Six Valuation Factors Software Executives Need to Know

The SEG Six Factors: 

Whether you are considering an exit in the near future or later down the road, there are several factors we think all executives should be aware of about a process. We’ve compiled a list of six factors that buyers, investors, and M&A executives like ourselves consider when evaluating a software company. Knowing this list, and preparing your company before a process, can go a long way in a successful exit.

  1. What Market is Your Company Serving?

Ring, ring. The phone rings with a software executive on the line, inquiring about selling their software company. While there is a plethora of questions we want to ask, the first things we want to know about include the market and product category. Is the Company serving a vertical or horizontal market? What is the total addressable market (TAM)?  How is the market evolving?  What are the market “pains” the Company is attempting to address?

Furthermore, knowing the Company’s market enables us to better understand its customers. Understanding a Company’s customer base gives deep insights on annual recurring revenue (ARR) trends (see SEG’s recent ARR blog), the type of customer the Company is targeting (consumer or business), the target customer’s size (i.e., small, medium or large), the method in which the Company is acquiring and retaining customers, etc.

It is critical for software executives and CEOs to know their market and customer base inside and out. These data sources are a wealth of information that can help a Company home in on the most attractive and profitable customers and tailor its sales, marketing, support efforts accordingly.

  1. How Modern is Your Software?

We get off the phone with the software executive, and what’s the next thing we do? Visit the Company’s website. A Company’s website often gives an indication of the modernity of the product technology. Software M&A experts may ask about the age of the technology, if it is legacy/on-premise or SaaS/cloud-based, customer satisfaction with the user interface (UI) and user experience (UX), and so on… Strategic buyers and private equity investors look for these factors to indicate the scalability and sustainability of the Company’s product. In addition, buyers will question the size of the customer support department as an indirect way to determine issues with the product. Failure to adequately invest in technology will, at best, reduce purchase price, and at worst, cause buyers to walk away.

  1. How Strong are Your Unit Economics?

Another factor we evaluate when putting a software company under the microscope is the Company’s unit economics. Specifically, we evaluate customer adoption, new logo growth, sales and marketing spend, average ARR trends, and retention.

Many buyers feel as though they can improve or “fix” some of these areas (e.g. sales and marketing issues), but it is critical to focus on select areas that are more impactful on a buyer’s decision making. For example, retention rates can be a show stopper or key driver. If net retention is strong to excellent (i.e., greater than 100%), customers are satisfied and prefer to use the Company’s product over competitors – to the point to where they are expanding usage across the customer base greater than churned customers. If retention is bad, it could indicate a product, onboarding, or customer support issue. A customer survey is a good way to address retention and can provide valuable insight into how to better serve customer market pains.

  1. Is the Company Financially Healthy?

What is the general financial health of the business? A few critical metrics we evaluate include ARR & revenue size, overall growth, gross profit margin, profitability, and percent recurring revenue.

  • Size/Scale – The size of a company, relative to its age, is sometimes a critical factor in evaluating the health of a business. A sizable business not only indicates a company is well-run and performing, but also, it indicates market adoption of the product.
  • Gross Profit Margin (GPM) – In SaaS-based businesses, we typically like to see at least a 75% GPM. This is a key driver in why many investors and buyers are attracted to software companies. A high gross profit margin means a potentially higher bottom line, more flexibility to reinvest in the company, and higher future earnings potential.
  • Profitability – A common misconception in the software market is profitability is king. However, many of our current clients favor growth over profits and invest heavily back into operations – especially sales and marketing. Why? Typically, growth indicates a market’s need for the solution and the Company’s ability to solve that pain. But, more importantly, greater growth (with favorable unit economics) and gaining more market share in the near-term can lead to greater profitability in the long-term.
  • Recurring Revenue – With today’s subscription model businesses, we like to see at least 70% recurring revenue. Buyers are attracted to this business model because it allows for more stability due to the recurring nature of the revenue stream. Buyers are willing to pay a higher price for a lower risk model, and also benefit from lenders willingness to lend against recurring revenue.

Industry benchmarks can help executives improve their Company’s financial health. For recent SaaS metrics, please find our Mid-Year Update, and for software (on premise/legacy) metrics, please find our 2018 Annual Report with most up to date benchmarks.

  1. How Strong is the Team Culture?

We’ve evaluated everything from the Company’s market, product technology, unit economics, and financials. These are all critical evaluation areas, but there is another critical factor that is often overlooked – team culture. We typically evaluate the Company’s structure, the leadership team, and overall values… a strong company culture can go a long way in a successful exit! At SEG, we like to work with people that are like us – team players and generally good people. And, nearly every client (see client videos David Durik & Paul Lachance) fits that bill.

  1. Who is in the Buyer Universe?

Finally, we look to the buyer universe to determine likely matches. After evaluating our network of buyers that fit the bill (including private equity investors and strategic buyers – public, private, and private equity backed), we consider other non-traditional buyers and industry leaders.

With each buyer, we consider several factors, including how likely a PE buyer would be to look at the Company as a platform investment, how the buyers would value the Company, or even how excited buyers would be about a potential opportunity. Evaluating current M&A deals in the market enables us to see if buyers in the segment are more focused on revenue or cost synergy, and how well this would fit in with the Company’s financial profile. We consider all these points to find the ideal buyer for our client’s needs.

If you are considering an exit down the road, it may be helpful to compile a list of your top 15 ideal buyers, list select attributes about each one (are they acquisitive, fund size, types of acquisitions, etc.), and start creating awareness. A couple of ways to get in front of these buyers include reaching out to the buyer’s partners or corporate development departments and getting involved in industry research (such as Gartner).

These six factors are key in evaluating software companies, not just for software M&A advisors like ourselves, but for strategic buyers and investors. As a software company executive, it is critical to know these factors before going into a process.

Software Equity Group often provides informal strategic guidance and advice to business owners in the years preceding a liquidity event. If you’d like to discuss any of these six factors above, please give us a ring.