You risked everything by leaving your comfortable, well-paying position with the large corporation to start your own software company. You devoted every waking hour (and many of your sleeping ones too) to your business for years, worked for low pay, and plowed all of your profits (what little there have been) back into R&D. So the question you have now is “what’s my company worth?” It is a question we frequently get from our software company clients, and a difficult one to answer, given the dynamics of the industry. This month’s article takes a stab at answering that question for you by discussing the factors that go into determining the value of a software company and providing some general rules of thumb.
General Valuation Methods and the Dynamics of the Software Industry
There are nine generally recognized ways to value a software business, although not all will be appropriate for your particular company, and a weighting of the various selected methods should be used. Each of these methods is briefly described below.
1. Sales Multiple
A quick and easy way to estimate the value of a software company is by applying a multiple to your annual revenue. For companies with significant direct costs of sale such as purchased hardware, applying the multiple to gross profit is more appropriate. There is some latitude in valuations based upon the growth of the company, using trailing (last 12 months), actual (fiscal year projections) and forecasted (next twelve months or fiscal year) revenue. The sales multiple method is not often used when revenues are highly volatile or declining. Sales of software companies typically occur in the 1 to 2 times revenue range, although sales at higher and lower multiples do occur.
2. Price Earnings Ratio
This traditional method of valuation has been applied to companies in all industries, and is the most often quoted method of valuation for public companies. P/E multiples ranging from 5 to 50 are common in the software industry, with growth of company and growth of industry directing the selection of the multiple. A reasonable valuation is generally around 10 times net income.
3. Internal Rate of Return Method
Internal rate of return is a classic financial methodology used in valuations, where projected profits are discounted back to the current period. The problem with software companies is that most of them do not have a stable enough history to rely upon the numbers. In other industries, the calculation might use up to ten years of projected cash flow, discounted back to present value and discounted a further fifteen percent. Software
companies would never use more than five years, and would employ a higher discount factor of twenty percent or more.
4. Free Cash Flow Model
This method is often used to value privately held software companies, with a range of five to eight times the cash available to spend after operating expenses being the usual method of calculation. Free cash flow is important when the buyer intends to finance the purchase using the revenue from the purchased company itself. Free cash flow is net income plus interest expense, income taxes, depreciation and amortization, minus software development costs capitalized in the current year and current year fixed asset purchases.
5. Replacement Value
This is one of the best ways to create some minimum value, especially for young software companies, or where the investment in technology has been heavy and the life span of the technology is long. Replacement value goes up where there is a high barrier to entry due to proprietary tools or patents or new technologies. The replacement value assigned to the software is determined by calculating the amount of time and cost which would be saved in the rewrite of the company’s products. The value of the installed base may generally be figured at around four times the recurring revenue.
6. Book Value Method
Book value is the amount of assets on the books in excess of the liabilities on the books. While an important accounting concept and important in managing the business, it is generally not very relevant in determining the true value of most software companies, since the value of the user base, recurring revenue stream, and cost to recreate the technology are largely ignored using this method. Also, book value for a software company may be influenced heavily by the company’s policy with respect to capitalizing software development costs. Book value is often multiplied by a multiple of 2 or 3, then used as a sanity check against other methods.
7. Liquidation/Salvage Value
This value, in software businesses especially, is only used as a minimum floor below which no offer should ever fall. Software companies have very little in the way of hard assets, and the most valuable assets are intangible.
8. Similar Company Transactions
A very logical way to examine the value of a company is to base the value upon what someone else is willing to pay for a like company. Unfortunately, information on private company transactions is rarely available, except when public companies purchase
privately held firms and must reveal the amount paid in their 10-Q and 10-K forms for public scrutiny.
9. Recent Internal Transaction Price
This value often sets the basic minimum if there has been such a transaction within a relevant time period. Qualifying transactions would include actual share sales prices, qualified stock options granted, valuations by independent appraisers if used for Employee Stock Option Plans under ERISA rules, or internal buy-sell transactions between partners. There is flexibility here, as in any valuation, based on the negotiation as to how the payment is to be made and over what time period, etc.
If you are going to sell your software company to a buyer who will operate it just as you have been operating it, then the above general formulas probably work pretty well. The highest values typically come, however, from a strategic sale; i.e. selling to a buyer who is able to generate much higher earnings out of the business.
A strategic buyer is generally a larger company in your same, or a related, industry which will be able to eliminate certain of your expenses or generate additional revenue by layering your product(s) in with products it is already distributing. A strategic buyer may be able to eliminate an entire layer of overhead, or may substantially increase sales of your product by selling it through its existing distribution channel, or increase sales of its other products by selling them through your existing distribution channel.
The key to determining the value of your company in a strategic acquisition, is to look not to what your company is worth the way you are operating today, but instead to what it will be worth to the buyer, taking into account the changes the buyer will make. To do this, make a rough estimate of the future revenue that the buyer will be able to generate from your business, and a rough estimate of what the related expenses will be. If the buyer is a publicly traded company, then its stock probably trades on a multiple of earnings. Apply this multiple to the amount by which your business will increase its net earnings, and you will have a good feel for how much your business could increase the value of the buyer company.
If what the buyer is primarily interested in is your technology, then the best way to determine the value of your company may be to determine how much it would cost the buyer to develop the technology. If what the buyer is primarily interested in is your customer base, then estimate how much it would cost the buyer to develop this level of market share. This same approach can be taken with any other possible benefit of your business to a prospective buyer. The point is that even if your business has always operated at a loss, there may be significant value to a strategic buyer.
Rules of Thumb
The value of your specific company will depend on a number of factors, as discussed above, including not only the financial factors such as revenue, net earnings, cash flow and balance sheet,
but also the size of the potential market for your products, your company’s market share, competition, your customer base, your technology, distribution channels, the skill of the work force you have in place, and a host of other factors. However, there are some rough rules of thumb you can use as a quick guide.
Software companies are generally worth somewhere between 1 and 2 times annual revenue. If your company is unprofitable, not growing, has a small market share and obsolete technology, then it is probably worth far less than 1 times annual revenue. At the other extreme, if your company has leading edge technology, is profitable, growing rapidly and is the dominant player in your niche, then it may be worth much more than 2 times annual revenue. Most software companies, however, will likely fall within the 1 to 2 times annual revenue rule of thumb.
For a more precise value of your company, you may wish to try The Dunn-Rankin Formula™. Developed by David Dunn-Rankin, from an analysis of available public company data and from personal experience, The Dunn-Rankin Formula™ is as follows:
[(net profit margin / 5%) + (growth rate / 10%)] ÷ 2 = multiple of revenue valuation
multiple of revenue valuation x annual revenue = value of company
The formula could be adjusted for unusual swings in sales or earnings. A rapidly growing company may use next year’s numbers with a present value discount. Since this is the “public” price, you need to adjust your value 20% – 50% downward to reflect the normal discount for stock of privately held companies. Obviously, if you use your current data, then this formula values your company as currently operated by you. So, to determine the likely value of your company in a strategic acquisition, you would need to adjust your profit margin, growth rate and revenue to the numbers that could be generated by the buyer, and then apply the formula.
The value of your software company will depend on a variety of factors that are specific to your company and its market. However, as a general rule of thumb, most software companies are worth between 1 and 2 times annual revenue.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.