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Enterprise software is considered to be among the world’s best business models, and for good reason: Revenue tends to be highly recurring. Switching costs, pricing power and customer retention rates are often high. And businesses have the ability to scale in a non-linear fashion owing to the fact that additional “units” of software can often be sold without incurring many (if any) incremental costs.
However, for those looking to acquire enterprise software companies, these benefits tend to come at a relatively steep price: Software businesses most frequently trade at multiples of recurring revenue, which stands in contrast to most other industries in which businesses tend to trade at multiples of EBITDA or cash flow. In other words, getting access to the world’s best business model doesn’t come cheaply.
With that said, not all software investment theses are created equally: There are indeed several different approaches to acquiring and building a software company, and each approach presents a different investment thesis, requires different operational and value creation strategies, and is likely to command different asking prices.
The purpose of this blog post is to present and evaluate 5 different approaches that buyers might consider in their pursuit of a software business. Though this list of approaches is by no means exhaustive, it does capture those that I tend to see most frequently. What I hope you’ll take from reading this post is that no single approach is perfect, and that each set of benefits inherent to each investment thesis comes at some sort of a cost.
Before we begin, it’s worth mentioning:
- The analysis that follows has purposely been generalized, and the results should be viewed as such. Nothing below should be interpreted as a rule or as a universal truth
- The names that I’ve ascribed to each of the 5 investment theses are imperfect at best, and shouldn’t be over-analyzed or taken too literally
- As usual, my commentary focuses on early-career individual acquirors who plan to take an active operational role in the business (often that of the CEO) after the consummation of the transaction. As a result, parts of my analysis might be less relevant to strategic acquirors or Private Equity firms planning to install highly experienced management teams within the companies in question
Why do Software Companies Trade at Revenue Multiples?
If the value of any business in any industry is equal to the present value of its stream of future cash flows, why would any rational investor pay a multiple of revenue, a metric that doesn’t tend to be terribly predictive of cash flow, all else being equal?
Broadly speaking, the reasons why fall into two categories:
- The Quality of the Business Model: As mentioned above, the business model underlying many enterprise software companies is uniquely attractive. Under the right circumstances, revenue and earnings have the potential to be highly stable, predictable, scalable, non-cyclical, and high margin, among other virtues. Due to the laws of supply and demand, such business models should reasonably be expected to command higher price tags.
- The Cash Flow Generation Characteristics of Subscription Models: The vast majority of software companies operate under subscription-based revenue models, and under such models, current earnings are not necessarily a reasonable proxy for the future earning potential of the company. This is so because acquiring new customers often requires large, upfront, one-time costs (often by way of sales & marketing expenses), but the revenue generated from these acquired customers tends to be spread out over much longer periods of time in the future through monthly or annual subscription payments. This asymmetry between current and potential future earnings is particularly acute for young companies, as well as those growing revenue at very rapid rates.
But even within software, as we’ll discuss below, not all businesses models are equally attractive. Though some do indeed appear to be as close to “bullet-proof” as any business model can be, others do not fit this description. Beginning in mid-2020 or so, it seemed as if the market was ascribing high-single-digit ARR multiples to all software companies, simply by virtue of the fact that they were a software company: In Q3 2021, the median revenue multiple in private market software M&A reached 8.0x. This was almost double the longer-term average of 4.15x that persisted between Q3 2017 – Q3 2020 (as I write this in Q3 2022, the median price has since fallen precipitously, though remains elevated relative to historical norms at 5.2x).
As you’ll see below, some types of software investment theses are indeed likely to require mid-to-high single digit ARR multiples, whereas others may only require mid-single digit EBITDA multiples. But price is only one variable among countless others that the prospective acquiror must consider.
Thesis #1: The “Growth Equity” Style Deal
- Acquisition Multiple: High. Average of ~3-4x ARR in the lower-middle market, but can reach 6x or higher
- Transaction Financing: Typically all equity, little (often no) debt
- Cash Funded to Balance Sheet After Closing: Can be material, depending on whether or not future cash burn (or investments required to sustain or accelerate future growth) needs to be financed
- Historical Revenue Growth Rate: Very high. Often 30%+ annually
- Historical EBITDA: Low. Often EBITDA or cash flow neutral to slightly negative
- Age of Seller: Often younger
- Age of Technology Stack: Often newer
- Required Revenue Growth Rate Moving Forward: Very high. Often 30%+ annually
- Value Creation Levers: Very much related to revenue growth
- Relative Execution Risk & Complexity: Medium
This is the investment thesis that I’ve seen most frequently over the past few years within the lower-middle-market. In these types of transactions, target companies are often growing revenue at a rapid pace, and also tend to demonstrate the characteristics that make the enterprise software business model so appealing: Highly recurring revenue streams, low customer churn rates, high gross margins, and a product that is mission-critical to the operations of the customer base without it representing a large percentage of their overall cost structures.
