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 defy all logic. This post explores the key elements that drive software company valuation multiples.
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 President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
Wednesday, June 17, 2009
Wednesday, June 10, 2009
Business Sellers - Beware of Potential Changes in the Capital Gains Tax
Thinking of selling your business? If you have planned it correctly, most of your transaction proceeds should be long term capital gains. Given the current political climate and the upcoming change in the White House, capital gains taxes will come under attack. If you are a business owner and are thinking of selling your business within the next 5 years, you may want to move up your exit timeframe says Dave Kauppi, President of MidMarket Capital, a Merger and Acquisition Advisor.
The reduced 15% tax rate on capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Reconciliation Act signed into law by President Bush on May 17, 2006. In 2011 these reduced tax rates will revert to the rates in effect before 2003, which were generally 20%.
We believe that with the AMT currently targeted for elimination, the $800 billion will be made up by raising taxes elsewhere, and I believe this "owner of capital" tax is the most vulnerable for increase. I expect that the long term capital gain tax rate will be moved to an upper limit of 28% by late 2010 for the high end income bracket.
Translation, the business seller is going to take a big hit on his after tax proceeds if his business sale is concluded after November 1, 2010. Let's look at a quick example. A 63 year old man started his business 25 years ago and he sells it for $5 million. All his equipment has depreciated so his basis is approximately $0. Under current tax laws he would have a $5 million capital gain from the sale of his business. His after tax proceeds would total $4,250,000.
If he sells after November 1, 2010, and the tax laws change as I am predicting. The same sale would net him $3,600,000. He lost $650,000 because of this change. If you wait until the actual change is voted into law, there will be a rush to the exits causing an unusually high number of businesses to be for sale. That would further reduce proceeds for the seller because of supply and demand pressures.
The most important tax issue, however, for the business seller continues to be the corporate structure (C Corp, S Corp, or LLC) and whether the business sale is an asset sale or a stock sale. First, unless you are planning on going public or have hundreds of stockholders do not form a C Corp to begin with. Use an S Corp or an LLC. If you currently are a C Corp ask your attorney or tax advisor about converting to an S Corp. If you sell your company within a 10-year period of converting to an S Corp the sale can be taxed as if you were still a C Corp.
Here is what happens when there is an asset sale of a C Corp. The assets that are sold are compared to their depreciated basis and the difference is treated as ordinary income to the C Corp. Any good will is a 100% gain and again is treated as ordinary income. This new found income drives up your corporate tax rate, often to the maximum rate of around 34%. You are not done yet. The corporation pays this tax bill and then there is a distribution of the remaining funds to the shareholders. They are taxed a second time at their long term capital gains rate.
Compare this to a C Corp stock sale. The stock is sold and there is no tax to the corporation. The distribution is made to the shareholders and they pay only their long term capital gain on the change in value over their basis. The difference can be hundreds of thousands of dollars.
This anticipated change to the capital gains tax rates will certainly add to the complexity of selling a business. I cannot stress how important a factor taxes will be in your successful business exit. Here is my summary checklist:
Tax Consideration Checklist Get Good Advice on Original Corporate Structure
If C Corp - Retain Ownership of all Appreciating Assets Outside Corporation - i.e. Real Estate, Patents, Franchise Rights: avoid double taxation
Look at Deal Economics First, Taxes Second
Make Sure Your Transaction Support Team has Deal Experience
Before You Go To Market, Work With Your Team to Understand Deal Structure vs. After Tax Proceeds
You Have the Right to Pursue the Minimum Payment of Taxes - Exercise Your Rights
It Is Never as Effective as an Afterthought
The Pros Can Match Your Desired Outcomes With the Right Tools. Be aggressive in your tax positioning of your sale, both with the buyer in your negotiations and with your filing with the IRS. The various deal structure options are very important issues that need to be understood from a tax impact perspective. Remember that a deal term that is favorable to the buyer for tax treatment is correspondingly unfavorable to the seller. You can bet that the buyer's team of advisors is well versed on this topic. Make sure that your team of advisors is equally well versed or you could end up with a much less than you thought in after tax proceeds.
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
The reduced 15% tax rate on capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Reconciliation Act signed into law by President Bush on May 17, 2006. In 2011 these reduced tax rates will revert to the rates in effect before 2003, which were generally 20%.
We believe that with the AMT currently targeted for elimination, the $800 billion will be made up by raising taxes elsewhere, and I believe this "owner of capital" tax is the most vulnerable for increase. I expect that the long term capital gain tax rate will be moved to an upper limit of 28% by late 2010 for the high end income bracket.
Translation, the business seller is going to take a big hit on his after tax proceeds if his business sale is concluded after November 1, 2010. Let's look at a quick example. A 63 year old man started his business 25 years ago and he sells it for $5 million. All his equipment has depreciated so his basis is approximately $0. Under current tax laws he would have a $5 million capital gain from the sale of his business. His after tax proceeds would total $4,250,000.
