Every Business Owner Wants to Know:
How Much Is My Company Worth?
By Terry Allen and Jim Rigby
Managing Directors of the Financial Valuation Group
Every business owner wants to know “What’s my company worth?” In addition to a
natural curiosity about the value of our companies, we need knowledge about our
company’s value to make decisions about taxes, employee stock options, business plans,
mergers, acquisitions, and strategic alliances.
The most difficult part of valuing a company is understanding that the process is very
subjective and varies depending on the purpose of the valuation. Valuations performed
for tax purposes, financial reporting purposes, divorces, or a merger or acquisition could
all result in different value conclusions about the worth of the company. Valuations
performed for different purposes are controlled by different guidelines. For example, tax
valuations are controlled by the tax code and regulations, IRS pronouncements, and tax
court opinions, while valuations for divorces are controlled by state laws and family court
decisions, which vary from state to state.
Whereas, valuations for tax purposes envision “hypothetical buyers and sellers” who
have no synergies and no special compulsion to make a deal. In merger and acquisition
transactions, synergies and various pressures to make a deal frequently enter the picture.
Prospective buyers and sellers often arrive at very different ideas about the value a
company because they approach the company from different perspectives and have
conflicting goals. Deals are completed when both parties can arrive at a win-win value
conclusion.
Value conclusions for software companies largely depend on qualitative, not quantitative,
analysis of the company. The story behind a financial metric is more important than the
actual numerical result. This story includes all the underlying factors such as market
synergy, technology, patents, distribution, user base, and the management team.
The buyer who will normally pay the most for your company is the one with the most
synergies, the one for whom the purchase of your company will generate the most sales
and earnings. This is why earnings focused valuation methods, especially discounted
cash flow models, are used most often.
There are nine methods commonly used to value software companies. Two methods are
focused on the company’s assets, five methods are focused on similar or comparable
companies, and two methods are focused on the earnings or cash flow generated by the
company. The methods are:
· Earnings Focused Value Methods
o DCF – Discounted Cash Flows
o Free Cash Flow
· Asset Focused Value Methods
o Replacement Value
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o Liquidation Value
· Market Focused Value Methods
o Internal Transaction Price
o Public Company Revenue Multiple
o Private Similar Company Earnings Multiple
o Public Company Earnings Multiple
o Private Similar Company Revenue Multiple
Many in the industry discuss two additional methods. However, they are probably the
methods least used by professionals in the industry and can be misleading about a
software company’s real value. The first method is the company’s book value on its
financial statements. It is typically misleading because it does not reflect any of the
company’s intangible assets or the company’s potential in the future.
The second method is based on “Rules of Thumb,” for example, a prescribed multiple of
revenue. A prescribed multiples of revenue assume that all software companies are
homogeneous and have the same profit structures, quality of technology, and future
potential. As a result, rules of thumb should be used with great care or, even better, they
should be avoided.
Earnings Focused Methods
In the merger and acquisition world, the earnings focused methods are the most common
methods utilized. These methods are highly sensitive to their underlying assumptions.
Therefore, careful analysis should be used to understand and support any assumptions
used in the method’s development.
Free Cash Flow Model
The free cash flow model has two variations, but both are based on the company’s cash
flow. The first variation uses a rule of thumb that a company is worth three to eight times
its cash flow represented by EBITDA (earnings before interest, taxes and depreciation
and amortization). The valuation process starts with a multiple of approximately four to
six times EBITDA and is adjusted upward or downward based on the qualitative aspects
of the company. In this variation, it is assumed the investor will be happy receiving
his/her capital back in three to eight years depending on the risk assumed.
EBITDA Rule of Thumb Example:
Determination of EBITDA:
Net income: $400,000
Plus: Taxes 100,000
Plus: Interest expense 50,000
Plus: Depreciation and amortization 250,000
EBITDA $800,000
Determination of company value –
EBITDA $ 800,000
Times: Rule of thumb multiple, adjusted for
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qualitative aspects of the subject company 5
Indicated value $4,000,000
The second variation, often referred to as the leverage buyout (LBO) model, is based on
the company’s free cash flow or net free cash flow. Free cash flow is defined as:
Start with: Net income
Plus: Taxes
Plus: Interest expense
Plus: Depreciation and amortization
Plus: Increase in debt (or less decrease in debt)
Less: Capital expenditures
Less: Increase in working capital (or plus decrease in working capital)
Equals: Free cash flow
In this model, the investor assumes that the company’s worth is equal to the down
payment plus the debt that the free cash flow will support after reserving some of the cash
flow (typically 5% - 15%) as a margin for error.
