In a recent survey, Consumer Reports found that a “modern/updated kitchen” still rules when it comes to ideal home features among home buyers. When it comes to shoppers of tech, software, or other online businesses, recurring revenue is the most attractive enticement.
And just as there are any number of other actions you can take to increase the value of a house — finishing a basement and painting high-traffic areas come to mind — there are steps you can take to enhance the value of your tech, software, or online business.
These actions are called “value drivers,” and in this article, we’ll discuss the top ones. Specifically, we will:
- Introduce you to the theory and importance of value drivers.
- Outline the top drivers of value that can impact the value of your tech, software, SaaS, or online business.
- Identify specific steps you can take to improve the value of your business.
What are you waiting for?
Table of Contents
- An Introduction to Value Drivers
- An Important Note on the Range of Values
- A Note on General Preparedness for Technology Businesses
- Value Driver #1: Increase Recurring Revenue
- Value Driver #2: Document Comparable Transactions
- Value Driver #3: Prepare a Buyer List
- Value Driver #4: Increase Total Revenue & EBITDA
- Value Driver #5: Strengthen Customer Base & Metrics
An Introduction to Value Drivers
Understanding and improving the value drivers for your tech, software, and online business are critical to maximizing the value of your company before you sell.
What is a Value Driver?
A value driver is any action you can take that can potentially improve the value of your business.
For example, the top value driver for technology, software, and online businesses is recurring revenue. If you know this is the top ‘driver of value’ for your business, you can focus your energies on improving this value driver.
Value Drivers Can Overlap, Especially for Technology & Software Companies
Value drivers can overlap. One value driver can positively affect multiple attributes of your business.
For example, increasing recurring revenue can have an impact on multiple value drivers. Or, increasing the LTV (lifetime value) of your customers can dramatically change the dynamics of the assumptions in your business plan, which can also affect multiple value drivers simultaneously.
The Importance of Prioritizing Your Value Drivers
The value of your business is in the eye of the beholder, and every buyer will prioritize certain value drivers more than others.
The advice of an experienced M&A advisor is invaluable when deciding which value drivers to prioritize first. A knowledgeable advisor can help you identify those value drivers that are most likely to generate the highest returns for you with the lowest associated risk.
When reading through the value drivers below, remember that the list is not black and white — there may be overlap within and across the value drivers. Regardless, exploring the potential value drivers is a critical component of increasing the value of your business.
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.
An Important Note on the Range of Values
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 the potential for strategic value.
- Strategic buyers are more likely to pay a higher price — or strategic value — though the price they are willing to pay will depend on the potential value of the combined synergies and the degree to which you can negotiate to receive a share of those synergies.
The difference between the price a financial buyer is willing to pay and the price a strategic buyer is willing to pay can be significant. No two companies will view your value drivers — either on an individual or collective basis — through the same lens. Valuation is subjective and 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 leverage your product base, as in IBM rolling out a product through its national salesforce. Nonetheless, there are a common set of value drivers that most buyers within an industry find important.
A Note on General Preparedness for Technology Businesses
Before we jump into the value drivers, let me proffer an important note on general preparedness. The message is simple, yet undervalued.
Be ready to sell at all times. Let me repeat. Be ready to sell at all times. And a final note for emphasis — be ready to sell . . . at all times.
In the tech space, unsolicited offers are commonplace. As a result, you must always be ready to sell.
You must be prepared if you wake up Monday morning and discover an email from a competitor with a note regarding a ‘potential strategic relationship.’ An uninvited overture leaves you little time for crafting a strategic response. The exact words you use when responding will be carefully poured over by your competitor. One minor, inconsequential sign of weakness can cost you millions of dollars in potential transaction value.
One former client responded to such an invitation from a much larger, well-capitalized rival — a dominant competitor in the industry, backed by a PE-firm that was in an acquisition frenzy.
