Top Ten Keys to a Valuable Valuation - Part 2

In our previous post on valuations, we went over some of the most common methods used to value software companies. In this post, we’re going to cover best-practices for presenting and justifying your desired valuation so that you can be better prepared to achieve an optimal outcome for your firm.

The Software Company Difference

In order to see the real difference between a software company and a traditional family firm, you have to compare the two side by side:

As you can see, the differences are numerous and that means approaches to valuation will differ as well. Some of the unique aspects of software firms such as scalability and high margins, also mean higher multiples. This is confirmed by multiples seen in the public markets, with software and other high technology firms trading on multiples revenue, while other types of businesses tend to be valued on multiples of EBITDA or net income.

The Type of Valuation

Preparing a valuation for the sale of your software company is much different than other types of valuation that you may be accustomed to, such as 409A valuations for common stock.

In order to utilize a market-based approach effectively, you need access to a database of relevant tech companies and transactions, as well as the ability to identify close proxies for your business when direct comps are lacking. An entrepreneur’s first instinct may be to ask their accounting firm for a valuation report, however, this may be beyond their scope and ability. Investing in the proper research to identify comparable companies and transactions that correspond to your size, business model and vertical industry increases the credibility of your valuation analysis.

The Valuation Presentation

When sharing the financial story of your business with buyers, it is important to emphasize the non-quantifiable, intangible assets of the firm in addition to the valuation analysis.

Highlighting assets such as intellectual property, staff domain expertise, and barriers to entry in your presentation helps tilt the build versus buy argument toward the M&A option. Because intangible assets are typically not factored into the valuation analysis, they provide valuable counterpoints that help defend and justify your desired valuation.

Required Financials

When preparing to sell your company, it is vital that you get a proper financial package in order for prospective buyers. At minimum, you will need to provide income statements, balance sheets and statement of cash flows for the past three years. You may also want to consider recasting the statements per GAAP (generally accepted accounting principles) standards, which could mean changing to accrual-based accounting or expensing any capitalized software development.

However, you will also want to ensure that you’re bringing pro-forma earnings statements from the last three years as well as forward three-year projections. This should be presented in a standard accepted financial model with assumptions about strategy, growth and profits.

Pro-forma statements may also exclude one-time expenses that are not part of typical operations or other items that the company thinks will obscure the accuracy of your company’s financial outlook for potential buyers. When preparing projections, you will want to exercise caution. The buyer may tie part of the value of the transaction to earnouts based on projected revenue and profit for your company.

Bonus Keys

There are a couple of other factors to keep in mind as you prepare your company’s valuation:

Timing a Valuation Presentation

One thing many entrepreneurs are surprised to learn is that the timing of the valuation presentation will be critical to the success of your company’s sale. Initial interactions with buyers should revolve around understanding your company’s value proposition and intangible assets — often, only a few financial indicators are shared at this stage with full financials provided later in the process. 

When it comes to providing a full valuation report, we generally advise companies to present a valuation as late as possible. Delaying the valuation presentation allows more potential buyers to come to the table, helping create an auction environment. Having more potential acquirers at the table encourages prospective buyers to pay more as they bid against each other, possibly exceeding the seller’s initial valuation expectations. Putting your stake in the ground too early may mean leaving money on the table.

Quality of Revenue

Earlier this year, we took an in-depth look at quality of revenue in our recent whitepaper, “Understanding your Quality of Revenue.” However, we will reiterate a few of its key points here, since quality of revenue plays a major role in how buyers determine the value of your company.

The relative quality of your revenue in the software industry is based on how much is recurring (i.e. part of a contractual obligation from your user to pay you for your service) and how much is one-time. The most valuable type of revenue on the market is, of course, recurring SaaS revenue. As opposed to on-premise software, the SaaS model enables companies to roll out changes to all users simultaneously, decreasing maintenance costs. In addition, the recurring, contractual nature of the subscription model helps provide a more consistent and predictable revenue stream.

However, optimal valuation outcomes are not limited strictly to SaaS companies. Many companies have been able to either successfully pivot to SaaS or establish a strong recurring maintenance revenue stream; companies with valuable IP, customers, or teams are often forgiven for quality of revenue issues.

Conclusion

Now, if you have reached the end of this post and would like to know more about common valuation methods, read Part 1 of this blog. We also covered many of these points in Corum’s Tech M&A Monthly webcast back in December. And of course, if you have questions about your company’s valuation or preparing your company for an exit, feel free to reach out to us here at Corum.