Software Capitalization in M&A DealsThe valuation of software capitalisation is crucial in mergers and acquisitions (M&A) deals. This article explores the methods and approaches used to assess software value, as well as the information necessary to conduct an accurate valuation.
Methods of Software Capitalization Valuation in M&A Deals
1. Cost Approach
The cost approach involves evaluating the software's value based on the expenses incurred in its development and maintenance. This method includes accounting for all costs associated with creating the software, including developer salaries, equipment and software tools expenses, as well as testing and deployment costs.
2. Current Revenue and Expense Analysis
This method is based on analysing the current revenue generated by the software, taking into account the current costs of support and development. It is also important to consider future expenses for software upgrades and scaling.
3. Revenue Forecasting
Revenue forecasting is based on assessing the future income that the software can generate. This requires considering factors such as market demand, growth rates, and customer acquisition and retention levels.
4. Comparison with Similar Software
This method involves analyzing the value of similar software or transactions involving the sale of similar software. Despite the challenges associated with the lack of information or the uniqueness of the software, this method can provide valuable benchmarks for valuation.
5. Combination of Methods
In most cases, it is advisable to use a combination of the above methods to obtain the most accurate software valuation.
Information Required for Valuation
1. Financial Projections
- Revenue Projections: Estimate future revenues, considering market demand, growth rates, and customer acquisition and retention rates.
- Expense Projections: Include costs such as research and development, marketing, sales, administrative, and operational expenses.
- Capital Expenditures: Predict future investments needed to maintain or grow the software's capabilities.
2. Historical Financial Data
- Income Statements: Historical data on revenue, cost of goods sold, gross profit, operating expenses, and net income.
- Cash Flow Statements: Historical data on cash flows from operating, investing, and financing activities.
3. Market and Industry Analysis
- Market Size and Growth: Assess the current market size and its growth forecast.
- Competitive Landscape: Key competitors and their market shares.
- Industry Trends: Trends affecting the software market, such as the use of AI and machine learning, data protection regulations, and omnichannel strategies.
4. Software-Specific Factors
- Unique Selling Propositions: Features and benefits that differentiate the software from competitors.
- User Base and Growth: Current user base, user acquisition rate, and churn rate.
- Pricing Model: Details on subscription, licensing, or other pricing models.
5. Discount Rate Determination
- Cost of Capital: Weighted average cost of capital (WACC), reflecting the industry's risk and growth potential.
- Risk Factors: Specific risks, such as technological obsolescence, competition, and market penetration challenges.
6. Terminal Value Calculation
- Growth Rate Assumptions: Estimate the perpetual growth rate of cash flows.
- Exit Multiples: Exit multiples, such as EBITDA, for estimating the terminal value of the software.
7. Scenario Analysis and Sensitivity Analysis
- Scenario Analysis: Develop different scenarios (best case, worst case, and most likely case) to understand the impact of various assumptions on the valuation.
- Sensitivity Analysis: Analyze how sensitive the valuation is to changes in key assumptions such as discount rate, revenue growth rate, and expense projections.
8. Legal and Intellectual Property Considerations
- Intellectual Property Rights: Assess the portfolio of patents, trademarks, copyrights, and proprietary technologies.
- Regulatory Compliance: Ensure compliance with various legal and regulatory requirements, including data protection laws and industry
-specific regulations.
9. Management Team and Organizational Factors
- Management Expertise: Assess the experience and qualifications of the management team.
- Operational Efficiency: Evaluate the efficiency of operational processes and the potential for scaling.
10. Customer and Partner Relationships
- Customer Contracts: Key customer contracts and their terms.
- Partnerships and Alliances: Strategic partnerships and alliances affecting the software's market reach and growth.
Detailed Description of Some Software Capitalization Valuation Methods in M&A Deals
Cost Approach
The cost approach is based on evaluating all costs incurred in creating and maintaining the software. This method is suitable for software that has recently been developed and has yet to demonstrate stable revenue or market position.
The following aspects are considered within the cost approach:
1. Direct Development Costs
- Labor Costs: Salaries of developers, testers, project managers, and other participants in the development.
- Equipment Costs: Costs of servers, computers, and other hardware necessary for software development.
- Licensing Fees: Costs of licenses for tools and development platforms.
2. Indirect Costs
- Project Management Costs: Expenses for administrative support, project management, and quality control.
- Training and Development Costs: Expenses for training, courses, and skill enhancement for the development team.
3. Overhead
- Rent and Utilities: Expenses for renting office spaces, paying utility bills, and other overhead costs.
- Marketing Costs: Expenses for software promotion, including marketing campaigns, advertising materials, and participation in exhibitions and conferences.
4. Depreciation
- Equipment Depreciation: Depreciation of equipment and software tools over their useful life.
Current Revenue and Expense Analysis
This method involves analyzing the current financial performance of the software. It is useful for software that has already been launched in the market and has stable financial flows.
The following elements are considered:
1. Current Revenue
- Analysis of Current Income: Study current revenue sources, such as subscriptions, licenses, one-time sales, and other incomes.
- Customer Base Analysis: Assess the current number of users, the rate of new customer acquisition, and the retention rate of existing customers.
2. Current Expenses
- Support and Maintenance Costs: Expenses for technical support, updates, and software improvements.
- Operational Expenses: Current expenses for marketing, sales, administrative, and operational costs.
- Infrastructure Costs: Expenses for servers, cloud services, and other technical resources required for software operation.
3. Net Profit
- Net Profit Analysis: Calculate net profit based on current revenue and expenses to determine the software's profitability.
Revenue Forecasting
Revenue forecasting involves analyzing the future financial flows of the software, which is especially important for software with high growth potential.
This method includes the following steps:
1. Revenue Projections
- Market Trend Analysis: Assess market demand, industry growth rates, and competitive environment.
- Revenue Growth Forecasting: Develop revenue growth models based on historical data, market forecasts, and the company's strategic plans.
2. Expense Projections
- Development Cost Projections: Estimate future expenses for developing new features, improving existing functionality, and implementing innovations.
- Operational Expense Projections: Predict future marketing, sales, administrative, and operational costs.
- Capital Expenditure Projections: Estimate investments needed for scaling and supporting the software.
3. Discounted Cash Flow Analysis (DCF)
- Discount Rate Determination: Calculate the weighted average cost of capital (WACC), considering the industry's risk and growth potential.
- Discounted Cash Flow Calculation: Forecast future cash flows and discount them to present value to assess the current software value.
4. Terminal Value Calculation
- Long-term Growth Rate Estimation: Determine the perpetual growth rate of cash flows.
- Exit Multiples: Calculate the software's terminal value using EBITDA or other financial multiples.
Valuation of software capitalization in M&A deals requires a comprehensive approach that considers various aspects, from financial forecasts to market analysis and legal factors. Combining different methods and gathering complete information allows for the most accurate software valuation, which is a key factor in a successful deal.
Authors:
Yauheni Khodzkin
Partner – IT Launchpad
