scale and are valued accordingly.

The owner and key employees may leave after the acquisition and may take their customer relationships and accounts with them. Those customers locked into contracts are less likely to leave. The acquisition can temporarily inject uncertainty into the marketplace and cause disruption or delays in pending sales situations. The integration efforts will introduce execution risk into previously routine revenue generating activities.

The acquiring company wants the existing customers to stay put long enough to get comfortable with the new company. Contracts with plenty of time remaining are their security.

How can you use this knowledge to your advantage? Here are some actions the owners should take in anticipation of selling their software or information technology 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.

Go on a mission to convert every time and materials revenue source you can to an annual contract. If you are a software company, for example, and you have customers that are not on an 18% - 20% annual maintenance contract, get those customers converted. A strategy might be a one time "get current sale" in return for signing an annual maintenance contract. Services companies should review their time and materials records with their regular customers and devise programs that convert those to annual fixed price programs. Software companies that also provide services, devise a concept where you provide departmental or functional outsourcing for your clients.

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.

Do you have any add-on modules that your customer 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 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 the 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 times 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 times on the revenue that is covered by contracts they acquire with the purchase of your information technology company.

On a value scale, contractually recurring revenue is a 10, expected historical revenue is a 6 and a sales pipeline is a 3. Move your 3's and 6's to 10's and recognize a big boost in your business selling price.

Go on a contractually recurring revenue hunt Before you sell your information technology company.
About the Author
Dave Kauppi (davekauppi@midmarkcap.com) is the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of technology based businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.
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