LBO example:
Determination of annual free cash flow –
Net income: $400,000
Plus: Taxes 100,000
Plus: Interest expense 50,000
Plus: Depreciation and amortization 250,000
EBITDA $800,000
Less: Capital expenditures (50,000)
Less: Increase in working capital (30,000)
Net free cash flow $720,000
Determination of annual amount available to service debt –
Times: Portion available for debt repayment 85%
Amount available to service debt $612,000
Determination of supportable debt –
Interest rate 9%
Repayment period 6 years
Present value of amount available to service debt
(supportable debt) $2,745,400
Determination of company value –
Down payment assumed (approximately 30%) $1,200,000
Plus: Supportable debt 2,745,400
Indicated value $3,945,500
As can be seen in either variation, the free cash flow model is based on several very
broad assumptions (including no debt assumed by buyer) and can easily be varied by
either the buyer or seller. For litigation and tax valuation purposes, the free cash flow
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model is more often used as a sanity check for a value conclusion, than as a valuation
model.
Discounted Cash Flow
Discounted cash flow (DCF) is the most common method used in mergers and
acquisitions and is being used more often for other valuation purposes, especially for
larger companies. Without a doubt, this is the best method for a buyer to use.
In this method:
· The value of the company is based on the free cash flow to investors, expected to
be generated in the future.
· The value is the sum of the net present values projected for future years (normally
3 to 5 years) plus the value of “continuing operations” after the projected period.
This method is frequently the only method applicable to companies in the start-up stage
and to companies expected to have extremely high growth rates driving even larger
growth in their profit margins. The difficulty in using this method primarily relates to
determining the risk that the company will not achieve its projections. The old adage that
the higher the risk, the higher the return, really applies in the DCF model. Thus, the
greater the risk of not achieving the projections the higher the required return required
(discount rate).
Discount rates applicable to DCF models for most software companies will vary from
20% to 70% depending on the risk to be assumed by the investors. The better
management can support the projection’s assumptions, the lower the discount rate
required and the higher the value indication for the company. Management needs to pay
particular attention to assumptions concerning:
· The potential user base and its size;
· The justification for how the company expects to achieve projected growth;
· The historical growth rates (if product is being shipped) and the reconciliation of
these rates with projected growth rates;
· The sales and marketing costs required to achieve the projections;
· The company’s infrastructure and its ability to support the projected growth;
· The future research and development costs required to continue the development
and enhancement of the products’ features.
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A simple DCF model can be illustrated by the following example:
Revenue Growth Rate 1.1 1.1 1.1
Year Year Year Continuing
1 2 3 Operations
Revenue 3,200,000 3,520,000 3,872,000 4,259,200
20.0% 20.0% 20.0% 20.0%
Net Income 640,000 704,000 774,400 851,840
Plus:
Depreciation 250,000 225,000 200,000 200,000
Less:
Changes in Debt 75,000 75,000 75,000 75,000
Changes in Working Capital 30,000 32,000 35,200 38,720
Capital Expenses 100,000 125,000 150,000 200,000
Net Free Cash Flow 685,000 697,000 714,200 738,120
Value Multiple 8
Value of Continuing Operations 5,904,960
Present Value Factor @30% 0.76923 0.59172 0.45517 0.45517
Present Value 526,923 412,426 325,079 2,687,735
Total Present Value 3,952,163
The DCF model should be applied by an experienced practitioner familiar with its many
variables and complications. The illustration above is a very simple format which does
not consider many issues, such as should the model be developed on an equity basis or on
a debt free/invested capital basis.
Asset Focused Methods
Every investor is concerned about the value of the booked or identifiable assets to be
acquired. The more tangible the assets (real property and equipment) the less risk an
investor generally considers they are assuming. Goodwill or blue sky is generally
considered to have the highest risk of all assets purchased. If the identifiable assets are
valued then the investor can quantify what portion of the purchase price is supported by
the highest risk assets (goodwill/blue sky).
