There are many factors to take into account when it comes to calculating the value of a company. The process gets even trickier if it’s a tech, software, or online business.
The procedure for valuing any business is the same: calculate its SDE or EBITDA and then apply a multiple. In some cases, a tech business may be valued based on revenue. However, multiples are significantly different for tech, software, and online companies.
And the factors that affect the multiples are different as well. Those considerations include:
- Scalability of the business
- Levels of risk and how they are addressed
- Recurring revenue
- The company’s growth rate
- The condition of the online code, and
- The cost to replicate the business.
In the following article, you’ll learn about the various valuation processes and formulas, and the steps you can take to increase the value of any tech, software, or online company. Ready when you are …
Table of Contents
- The Valuation Process for Tech, Software & Online Businesses
- Valuation Formula for Tech, Software & Online Businesses
- Method #1: Multiple of EBITDA
- Method #2: Multiple of Revenue
- Deciding Which Method to Use
- EBITDA Multiples for Tech Businesses
- Factors that Affect the Multiple
- Factor #1: Scalability
- Factor #2: Business Plan & Assumptions
- Factor #3: Risk
- Factor #4: Recurring Revenue
- Factor #5: Contracts
- Factor #6: EBITDA
- Factor #7: Growth Rate
- Factor #8: Customer Concentration
- Factor #9: Customer Base
- Factor #10: Customer Database
- Factor #11: Staff
- Factor #12: Sales Team
- Factor #13: Metrics
- Factor #14: Code
- Factor #15: Cost to Replicate
- Using Comparable Transactions To Value Your Company
- Tips for Finding Comparable Transactions
- An Important Note on the Range of Values for Small to Mid-Sized Businesses
- How Industry Activity Affects Value
- Synergies & Strategic Value
- Valuation & Deal Structure
- Business Valuation in the Real World
- How Big is Too Big?
- Other Factors that Can Affect Business Value
The Valuation Process for Tech, Software & Online Businesses
You don’t need a formal valuation to find out what your tech, software, or online business is worth. It’s better to receive an opinion from someone who is in the trenches than to receive a formal appraisal from an appraiser with no real-world experience in the purchase and sale of companies. This is one of the primary reasons we don’t recommend Third-Party Appraisals.
Here is a summary of the steps we go through to value a tech, software, or online company:
1) We gather information on the company, such as a questionnaire, financial statements, and key metrics.
2) We analyze the information, and perform additional research, if necessary.
3) We establish a baseline value for the company based on Fair Market Value (FMV).
4) We discuss our initial baseline value with the owner, assessing the potential for strategic value from a synergistic buyer, and tweak our valuation model to account for possible synergies and other information we gain during our discussion.
Related Resource: M&A Talk Podcast — Jeff Wald, Founder of WorkMarket, on a $100 Million+ Exit — In this episode of M&A Talk, I interviewed Jeff Wald, who successfully founded and exited several technology companies. His most recent exit was a $100 Million+ exit to ADP.
Valuation Formulas for Tech, Software & Online Businesses
There are two primary methods for valuing an online business:
Method #1: Multiple of EBITDA
The primary method for valuing nearly all tech, online or software companies is based on a multiple of EBITDA. For example, a company with an EBITDA of $2 million, and an expected multiple of 5.0, will be valued at $10 million.
A multiple is the inverse of ROI or a capitalization (cap) rate. For example, a 5.0 multiple is equivalent to a 20% ROI or cap rate. A 4.0 multiple is equivalent to a 25% ROI or cap rate (¼ = 25%).
Businesses are valued using a range concept because the possible values for a business are much wider than for other investments. For example, a business may be valued at a 4.0 to 6.0 multiple. This represents a potential range in value that can differ by up to 50%. Where in the range your business falls depends on its value drivers.
How are the intangible facts of my business taken into account? The intangible attributes of your business are taken into account when determining where in the range of values your business falls. If your business has a significant number of positive factors, your business will fall higher in the range of potential values. Buyers in the middle market value an intangible asset to the extent that it produces revenue or cash flow. If an intangible asset does not generate revenue and cash flow, then most buyers won’t place significant value on it.
Consider this situation: if buyers don’t place a high value on intangible assets that don’t generate cash flow, why did Facebook pay $1 billion for Instagram when Instagram only had 13 employees at the time? They paid that amount because Facebook could exponentially leverage the potential of Instagram. Such cases are far less common in the middle market, and especially in the lower middle market. It is important to note that there are vast differences between public and private companies.
What if my company’s revenue is high but EBITDA is minimal? If your business model is sound and you are re-investing excess profits to fuel growth, your company may be valued based on a multiple of revenue. If your business model is unsound, the Fair Market Value (FMV) will be low for your business, but the strategic value could potentially be high — but only if a strategic buyer can easily address any underlying problems with your business model.
