Software Valuation: How to Value a Software Company

Valuing software companies is both an art and a science for entrepreneurs and investors in today’s dynamic technology landscape. These coveted gems warrant meticulous valuation, though no perfect formula exists. However, the proven methodologies presented in this blog post can provide a solid approximation of a software company’s value.

This blog post introduces two prevalent valuation methodologies: income-based and market-based approaches. Other valuation methods exist, including the asset-based approach method. However, they are seldom employed in the context of software companies and are thus not the main focus of this blog post.

Use cases of company valuation

Before embarking on the journey of valuing a software company, it’s crucial to understand the significance of knowing its value. Grasping your software company’s valuation offers essential insights that serve various purposes, including:

• Selling your company: an accurate valuation is vital in securing top dollar when selling your software business. By understanding your firm’s valuation and drivers, you can pull the right levers to optimize pre-sale value.
• Secure investment and financing: when looking for external funding (e.g., venture capita or private equity), understanding your software company’s value upfront will significantly help during the negotiations with the capital providers.
• Expanding your business: when pursuing significant growth through M&A or organic means, establish your firm’s baseline value first. This valuation benchmarks where you stand today and helps assess the impact of future moves.

Software company valuation methods

Two common methods exist for valuing software companies. The income approach involves performing a discounted cash flow (DCF) analysis to estimate value based on expected future earnings. The market approach examines valuation multiples from comparable public entities or M&A deals to derive the company’s worth. Both methods have pros and cons, and the selected approach is usually determined by the analyzed software company’s financials and operations and the purpose of the valuation.

Income-based approach

The income-based appoach follows the discounted cash flow (DCF) analysis which values a software company based on its future free cash flows. The first step in the DCF is creating a detailed financial model where typical revenue growth, expenses, capital expenditures, and working capital are projected for the next 3-5 years. These projections may stem from management guidance, historical performance, or our estimation of the company’s and the market’s future trajectory.

After the projected period, a stable growth rate is assumed, known as the terminal growth rate. We can use our projections to calculate the future cash flows of the software company. These cash flows are then discounted at a rate reflecting the company’s capital cost or the investor’s required return (depending on the valuation’s purpose). This discount rate may be adjusted for other factors, such as political, economic, ownership, and business continuity (e.g., start-up) risks. Discounting the cash flows determines their present value and the company’s valuation, also known as the enterprise value.

In the context of M&A, it’s important to highlight that if you are selling your software business, the amount received will be the equity value of your business and not the enterprise value. The equity value is derived from the enterprise value after adjusting for net debt, normalized working capital, preferred shares, and minority ownership (if any).

Once done with the DCF modelling, we can condact a sensitivity analysis to assess the impact of alterations in crucial assumptions (such as discount and terminal growth rates) on the valuation outcome. This aids in understanding the range of potential values and the sensitivity of the valuation model to different variables.

Pros and cons of the income-based approach

Relying on the Discounted Cash Flow or income method to ascertain the value of software companies can present several notable advantages, including

• Cash Flow Focus: DCF considers the company’s projected future cash flows, enabling a detailed examination of revenue streams and financial performance.
• Flexibility: DCF can incorporate changes in growth rates, discount rates, and terminal values, accommodating the dynamic nature of the software industry and its potential for rapid shifts.
• Intrinsic Value: DCF aims to estimate the intrinsic value of a company, which aligns well with assessing software companies that might have intangible assets (IP, brand, user base) as key value drivers.
• Long-Term Perspective: It emphasizes long-term value, aligning with the nature of software companies that often invest heavily upfront for future returns.

Nevertheless, the DCF method is not without its set of drawbacks, necessitating users to diligently acknowledge and factor in these limitations:

• Uncertain Projections: Accurate forecasting of cash flows can be challenging in the fast-changing software industry, where future growth rates and market conditions are subject to significant uncertainty.
• Sensitivity to Assumptions: DCF is highly sensitive to assumptions like growth rates and discount rates, and small changes in these inputs can lead to significant value changes.
• Inadequate for Rapidly Growing Firms: DCF’s terminal value calculation might need to adequately capture the potential for rapid growth in software companies, as it assumes perpetual cash flows beyond the forecast period.
• Neglects Market Sentiment: DCF doesn’t explicitly consider market sentiment, which can heavily influence software company valuations, especially in sectors driven by hype and innovation.
• Complexity: the DCF analysis involves intricate calculations, making it the most complex valuation method in most cases.

While helpful for mature software companies with stable growth and profitability, investors often prefer more straightforward multiples methods even for these companies. They may use DCF results to derive revenue or EBITDA multiples. DCF’s value lies more in understanding value drivers than definitive valuation and illustrating which metrics affect valuation the most.

Market-based approach

Valuation multiples benchmark a company’s value against a selected financial metric. For public companies, equity multiples like share price to earnings and book value are commonly used. For private software companies, enterprise value multiples like EV/EBITDA and EV/Revenue are popular with analysts and investors.

The EBITDA and Revenue multiple

Finance professionals favor the EBITDA multiple due to its independence from capital structure, enabling comparison across varying debt levels, and its focus on genuine cash generation irrespective of accounting decisions.

Although the EBITDA multiple is commonly employed for enterprise valuation, situations arise where alternative multiples are better suited. The most common alternative is the revenue multiple, which works well with start-ups or companies with negative cash flow and net income.

Other types of multiples, such as EBIT, can be used for businesses with substantial depreciation and amortization, common in asset-heavy sectors like industrials and energy.

Finding the multiple

After we select the financial metric we want to multiply (revenue, EBITDA, EBIT, etc.), the second step is calculating the multiple. The two most common sources of comparable multiples are publicly traded companies and precedent transactions.

Comparable company analysis: this method scrutinizes the median or mean EBITDA multiple within your business’s industry or peer set. Accurate execution necessitates extensive industry insight and research to identify suitable peer companies. Further adjustments may be required to align the resultant EBITDA multiple with variations in characteristics and operations.

Precedent M&A transactions: employed primarily in M&A deals, this approach scrutinizes valuation multiples from relevant past transactions. Its applicability hinges on the prevalence of recent transactions among businesses akin in size and scope to your software company. Remember that financial specifics in private company transactions might be restricted, requiring adjustments to accommodate premiums paid for potential synergies.