Valuations: What's Your Company Worth?

Now hear Internet Insider throughout North America and on the Net.

---

With the explosive growth and maturation of the software industry since 1980, the issue of valuing software companies for sale, merger and alliances is becoming increasingly important. However, for most software companies, the valuation methods used for traditional companies can't be used. There is simply no bluebook for software companies.

This article will discuss the unique aspects of the software industry and nine ways to value software companies. We will also look at elements that determine a software company's worth that are not normally considered in valuation models. Our data is drawn from Corum's detailed work in valuing hundreds of companies in the software industry and Software Publisher magazine's exposure to several thousand software firms.

Prospective buyers will place a value on your firm for many reasons including market synergy, technology, patents, distribution, and user base. There are basically nine ways you can value any firm: sales multiple, price-to-earnings ratio, free cash flow model, book value, liquidation/salvage value, replacement value, similar company transaction, internal transaction price and discounted cash flow.

A word of caution before we look at each of the methods in detail: The optimum valuation method is going to be different depending on if you are the buyer or the seller. Obviously, as the seller you are looking for the maximum value; while the buyer will be arguing for the minimum value. While we have been involved in scores of valuations and transactions involving companies for strategic alliances, investment, merger and acquisition, we find that the valuations can range 10 to 1 in some cases depending on the viewpoint and the method used.

The best buyer, the one willing to pay the most, will normally be that firm that gains the greatest leverage in sales and profits through purchasing your company, which is why revenue-based valuation models are usually the most popular.

Sales multiple

Sales multiple is the most common valuation method used. Various books on the subject and "experts" will tell you that the sales multiple can be anywhere from one-half- to four-times the sales depending on the situation. The current rule of thumb in privately held software companies is that the value of a software firm is around 1.5-times trailing software revenue.

Sometimes a higher multiple is used if the company has an exceptional technology in a high-growth or high-profit mode. The multiple would be less if sales are decreasing or the market is shrinking. In 1993 and early 1994, transaction averages actually were somewhat higher than this historical norm, with many firms selling in the two-times sales range.

Before we look at this further, it's important to examine what software sales should include. These are new software sales, recurring license fees, maintenance fees, consulting fees, add-on modules and services, initial support and training, supplies and software sales of third-party products (net margin only).

Warning: Be careful of what period you measure! There are actually five base periods you can use for calculations. Those are prior year, last recorded fiscal year, last 12 months and next fiscal year. The most common base period used, on which both the buyer and seller can agree, is the last 12 months of history. Obviously, if you are selling a company in a high-growth mode, you want to argue for a multiple of current fiscal year, the next 12 months or even the next fiscal year.

Price-to-earnings ratio

The next method of valuing a private firm and the second most popular, is price-to-earnings (PE) ratio, which is multiple of net profits. However one problem with the PE model is that software companies really don't have enough profitable operating history to provide a legitimate ratio and many firms in start-up may have little in profits.

A private company classically will value conservatively at 10-20- times trailing 12 months earnings. Public companies will value anywhere from 10-times earnings to 50-times, depending upon the market. Private companies don't garner the same kind of valuation as public companies. This is called a "liquidity" discount because private firms don't have the credibility, access to debt or resources of a public firm.

Obviously if you are selling and in a high growth mode, you want to project forward to at least the next current fiscal year earnings, even if you use a lower multiple.

A problem with using PE multiple is that the record of private companies frequently doesn't reflect the true cost of business, thus financials may have to be recast. Earnings may be artificially low because the owners have been charging rent on a facility they own, taking royalties out of the company, or paying themselves large salaries and bonuses. (If you are a seller and taking out excessive salary, note that below the net income line in a recasting of the financials.) Conversely, the earnings might be overstated, which is much more common. The reason for this is that often the owners are not taking competitive salaries. If they were taking competitive salaries and benefits, there would be little or no profit.

Free cash flow model

The next method of valuing a company, the cash flow model, is classically used in leverage buy-out situations. Your cash flow is earnings before interest, taxes, depreciation and amortization (EBITDA). This model takes free cash flow available for repayment of debt, times some multiple. The classic cash flow model is three- to eight-times the free cash flow, with the average being about five- to six-times for a software company.

Book value

Book value is basically the net worth of the company on the balance sheet. While book value is a popular method used in traditional companies to establish a value for the company, it isn't relevant for software firms since there is often little in the way of hard assets. Most of the value of software companies is intangible-technology, user base, dealer base, leads, and intellectual property.

Liquidation/salvage value

Like book value, liquidation, breakup or salvage value of most software companies is seldom used as there is little in the way of hard goods and assets (bricks and mortar) with ready cash value. There is no "bluebook" in software.

However, the cash liquidation value could be high if the software has some unique proprietary capabilities, perhaps a patentable algorithm, or an established trade name, user or dealer base that can be sold off separately. The time when liquidation value is relevant is when the company can effectively sell source rights on a repeated basis to users, dealers, and OEMs. This does not leave much value to the "core" remaining company, but it may be the best way to generate a greater total value through multiple transactions.