Unfortunately, the underlying tones in my client’s ingratiating response likely were interpreted by the potential acquirer as more than eager and perhaps even as a sign of desperation. The mishap could have cost our client hundreds of thousands of dollars at the negotiating table, but we were able to reverse the damage through a series of calls with the company in which we carefully re-established our strategic position and outlined other options our client was considering, such as JV, raising money, etc. Preparation prevents such mishaps, and a lack of preparedness is perhaps one of the major reasons businesses don’t sell.
My general note on preparedness is redundant with executing your company’s value drivers as outlined below. Given its importance, however, I summarize the general essence of preparedness here:
- Financials: Your financials should be squeaky clean. Retain another CPA firm (not the 0ne that regularly prepares your books) to independently review your financials to ensure they will meet the buyer’s rigorous due diligence process.
- Documentation: All areas of your business should be properly documented, including legal, operational, human resources, and so on.
- Management: Your management team should be able to run your business without you and should be bound by employment, confidentiality, non-solicitation, and invention assignment contracts.
- Staff: Retention plans should be in place for your key employees and key employee concentration issues should be mitigated.
- Business Plan: You should have a business plan and projections with clearly documented key assumptions, and your metrics should be on a positive upward trend.
- Contracted Revenue: Contracted revenue should be transferable to a new buyer. Retain an attorney to review your customer contracts to ensure they can be assigned in the event of an acquisition.
By executing your company’s value drivers, your company will likely be ‘well-prepared’ but there’s always the risk that you neglect an element of preparedness that is not addressed by your value drivers. Regardless, it’s prudent to hire an M&A advisor to review your company and conduct pre-sale due diligence to ensure you have all your ducks in a row before you go to market.
Executing such a plan will help ensure that you maximize the value of your company regardless of when the sale takes place, and regardless of whether the sale is the result of a careful strategic plan or an unsolicited offer from a competitor.
Let’s now dive into the top five value drivers that can impact the value of your company.
Value Driver #1: Increase 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 revenue generated from new sales, and buyers are willing to pay significantly more for a business that generates recurring revenue as opposed to revenue generated from new sales.
Examples of companies with recurring revenue include:
- Netflix – Monthly subscription fee
- Spotify – Monthly subscription fee
- Apple – Recurring subscription fees for Apple Music, iCloud, etc.
- Accounting Software – Subscription fees for QuickBooks, Xero, etc.
- Web Hosting – Subscription fees for GoDaddy, Bluehost, etc.
- Microsoft – Recurring subscription fees for Office 365, etc.
Examples of companies WITHOUT recurring revenue include:
There is a difference between recurring and repeat revenue. While it is good to have repeat revenue, it is unpredictable as a form of income. Recurring revenue is auto-debited from the user’s credit or debit card on a regular schedule, such as with cell phone bills, gym memberships, 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. The higher the LTV, the more a company can afford to invest in acquiring customers (customer acquisition cost, or CAC), and the more scalable the business is.
Not only should you focus on increasing recurring revenue, but you should also focus on customer retention. 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 caused by a number of issues, from product features to the overall user experience.
Fix any leaks in your metrics before you scale your business. Improve retention before attempting to increase recurring revenue. Nail down your value proposition before you attempt to scale. Nail it before you scale it.
Recurring revenue is viewed as less risky by acquirers versus forecasted revenue based on new product sales, which is heavily discounted by buyers. If the revenue is not contracted, the owners may 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 when buying a business.
Uncertainty can also kill sales in the pipeline for B2B businesses. Contracts ensure retention and offer the acquirer enough time to build trust with the customer post- closing. This means that businesses with contractually recurring revenue will sell at higher multiples than non-contracted revenue.