Method #2: Multiple of Revenue
The second most commonly used metric to value tech, software, and online businesses is a multiple of, or percentage of, revenue.
For example, a company generating $10 million in revenue that is valued at 80% of its revenue is worth $8 million.
This method is more applicable when the expense structure of your business is likely to change post-acquisition. This will only happen in the case of a strategic acquisition in which your business will be integrated with the buyer’s and significant synergies will result. If the buyer’s margins are expected to significantly increase as a result of the acquisition, you may argue to value your company based on its revenue. Notice I carefully selected the word “argue.” That’s because a buyer will not volunteer to pay more for your company than they have to. The excess value will only come as the result of skilled negotiations or positioning, or both.
Deciding Which Method to Use
Deciding which method to use — multiple of EBITDA or multiple of revenue — is more art than science.
- Multiple of revenue. In general, a multiple of revenue is applicable only if you are dealing with a synergistic buyer who will be integrating your company to some extent with theirs.
- Multiple of EBITDA. If the business will be run on a standalone basis after the closing, then you are generally restricted to valuing your company on a multiple of EBITDA.
These guidelines are just that — guidelines. They are no substitute for an expert’s opinion from someone who is active in the marketplace on a full-time basis.
EBITDA Multiples for Tech Businesses
Most middle-market companies with revenues from $5 million to $20 million will be valued at 4.0 to 6.0 times their EBITDA, and companies generating $20 million to $50 million in revenue will be valued at 5.0 to 7.0 times their revenue. Small companies with revenues of less than $5 million will generally be valued at 3.0 to 5.0 times EBITDA.
Why do publicly traded companies sell at 20 to 30 times EBITDA? They don’t. Most are valued at 15 to 30 times earnings, which is after interest, taxes, depreciation, and amortization.
Here is a summary of EBITDA multiples for the S&P 500 by industry sector from 1995 – 2020:
- Communications: 11 – 12 times EBITDA
- Consumer Discretionary: 13 – 18 times EBITDA
- Consumer Staples: 13 – 15 times EBITDA
- Energy: 7 – 15 times EBITDA
- Health Care: 14 – 15 times EBITDA
- Industrials: 11 – 14 times EBITDA
- Info Technology: 11 – 18 times EBITDA
- Materials: 10 – 14 times EBITDA
- Utilities: 11 – 12 times EBITDA
Note that this is for companies in the S&P 500. These are the largest, most prestigious, and most respected companies in America. Multiples for middle-market companies are proportionally smaller.
Factors that Affect the Multiple
Here are some of the factors that can impact the multiple you can expect to receive for your business.
Factor #1: Scalability
Buyers will assess what is involved in scaling your company. The more scalable your company is, the higher the multiple you will receive. If your company is heavily dependent on distribution channels that are not scalable, or if your services are customized, then you will receive a lower multiple. Viral business models are more scalable than direct B2B sales, and will therefore receive higher multiples.
The degree to which your business is scalable also hinges on the buyer’s distribution channels. If the buyer’s company has distribution channels it can use to market your business on a scalable basis, they can afford to pay a higher multiple.
Factor #2: Business Plan & Assumptions
You will receive a higher multiple if you have consistently achieved milestones outlined in your business plan. This is because the buyer is more apt to place confidence in your business plan if you have a demonstrated history of repeatedly hitting your targets. The stronger the foundation on which your assumptions lie in your business plan, the more credence buyers will lend to your plan. If you consistently hit targets, buyers are more likely to view your future plans as credible.
On the other hand, if your business plan is based on a 200% growth rate but you have only achieved a 20% historical growth rate, you are less likely to be viewed as credible. Buyers are wary of sellers who have wild dreams and minimal growth rates with unrealistic business plans showing high growth rates and who claim they can sell their business to Google or Amazon.
Your long-term vision should be broken down into achievable short-term objectives that are regularly met. Any assumptions in your plan should be realistic and built on a solid foundation. Your sales forecasts should also be conservative and based on historical data. Conservative sales forecasts can help minimize problems during due diligence — if you don’t achieve your forecasts, this can be labeled a material adverse change (MAC) and may trigger the possibility of termination of the sale for a buyer in the advanced stages of a transaction.
Inconsistencies in your business plan also cause a loss in credibility and trust, both of which are fundamental to receiving top dollar for your business and minimizing protective deal mechanisms (escrows, reps & warranties, etc.). Any inconsistencies in your plan will result in more thorough due diligence by the buyer, a lower purchase price, and an increase in protective deal measures.
Factor #3: Risk
Value is directly related to risk. The value of any incoming producing asset is based on only two things:
- The expected future cash flows (return)
- The uncertainty of receiving those cash flows (risk)
The relationship between these two elements can be expressed on a graph or chart — the higher the return, the higher the value — and the lower the risk, the higher the value. This is known as an indifference curve.
