We are often asked in our acquisition practice why valuations for software companies are higher than valuations for businesses with a more traditional business model, such as services, for example.
In this expert contribution, I will explain a few aspects of why the valuation of businesses based on the model of software product development and marketing is often higher.
Future cash flows
The value of a business is usually determined by its growth trend and the degree of certainty of its future free cash flows. The higher and more certain that free cash flow is, the higher the value buyers place on the business. Software is ideally suited to generate high future cash flows. Why? Because once a software product is developed, its sale and delivery requires relatively less effort than for, say, agricultural products or the production of heavy machinery.
Once developed, a software product is relatively easy to deliver, especially with the help of the Internet. Software product development and marketing is therefore often seen as a scalable business model. After an initial investment in the product, success with an initial group of customers is easily replicable.
Scalability
The attractiveness of this business model has to do with the fact that when scaling up such a business, revenue can increase rapidly, and combined with limited cost increases, this in turn leads to high free cash flows for the equity providers.
This is why we also regularly encounter multiples on revenue rather than EBITDA in acquisition practice. There are good benchmarks available today for valuing software production companies based on revenue multiples, and the differences with the valuation of more traditional business models in the IT sector are significant.
Developing a software product?
There are several ways to start the development of a software product:
From scratch
Frequently we see that this happens from "scratch. Developers start with a blank sheet of paper, so to speak, and set to work developing a product for a particular problem area. This may or may not be done in collaboration with an initial client.
Commissioned
There are also businesses that develop a product commissioned by a customer, where the client expects in advance that there will be a large market waiting for the idea. Client and contractor can then agree on ownership of the rights to the product and its marketing after the project is completed. The obvious solution would then be for the software developer to handle the marketing and for the initial client to act as a referent.
Problem solving
What we also encounter is that a software company has solved a particular problem several times for a new client and, as a result, discovers that there might be a need for a standard software product for the problem area in which the various assignments have been realized. This route from custom to standard software is not an easy one, if only because a business that successfully completes custom development projects is not necessarily also successful in building and marketing standard software products. These are two different business models with their own specific critical success factors and different value drivers.
There are different ways to arrive at a software product, and if a business offers a software product on a subscription basis (SaaS), it can expect a higher valuation than an IT company that uses a traditional business model.