Tips for increasing recurring revenue
- Increase Pricing: Test the elasticity of your pricing. The entirety of a price increase falls to the bottom line (net of direct costs, such as sales commissions), and an increase in profitability can dramatically improve the value of your business. Here is an example of the potential effects on the value of a business of a 10% price increase:
- Before Price Increase:
- $10 Million in Revenue
- $2 Million in EBITDA
- 5.0 Multiple
- Valuation: $2 Million EBITDA x 5.0 = $10 Million
- Before Price Increase:
- After Price Increase:
- $10 Million x 10% Price Increase = $1 Million in additional Revenue & EBITDA
- $11 Million in Revenue
- $3 Million in EBITDA
- 5.0 Multiple
- Valuation: $3 Million EBITDA x 5.0 = $15 Million
- In this case, a 10% price increase resulted in a 50%, or $5 million increase, in the value of the company.
- Offer Maintenance Contracts: Convert your customers to using annual maintenance or other long-term contracts. Increase pricing and offer to grandfather legacy customers into your old pricing structure if they agree to sign a long-term contract.
- Create Add-On Modules: Offer a discounted price if customers purchase add-one modules — let customers know in advance that you will soon be increasing prices and offer to grandfather them into your old pricing model if they are willing to sign a contract.
- Create Sales Incentives: Reward salespeople based on the type of revenue they generate — contractually recurring revenue should be rewarded more than one-time, transactional revenue.
- Track Metrics that Affect Recurring Revenue: 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, and leads by lifecycle. 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.
- Improve Retention: Improve customer retention through product improvements.
- Tip: If you haven’t read The Lean Startup, we recommend doing so. To improve retention, shortcut the customer feedback loop. Create either incremental or dramatic changes to your product in the form of minimal viable products (MVPs) through weekly sprints with your team, and obtain early feedback on your iterations from your customers. Incorporate customer feedback into every weekly iteration. Your objective should be to quickly iterate to a solid value proposition that resonates with your user base. Once you have done so, then you can begin priming the pump and scaling up your business.
Value Driver #2: Document Comparable Transactions
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 — unless your company is also valued in the hundreds of billions of dollars. If you point out comparable transactions in your negotiations with a buyer, stick to comparisons of companies in your industry that are similar in size and market potential to your own.
Comparable Transactions are Scarce
Finding comparable transactions is difficult with small businesses and even more so with tech companies. Typically, all parties involved in the sale will wish to keep the price and terms secret, especially the buyer. Serial corporate acquirers do their best to keep the prices they pay confidential because knowledge of the valuation could drive up the price they have to pay for future acquisitions. As a result, future sellers could use this knowledge against them if details of their acquisition prices are widely known.
Reporting Transaction Data is Not Mandatory in Most Cases
Public companies are required to disclose the price and terms of an acquisition via Form 8-K with the SEC only if the transaction is considered ‘material.’ No such requirement exists for privately held companies.
Most transactions in the lower and middle middle-markets involve a private purchaser (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.
‘Material’ is not defined, but is generally believed to include acquisitions in excess of $50 million to $100 million dollars, or based on a threshold as a percentage of revenue of the acquirer. For example, the transaction might be considered material if the revenue of the target is greater than 5% to 10% of the revenue of the acquirer.
Transactions Must be Relevant
If knowledge of larger transactions does exist, they are often considered irrelevant unless they are similar in size to the target. Billion-dollar transactions have few similarities 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 for them to be considered relevant.
Information is Usually Limited
Transaction databases do exist. However, the information in these databases is limited and is used primarily by appraisers who are valuing a business for legal purposes (e.g., divorce, estate planning, etc.). In addition, few databases include the name or other identifying information of the subject company, and the information cannot be verified and is dismissed by buyers as a result.
Here are tips for documenting comparable transactions:
- Obtain Information Directly from the Source: Your best bet for documenting comparable transactions is to obtain the information 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 as well. 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 future prices they must pay. In other words, they don’t want the information to be used against them.
- Google Alerts: Set up Google Alerts to alert you to acquisitions in your industry, using the following keywords:
- Industry Keywords — Software, tech, online business, etc.
- Size Keywords — Small, middle-market, lower middle-market
- Acquisition Keywords — M&A, acquisition, acquire, 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.
