Whilst analysing an EV/Revenue multiple or an EV/EBITDA multiple is relevant to the valuation of software companies, there are additional metrics which should be considered.
The technology industry appears to be starting 2022 strongly. Growth is being generated by a global acceptance of cloud-based technologies and the need for workers to adapt to hybrid working arrangements which in turn has increased demand for software to facilitate these requirements.
As a Cambridge-based M&A boutique, it follows suit that we have seen a lot of activity in this industry with over $100bn of transactions in the trailing twelve months (LTM) from February 2021, including the $40bn sale of Arm to Nvidia (the transaction has stopped since publication) and the region is showing no signs of slowing down.
Some industries are fairly uniform when it comes to valuations, with a handful of businesses that may stray from the trodden path. This is not necessarily the case with software companies. The highly competitive market and the level of IP associated with the industry means there is often a bigger uncertainty over where the overall value of the business is derived.
Most business valuations are likely to consist of an EV/Revenue multiple or an EV/EBITDA multiple. When looking at an EV/EBITDA multiple, the EBITDA used should be adjusted for one off income or expenditure with a view to determine what a ‘normal’ level of EBITDA would be for the business in its current state and moving forwards.
Whilst both the above are relevant in the valuation of software companies, there are additional metrics which should be considered which may be less common in other industries.
This is calculated as a percentage of the number of customer leaving the overall customer base. Particularly so in software businesses where subscriptions and recurring revenue are rife, retaining customers is imperative in driving value in the business.
Akin to the above, the annual recurring revenue itself is a metric which should be considered on valuation.
Total revenue divided by total number of customers, indicative of any dependence on a small number of customers.
Sufficient, reliable forecasting is required for expected profits in future years. This is likely to be a more mature business with visibility over revenue streams, for example where subscriptions and recurring revenues can be accurately predicted. In essence it’s a combination of Customer Churn and ARR where sufficient additional information is available.
Whilst this is indicative of what a purchaser may pay for the business, in terms of the company’s actual value, factors such as strategic premia, or distress discounts would need to be considered in determining the sold company’s underlying value (and therefore its suggested multiple).
The technology sector displays a wide range of multiples depending on the company being valued, with small nuances in business activity potentially driving a significant swing in the value of the business. For example, companies that own strong IP can benefit from a significantly higher multiple than those that work on a consulting and integrating model using third-party software.
The main, and most broadcast, cause for concern in the industry stems from supply chain issues – particularly relating to semiconductors. Whilst software itself may not depend on these, the machines required to develop and use the software does. Even premium purchasers of semiconductors such as Apple and IBM are struggling to have orders fulfilled which is filtering down through the market. This would have to be taken into consideration when considering the current enterprise value of the business as the ability for a company to convert its opportunities can influence its value.