In December, we talked about the different ways to address the issue of valuation. Because there is so much information to cover, we wanted to revisit this topic and expand on some of the key points. To start, we’ll go over some of the most common valuation methods and in a second post, we’ll break down what makes a software company different when it comes to the valuation process.
There are many different valuation methods available to software companies. Some of these methods are market-based, which rely on comparisons to other like-type companies. Others look at your future cash flows or previous investments in research and development. Other methods such as internal transaction price, book value, liquidation value and internal rate of return aren’t as useful to software companies since they don’t take into account the cost of creating the technology or future growth prospects.
Understanding these methods and whether they apply to your company is the first step to realizing your value today and building toward the valuation you want in the future.
Public Company Multiples
Public multiples are one of the most common valuation methods for software companies because it uses information that is readily available from a variety of public companies. These numbers can also represent the public measure of value for different sectors. We usually use two different metrics for comparison: enterprise value to sales as well as enterprise value to EBITDA.
When we build peer groups, we seek to organize companies by sector, revenue mix or growth profile. Some companies exist in multiple markets or have a variety of different aspects that come into play, and are thus not ideal for comparison purposes.
It should be noted that a valuation based on public company multiples does not reflect the buyer’s premium for strategic value or change of control. It also doesn’t reflect the appropriate discounts either, as public companies are often valued higher than similar private companies due to their size and liquidity. Therefore, it’s important to balance this approach with others, and an experienced valuation team can help in this regard.
Another common method for valuing a technology company is using comparable transactions. Transactions for similar types of software solutions are ideal, but given that the majority of transactions have undisclosed terms, companies with similar business models, size, growth or profitability are suitable substitutions. Enterprise value to sales and to EBITDA are the main metrics incorporated into the analysis, while enterprise value to the number of employees can serve as a sanity check, particularly for services-oriented firms.
It’s important to keep in mind that relevant transactions have an expiration date, especially in the fast-moving tech industry. Typically we focus on deals that happened in the past three years; yesterday’s cutting-edge technology may become a commodity tomorrow.
Discounted Cash Flow
Discounted cash flow (DCF) is one of the most well-known methods for determining valuation across all industries, not just tech. DCF approximates the present value of a company’s future cash flows and for this reason, is popular among young, growing tech companies that don’t have enough of a track record for the other valuation methods.
Revenue and EBITDA projections for the next three years are necessary for this analysis, in addition to determining an appropriate discount rate. Mature companies may use rates as low as 10-15% when calculating the weighted average cost of capital, while venture capitalists use discount rates as high as 50-70% in the pre-revenue stage. Small tech companies with a track record of steady growth may want to explore a rate somewhere in between.
Creating a set of projections is one of the more difficult aspects of this analysis. Companies are often tempted to assign a fixed growth rate to their current year’s numbers; however, a bottom-up approach with recognizable drivers such as customer acquisition cost and churn is far more credible.
Given the number of variables involved in this type of analysis, including the credibility of your projections, discount rate and terminal multiple, this approach is relatively vulnerable to buyer scrutiny and will need to be balanced out by other methods.
Replacement value is a less commonly used technique, however, it is an incredibly important method for determining the value of certain companies. Essentially the purpose of this method is to show a potential buyer whether or not it would cost more for them to build the same team and the same software on their own. Obviously, this is only an approximation since there will be prior legacy work accounted in this method and a rough estimate concerning the time to market factor.
This method is most commonly used for companies with significant investments in IP and low or inconsistent revenue and earnings.
When it comes to finding a balanced approach for the chosen valuation methods, calculating a weighted average is the preferred option. You can assign the same weighting to each method or adjust the weighting depending on the type of company that you own.
To give you an example, a SaaS startup with low historical revenue but significant projected growth will likely want to put more weight on DCF and less weight on comparable transactions and public peer multiples.
It’s important to note that while these methods are helpful in determining a ballpark range of values for your company, their effectiveness may be limited when negotiating with a single buyer in an M&A setting. Our experience has shown that going through a managed process with an M&A advisor and creating an auction environment with two or more potential buyers is the best way to achieve an optimal outcome for your firm.
Now that we’ve covered many of the commonly-used valuation methods, stay tuned for Part 2, where we discuss timing and the preparation required to present your valuation to potential buyers.