- Meetup Groups: Attend tech-related meetup groups and network with those in your industry to attempt to form new relationships that may lead to useful information.
- Professional Advisors & Investors: Network with angel investors, 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 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 away their time for free.
Value Driver #3: Prepare a Buyer List
The action of preparing a buyer list is a high-value activity that takes little time but offers significant long-term value. This simply involves setting up a spreadsheet with a list of potential buyers who may consider purchasing your company. This can also include sources of information that can be used to prepare a buyer list — such as industry directories, publications, events, and so forth.
Why is a buyer list important?
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 50-200 potential buyers.
A List is Necessary to Maximize Your Price
Many clients come to us wishing to sell their company. During our preliminary conversations, or when we perform an assessment of the company, we ask them who is likely to buy their company. Many business owners name five to ten potential buyers and draw a blank when asked to expand the list. Often, most of these buyers are either too small or too large to be a suitable acquirer.
As a result, we are left with two to three potential buyers to approach. This won’t work in most cases and puts us at a great disadvantage when trying to sell the company.
A List of 100-200 Buyers is Necessary to Conduct a Private Auction
When selling your company, if you wish to maximize your price, it’s necessary to create a carefully orchestrated frenzy of activity through a private auction. A list of 100-200 buyers in most cases is necessary to produce the 30-40 conversations that are required to receive 5-10 letters of intent.
It’s through this bidding process that we maximize the price. The more letters of intent we receive, the higher we can drive up the price. 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 renegotiations during due diligence.
Maximize Your Odds with a Large List
It’s possible to sell your company with a small list of buyers in certain instances. However, it’s important to maximize your odds of success when selling your business because so many things can go wrong. For most companies, a list of at least 50 targeted buyers is necessary — 100-150 is better.
Buyers Must be a Good Fit
Not only should the list be large, but the buyers on the list must be targeted — the list should contain buyers who are a good fit in terms of both size and services and who are in a position to acquire you.
The Right Size
The buyer should be big enough, but not too big. Ideally, the buyer should generate at least five times your company’s 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, the buyer will be too risk-averse — such a transaction may represent too much of a gamble for the buyer. The larger the buyer, the less risk the transaction represents to them and the easier it may be for them to pull the trigger.
Write Yourself a Check for $10 Million
The more concentrated the ownership of the buyer, 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 Write Yourself a Check for $10,000
Now, try the same exercise but cross a few zeroes off the check. You’ll still be circumspect, but your appetite for risk has increased.
The same holds true with buyers in the real world. We see 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 won’t stomach the risk and seeks to offset the risk by 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, such a strategy can work. But if you want to receive the highest price possible (i.e., if you like money), 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 the right size — 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, though there are always exceptions, such as Facebook purchasing Instagram.
A $1 million acquisition takes just as much time, energy, and money as a $500 million acquisition. As a result, most buyers focus on acquisitions that are 5% to 20% of the size of their company. If the acquisition is unlikely to make a dent in their business, they’ll be unlikely to consider it. Yes, there are rare exceptions, but you shouldn’t count on exceptions for one of the most important transactions of your life.
The same is generally true for technology companies. Most acquirers of technology-related companies seek customer validation — in the form of revenue. If a business doesn’t generate sufficient revenue, the buyer often considers such acquisitions to be too risky.
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 operating simultaneously — and most funds have a lifespan of ten years. While the time varies, they may launch a new fund every two to three years.
The Largest Private Equity Fund Ever
In 2019, Blackstone raised the largest-ever private equity fund — $26 billion. To invest $26 billion, Blackstone would have to complete 2,600 acquisitions over a five-year period (a typical investment period for a ten-year fund) if the average transaction size were $10 million ($26 billion / $10 million = 2,600 acquisitions). To reach that target, they would have to complete two acquisitions per day, assuming 250 workdays per year, or 1,250 days over a five-year period (1,250 days / 2,600 acquisitions = 2.08 acquisitions per day). Given that a typical private equity group considers 100 companies for each acquisition they make, they would have to consider 260,000 potential acquisitions to complete 2,600 successful acquisitions. In other words, they would have to consider 208 potential acquisitions per day.