Your objective, therefore, should be to minimize the buyer’s perceived level of risk. To do this, you must first identify areas of potential risk in your business and then develop strategies to mitigate those risks. Common sources of risk include:
- What if we lose a major customer?
- What if we lose a key employee?
- What if a large VC fund backs a competitor?
- What if a startup creates an innovative solution?
Identifying risks in a business requires pattern-recognition abilities combined with broad knowledge and is another area where decision-making is more art than science. Someone experienced in negotiating with buyers is more likely to be in tune with the marketplace and can more accurately predict what buyers may perceive as risky in your business. This is one of the fundamental services we perform during our initial assessment for a business owner.
Factor #4: Recurring Revenue
Contractually recurring revenue is the number-one value driver for all software and tech businesses. Recurring revenue is viewed as more valuable than the revenue generated from new sales, and buyers are willing to pay significantly more for recurring revenue than for revenue generated from new sales.
Recurring vs. Repeat Revenue: Recurring revenue is auto-debited from the user’s credit or debit card on a regular schedule, such as a cell phone bill, gym membership, or online services (e.g., Netflix, Spotify, etc.). Recurring revenue is more predictable and results in a higher customer lifetime value (LTV) than non-recurring revenue. Repeat revenue is where there is no regularly scheduled payment and therefore revenues cannot be reliably predicted. Think Amazon purchases.
Factor #5: Contracts
Contracted revenue is always viewed as less risky by acquirers, as opposed to non-contracted revenue. Forecasted revenue based on new product sales — or revenue that is non-contracted — is heavily discounted. If the revenue is not contracted, the owners can leave and take their relationships with them, or customers can leave during the transition phase due to the uncertainty an acquisition creates in the mind of the marketplace. As a result, contractually recurring revenue is the gold standard and is the most sought after.
Contracts ensure retention and give the acquirer enough time to build trust with the customer post-closing. As a result, businesses with contractually recurring revenue will sell at higher multiples than those with just non-contracted revenue.
Assignability: One additional important area of concern is the assignability, or transferability, of contracts in the event of a sale. This can apply not only to customer contracts but also to other third-party contracts, such as landlords or vendors. Many contracts do not explicitly address assignability and are therefore considered a risk factor in the event of an asset sale.
One common solution is to structure the transaction as a stock sale. However, many buyers are unwilling to do this due to the possibility of contingent liabilities. Many third-party contracts, particularly contracts with landlords, include a “change of control provision.” A stock sale would often be characterized as a “change of control” situation as defined under such a provision and would therefore require approval by the third party. One method for skirting change-of-control provisions is a “reverse-triangular merger.” However, these are normally reserved for larger transactions ($10 million to 50 million-plus) and this topic is beyond the scope of this article.
While assignability is important, the most crucial concern regarding customer contracts is that the contract simply exists. In most cases, businesses do not have contracts with their customers, and customers are therefore free to come and go as they please.
Long-term contracts are viewed as highly favorable by buyers and are a major value driver. If you do decide to switch your customers to contracts, be sure to include a clause addressing assignability.
Factor #6: EBITDA
The most common method acquirers use when valuing tech companies is establishing a baseline value based on a multiple of EBITDA. EBITDA is the starting point of nearly all negotiations in the middle market. For most industries, EBITDA multiples are somewhat predictable and acquirers rarely stray from prevailing multiples.
For example, if your company generates $3 million in EBITDA, then most buyers will value your business at 4.0 to 6.0 times your EBITDA, or $12 million to $18 million.
How does a buyer determine where in the range you fall? It’s simple — all the other factors besides EBITDA. In other words, nearly every buyer initially establishes a baseline value based on a multiple of your EBITDA and then increases or decreases the price within that range (4.0 – 6.0 multiple) based on your value drivers.
The higher your EBITDA, the higher the baseline value of your company. If you increase your EBITDA by 50% (to $3 million from $2 million), the value of your company will increase by 50% as well (to $12 million to $18 million from $8 million to 12 million) — based on a 4.0 to 6.0 multiple. Not only will you put an additional $1 million in your pocket per year, but you will also put an additional $4 million to $6 million in your pocket at the closing table.
It’s all about EBITDA. Go get “EBITDA” tattooed on your knuckles or your neck — or both — to serve as a constant reminder. Not only will your EBITDA increase, but buyers will be equally impressed by your devotion to their favorite acronym.
Factor #7: Growth Rate
The faster the growth rate of your company, the higher the multiple you will receive. For example, a business with a growth rate of 10% may receive a 4.5 multiple, while a business with a 50% growth rate may receive a 6.0 multiple.
