Business valuation of security software development companies

Companies developing security software applications fall within the custom software industry sector. It is classified under SIC code 7371 and NAICS 541512.

Information systems security concerns in companies large and small are a major reason this sector of the software industry has experienced rapid growth in recent years. In 2011, over 49,000 US based firms have been responsible for over $65.4B in total annual revenues. The industry as a whole employs well over 555,000 professional and administrative staff.

Yet the vast majority of security software companies are considered small to mid-size businesses. The average firm produces about $1,500,000 in annual sales with a staff of just 12.

Business valuation of security software development companies

As with any software business, you have a number of well known valuation methods to value security application development firms. These companies are common acquisition targets so you can use the recent business sales as a guideline to estimate the value of a company in this industry.

These sales comparables are an important source of valuation multiples that you can use in calculating the business value in relation to a range of financial performance factors. Here is our short list of valuation multiples to consider:

• Enterprise value (EV) to gross revenues or net sales
• EV to seller’s discretionary cash flow
• EV to EBIT or EBITDA
• EV to hard assets such as Property, Plant and Equipment (PPE)
• EV to total business assets
• EV to book value of owners’ equity

Example: Using valuation multiples for security software company appraisals

Let’s pick a typical firm in this industry with the following financials to demonstrate the technique:

• Revenue: $1,500,000
• EBITDA: $250,000
• Total business assets: $1,200,000

We next apply the valuation multiples to the corresponding financial performance bases to calculate the business value:

As the above table shows, the calculated values can differ quite a bit. This depends on how our example business financials compare to its industry sector peers. For example, this company appears to be relatively asset rich for its level of revenues and profitability.

Valuation methods for cash cow businesses

If you need to get a top notch business appraisal, consider using a number of different business valuation methods. This multi-method approach to business valuation is standard in professionally prepared appraisals.

The reason is that each method sheds a different light on business value. Hence, seeing the results from a number of methods gives you a well rounded picture of what the business is worth.

One way to handle your valuation is to apply every available method. In practice though, you may decide to choose some valuation methods over others. A specific choice of valuation methods can be more suitable for your situation and significantly reduce the complexity of your business appraisal.

Special business valuation case: the cash cow company

One special case is the so-called cash cow company. These businesses are steady earners that generate consistent returns for their owners despite changes in the economic conditions, competitive pressures and even ownership transitions.

Here are some examples of cash cow companies:

• Established providers of niche products and services to a number of corporate or government customers.
• Firms enjoying long-term contracts with their customers. Examples are contractors to national governments such as the US Federal agencies.
• Companies in a highly protected market with barriers established by unique technology, regulatory requirements or high initial capital investment needs.
• Businesses that have established themselves as institutions in their market. This tends to result in stable recurring earnings from a large number of loyal customers.

Valuation methods used for cash cow businesses

Here are some method suggestions that you can apply to valuation of a steady earner company:

• Direct capitalization valuation methods
• Market comparison to recently sold businesses
• Asset based valuation methods that measure business goodwill

Capitalization methods such as the Multiple of Discretionary Earnings technique are especially well suited for appraisals of these businesses. The methods reply upon a single measure of business earnings to estimate what the business is worth. This works because it is relatively straightforward to predict the earnings of the cash cow business based on its historic performance.

Predictable income stream prospects make cash cow companies highly desirable acquisition targets. As a result there are usually plenty of comparable business sales. You can use valuation multiples derived from such transactions to estimate your business value with considerable accuracy.

Recurrent earnings that characterize cash cow businesses usually point to a loyal customer base. Firms with strong customer following tend to build highly valuable business goodwill. You can use the Capitalized Excess Earnings method to measure the goodwill as well as the total business enterprise value.