This is a long-winded way of telling you not to approach Blackstone if you wish to sell your $10 million dollar company.
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.
In addition to size, the buyer of your company should offer similar products, sell to the same customers, or sell through the same distribution channels as yours. This accomplishes two important objectives: 1) It gives the acquirer sufficient motivation to complete the transaction, and 2) 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. 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 likely little synergy between Bunghole and your company, unless your company offers products or services that may be complementary to Bunghole’s, and Bunghole would lack sufficient motivation to acquire your company and would therefore be willing to 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.
Obtaining Contact Information
For larger companies, the best way to get the attention of a potential acquirer is by contacting the manager of a division whose area could benefit from a complementary product like yours. We call this individual an ‘internal champion.’
Not only should the company be sufficiently motivated to complete the transaction, but the individuals involved in the transaction should be as well. So, in addition to preparing a list of potential buyers, your list should also include names and contact information of buyers in those companies who have decision-making power and who can personally benefit from the transaction.
How does the buyer list affect your valuation?
Fair Market vs. Strategic Value
The buyer list won’t affect the ‘Fair Market Value’ (FMV) of your business. However, it can affect its 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 can leverage your technology and fold it into their existing suite of products, or Bob the Builder?
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 a financial buyer, the value of your business can be more accurately predicted. If, however, strategic value exists, the potential value range can vary widely. Note that it’s not necessary for your list to include financial buyers unless the financial buyer owns a portfolio company in your industry.
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 actually complete transactions — not just talk about completing transactions. Selling your company to a buyer who has never purchased a company before is a risky proposition with low odds of success.
Here are tips for documenting comparable transactions:
- Spreadsheet: Prepare a spreadsheet with two tabs — one for potential buyers and one for potential sources of buyers. The buyer list should contain the following columns: name of the company, contact name, website, contact information, # of employees, revenue, completed acquisitions, and potential synergies. The potential sources should contain a list of the sources and any relevant contact information.
- List Size: Your list should contain a minimum of 50 buyers, and ideally, at least 200.
- Company Size: Most companies on the list should be 5-20 times the size of your company.
- Products & Services: The companies on your list should offer products or services that are complementary to yours.
- Acquisitions: Note if the company has recently made any acquisitions. If so, jot down any details of the transaction that you are aware of, including the name of the company, size, etc.
Value Driver #4: Increase Total Revenue & EBITDA
The number one thing you can do to improve the value of your company is to increase your total revenue, or, more importantly, your EBITDA. What makes this different than Value Driver #1, which is to Increase Recurring Revenue? The difference is that increasing total revenue, and therefore EBITDA, takes a significant amount of time, energy, and investment. Increasing recurring revenue is the fastest way to impact your bottom line.
After looking at those options, you should consider the other value drivers in order to decide your next steps. The value drivers should be prioritized based on the potential return and risk, as well as the time and investment in implementing them — in other words, use the RVD Model.
As discussed in Value Driver #1, generally speaking, most software companies’ contractually recurring revenue is valued at a baseline value of 200%. For example, if your company generates $2 million in contractually recurring revenue, then most companies will be willing to pay you a baseline value of $4 million as a starting point.
The easiest way to increase EBITDA is to increase prices. All of your price increase (less any direct costs, such as sales commissions) will increase EBITDA.
For example, if your business generates $10 million in revenue and $2 million in EBITDA and is valued at a 5.0 multiple, or $10 million, and you increase prices by 10%, your new EBITDA will be $3 million, and the value of your business will be $15 million ($3 million EBITDA x 5.0 = $15 million). In this case, a 10% price increase resulted in a 50% ($5 million) increase in the value of the company.
Another 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 fairly predictable, and acquirers rarely stray from prevailing industry 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 — they will consider all of the other factors other than 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 to 6.0 multiple) based on all the other factors. 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 (a range of $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.
