Software Company Business Valuation - Why Is It So Difficult?

Updated on June 16, 2020
David Kauppi profile image

Dave Kauppi is an M&A Advisor and author of "Selling Your Software Company - An Insider's Guide to Achieving Strategic Value."

Software Company Valuations

Current Valuation Models May Not Work

Owners of software companies are rarely satisfied with a business valuation they get from an accounting firm or a valuation firm. They are frustrated because those valuations are pretty much governed by standards that are applied over all businesses, whether manufacturing, services, distribution, etc. I am inclined to agree with these software entrepreneurs because software companies have unique characteristics that create value that the current valuation algorithms fail to account for.

Software Marginal Costs Approach $0

Software Marginal Costs Approach $0
Software Marginal Costs Approach $0

Marginal Cost Versus Exponential Scalability

In Business School we learned about the concept of marginal cost and economies of scale. The principal was that once you hit a certain production volume, your cost to produce that next item would decline because you were able to spread your fixed cost over a greater number of units. However, the marginal cost in traditional manufacturing is still a function of material, labor, and capital cost inputs that may vary by volume, but that variance is a linear function. So for example, going from producing 1,000 items to producing 10,000 items may lower your per unit materials cost by 20% because of volume discounts.

Today, software as a product offering behaves much differently in terms of the marginal cost of production. Once you have written and debugged the software and have had it installed and successfully operational with a critical mass of customers, the economics become very favorable. With the majority of software today either downloaded including a digital copy of the user manual, or offered as a SaaS, the marginal cost for that next copy is effectively $0.

The smaller software company with a small customer base and a small sales force is generally not able to hit a critical mass necessary to unleash the exponential power of this inherent, almost 100%, gross margin. So you can see the constraints put on a valuation firm in trying to value this company for anything other than its own ability to execute.

Software Company Valuation Puzzle

Software Company Valuation Puzzle
Software Company Valuation Puzzle

Microsoft or Google Should Buy My Software Company

The software entrepreneur is an avid watcher of industry developments and tracks the latest M&A activity in their market niche. They site that Tech Giant A recently acquired the largest competitor in their space with $300 million in sales and 2,000 installed accounts for $1.5 billion. They then make the leap that their $5 million in revenue company should be worth 5 X revenue, or $25 million. It does not work that way. Large companies with scale are valued at a very significant premium to a similar smaller company.

Very large companies almost always want to buy only large companies. There are a few exceptions to this rule. One is a company that has a large user base and has grown organically but has little to no revenue to speak of. The second possible exception is a company that has developed a highly specialized and unique technology in one of the future stars categories like IOT, data analytics, artificial intelligence machine learning, or blockchain.

Because the big companies are looking to move the needle with an acquisition, their M&A teams do not engage with small software companies as acquisition targets. So basing the business value on the results that Microsoft could achieve by unleashing your product with their massive power in the marketplace is not a reality.

Buyers are Skeptical of Hockey Stick Growth

Now in a valuation technique called discounted cash flow, a valuation firm is able to build growth assumptions into the model in order to account for the company with hyper-growth projections. The practical reality is that buyers are very skeptical of valuations that rely on this type of growth. The other flaw is that those growth assumptions can only be achieved with a large capital infusion to support the growth or by leveraging the market presence and scale of the acquiring company post acquisition. The acquiring company will argue that they should not pay for future performance that will largely be the result of their brand name and resources.

The Magic of Competitive Bidding in M&A

The Magic of Competitive Bidding in M&A
The Magic of Competitive Bidding in M&A

Valuation Opinions Versus Market Validation

So you can see the dilemma. The software entrepreneurs know that they have created tremendous potential and if they had the resources and scale, they could approach that zone of exponential gross margin. The buyers' default position on value is usually some conservative multiple of EBITDA and unless forced to move off of that position, that will be their offer. The art in the process is to help multiple buyers recognize the performance potential of overlaying your company's assets onto their sales force, install base, brand name, and distribution capability. The first level of this analysis is to project your product sales in this new environment. Don't forget the price increases that the brand name owner can initiate, often up to a 40% premium over the smaller company's price. Phase two of this strategic positioning is to introduce the potential additional product sales the acquiring company could realize by incorporating your product into their overall offering to make it more competitive.

The more buyers you have engaged in this process the greater the probability that this messaging will resonate with them and they may start to do some calculations on post acquisition synergy, revenue and profit expansion. So let's say that one buyer looks at the potential as 1+1=2, the second thinks 1+1=2.5, the third views it as 1+1=3, and the fourth thinks the acquisition produces 1+1 =3.5. Now let's say that the starting bid position for each one was very close to a 5 X EBITDA valuation and you reject each of those bids. Well, the 1+1=2 buyer will probably drop out. The others will recognize that they can afford to enhance their bids based on the additional synergy value they have identified.

As an example, your current EBITDA is $1 million and your valuation at 5 X EBITDA = $5 million. Buyer 1 continues to value you at $5 million. The others may do a theoretical value calculation using the post acquisition performance of the combined companies or total synergy value. That might create values such as Buyer 2 at $6 million, Buyer 3 at $7 million and Buyer 4 at $8 million. Remember, this number is a theoretical ceiling value and the buyers normally don't give the seller any more credit than necessary for the post-acquisition performance that is largely due to the buyers resources.

The objective is to convince the buyers to increase their bid to give the seller 25% credit for the post-acquisition performance bump. The resulting bids would then be, Buyer 2 at $5.25 million, Buyer 3 at $5.5 million, and Buyer 4 at $ 5.75 million. If the deal closes at this top number, then the buyer would have earned a strategic value premium of 15%.

The Market Has Spoken

You have done all of the right things to get multiple buyers involved, captured and presented your strategic value proposition, and have negotiated hard to the finish line. You recognize that this process has provided the ultimate company valuation. The decision now becomes, is it enough for me to sell?

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.


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    • David Kauppi profile imageAUTHOR

      Dave Kauppi 

      18 months ago from Hinsdale, IL

      Thanks for reading. If you like our content, you may want to look at our Book on Amazon Selling your Software Company - An Insider's Guide to Achieving Strategic Value


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