There are two ways to value businesses with high growth rates:
1) Value the business based on a higher multiple of historical earnings.
- e.g., 6.0 times TTM (trailing-twelve months) EBITDA.
2) Value the business based on a combination of historical and projected EBITDA.
- e.g., If last year’s EBITDA was $1 million, and this year’s projected EBITDA is $1.7 million, the business may be valued based on a blended EBITDA — for example, $1.4 million.
Valuing a business with a high growth rate is not straightforward and requires taking dozens of factors into consideration. When we value a business with a high growth rate, we create a weighted EBITDA that we believe is most representative of the business and that we feel buyers will accept.
Factor #8: Customer Concentration
Customer concentration (or diversity) is another critical factor that can affect the value of your business. Ideally, no single customer should generate more than 3% to 5% of the total revenue of your firm. The higher the concentration of any one customer, the higher the risk to the potential buyer.
In some businesses, this risk can be offset if you have a strong management team that will remain with the business after the closing and that has a strong relationship with your customers. If customers primarily have relationships with employees of your company who will stay with the company post-closing, the relationship is less likely to be jeopardized during the transition process.
There are also other methods for mitigating this risk to the buyer. These methods generally fall into three categories:
- Actions you can take prior to the sale include asking customers to sign a long-term agreement, and “institutionalizing” these clients — thus reducing personal relationships you have with any customers.
- Due-diligence strategies to assess the risk — such as customer surveys and interviews during due diligence.
- Protective deal mechanisms to reduce risk if a customer is lost — such as earnouts, holdbacks, or other contingent payments.
Factor #9: Customer Base
Critical Mass of Customers: Larger companies prefer that you have a critical mass of customers. This ensures that you have developed a high-quality product that presents a lower risk to the company. The broader and more diverse your customer base, the greater the likelihood that the user experience will be high, assuming that retention and engagement are also high for your product.
Customer Adoption Lifecycle Diversity: Your customer base should consist of not just early adopters, but late adopters as well. Many software companies make fast progress initially as they sell to early adopters who are willing to take a risk on unproven software, but they stall once they have exhausted the supply of early adopters.
Ideally, your business should have a balance of early adopters, the early majority, the late majority, and a handful of laggards. Of course, small innovative companies’ customer bases will consist primarily of early adopters and the early majority, but the more diverse your customer base, the better. Adoption diversity signals to the buyer that you are obtaining strong traction with your customer base across all adoption lifecycles and that you have a sound “product fit” with your customers. This can also be backed up with strong customer metrics such as product engagement and customer retention to demonstrate to the buyer that customers use and value your products or services.
Factor #10: Customer Database
Selling a product to an existing customer (i.e., upselling) is easier than establishing a new relationship with a customer. A robust CRM offers an acquirer the ability to roll out its product suite to your customer base. The more information your database contains, such as demographics and other targeted data, the more targeted and therefore successful these campaigns will be. The more information your customer base contains that allows the acquirer to develop targeted campaigns, the more value the buyer will see in your database.
Factor #11: Staff
While most acquirers of tech companies focus on your products and services, many buyers also place an emphasis on the quality and depth of your team. The deeper and more experienced your team, the higher the multiple you will receive.
It is important to have confidentiality, non-compete, and non-solicitation agreements with your employees. Implementing a retention plan will also help ensure your staff remains with the acquirer throughout the transition period. Such a plan reduces risk for the buyer and therefore contributes to receiving a higher multiple.
Factor #12: Sales Team
A lack of salesperson diversity will hurt your purchase price. Ideally, you should have a strong sales backlog with no concentration or dependency on any one salesperson. For example, if one salesperson generates 50% of your revenue, buyers will view this as excessively risky and will therefore offer a lower purchase price or include protective deal mechanisms to mitigate the associated risk.
Before you sell, purge underperformers from your business, establish sales targets, and move unproductive salespeople to straight commission. If a salesperson costs you $75k per year, and they aren’t generating any profitable revenue for your company, they cost you $375,000 in purchase price at a 5.0 multiple ($75k x 5.0 = $375k).
Hiring salespeople before you plan on selling your business is a risky investment. What happens if they are unsuccessful one year later? It usually takes at least one year to receive a return on your investment when hiring salespeople. When hiring salespeople, the 80/20 rule applies — the fewer salespeople you hire, the lower your chances of hiring a superstar. You must normally hire five to 10 salespeople to find one or two good ones.
Many tech founders have no sales experience and attempting to build a sales team before you sell is a risky investment and can decrease earnings. Salespeople who come from larger companies may also be accustomed to infrastructure and may have a difficult time being productive in your company if you lack sales systems and infrastructure. You should build sales systems to support the sales team — CMS, databases, sales material, presentations, milestones, etc — before you build out your sales team. Hire a freelance sales management expert to guide you through the process if you don’t have a sales background.
