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Trends & Developments - Feb 2015 - Corporate Finance: Valuing Software Companies

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Valuing software companies can be based on the same core valuation methodologies for valuing a business which considers either the:

Income approach – DCF
Market approach – Multiples of revenues and earnings

Both the income approach and market approach consider the risks of achieving future increasing profitability – the more risk the higher the discount rate for a discounted cash flow model and lower the value; the more risk the lower the multiple for a market based approach and lower the value.  For both approaches, the risks are based upon the factors impacting the ability to grow future revenues and cash flows.

Software companies primarily are valued based on revenue multiples. What drives the revenue multiple is expectations for future revenue growth and related profitability, which typically focuses on gross margins.  When we talk about revenue multiples, we typically are presenting Enterprise Value/TTM Revenue (Equity and Debt/Last 12 months).

The need to value a software company often begins long before determining what the business can be sold for.  The need typically develops when a company needs to raise money from outside investors – venture capitalists – to provide capital for future growth.  Those venture capitalists will assess the risks associated with the business.

Some examples of the risks –

  • Is there a meaningful sized market?
  • If the market is meaningful sized, can you succeed in what will likely be a competitive market?
  • Do you have or can you put together the team that can execute the plan?
  • Is what you're creating unique and not easily replicated by other competitors?
  • Are there many potential acquirers for your company?

I am going to talk about how software companies are valued at the point at which they have developed a revenue base and discuss some of the key factors and metrics that are used to evaluate expectations for future growth, which is used to determine what the revenue multiple will be.

While there are traditional, on-premise software companies that typically charge significant license fees up front and receive maintenance fees going forward, there has been huge growth toward Software as a Service ("SaaS") companies as users have become more comfortable using software in the cloud and paying monthly fees. 

While valuation for both traditional and SaaS models are based on the same concepts, I'm going to focus more on SaaS businesses.  Generally, over the last few years SaaS companies have been growing faster and commanding higher revenue multiples.

The accounting for revenue generally differs between SaaS companies and on-premise software businesses because generally the large upfront payment for an on-premise business may be recognized over the life of the contract. For an SaaS business, revenue would be recognized each month with each monthly payment.

According to the Software Industry Financial Report for Q3 2014 published by Software Equity Group, for the M&A market the median exit multiple for on-premise software companies was 2.4 x revenue and for SaaS companies the median was 4.1 x revenue.  It is interesting to note that on a TTM (trailing twelve months) basis, the M&A transactions with the highest multiples involved a large public or private acquirer (> $200M in revenue) acquiring small targets (<$20M in revenue) with median multiple of 3.4 x revenue looking at the total SaaS and on-premise acquisitions.

Information on historical and projected growth rates is not typically publicly available for M&A transactions. However, for Q3 2014, we can observe that for publicly traded on-premise software companies the median revenue multiples for companies with TTM revenue growing between 0% and 10% was 3.1x and for companies with TTM revenue growing in excess of 40% was 4.9x.  The difference in multiples is even more pronounced for SaaS companies where the median revenue multiples for companies with TTM revenue growing between 0% and 10% was 2.9x and for companies with TTM revenue growing in between 40% and 50% was 9.1x and growing in excess of 50% was 12.2x.  Typically, you can't achieve and sustain such high growth rates without raising outside capital. If you're interested, the Software Equity Group (link--http://www.softwareequity.com/index.aspx) reports have a lot of information on valuation metrics for software and internet companies.

Now to discuss some of the specifics of evaluating revenue growth – both historical and projected.  Both the company raising money, or looking to sell, and a potential acquirer or investor will evaluate projected revenues.  Typically, a company looking to raise money or sell will want to emphasize projected revenues and an acquirer/investor will emphasize historical TTM performance and often a run-rate (quarterly or monthly) will also be considered.  Historical revenue growth rates will be evaluated and are critical factors in assessing the likelihood of future growth of revenues and timing of future profitability.  Additionally, particularly for on-premise software companies, recurring and non-recurring revenues will be analyzed separately and valued differently.  A large one-time project will not command the same multiple as recurring revenue.

Revenue growth is clearly impacted by the competitive environment in which a software company operates. Therefore, being able to demonstrate the ability to introduce a software product to different types of customers, or different types of software products to specific types of customers, is important.  You need to substantiate the continued growth for revenues from existing products, or the viability of a newly introduced product or market.

Now let's talk about the critical factors to consider when evaluating the "quality" of the revenue because revenues are not created or, for that matter, valued equally:

3 significant factors impacting the "quality" of revenues:

  • What does it cost to get a customer?
  • What is the profitability of the customer acquired (based on the gross margin on revenues and the length of time you keep a customer)?
  • How effectively are you able to retain customers? Conversely, what is your churn rate?

These factors are really highlighted when looking at SaaS businesses given that the payments are spread out more evenly over the term with a customer (i.e., there typically is not a significant payment made up front).  The discussion that follows presents some of the metrics that are used to analyze a software company and are important considerations in estimating value.  These formulas can be further refined and in practice would be applied to different buckets of revenue (i.e., particular software offering, large companies vs. small companies, customers by types of businesses, new customers vs. old customers, etc.).  I'm using these formulas to illustrate the concepts.

Customer Acquisition Costs ("CAC")

If a company has high customer acquisition costs, more capital will be needed to grow the business.  What also needs to be considered is what the expected payback in terms of revenue, and profit, will be from the customer once the customer is acquired.  This relationship can be measured through what is called a CAC Ratio.  The CAC Ratio reflects how much new customers contribute back as gross margin within a year and can be calculated as follows:

CAC Ratio = Increase in Gross Margin Generated for a Quarter x 4
  Sales & Marketing Costs for the Prior Quarter

Depending on the time period it takes to get a customer, the formula would be adjusted.  If the time period is short you could use the sales and marketing costs expended in the current quarter.

So what does it mean if you have a CAC Ratio of .5?  A CAC Ratio of .5 means that you get back half of you investment in a year and that you have a payback period of 2 years.

Churn Rate

A low churn rate can substantiate the viability of the revenues derived from a software product.

Monthly Churn Rate = # of Customers at Beginning of the Month
  – # of Customers at the End of the Month
  # of Customers at Beginning of the Month

In calculating the monthly churn rate, the number of customers at the end of the month does not include newly added customers during the month.  This is because the calculation is trying to isolate the ability to retain customers from the ability to obtain customers.

Customer Lifetime

Average Customer Lifetime = 1
  Monthly Churn Rate

For example, if the monthly churn rate is 4% the average customer lifetime is 25 months or approximately 2 years.

So if we consider our initial CAC ratio of .5 implied that the payback for acquired customers is approximately 2 years and if the calculated average customer lifetime is 2 years, this is not a great situation.  It should be apparent that the shorter the payback from an acquired customer and the longer the customer lifetime, the more valuable the customer is.

To tie it altogether, the ability to control churn is critical as it significantly impacts valuation through impact on revenue and profitability.  Lower churn results in higher revenues and higher revenue growth, and therefore more gross margin that can be reinvested to grow sales. If the churn rate is stable, there is less risk associated with projected future revenues and cash flows and higher value.


Trends & Developments - February 2015

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