The easiest way to increase EBITDA is to reduce expenses. You should pinch every penny for two to three years prior to your planned exit. For every dollar in expenses you cut, not only will you save one dollar, but you will also receive four to six additional dollars at the closing table.
If you cut expenses by $200,000 for two years prior to the sale and the sale process takes one year (a total of three years), you will put an additional $1.4 million to $1.8 million in your pocket — $200,000 (Year 1) + $200,000 (Year 2) + $200,000 (Year 3) + $800,000-$1.2 million (Increased Purchase Price ).
Make More Conservative Adjustments when Calculating ‘Adjusted EBITDA’
Adjusted EBITDA also includes adjustments, such as your salary, perks, professional fees, rent, and so forth. Be as conservative as possible when making adjustments. When assessing the veracity of your adjustments, buyers may not explicitly mention their concerns, but they will discount the purchase price to offset any increased risk in adjustments that can’t be verified. They will also question your credibility, and your aggressive stance might be considered an increased element of risk for them.
As a result, they may be disincentivized from retaining you post-closing and may take actions to mitigate their risk, such as lowering the price, conducting more thorough due diligence, expanding the scope of reps and warranties, increasing the amount of holdbacks, or increasing the amount of seller notes (a seller note is subject to the right of offset in the event of fraud).
The Importance of Credibility
Your goal should be to improve your credibility. You want to be viewed as having strong management ability, judgment, and ethics — as a result, you will receive a higher salary post-closing if they retain you and fewer purchase-price mechanisms to reduce their risk.
Minimize the Total Number of Adjustments
How do you do this? It’s simple — minimize the number of adjustments you make two to three years prior to the sale of your company. The fewer adjustments you make, the lower the perceived risk to the buyer, and the more likely you will sell at a higher multiple of EBITDA. While this will cost you tax dollars, you will receive a multiple of the earnings back in the form of an increased purchase price.
Here is a summary of tips for increasing revenue and EBITDA:
- Increase Pricing: Experiment with the elasticity of pricing to test if you have the capability of increasing prices in your business.
- Reduce Expenses: Reduce unnecessary or discretionary expenses two to three years prior to the sale.
- Adjusted EBITDA: Reduce the total number of adjustments two to three years prior to the sale. Ensure you have clear backup documentation for any adjustments you do make.
Value Driver #5: Strengthen Customer Base & Metrics
Larger companies prefer that you have a critical mass of customers. This ensures that you have developed a higher-quality product that presents a lower risk to the company. The broader and more diverse your customer base, the better the likelihood that the user experience will be high, assuming that retention and engagement are also high for your product.
Adoption Lifecycle Diversity
The stronger your customer base, the higher the purchase price you will receive. Your customer base should consist of not just early adopters but also late adopters.
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. However, the more diverse your customer base, the better. Adoption diversity signals to the buyer that you are obtaining strong traction with your customer base and that you have a sound product fit.
Blue Chip Customers
Acquirers of B2B companies place a high value on relationships with Fortune 500 and blue-chip customers. They assume that if your product is good enough to satisfy the needs of these companies, the next challenge is to scale your business by building a strong sales team and infrastructure.
Most acquirers view building an engaging product as riskier than scaling a company through sales and marketing efforts. National or Fortune 500 customers also hold a strategic value for certain buyers as these relationships can serve as an opportunity to sell their entire product line to the company.
Blue-chip customers are also valuable because it’s easier to upsell to an existing account than it is to establish a new account. For example:
Intuit (the parent company of QuickBooks) acquired Credit Karma for $7 billion in 2020. By acquiring Credit Karma, Intuit could market its other products to Credit Karma’s 100 million registered users. It’s much easier for Intuit to attempt to upsell 100 million existing customers that already have a relationship with Credit Karma than it would be for Intuit to acquire 100 million new customers.
Potential acquirers may purchase your company solely for the existence of relationships your company has with well-established customers. This allows the buyer to upsell your customers with additional products they offer.