Factor #13: Metrics
Create a dashboard that includes key metrics for your business such as customer retention, customer churn, lifetime value (LTV), customer acquisition cost (CAC), months to recover CAC, customer engagement, leads by lifecycle, and so forth. The majority of key metrics have an effect on the amount of recurring revenue, either directly or indirectly, and tracking these metrics allows you to spot leaks in your funnel and quickly correct those leaks, so you can maximize recurring revenue. These metrics also provide a basis for your assumptions in your business plan. Consider tracking the following metrics:
- Product Metrics
- Customer Retention Rate. If your business suffers from high attrition (i.e., low retention or high customer churn), your business will have a difficult time scaling. Poor retention issues can be due to a number of problems, from product features to the overall user experience. You should first fix any leaks in your funnel before you attempt to scale your business. In other words, improve customer retention before attempting to increase recurring revenue. Customer retention rate and engagement collectively say everything about how “sticky” your product is. If churn is high, conduct exit surveys to discover the reason for cancellations.
- Product Engagement. Track logins, refund requests, feature usage, and length of sessions to determine what is important to users, and use this data to improve the quality of your product.
- Product Quality Metrics. Track bugs, support requests, and feature usage to improve the quality of your product, and reduce its complexity (which will improve its scalability).
- Customer Metrics
- Customer Metrics. Track the total number of customers and customer satisfaction levels via customer surveys.
- Financial Metrics
- Lifetime Value (LTV). LTV is at the heart of your metrics and is the total dollar value of a customer during their lifetime. LTV is strongly related to your customer acquisition cost (CAC). The higher your LTV, the higher your CAC can be. For example, if your LTV is only $100, you can spend a maximum of $100 to acquire each customer. On the other hand, if your LTV is $5,000, you can spend significantly more than $100 to attract each customer. A higher LTV enables a higher CAC — or allows you to invest more in acquiring each customer.
- Customer Acquisition Cost (CAC). Your CAC can be expressed either as an absolute dollar amount (e.g., $225) or as a percentage of your LTV (5%). Your goal should be to lower CAC over time by building scalable sales and marketing systems.
- Monthly Recurring Revenue (MRR). Track the percentage of your revenue that is recurring.
- Marketing Metrics
- Leads by Life Cycle Stage. Track leads, conversion rates, and time between steps in your sales funnel to serve as the foundation of projections and identify leaks in your sales cycle.
- Traffic. Break down traffic by new visitors vs. logins from existing customers.
An Important Note on Customer Acquisition Cost (CAC) & Other Customer Metrics: CAC is a double-edged sword. A high CAC is good because it means your customer relationships are more valuable. For example, if the average CAC in your industry is $5,000 and you have 1,000 customers, it would cost a company $5 million ($5,000 x 1,000 = $5 million) to replicate the value of your customer base, assuming there is no overlap between your customer base and theirs. If there is a strong product fit between your customer base and the acquirer’s product line, it may be a prudent investment for the buyer to purchase your company solely for the value of your customer base, especially if time and lost opportunity costs are a factor in your industry.
On the flip side, a high customer acquisition cost can be a negative factor because it limits scalability. The potential scalability of a business is limited by its customer acquisition cost. The higher the CAC is relative to the lifetime value (LTV) of each customer, the less scalable your business is. For example, a business with a CAC of $50 and an LTV of $10,000 would be considered highly scalable, whereas a business with a CAC of $1,000 and an LTV of $2,000 would not be considered highly scalable. It’s the ratio that matters — not the absolute numbers.
Several additional factors need to also be considered. One important factor to consider is your cash-flow cycle. The cash flow cycle is the amount of time it takes for your firm to convert a sale to cash. Most tech companies have a short cash-flow cycle and are therefore highly scalable. But if you operate an online business with significant inventory levels, offer customized products, and offer your customers terms, then your sales cycle may be long. A long cash flow cycle limits the scalability of a business and also normally requires that the buyer make large working capital injections to fund future growth. Both factors drive down the purchase price.
What can you do? Maintain a centralized dashboard with your key metrics and monitor your metrics on a regular basis. Monitor your customer acquisition cost, customer retention, lifetime value, and other key metrics. Then develop weekly sprints with your deal team to slowly improve these metrics over time. Track your metrics on a weekly or monthly basis in a spreadsheet.
For example, if your customer acquisition cost lowers to $900 from $1,000 and your customer lifetime value increases to $5,500 from $4,000, you can use these improved metrics in your projections and base the value of your firm on the improved metrics, as opposed to the lower historical metrics. Documenting the assumptions in your projections allows you to more easily defend your pro forma P&L and therefore your asking price, which is predicated on your pro forma. Remember that your pro forma P&L, or projections, are built on your assumptions (i.e., key metrics) — so documenting and tracking your key metrics lays a solid foundation for a price that is based on your projections.