If he sells after November 1, 2010, and the tax laws change as I am predicting. The same sale would net him $3,600,000. He lost $650,000 because of this change. If you wait until the actual change is voted into law, there will be a rush to the exits causing an unusually high number of businesses to be for sale. That would further reduce proceeds for the seller because of supply and demand pressures.
The most important tax issue, however, for the business seller continues to be the corporate structure (C Corp, S Corp, or LLC) and whether the business sale is an asset sale or a stock sale. First, unless you are planning on going public or have hundreds of stockholders do not form a C Corp to begin with. Use an S Corp or an LLC. If you currently are a C Corp ask your attorney or tax advisor about converting to an S Corp. If you sell your company within a 10-year period of converting to an S Corp the sale can be taxed as if you were still a C Corp.
Here is what happens when there is an asset sale of a C Corp. The assets that are sold are compared to their depreciated basis and the difference is treated as ordinary income to the C Corp. Any good will is a 100% gain and again is treated as ordinary income. This new found income drives up your corporate tax rate, often to the maximum rate of around 34%. You are not done yet. The corporation pays this tax bill and then there is a distribution of the remaining funds to the shareholders. They are taxed a second time at their long term capital gains rate.
Compare this to a C Corp stock sale. The stock is sold and there is no tax to the corporation. The distribution is made to the shareholders and they pay only their long term capital gain on the change in value over their basis. The difference can be hundreds of thousands of dollars.
This anticipated change to the capital gains tax rates will certainly add to the complexity of selling a business. I cannot stress how important a factor taxes will be in your successful business exit. Here is my summary checklist:
Tax Consideration Checklist Get Good Advice on Original Corporate Structure
If C Corp - Retain Ownership of all Appreciating Assets Outside Corporation - i.e. Real Estate, Patents, Franchise Rights: avoid double taxation
Look at Deal Economics First, Taxes Second
Make Sure Your Transaction Support Team has Deal Experience
Before You Go To Market, Work With Your Team to Understand Deal Structure vs. After Tax Proceeds
You Have the Right to Pursue the Minimum Payment of Taxes - Exercise Your Rights
It Is Never as Effective as an Afterthought
The Pros Can Match Your Desired Outcomes With the Right Tools. Be aggressive in your tax positioning of your sale, both with the buyer in your negotiations and with your filing with the IRS. The various deal structure options are very important issues that need to be understood from a tax impact perspective. Remember that a deal term that is favorable to the buyer for tax treatment is correspondingly unfavorable to the seller. You can bet that the buyer's team of advisors is well versed on this topic. Make sure that your team of advisors is equally well versed or you could end up with a much less than you thought in after tax proceeds.
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
Wednesday, June 03, 2009
Maximize The Selling Price of Your Business - Seminar Announcement
As baby boomers retire, business wealth transfer is expected to reach $10 trillion in the coming years. Join us to hear professionals from Bernstein Global Wealth Management, MidMarket Capital Mergers and Acquisitions, Selden Fox CPAs, and Freeborn & Peters Attorneys at Law discuss ways to leverage the sale of your business to achieve multiple goals.
Among the topics they will explore are:
•Why your business selling price is largely determined by how you sell it
•How to minimize your taxes through proper deal structure
•What wealth planning strategies to consider to achieve your long-term goals
•What the role of the M&A attorney is and why it’s important
The Seminar is designed for businesses with revenues between $5 million and $50 and owners that anticipate an exit, transition to the next generation, or an outright sale within the next several years.
DATE
Tuesday, June 23, 2009
2:00–5:00 p.m.
Followed by a reception
LOCATION
Chicago Marriott Oak Brook
1401 West 22nd Street
Oak Brook, IL
Contact Dave to RSVP for this invaluable seminar!
Dave Kauppi
MidMarket Capital
630.325.0123
davekauppi@midmarkcap.com
Owners' and Companies' identities will be protected with the strictest of confidentiality.
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
Among the topics they will explore are:
•Why your business selling price is largely determined by how you sell it
•How to minimize your taxes through proper deal structure
•What wealth planning strategies to consider to achieve your long-term goals
•What the role of the M&A attorney is and why it’s important
The Seminar is designed for businesses with revenues between $5 million and $50 and owners that anticipate an exit, transition to the next generation, or an outright sale within the next several years.
DATE
Tuesday, June 23, 2009
2:00–5:00 p.m.
Followed by a reception
LOCATION
Chicago Marriott Oak Brook
1401 West 22nd Street
Oak Brook, IL
Contact Dave to RSVP for this invaluable seminar!
Dave Kauppi
MidMarket Capital
630.325.0123
davekauppi@midmarkcap.com
Owners' and Companies' identities will be protected with the strictest of confidentiality.
Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist
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