For example, the cost to acquire (customer acquisition cost) blue-chip accounts is very high and the existence of these relationships can have a tremendous impact on the value of your company.
Customer diversity is another critical factor for buyers. 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 a buyer. But this risk can be mitigated if you have a strong management team. If the customer primarily has relationships with employees of your company who will stay with the company post-closing, then 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 the following two categories:
- Actions you can take prior to the sale. These include asking the customer to sign a long-term agreement and ‘institutionalizing’ the client — that is, reducing the personal relationships you have with any customers.
- Deal structure mechanisms. These include methods to assess the risk, such as customer surveys and interviews during due diligence, and mechanisms designed to reduce risk if a customer is lost, such as earnouts, holdbacks, or other contingent payments.
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 leases with landlords or vendor agreements. 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 (i.e., unknown) 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’ 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 ($10-50 million+), and this complex topic is beyond the scope of this article.
Perhaps the most important concern regarding customer contracts is the existence of such a contract. 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.
A customer database, such as a CRM, is valuable to buyers for several reasons. One reason is so the acquirer can market their products to your existing customer database. As previously mentioned, selling a product to an existing customer (i.e., upselling) is easier than establishing a relationship with a new customer.
A robust CRM offers the buyer the ability to implement scalable methods for rolling out their product suite to your customer base. The more information your database contains, the better. Demographics or other targeted information allows the acquirer to develop targeted campaigns.
In the example of Credit Karma, it would be valuable for Intuit to know which Credit Karma customers own a business — Intuit could then develop targeted email campaigns offering those customers a free trial of QuickBooks or other solutions for small businesses. Intuit could also develop targeted campaigns based on the user’s credit score — for example, lines of credit could be offered for those with high credit scores, or credit-builder programs could be offered for those with low credit scores.
Regardless, the more information your customer base contains that allows the acquirer to develop targeted campaigns, the more value the buyer will see in the database. Without this information, it’s likely Intuit would alienate Credit Karma’s customer base if they blasted out non-targeted campaigns on a frequent basis (e.g., nuns don’t want emails about Viagra).
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, then 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 critical factors 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 more costly it is to scale the business.
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.
But several additional factors need to be considered. One important factor to keep in mind 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, carry significant inventory levels, offer customized products, or offer your customers terms, your sales cycle may be long. A long cash flow cycle limits the scalability of a business and 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. Watch your customer acquisition cost, customer retention, lifetime value, and other key metrics. Then develop weekly sprints with your deal team to slowly improve those 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 company on these newer metrics, as opposed to the historical metrics.
Documenting the assumptions in your projections allows us to more easily defend your asking price, which is based on your pro forma. Your projections (pro forma) are built on your assumptions (i.e., key metrics) — so documenting and tracking your key metrics lays a solid foundation for your projections.
Here is a summary of tips for improving your customer base and metrics
- Customer Diversity: Build a diverse customer base consisting of a critical mass of customers at various adoption stages of your business.
- Blue Chip Customers: Build sales infrastructure and a team that gives you the capability to acquire larger customers.
- Customer Concentration: Minimize customer concentration. Institutionalize customers that generate a significant percentage of your overall revenue and reduce your personal involvement in these relationships.
- Contracts: Ensure customer contracts are assignable in the event of a sale. Develop incentives to convert customers to long-term contracts, such as grandfathered pricing or free add-on modules.
- Customer Database: Build a robust customer database that contains detailed information on your customers that will allow a buyer to develop scalable, targeted campaigns.
- Key Metrics: Build a centralized dashboard to track your key metrics. With your deal team, prepare a backlog of projects designed to improve and track the improvement of your metrics over time to serve as the foundation for your financial projections.
In the tech, software, and online business realms, knowledge of value drivers is critical to improving the value of your company. As you can now see, understanding and identifying the top value drivers in your business is key to making adjustments that will help you improve the value of your business before you put it on the market.