Factor #14: Code
Astute buyers will often hire a third-party firm to conduct a code audit during the due diligence process. The company that performs the code audit is normally bound by an obligation to maintain the confidentiality of the source code and they will compile a report to submit to the buyer regarding the quality of your code. This way, the buyer does not obtain your source code during due diligence.
If a buyer determines you have legacy or spaghetti code, or both they will either terminate their offer or reduce the purchase price to offset the increased cost of rewriting and cleaning up the code.
If you are serious about selling and are not a developer, it would be wise to hire a third party to audit your code to ensure the code is clean, scalable, and well-documented before you put your company on the market.
Factor #15: Cost to Replicate
Your company must have proprietary technology or other attributes that are difficult to replicate if you wish to receive strategic value for your company. If your software, technology, or business is easy to replicate, you may be able to sell your business, but you will not receive top dollar. Buyers will not pay you what you have invested, but will instead weigh the potential returns of purchasing your company vs. the cost of replicating your product in-house. This is known as a buy-vs.-a-build comparison. Ask yourself the following questions when attempting to assess if a company can easily replicate your business:
- How much would it cost to replicate your software and processes?
- How long would it take to build your product, software, or technology from scratch?
- What would it cost to develop your software internally? The cost to write code internally can be estimated using the COCOMO model, which estimates the cost based on the number of lines of code times 3.6 months per 1,000 SLOC (source lines of code).
Using Comparable Transactions To Value Your Company
Buyers will dismiss you as unrealistic if you compare your business to Amazon, Facebook, Google, Dropbox, or other companies with market capitalizations in the hundreds of billions of dollars. That is unless your company is also valued in the hundreds of billions of dollars, in which case you probably shouldn’t be reading this. If you do attempt to point out comparable transactions in your negotiations, stick to comparisons of companies in your industry that are similar in size and market potential to your own.
Desire to Keep Price Secret. Finding comparable transactions is difficult with small businesses and even more so with tech companies. The parties — especially the buyer — wish to keep the price and terms secret. . Serial corporate acquirers do their best to keep the prices they pay confidential, as knowledge of the purchase price could drive up the price they have to pay for future acquisitions since future sellers could use this knowledge against them. Public companies are required to disclose the price and terms of an acquisition via Form 8-K only if the transaction is considered “material.” No such requirement exists for privately held companies.
Most Transactions are Private and Not Reported. Most transactions in the lower and middle market are either purchases by a private company, meaning the transaction does not have to be reported to the SEC, or if the purchaser is publicly held, the transaction is not considered material, and does not, therefore, have to be reported on the SEC’s Form 8-K. “Material” is not defined but is generally believed to be in excess of $50 million to $100 million dollars, or a threshold as a percentage of revenue. An example of this is that a transaction is material if the revenue of the target is greater than 5% to 10% of the revenue of the acquirer.
Large Transactions. If public knowledge of larger transactions does exist, they are generally considered irrelevant. Billion-dollar transactions have little similarity for tech companies in the lower middle market. Additionally, there is a big difference between valuing public and private businesses. As a result, it’s important that comparable transactions are similar in size and market potential for them to be considered relevant.
Transaction Databases. Transaction databases do exist but the information in these databases is limited. Such information is usually used exclusively for valuation purposes using the market approach. Few databases include the name or other identifying information of the subject company and what information is included cannot be verified and is therefore summarily dismissed by buyers.
Keep Your Eyes Open: We recommend that you begin ‘keeping your eyes open’ for possible comparable transactions. You can do this several years in advance of the sale. The more data you have on comparable transactions, the more ammunition you will have to defend your price when it comes time to sell your business.
Tips for Finding Comparable Transactions
- Obtain Information Directly from the Source: Your best bet for documenting comparable transactions is to obtain them directly from sources within your industry. The more information on each transaction you have, the stronger your case will be. If the transaction information appears in a reputable publication, then your argument can be more convincing. Sellers and advisors are more likely to share transaction information than buyers since buyers normally seek to keep the information private so as to not drive up futures prices they must pay.
- Google Alerts: Set up Google Alerts to alert you to acquisitions in your industry, using the following keywords:
- Size Keywords — Small, middle market, lower middle market
- Industry Keywords — software, tech, online business, etc.
- Acquisition Keywords — M&A, acquisition, acquire, etc.
- Example: Middle market software acquisition, small tech acquisition, etc.
- Industry Events: Attend industry events and network with well-connected influencers in your industry. Ask them if they know of any recent acquisitions, or if they know of anyone who may have been a party to an acquisition — an insider, employee, seller, buyer, advisor, etc.
