What Factors Impact a Software Company Valuation?

Owners of a software company need to be thinking about how to grow the value of their company.  Understanding some of the factors can help with strategic decisions to drive maximum shareholder value.

A software company will typically be valued by a buyer or investor on factors beyond the financial projections and future cashflows.  Financial buyers that are making their decisions primarily on a cashflow basis, will often offer low valuations, compared to a strategic buyer.  The factors will often be unique to each possible buyer, which makes it important for the seller of a software company to try to understand a buyer’s motivation.

Some of the factors beyond financials include:

Client Base:  A software firm’s client base can have a significant impact on a valuation.  For a buyer, if a target firm’s client base can expand their market or provide a complimentary solution for their IP to increase the revenue from their client base, this has value to the buyer.  In some cases a buyer will be looking to diversify out of their core market and will use an acquisition to buy entry into new markets for their existing products.

Intellectual Property:  How unique is your firm’s IP and what would be the cost to replicate?  Ideally your firm has IP that would be expensive and difficult to replicate, which creates a barrier to entry for competitors and allow for a higher license fee.  A software firm must have clear ownership of their IP.  Where contractors or offshore development is used, legal agreements must be in place to clearly define that ownership of the software resides with the software company.

People:  How depended is the business on key individuals, especially if they are founders/large shareholders?  It is common after an acquisition for founders and large shareholders to move on after a period of time (see blog on Why Do Owners Leave after Selling Their Companies).  The buyer needs to know the organization will continue to operate and grow without the founders.  High turnover, or a heavy reliance on contractors that may not be committed to the firm would be factors negatively affecting the value of a software company.

Strategic Relationships:  If a software firm can provide a buyer with strategic relationships that they do not already have and would be difficult to get, this will have value for the buyer.  When negotiating strategic relationships and partnerships, it is important to try to limit clauses that may limit assignment of the agreement in the event the software company is sold.

Revenue Sources:  Buyers love recurring software revenue.  From a buyer’s perspective, a question can be: “what am I left with if everyone quits after the purchase is completed”.  Contractual recurring revenue provides a predictable revenue stream and will be given a higher value when it is included with the buyer’s financials.  Software companies should look for opportunities to make non contractual revenue that recurs into contractual recurring revenue.  In many cases a client may prefer an annual predictable commitment that can be budgeted.