How do you sell a software company? How long does it take? Who are the potential buyers?
I can assure you that selling a software company is a complex transaction. In fact, the one regret I hear over and over again from my peers is that it was harder to find qualified buyers than they could have ever guessed. Preparation and realistic expectations are key to achieving a closed transaction.
Whether you’re a founder or just have some equity, there’s a lot you need to know before you decide to sell your software company, things that you won’t actually learn until you’ve been through the process.
I was talking with a founder the other day who is in the position to seriously consider selling his company. It’s not his first startup, but the previous one just gradually withered away due to a lack of potential buyers and the founder’s distraction with the new project. I decided to write down my points so that I could share with others about how the process typically works.
How to know when it’s time to sell
Software companies that get sold usually fall into 4 different categories:
- The business is struggling and you’re tired, out of ideas, not engaged and just want the problems to go away. Basically, you have to sell. This makes it challenging to find a buyer.
- Business is great and growing quickly. These are tricky companies to sell because the founders usually can’t agree on a realistic valuation. Lots of interested buyers but few offers anywhere near the asking price. Basically, the seller is looking for the highly elusive ‘godfather offer’ and it rarely appears.
- Life Happens and you need to sell. In a business when all the important assets go home each evening, life happens. People get sick, divorced, need to move locations, or have changing family commitments. This can create exciting opportunities for buyers and allow the seller to remain engaged on a part-time basis.
- You’ve reached the limits of your abilities in one area. You’ve built a solid company but as a technical founder, you struggle to manage large sales teams or engineering teams. These companies typically want to be acquired by a larger company and take advantage of their scale. This allows the founders to stay engaged as employees and allows the larger company to quickly scale both the product and go-to-market side of the company. These are ideal situations and all parties can come out ahead under the right deal terms.
Often, the decision to sell is based on a combination of the above reasons.
How to make the decision to sell
The three types of buyers
(1) A larger company. This is a related company with similar products and customer base. Valuations are at the upper end of the range. The founders are given strong incentives to stay engaged to continue growing the business. The acquiring company is either looking for new product functionality, customers or both. This is the most common exit for lower middle market software companies.
(2) Private equity. These firms usually buy out all of the existing owners and investors and may put company leadership on a profit plan to keep them around and motivated. These transactions usually happen at the higher end of the lower mid-market. A typical PE firm won’t even look at companies with less than $1m in EBITDA. These transactions, while potentially at very high valuations are exceedingly rare. You really need something special to get through the multiple rounds of screenings and to pass the due diligence.
(3) An individual or small group will look to purchase a technology company to add to a portfolio. Valuations are usually lower, but these firms will consider smaller companies as their primary concern is to maintain the existing cash flows and earn a fair return on their invested capital.
Realistic Valuations for Software and B2b Services Companies
First, be aware of the actual multiples in closed transactions for companies your size. Asking price vs cash flow is king in attracting the right kind of buyers. Realistic multiples attract realistic buyers. Realistic buyers have deep pockets, are happy to pay a fair price and have the expertise to maintain and grow software companies. They are in the business of software, not out of industry financial buyers enamored with the cash flow potential of a software company.
To learn what’s realistic, it helps if you’ve already received and rejected one or more offers in the recent past. This sets the stage for realistic expectations on your part. Ignore what you see in the news and the multiples you see in the stock market for companies many orders of magnitude your size. You’ve built a great business, but you aren’t Google or Facebook. Being honest with yourself is key.
If you don’t have a solid offer, you should at least be investigating one or more implied offers. These hints and clues will come from partners, customers, competition, even investors and advisors with connections to other companies in your industry. Knowing what a “good” offer looks like can help guide you through the negotiating process. Nothing turns off a potential buyer like a seller over-negotiating an already strong offer.
If you have none of these, selling the company is going to be a lot more difficult — but not impossible. In this case, acquisition is a lot like fundraising. If you don’t have any offers or leads, you need to build connections and relationships. You’re basically putting together a pitch deck and going door to door. Working with an intermediary can help, especially if your network of buyers is small, the success fee paid can more than offset the time and expense of building up your own network.
Establish Shareholder Consensus
The second thing you need to do before you make the decision to sell is talk to your board, your current investors, your executive team, and your advisors. Everyone has to be in line, on board, and ready to move forward with proper expectations. When an offer arrives, you will only have a couple of days to accept, reject or counter. Knowing where all the stakeholders stand will allow you to decide quickly on how to deal with an offer.
Prepare the Software Company to be Sold
There are basically three ways to calculate the value of your company.
- Service-based companies are usually valued at 1x to 2x annual revenue. This can creep up to 3x with strong recurring revenue from brand name clients.
- Product companies are valued at 2x to 10x annual revenue, depending on the market for the product, the demonstrated revenue growth and a number of other specifics related to the unique opportunity.
- In cases of extreme opportunity and innovation, a product company can be sold for 20x to 50x annual revenue. These companies usually have a significant technical innovation protected by multiple patents.
There are two things you’ll have to do to sell your software company: (1) Show you’re worth the sale price and (2) prove the legitimacy of your operations.
To show your worth, if your company is taking in $2 million in revenue and your valuation comes out at 10x, or $20 million, you need to be able to show the acquirer the path to $20 million in revenue within a three- to five-year time frame. The more objectively you can show that return, the more likely you’ll get your asking price.
There are a number of ways you can do this, but talking about it won’t be enough. You’ll need to demonstrate how you have put more resources into sales and/or marketing to produce revenue. How you have brought on additional sales people, trained them and have them hit quota in 6-12 months is key. Your revenue generation needs to operate like a machine.
Doing the same with new products and features will also be important. Showing examples of how you went from a product request to the monetization of that request in a few months will build confidence in your organization and show how your company is a money making machine.
Due Diligence on Software Company Sales
To prove your legitimacy, you’re going to have to go through due diligence. This happens after a LOI has been accepted by both parties.
During due diligence, you’ll have to show that the structural integrity of your company is clean. This means you’ll need to:
- Open your books so they can audit your financials.
- Have a deep dive technical review to uncover any technical issues which could prevent the new owners from realizing a return on their investment.
- Show a clean cap table, with all the equity in the company past, present, and future accounted for.
- Sit your lawyers with their lawyers to sniff out liability and risk.
- Interview and background check your management team and key employees.
There will be little time between the initial interest from the acquirer and due diligence. Be ready to go once a qualified buyer is identified.
Timeline to Sell a Software Company
Due diligence will take 30-90 days to be completed. Delays can happen of course, but your best bet is to follow the above advice, have reasoned expectations and have your financial and operations ducks in a row.
Of course, buyers will be working multiple potential deals so they tend to focus their efforts on their best opportunities. Sometimes, the buyer will drop off the face of the earth for weeks only to reappear and be ready to move quickly. In these situations, I assume the buyer couldn’t reach a deal with the other seller and I’ve just moved into the lead position.
A general timeline looks something like 1–2 months to prepare and line up interested buyers, 2–3 months to get a solid offer in place, 1–2 months of due diligence. That’s from 4 to 7 months, to sell a software company from start to finish. The process is not quick, but it should not drag. The really interested buyers will remain responsive. Competition from multiple buyers can do wonders to move the deals along and sweeten the offers when it is time to sell a software company.
About the Author
David is a licensed business broker in California. With over 20 years experience in the software business, his practice focuses on software and b2b services companies having revenues between $2m-$30m. His current clients are here.