- Meetup Groups: Attend tech-related meetup groups and network to attempt to form new relationships that may lead to potentially useful information or other relationships.
- Professional Advisors & Investors: Network with angels, attorneys, accountants, investment bankers, M&A advisors, private equity, and other professionals to obtain transaction information. Set up Google Alerts to alert you to tombstones that investment bankers and M&A advisors may place on their website after a successful transaction. Offer to pay professionals for their time — the more successful the professional, the less likely they will be to give their time away for free.
An Important Note on the Range of Values for Small to Mid-Sized Businesses
The value of your business will vary widely depending on who the buyer is. For example:
- Financial buyers are constrained to valuing a company based on its Fair Market Value (FMV) by paying a multiple of a company’s earnings (EBITDA), unless they own a portfolio company with strategic value. The primary exception is when interest rates are very low and lending criteria are loose.
- Strategic buyers are more likely to pay a higher price — or strategic value — but the price they are willing to pay depends on the value of the combined synergies.
The difference between the price a financial buyer is willing to pay and the price a strategic buyer can afford to pay may be large. No two companies will view your value drivers, either on an individual or collective basis, through the same lens — valuation, therefore, differs from buyer to buyer. Your business can have a wide range of possible values if your business is large and your technology is exponential, or if a buyer can highly leverage your product. Nonetheless, there is a common set of value drivers that most buyers within an industry find important.
How Industry Activity Affects Value
Value Depends on Who the Buyer Is: The potential range of values for your company can vary widely depending on who the buyer is. When assessing the potential value of your company, it’s important to consider who is most likely to acquire your company, and their motivations for doing so. If the buyer is likely to be financial, then the value of your business is much easier to predict. If strategic value exists, then the potential value range can vary widely.
Acquisition Activity in Your Industry: It’s also important to consider the acquisition appetite and actions of potential buyers on your list. How many acquisitions have they made? What prices have they paid, if this information is available? How common are acquisitions in your industry? An ideal buyer has acquired multiple companies and has demonstrated the ability to complete transactions. Selling your company to a buyer who has never purchased a company before is a risky proposition.
Synergies & Strategic Value
If you own a software company, who do you think is likely to pay more for your company — another software company that generates $200 million per year, has received seven rounds of venture capital financing, and who can leverage your technology and fold it into their existing suite of products, or your local bakery?
Any value for synergies that are in excess of prevailing EBITDA multiples can only be measured and obtained through negotiations by way of a private auction with multiple buyers competing with one another. In other words, if the baseline value of your company is $12 to $18 million based on a 4.0 – 6.0 multiple and there are several buyers who may pay for synergies, then the only way to value your company is to negotiate an actual price with those buyers.
Several back-of-the-envelope methods can be used to estimate the value of the synergies and the percentage of the value of those synergies that you may receive, however, such an estimate is just that — an estimate. If your company is likely to be sold to a synergistic buyer, then only a baseline value can be established by your M&A advisor at the outset. You won’t know the true value until you actually sell your company.
Valuation & Deal Structure
You can’t talk about value without discussing deal structure. There are five factors to consider when determining what effect deal structure has on value:
- Assets Included: What does the purchase price include? Does it include real estate, inventory, and working capital? You must compare offers on an apples-to-apples basis.
- Cash Down: How much cash down do you receive at closing? Transactions that include more cash down at closing are lower risk for sellers, and the purchase price will therefore be lower than for offers with less cash down.
- Financing: Is a third-party (e.g. bank) financing the sale or are you financing the sale? If you are financing the sale, you must take this risk into account when evaluating a potential offer. This represents a risk for you, and the purchase price should be higher to offset this risk.
- Contingent Payments: Is any portion of the purchase price contingent on any future events, such as an earnout, escrow, or holdback?
- Post-Closing Adjustments: Are there any post-closing adjustments to the purchase price? Most M&A transactions include a normalized level of net working capital and include a post-closing adjustment to account for any changes in working capital between signing the LOI and closing. These adjustments can significantly affect the purchase price.
If you hear that a business sold at $10 million dollars, you can’t assess the attractiveness of that price without also knowing the deal structure. How much cash down did the offer include? Was it a stock or asset deal? Was part of the purchase price contingent on future events? Only when you have this information can you assess the true merits of an offer or comparable transaction.
Business Valuation in the Real World
When you engage an investment banker or M&A advisor to sell your company, one of their initial tasks is to prepare a list of potential acquirers — ideally, this list should contain 50 to 200 potential buyers.
Many clients come to us wishing to sell their company. During our preliminary conversations, or when we perform an assessment of their company, we ask them who is likely to buy their company. Many business owners name 5-10 potential buyers and draw a blank when asked if they can expand the list. Oftentimes, the majority of these buyers are either too small or too large to be a suitable acquirer, or have never completed an acquisition before. As a result, we are left with two or three potential buyers to approach. This won’t work in most cases and puts us at a great disadvantage.