Replacement value

Replacement value is actually one of the best ways of creating some minimum value, particularly for a young software company or a firm where there is much time invested in the technology. For example, a young company may not have much in the way of sales, user base or dealer base, but it may have spent an extraordinary amount of time and energy and put a great deal of proprietary capability into its product. Thus, the replacement value could well be the highest value it can achieve, because the lack of operating history prevents the other methodologies described above from being applied.

Replacement value also tends to be useful for those firms that have been in business for a long time where there has been an extraordinary amount of time and money expended on the product, which may not be reflected in current revenue and profits because the firm is transitioning platforms, versions or distribution.

The old axiom of replacement value equaling employee-year times some cost per year (e.g. $100,000) isn't as valid as it once was. The reality is that for successful companies pure R&D is often only a small portion of the total cost, and there is the critical issue of time-to-market (window of opportunity).

Thus, today's methods of replacement value try to capture total costs including work done in prior versions of technology, cost replacement user/dealer base and valuing of assistance by technology partners. Also, savvy buyers will understand that pure replacement cost quotes by their R&D people or other developers don't really include lost time-to-market.

Similar company value transaction

One of the most logical ways of looking at a firm is based on what someone else is willing to pay for a like type company. Unfortunately, using public firms as a comparison may greatly overstate the value of a private firm, so you have to look at similar private company transactions.

This requires investigation since such statistics are not readily available. One way you can tell is to look at the acquisitions of a private software company by a public firm. Experts in the industry such as Corum or accounting firms can give you an idea of what comparables there are.

Internal transaction

The internal transaction method often will set the basic minimum for the value of the company. This value is based on the last price of stock sold to an investor, used in a buyout of share or for stock options. Granted, this may not have much to do with any other valuation methodology, but it is useful in negotiation.

Discounted cash flow

Discounted cash flow is a classic financial methodology used in valuation where an end value of projected profits are discounted back to the current period to reflect some value. This is especially useful for firms in the formative stages, soon to enjoy heavy growth and related profits. The problems with software companies is that most don't have a very stable history, so how much you should believe in the accuracy of future projections is debatable. Traditional firms would, for example, use up to 10 years with perhaps 10 to 15 percent discount factor. Software companies should never use more than about five years, and usually only three years, with a much higher discount factor of 20-30 percent.

Using ABC Company, a disguised real company that was just sold, the discounted cash flow model assumes a revenue multiple of 1.5 to capture the terminal value for the residual year (1996) and a conservative discount rate of 30 percent yields the figures below:

Discounted Cash Flow Method

                                  1994      1995      1996     

Projected revenue                $5.0  M     $8.0 M    $12.0  M
After tax cash flow               0.975M      1.56M      2.34 M
Present value
    of after tax cash flow        0.75 M      0.92M      1.065M
Present value of residual                                8.19 M
TOTAL PRESENT VALUE                                    $10.93 M

It should be kept in mind that not all methods can be applied to any given company. For example, if your company is a new start-up you won't be able to use sales multiple or PE, but you could use replacement values, discounted cash flow or similar company transaction. An established firm that has sales history and heavy profits might do best using PE, and sales multiples. The tables below show how you might calculate multiple models for ABC Software.

Sales Multiples Method

                        1993      1994      1995      1996
Revenue                $3.0 M    $5.0 M    $8.0 M    $12.0 M
EBITDA                  0.9 M     1.5 M     2.4 M      3.6 M
Net income              0.59M     0.98M     1.56M      2.34M

Model               Multiple      Value   Avg Value

Revenue multiple   low  --  1.5X  $3.0M     $4.5 M  $  6.75M
                   high --  3.0X  3.0M        9.0M
Cash flow EBITDA            6X    0.9M        5.4M     5.4M
PE multiple        low  -- 10X    0.585M      5.85M    8.78M
                   high -- 20X    0.585M     11.7M       
Replacement value   30 years      0.15M       4.5M     4.5M

Most often, the best thing to do is to pick the methods that apply to your firm and put them into a weighted average. You should use the higher weightings on those methods that are the most relevant and easiest to justify and defend. An example, using ABC Software, as shown below:

Methodology             Value        Weight (%)     Value

Sales multiple          $6.75  M     20 percent     $1.35M
Cash flow EBITDA          5.4  M     15 percent      0.81M
Earnings multiple         8.78 M     20 percent      1.76M
Replacement value         4.5  M     15 percent      0.68M
Discounted cash flow     10.931M     30 percent      3.28M      
                                    ---             ------
TOTAL (Weighted Avg. Valuation)     100 percent     $7.88M

This provides a short overview of the methodologies to value a software company. Unfortunately, the process can be more subjective than objective with intangible issues and strategic partner "fit" bearing heavily on the final valuation. For example, the presence, or absence, of key founders or product developers can have a material impact on value. Similarly, the capabilities of the acquiring company or investor are important variables. Thus, use multiple methods, attempt to consider all the issues, and understand your structure options (as structure is more important than valuation). Be creative in how you structure the deal in order to get the value you want.

Bruce Milne is founder of Corum group Ltd., a firm specializing in investments, merger and acquisition, and strategic assistance for software companies. He is an advisory board member for Apple, Comdex, Microsoft and IBM, and leader of the national Selling Up Selling Out conference series. Milne can be reached at 206-455-8281.

This article originally appeared in the November/December 1994 issue of Software Publisher.

LinkExchange Member