Though this all sounds terribly attractive on the surface, these benefits (particularly the growth rate of revenue) tend to come at a cost: Namely, the high price that a buyer typically has to pay to acquire such a company, especially if the acquisition process is a competitive one. Recall that not all great businesses necessarily make great investments. Several challenges flow from the elevated purchase prices typical of this thesis, including:
- Ignoring the potential for market-driven multiple expansion between entry and exit (as this is something that one can rarely count on), aggressive and sustained revenue growth is effectively a prerequisite for any meaningful equity value to be created.
- Being a first-time CEO is difficult. Growing a company at 30% per year (or more) for 5 years (or more) is difficult. Having to manage both of these dynamics simultaneously is very difficult
I’m not suggesting that this is an inappropriate investment thesis for a first-time CEO to pursue (as this thesis can and does work), but I am suggesting that buying a company at 5x revenue is a fundamentally different bet relative to purchasing a company at 5x EBITDA.
Though investors the world over tend to target rapidly growing markets, if you’re planning to pursue this particular investment thesis, I would suggest being particularly selective about the market in which you acquire, to ensure that it’s of the rapidly growing variety: Growing revenue at 30% per year in a market growing at 30% per year is one thing, but having to do so in a slow-growth or stagnant market is another thing entirely, especially for an inexperienced operator.
Thesis #2: The “Services to Software” Deal
- Acquisition Multiple: Usually based on EBITDA. Could include a small component based on revenue.
- Transaction Financing: Mix of equity and debt
- Cash Funded to Balance Sheet After Closing: Often not required
- Historical Revenue Growth Rate: Varies
- Historical EBITDA: Varies, but usually EBITDA margins at 10%+
- Age of Seller: Varies
- Age of Technology Stack: Varies. May not yet exist
- Required Revenue Growth Rate Moving Forward: Varies, though this thesis often focuses on changing the composition of revenue as much as it focuses on growing the absolute number of revenue dollars
- Value Creation Levers: Various, though the most successful transactions see buyers acquire at a services multiple (EBITDA) and sell at a SaaS multiple (ARR)
- Relative Execution Risk & Complexity: High
This investment thesis would see an acquiror purchase a service-oriented business with a view towards ultimately transitioning it into a software business (ideally in whole, though sometimes in part). In some instances, target companies already have a nascent software revenue stream, whereas in others there is no software revenue stream at all. In either case, the buyer is making a fundamental bet that the services in question, or the business problem that the company exists to solve, can and should be addressed through the provision of software. There are several advantages to this thesis, including:
- The entry price is typically expressed as a multiple of EBITDA, not revenue
- These companies tend to be profitable, and partially as a result, can often support some amount of leverage as part of the purchase, and often don’t require cash to be funded to the balance sheet beyond day-to-day working capital requirements
- There are many possible levers to create equity value beyond just revenue growth
- Even if the transition from a service company to a software company fails, there are still ways in which the investment can be a profitable one for all involved
However, just like every other thesis presented in this post, these benefits don’t come for free. Some potential “prices of admission” specific to this investment thesis include:
- In order to buy at a services multiple and exit at a software multiple, the software revenue stream will have to grow substantially between entry and exit. In this way, one could argue that the revenue growth being asked of a first-time CEO here is not dissimilar from the “growth equity” style investment thesis discussed above
- Some business problems are indeed best addressed through the provision of software, but others simply are not. Acquirors pursuing this investment thesis need to be highly confident that their target company operates in the former camp, and not the latter. Making this challenge particularly acute is the reality that first-time CEOs often learn more about their companies in the first 1-2 months running it than they did in the 6-12 months of due diligence that preceded their purchase.
- Building a software business (be it from scratch, or off of a very small existing base) within a company that has decades of experience as a services business is likely to be incredibly operationally difficult. Almost every aspect of the company, from hiring, to organizational design, to compensation, to cost structure, is likely to have to change materially. As a result, execution risk is likely to be very high.