When selling your company, if you wish to maximize your price, it’s necessary to create a frenzy of activity through a private auction. A list of 100 to 200 buyers is necessary to produce the 30 to 40 conversations that are required to receive 5 to 10 letters of intent. It’s only through this bidding process that we maximize the price of the business. The more letters of intent we receive, the higher we can drive the price up. If buyers know they are the only buyer negotiating with you, then they know they have you pinned in a corner. Not only will you receive a lower price, but you are also in a weak position and susceptible to renegotiating major deal terms during the due diligence process.
In certain instances, it’s possible to sell your company using a small list of buyers, however, it’s important to maximize your odds of success when selling your business because so many things can go wrong. If a competitor is desperate to purchase your business as a defensive move, as opposed to an offensive move, then a small list may suffice. But, for most companies, a list of at least 50 targeted buyers is necessary — 100 to 150 is much better.
Not only must the list be large, but the buyers on the list must also be targeted — in other words, the list should contain buyers who are a good fit in terms of both size and services and who have the cash to acquire you.
The buyer should be big enough, but not too big. Ideally, the buyer should be at least five times the size of your company in terms of revenue. If your company generates $10 million per year, then the buyer should generate at least $50 million per year in revenue. If the buyer is too close in size to your company, then the buyer is likely to be too risk-averse — such a transaction may represent too much risk for the buyer. The larger the buyer is, the easier it will be for them to pull the trigger.
The more concentrated the ownership, the more true this is. Imagine if you were purchasing a company similar in size to your own. Get out your checkbook and write yourself (or me, if you are feeling highly charitable) a check for exactly what you wish to sell your company for. If you want $10 million for your company — write yourself a check for $10 million. Now imagine writing a check of that size to acquire one of your competitors. Do you have the guts to make the leap?
Now, try the same exercise but cross a few zeroes off the check — write it for $10,000 instead of $10 million. You are still likely to be circumspect, but your appetite for risk has likely increased. The same goes for buyers in the real world. We see far too many entrepreneurs who are in sole negotiations with one buyer — and that buyer is the sole owner of a company similar in size to their own. In most cases, the owner can’t stomach the risk and will seek to offset the risk through a large earnout or another form of contingent payment, or through driving the price down.
If you are desperate and not looking to maximize your price, then such a strategy can work. But if you want to receive the highest price possible, then it’s important that the buyers on your list are the appropriate size.
How Big is Too Big?
While no magic number exists for determining when the buyer is too big — the acquisition of your business should be able to move the needle for the buyer. If you own a business generating $1 million in revenue, then approaching companies generating $500 million in revenue likely won’t work.
A $1 million acquisition takes just as much time, energy, and money as completing a $500 million acquisition. As a result, most companies focus on acquisitions that are 5-20% of the size of their company. If the acquisition is unlikely to make a dent in their business, then they won’t consider it.
The same is generally true for technology companies. Most acquirers of technology-related companies seek customer validation — in the form of revenue. If the business doesn’t generate sufficient revenue, then they often consider such acquisitions to be too risky.
Financial Buyers: This truth applies not only to strategic buyers, but also to financial buyers, such as private equity groups. Most private equity groups have a series of funds — and most funds have a lifespan of ten years. While the time varies, they may launch a new fund every 2-3 years.
But don’t some companies acquire pre-revenue businesses? Yes, there are always exceptions to the rule, but you shouldn’t count on exceptions when selling your company. Such rules are the exception, not the rule.
Other Factors that Can Affect Business Value
In addition to size, buyers should offer similar products, sell to the same customers, or sell through the same distribution channels as yours.
This does two things:
- it gives the acquirer sufficient motivation to complete the transaction, and
- it offers the possibility of synergies, which can drive the price up.
While a quirky tagline or memorable name may make a company jump out at you, look for actual synergies between the companies. For example, unfortunately, it’s unlikely Bunghole Liquors will acquire your software company. Even if Bunghole were to acquire your company, it’s unlikely they would pay in excess of Fair Market Value. There is probably little synergy between Bunghole and your company, unless your company offers products or services that may be complementary. This means Bunghole would lack sufficient motivation to acquire your company and would most likely pay less than other companies.. While Bunghole’s tagline is certainly compelling “We’re not #1 butt, we’re right up there” — a compelling tagline alone does not create synergy.
As we have discussed, there is much you can do during your preparations, and through the sales cycle, to increase the value of your company, though the final determination of the value does not happen until it actually sells. With so many factors to consider about the value of your tech, software, or online company, working with an advisor with knowledge of the industry and real-world experience selling companies will give you a solid plan for evaluating the value of your company and steps for how to increase the value before you sell.