A central technique under this approach is the comparative transaction method. It is especially useful for valuing private software firms. In a nutshell, the method lets you determine the value of your software firm in comparison to similar companies that have recently sold.
Privately owned software companies with a solid track record of profitability are frequent acquisition targets. You can study the selling prices of successfully closed deals in relation to the financial performance of such companies.
Valuation multiples are the usual tools to estimate the fair market value of your software company using the market approach. For example, you can calculate your company value in relation to its revenues, gross profit, net income, EBIT, EBITDA, discretionary cash flow or business assets.
One of the main advantages of using such valuation multiples is that they are based on actual sales thus offering a highly objective and defensible way to estimate what your software company is worth. This is especially useful if you need to prove your business value to a skeptical investor, or defend your valuation in court or before the tax authorities.
Example – valuing a custom software development company using valuation multiples
We will take a typical contract software development firm with the following financials:
- Gross revenue: $1,300,000.
- Net sales: $1,200,000.
- Gross profit: $1,000,000.
- Net income: $230,000.
- EBIT: $370,000.
- EBITDA: $385,000.
- Seller’s discretionary cash flow (SDCF): $400,000.
- Furniture, fixtures and equipment (FF&E) assets: $450,000.
- Total business assets: $500,000.
- Book value of owners’ equity: $225,500.
We pick a set of reasonable valuation multiples and estimate the value of this software company as follows:
|Multiple||Multiple value||Business value|
|Business value based on gross revenue||1.5||$1,950,000|
|Value based on net sales||1.55||$1,860,000|
|Value based on gross profit||2.0||$2,000,000|
|Value based on net income||8.5||$1,955,000|
|Value based on EBIT||5.0||$1,850,000|
|Value based on EBITDA||4.9||$1,886,500|
|Value based on SDCF||4.0||$1,600,000|
|Value based on FF&E assets||3.75||$1,675,500|
|Value based on total assets||4.0||$2,000,000|
|Value based on owners equity||7.0||$1,578,500|
|Average Business Value||$1,836,750|
Each business value estimate can shed a different light on what drives the value of your software company. For example, a high business valuation result based on EBITDA may point out that the company manages its profitability better than the industry average.
An asset rich firm will likely show a higher business value estimate based on the value of its total assets, both tangible and intangible, such as internally developed technology or business processes.
Using business valuation as a strategic tool
Showing how business value depends on your company performance in this way can help you in strategic planning and decision making.
A key question: what value factors can be improved to increase the overall business value? You can focus on the areas that can enhance the value of your company, then measure the result by repeating your business appraisal.