Two asset-focused methods are generally considered when valuing a software company.
They are the replacement cost method and the liquidation value method.
Replacement Cost
The replacement cost method is based on the assumption that the company is worth what
it would cost to replace all of the company’s identifiable assets. Replacement cost values
tend to be most useful in two situations:
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· First, for young software companies, with few, if any, sales, user base or dealer
base. This may be the highest value indication possible when the primary
investment has been in the technology or product.
· Second, in a company with an operating history which does not reflect its
investment (time and money) in it product. The company maybe making a major
business model change in its platform, versions or distribution channel.
Tangible assets can generally be estimated from the costs of purchasing a comparable
replacement item, but the technology is generally more difficult to value. Most often the
starting point for software value is the cost to recreate. The cost is generally computed in
dollars per labor year to create or dollars per line of executable code. One of the more
advanced methods to determine software development costs is the CoCoMo II Model
developed at the University of Southern California.
The problem with the replacement cost method is that it does not reflect the loss in value,
because of the time-to-market delays. Valuable windows of opportunity will probably be
lost, by any party recreating the software.
This method is most often used when making buy (acquisitions) versus make (create it
ourselves) decisions. Obviously, the time to market and lost opportunity costs are a
major part of the decision.
Liquidation Value
The second asset-focused method is the liquidation value. Liquidation value is the value
of the individual assets if the company were to be liquidated today. Again these values
are easier to obtain for the tangible assets than they are for the intangible assets, including
the technology. Often in a liquidation scenario, the technology/software may have no
practical value. This method generally produces the lowest value for the firm.
Liquidation value should not be used unless the company is considering liquidation.
“Market Focused Methods”
Market focused valuation methods are based on the concept that a company’s value is
equal to the price that an investor would pay for a similar company or investment. There
are five market focused methods normally used in valuing software companies.
In recent studies of publicly-traded software companies, we found the highest statistical
correlation to the price to book value multiple. This is counter intuitive and not accepted
by most professionals, but merits additional study and may be a useful method in certain
situations.
Internal Transaction Price
The first market focused method is the internal transaction price. This method assumes
the stock’s current price should at least be equal to the last price paid for the company’s
stock or the last transaction price. The last transaction may have been a sale of company
stock, or the price at which incentive stock options were granted. The company’s value
is determined by multiplying the stock price by the total number of shares outstanding.
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This method in the negotiation process is often referred to as a “negotiating floor value.”
The analyst should carefully consider if the transaction price paid was an arms-length
transaction or a bargain price which was utilized to accomplish another purpose. Another
issue to be considered is changes in the company which would affect its value since the
transaction took place.
Public Company Revenue Multiple
The second market focused method is the public company revenue multiple. This
method looks at public software companies and calculates a revenue multiple by dividing
the public company’s market capitalization by its revenue. For example, if a company
had a market capitalization of $10,000,000 and revenues of $3,000,000, its revenue
multiple of 3.33 times.
Company market capitalization 10,000,000
(same as in the revenue multiple calculation)
Company’s latest 12 months revenues 3,000,000
Revenue multiple 3.3 x
This method is most often used because of its simplicity, but its simplicity comes with
difficulties in its application. In order for the revenue multiple to be applicable, it
assumes the various companies produce the same or similar profit margins and cash flow.
Would you pay the same revenue multiple for a company that produced $.40 profit for
each dollar of sales and one that produced $.20 profit for each dollar of sales?
In addition, comparability in the size of the market place, growth rates, market
penetration, user base, and distribution channels must be considered, as multiples of
revenue paid by investors, are based on many factors.
Experience shows us that private companies normally have lower revenue multiples than
public companies. These lower multiples result from the fundamental differences
between public and private companies. These differences result from public companies
typically having more access to investment capital and financing, depth of management,
larger revenue bases and many other advantages over private companies.
