Business valuations of software companies use proven methodologies to arrive at an indication of value. If the technology is one in demand, however, the valuations provided by the markets can be off the charts. This article discusses how the pros value software companies and the limitations to their approach.

The Influence of High-Profile Tech Deals

Software company owners looking to sell their companies are often inspired to start the process after reading about the latest high profile, stratospheric acquisition price paid by a large tech bell weather company. The transaction metrics (i.e., transaction value to sales or transaction value to EBIT) sometimes defy all logic.

The new, would-be seller applies these metrics to his company's sales and EBIT and determines that IBM, Microsoft, Google, Oracle, Cisco, etc. should be ready to get into a bidding war over his $5 million in revenue, game changing, best-in-breed software company for a value of 8X revenue.

Let's break down the methodology that professional business valuation firms use as their standard in arriving at a company's indicated value. Their approach calls for a triangulation of three valuation methodologies.

Public Company Comps

The first is a comparison to publicly traded companies in the same category. It is very interesting to look at the lists that the valuators come up with. Technically they are all software companies with SIC Code 5734-01, but they are as alike as apples, coconuts, watermelons and blueberries. True, they are all fruit; but that is where the similarity ends.

Next, they take the valuation metrics of these publicly traded companies. The most commonly used are sales to enterprise value and EBIT to enterprise value. Next they come up with the median value (one half of the companies are above the value and one half are below). They then apply what is best described as an arbitrary discount factor to account for the value differential between public companies and small, closely-held companies. They come up with their adjusted metrics then apply them to the target company and voila: you have one of the valuation legs completed.

Completed Private Company Transactions

The valuation analyst next applies the same approach to actual completed transactions. If the buyer was a public company, then the metrics are publicly available. If the transaction is between two privately held companies, the metrics are only available on a voluntary basis. Maybe 10% of these participants release information about these transactions. These unreported deals are probably the best fit in terms of comparables, unfortunately.

In order to get a meaningful number of transactions, the analyst often is forced to use transactions from a 5-10 year period. Do you know how to say tech bubble or tech meltdown? This is not a simple process.

The Old Reliable — Discounted Cash Flow

Wait, maybe we can add some much-needed precision with the third valuation technique, the discounted cash flow method. First, calculate a risk-adjusted discount rate. After three pages of explanation, you'll usually arrive at a discount rate of between 24–30%. Next, project the after-tax cash flow for the next five years and discount it to present value.

They then calculate the terminal value of the company (five years of year five cash flow discounted by the risk-adjusted rate less the projected growth rate). They discount that number to present value and add that to the discounted cash flow to create the third leg of the valuation stool.

How many software companies are not projecting hockey stick growth during the valuation period in question? Not only are these projections very aggressive, but cash flow margins are projected to improve by a factor of three times during this same period.

The Seller's Research Helps Set Valuation Expectations

Now our seller is armed and dangerous with his company's value. That becomes his minimal acceptable offer and it must all be in cash at closing. To use a Wall Street saying, this company is priced for perfection. We often discover during a sell-side engagement that these projections are not just missed, but they are missed by a large margin. In spite of this, the seller's valuation expectations remain the same.

All is not lost, however. One of the unique aspects of selling a software company is that if the technology is fresh (think SaaS, mobile apps, virtualization, cloud computing), financial multiples are often not the driving force in the buyer's valuation equation.

For Some Tech Companies, the Market Exceeds Expectations

One thing that we have learned in the representation of software companies for sale is that the value is subject to broad interpretation by the market. We find that strategic buyers in this space are driven by such considerations as first mover advantage, time to market, development costs, customer acquisition costs, customer defections and enhancing an existing product suite.

The better the target company addresses these issues, the greater the post acquisition value creation potential. If the right buyer is located and recognizes the seller's potential when integrated with the new owner's distribution channel and customer base, we may find an even bigger hockey stick then our very optimistic sellers. If two or three buyers recognize a similar dynamic, then the valuations can become very exciting.