Valuation of Software Companies – The Market-Based Approach

After going over the ins and outs of the asset-based approach in last week’s blog, our focus this week is exploring the market-based approach in the valuation of a software company.

The market-based approach derives its strength through its ability to consider actions of actual market participants. However, it is typically hard to find a truly comparable company given the uniqueness of each software company. There is often an additional layer of difficulty if comparable software companies are private, as these companies typically do not disclose much information to the public (e.g., financial data, terms of transactions, etc.).

That being said, a market-based approach will still be considered if there are any comparable companies found. This approach typically reviews the market valuation multiples involved in the particular transaction, such as EV[1]/Revenue or EV/EBITDA[2].

In the assessment of the appropriate multiples for use in the valuation of the subject software company, one should consider some relevant factors, including:

• Sustainable competitive advantage – whether competitors can easily provide a comparable or substitute product.
• Visibility and predictability of revenues – certainty of revenues and the predictability of future revenues reduces risk in the valuation.
• Customer retention – customers who are “locked-in” or have high switching costs implies better retention and increases predictability of future revenues.
• Gross margins – a higher margin means a higher profitability to the company for each revenue dollar earned. It has been observed that a company with higher profitability margins typically can demand a higher valuation multiple.
• Marginal profitability – low incremental costs related to new customers allows growth in customers to substantially impact the bottom line. Similar to gross margins above, the more a company is able to generate revenue that flows to the bottom line, the higher the valuation multiple it can demand.

We wish to note that the above list is not exhaustive, as there are many other factors to consider when deriving a suitable valuation multiple observed from the market. As such, careful consideration of the determined comparable companies is required, including whether the company is truly suitable in the valuation of the subject software company.

Next week, our blog series – The Valuation of Software Companies – will come to a close as we dive into our last segment on the earnings-based approach.

[1] Enterprise Value

[2] Earnings before interest, tax, depreciation and amortization