These private company multiple differences are generally adjusted for by various means,
such as fundamental adjustments, size adjustments, and/or growth rate adjustments. In
the software M&A world, the fundamental discount is often used for its simplicity. A
simple valuer’s subjective discount is applied to the multiple, thereby lowering the public
company value indication by the discount percentage. Fundamental discounts are
generally considered to begin at 25%. Although the fundamental discount is used in the
software M&A world, other adjustment methods are more commonly used for tax and
litigation valuation purposes.
Private Company Revenue Multiple
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The private company revenue multiple method is very similar to the public company
revenue multiple method. The primary difference is that instead of the multiple being
derived from the publicly traded stock prices, the multiple is developed from transactions
that took place in the merger and acquisition world. The transaction price is divided by
the companies revenue to derive the revenue multiple. The primary advantage of the
private company revenue multiple is that there are no fundamental differences between
the private transaction companies and the company being valued.
The advantage is offset by the difficulty in obtaining objective data about the transactions
compared to the readily available financial data for public companies. Using professional
assistance from the valuation or M&A world will generally provide the most efficient
means for obtaining relevant multiples applicable to a particular company.
Public Company Earnings Multiple
The public company earnings multiple is very similar to the revenue multiple, except it
compares market capitalization to some level of company earnings. The concept behind
using a multiple of earnings is that earnings more effectively reflects the difference in the
return to the investor between companies than the revenue multiple. This method has
two primary considerations, first the earnings period that most represents the company
and the level of earnings to use in computing the multiple. The most common earnings
period used is the latest twelve months, but based upon the particular situation it may be
more appropriate to use: the prior year, the last fiscal year, or the next year as projected.
The appropriate level of earnings has been hotly debated. Price to net income is the most
popular, but so many companies (including a little over 50% of public software
companies) do not have a positive net income. Other levels of income to be considered
are pretax earnings, gross cash flow, earnings before interest and taxes (EBIT), and
earnings before interest, taxes, depreciation and amortization (EBITDA).
The earning multiple is computed as follows:
Company market capitalization 10,000,000
(same as in the revenue multiple calculation)
Company’s latest 12 months earnings 1,250,000
Earning multiple 8 x
Another difficulty is using an earning multiple is that a private company’s financial
statement may not reflect the company’s true earning potential. Often the financial
statements need to be restated as they are artificially low. Earnings should be increased
by the amount of royalties paid to the owners, excessive salaries and benefits (in excess
of fair market value) paid to the owners, excess rent on facilities leased to the company
and any other similar expenses recorded in the company’s financial statements. Each of
the historical years financial statements (up to 5) should be restated as follows:
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Net Income 649,000
Add back taxes 432,667
Earnings before taxes 1,081,667
Restatements
Royalties paid to owner 80,000
Excess rental payments 35,000
Excess compensation 150,000
Restated earnings before taxes 816,667
Restated taxes 326,667
Restated net income 490,000
Application of the earnings multiple would look like:
Restated
Net
Income
x
Earnings
Multiple
=
Public
Company
Multiple
Value
Indication
x
Fundimental
Discount
=
Value
Indication
490,000 x 15 = 7,350,000 x 50% = $3,675,000
Valuers should remember, that just like when using the public company earnings multiple
a discount for the fundamental differences between private and public companies should
be applied to the public company earnings multiple value indication.
Private Company Earnings Multiple
Like the private company revenue multiple, the earnings multiple is derived from
transactions that took place in the mergers and acquisition world. The earnings multiple
is computed by dividing the transaction price by the appropriate earnings of the company.
The earnings multiple developed from private company transactions is not subject to the
fundamental or other adjustments applicable when using a public company earnings
multiple.
The most difficult part of using private company multiples especially multiples other than
a revenue multiple, is finding reliable data to use. Today, there are several information
providers who collect private company transactions data for analysis. Check with your
professional appraiser or M&A professional, who have access to this data.
Although this method is not typically used by software M&A specialists, it is very
commonly used in valuations prepared for tax and litigation purposes.
Conclusion
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Every company has varying value indications resulting from: the valuation methods
selected, purpose of the valuation (tax regulations, court precedents, etc.), synergistic
benefits considered, or if valued for total ownership or partial ownership. The company
owner must understand that the company will have different values if valued for different
purposes and that the value changes over time, even if the company is basically the same.
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