How to value a software company
If you own a software firm, plan to start one or acquire an existing company, here are some interesting facts to consider:
The two main segments of the software industry are custom software services and pre-packaged products.
Software development services firms
Classified under the SIC code 7371 and NAICS 541511, the firms in the software service industry concentrate on creating solutions for clients, usually other businesses.
The industry segment as a whole counts over 55,000 establishments in the US alone. Moreover, these software companies employ around 494,000 people and generate over $84.9B in annual sales. However, the average contract software development company makes about $1.54M in annual revenues and employs a staff of 9.
Software product development companies
Software companies that develop and sell their own products are classified under the SIC code 7372 and NAICS 5112. The pre-packaged software industry has just under 8,300 firms operating in the US market with a total employment force of some 386,900.
The segment generates an impressive $135.4B in annual sales. An average company does about $16.4M in revenues per year with a staff of 46.
One interesting observation you can make is that the software services industry creates fewer dollars with more people. One reason is that the software services are more labor intensive. However, the service companies have an easier time establishing a loyal customer base and recurring business.
Key value drivers for software companies
Regardless of which market segment your software company is in, these key factors make the major difference to its value:
Earnings growth prospects
Software products can be highly profitable if focused on the right market segment with significant demand. Product firms especially can experience significant revenue growth quickly with the right product mix.
Keeping costs under control is not an easy task for a software company. The costs of developing and marketing software products are very high. The firms that manage growth while keeping their cost from escalating are far more valuable than their unprofitable counterparts.
Stability of earnings
Maintaining consistent level of sales and profitability can be very difficult especially for pure product software companies. Competition can introduce an alternative product and sudden market changes can make a star product obsolete very quickly.
This is where the service companies tend to do better – the customer loyalty tends to translate into repeat business, stable prices and steady earnings. The costs of entering the new market segments are also lower for software services companies as they tend to rely on existing customers and referrals to do so.
Business valuation methods for software companies
As with any business, you can value a software company three ways, known as appraisal approaches:
- Asset – based on the company’s asset base.
- Income – based on the firm’s earning power and risk.
Established software firms tend to be frequent acquisition targets. Hence, there is solid evidence of their market value as shown by the actual business selling prices. Thus, you can use the market valuation methods quite effectively to appraise your software business.
At the same time, the growth potential is a key element of value in any software company. So income-based business valuation methods, such as the Discounted Cash Flow technique, are an excellent choice to value a software firm.
Combined Market and Income approach: First Chicago Method
For a highly accurate business appraisal, you can combine the two approaches. This technique is often referred to as the First Chicago method. Under this method, you can assess the value of your software business using the Discounted Cash Flow method. This requires that you create a set of earnings forecasts and assess the business risk.
Since the future is never certain, you can improve the accuracy and validity of your business appraisal by repeating the Discounted Cash Flow analysis under a couple of possible scenarios. For instance, you can consider the worst case and best case outcomes. After that, average the results to come up with an estimate of what your company is worth.
The market comparisons serve as the objective proof to back your income-based valuation results. Importantly, the market valuation is based on the actual data on similar business sales. As a result, it tends to act as a sanity check on your forward-looking income-based valuation.
Again, combine the income and market-based valuation results for a highly defensible, comprehensive estimate of what your software company is worth.