Build Your Recurring Revenue Before You Sell Your Software Company
Learn some of the best ways to build recurring revenue in your software company
Owners should take several actions 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 they are implemented prior to the sale, the buyers will reflect that in an enhanced purchase price.
It is fascinating to watch the tectonic shift in the business models of every company from the software giants like Microsoft, Oracle and Adobe down to the ten employee IT consulting firms. Remember the days when you would buy a PC with the Microsoft operating system pre-loaded and all you had to purchase was a license for Microsoft Office? Well, in most cases, that was the last revenue that Microsoft received from you until you purchased your next PC 5 years later.
All of these giants have now switched to the subscription model, a cloud-based model or the SaaS (software as a service) model. In the initial implementation, revenues may take a small dip as you exchange one up-front license for a monthly recurring charge, but, in the long run, this approach is a big win for the companies. It smooths out their revenue stream, makes revenues more predictable and ultimately causes an increase in revenue.
Don't take my word for it, just look at how the stocks of Microsoft and Adobe have performed following the full implementation of this strategy. Well this strategy has trickled down to the smaller software and IT services companies as well. Project-based IT consulting companies are disappearing, VARs (value-added resellers) are attempting to become MSPs (managed services providers) and small software companies are rolling out their cloud version software. The results have been dramatic, with the growth of these business models matching what is happening on the upper end.
Every dollar that a business buyer keeps in his or her pocket is a dollar that the business seller will not receive. This is largely determined by the state of the business when the buyer is in the negotiation process. The most important metric is normally EBITDA. Another very important factor is recurring revenue. If a business implements recurring revenue improvements 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 the company for the improvements.
Review all long-term maintenance contracts and implement price increases that are covered by any annual increase limits. Send the sales team out to all accounts that are not on the latest version. Make those accounts current with the appropriate license and maintenance level increase.
Identify all accounts that use your software and are not currently covered by an annual maintenance contract, but rather by a time and materials (T&M) contract. Offer them a one-time fee to get the latest software version if they agree to execute an annual maintenance agreement.
Are there any add-on modules that the customer base has been slow to adopt? Offer a two 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 the company's level of contractually recurring revenue. That is the most important financial driver of the value of a software company.
Cut Where Necessary
Tie these actions directly to the sales team's commission plan. The commission plan should tell the sales reps exactly what is valued. A higher commission rate should be applied to recurring revenue contracts. If there are poor performers, immediately put them on notice. Leaders may tie their future employment to meeting some short-term goals in these strategic areas.
If they continue to underperform, let them go. A buyer that is looking at any business will rightfully question the management capability when they find, in due diligence, that a poor performer was allowed to continue draining benefits from the company. If there is concern that firing the sales rep would be disruptive to the established 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 the company $50,000 in EBITDA and the company will sell at a 7X multiple, this laggard will cost $350,000 in transaction value.
The key short-term strategy in maximizing a company's value in the marketplace is to increase the level of contractually recurring revenue. As an acquiring company looks at the company as a potential acquisition target, they place a value of, for example, 1X on projected new sales supported by historical performance. They will place a value of 2X on the revenue that is covered by contracts they acquire with the purchase of the software company.
Finally, a very important component in any technology business sale is the percentage of transaction value paid as cash at close. The greater the percentage of company sales that are covered by contractually recurring revenue contracts, the greater the percentage of transaction value that will be paid in cash at close. The greater the percentage of revenue that is based on new sales or time and materials revenue, the greater percentage of transaction value will be shifted into some future, contingent transaction value such as an earn out. Buyers hate risk and love certainty. Provide them with that certainty of contractually recurring revenue and you will be rewarded with a higher business selling price and a greater percentage of that price in cash at closing.
Written by Dave Kauppi
Dave Kauppi is a Merger and Acquisition Advisor with MidMarket Capital, Inc. Dave is based out of the greater Chicago area and specializes in Technology, Information Technology, Healthcare and intellectual property focused companies. Dave is also the author of the Exit Strategist Newsletter.