- This may be less intellectually interesting to those interested in pursuing a “pure-play” software investment thesis
Thesis #3: The On-Premise to SaaS Deal
- Acquisition Multiple: Usually based on EBITDA, but low-single-digit ARR multiples are possible
- Transaction Financing: Can be a mix of equity and debt, though acquirors should be careful about the use of debt in anticipation of the coming “J-Curve”
- Cash Funded to Balance Sheet After Closing: Varies. Often no required, unless the pending “J-Curve” needs to be financed
- Historical Revenue Growth Rate: Usually muted, often single digit annual growth rates
- Historical EBITDA: Usually high: 20%+
- Age of Seller: Older
- Age of Technology Stack: Older
- Required Revenue Growth Rate Moving Forward: Usually this thesis focuses on changing the composition of revenue as much as it focuses on growing the absolute number of revenue dollars
- Value Creation Levers: Various
- Relative Execution Risk & Complexity: High
Though this migration is often discussed as if it’s a singular act, in its most basic form it’s actually composed of two different (though often closely related) fundamental changes to a business. Namely:
- Primarily Financial: Migrating away from one-time, perpetual use license fees in favor of a recurring subscription revenue model
- Primarily Product: Re-architecting (or re-writing) your software from a single-server-single-tenant architecture to a single-server-multi-tenant architecture, often necessitating the use of a new or different technology stack (a tech stack refers to the combination of platforms on which both the front and back ends of your software are built)
Companies who successfully navigate both of these transitions are often richly rewarded for their work: $1 of perpetual-use revenue generated by an on-premise software company is roughly ~4-5x less valuable than that same dollar of subscription revenue generated by a SaaS company (for a real-world exploration of two first-time CEOs who successfully navigated this journey, check out the following podcast episode: Buy at 5X EBITDA, Sell at 8X Revenue: The On-Premise to SaaS Transition of FieldEdge)
However, the large value-creation potential inherent in this thesis comes at a very steep price. Among other things:
- Purely on-premise companies are becoming increasingly difficult to find, as the majority of legacy software companies have either ceased operations or have already navigated this transition themselves
- A constant battle for resources, time and attention between the “current business” (existing on-premise software that is presumably paying 100% of the bills) and the “new business” (SaaS product that may not yet exist, that is presumably paying 0% of the bills, but is necessary for the long-term survival of the company)
- The Complete Overhaul of the Company’s Financial Model: This transition will likely completely change both the revenue and profitability profile of your company. More specifically, in the near-term, both your revenue growth and your profitability will be significantly impaired, with the latter often needing to be financed somehow. Otherwise profitable companies can quickly find themselves in a liquidity crunch if not planned and structured properly.
- The change in your revenue model will make it extremely difficult for you to clearly, properly, and fairly incentivize your salesforce via their incentive compensation plans, especially if you’re asking them to sell both the “old” and “new” products simultaneously
- The transition to SaaS often necessitates the creation of completely new organizational disciplines (and/or departments, and/or people) that didn’t need to exist in the previous on-premise regime. Building new organizational disciplines from scratch is incredibly difficult at the best of times, never mind when you’re having to deal with all of the problems mentioned above
- Like many large-scale organizational changes, the transition from On-Premise to SaaS will almost certainly create cultural issues that will need to be managed carefully
I have written about this investment thesis extensively in the past. Interested readers are encouraged to read:
- Migrating Your Software Company from On-Premise to SaaS: Part 1
- Migrating Your Software Company from On-Premise to SaaS: Part 2
Thesis #4: The “Legacy Software” Deal
- Acquisition Multiple: Usually EBITDA
- Transaction Financing: Mix of equity and debt. Likely the thesis that would use the most leverage of all.
- Cash Funded to Balance Sheet After Closing: None beyond day-to-day working capital requirements
- Historical Revenue Growth Rate: Usually muted, often single digit annual growth rates
- Historical EBITDA: Usually high: 20%+
- Age of Seller: Older
- Age of Technology Stack: Older
- Required Revenue Growth Rate Moving Forward: Minimal
- Value Creation Levers: Several, though usually related to a combination of pricing & cost control, both built upon a foundation of strong customer retention
- Relative Execution Risk & Complexity: Low
Though this investment thesis isn’t particularly common among entrepreneurs looking to acquire and operate a single private company, it is reasonably common among other types of buyers, namely those with long hold periods (sometimes with no intention of ever selling) and avenues for further deployment of the profits generated by their portfolio companies. In this investment thesis, businesses are primarily purchased for their ability to generate cash flow, not for their revenue growth potential.
At the risk of over-generalizing, acquirors pursuing this thesis often:
- Purchase companies selling products that are mission-critical to the operations of their customers (and, as a result, tend to enjoy high customer retention levels, switching costs and pricing power)
- Raise prices on existing customers
- Decrease (sometimes turn off entirely) funding dedicated to future growth initiatives
- Maintain or increase funding dedicated towards existing customer retention
- Trim operating expenses (usually growth-oriented ones like new salespeople, new developers, new product R&D, etc.) to extract as much cash flow from the business as possible
- Aggressively pursue add-on sales to existing customers, sometimes at the expense of new customer acquisition
Buyers pursuing this investment thesis are most likely to achieve their desired returns through dividends, share repurchases and/or recapitalizations as opposed to pursuing a sale of the company (though sales aren’t completely out of the question). One of the reasons why is because the realistic universe of acquirors 5-7 years from now is likely to be small, at least relative to the other investment theses that we’ve profiled. It is partially for this reason that many acquirors pursuing this strategy employ infinite hold periods.
This thesis, like all of the others, presents prospective acquirors with several merits to consider, including a low relative purchase price, the ability to support leverage, and modest revenue growth requirements of the new owner in their pursuit of equity value. However, these benefits don’t come without their associated costs, including:
- Risk of meaningful disruption stemming from the emergence of new technologies that may quickly displace the legacy software being offered
- Muted product R&D spend may eventually negatively impact customer churn rates
- These code bases tend to suffer from unduly high levels of technical debt, which can significantly impair operations across the entire company
- Culturally, these types of investment theses tend to be difficult and highly disruptive for the company’s employees. Often, the most ambitious and enterprising people attrit, leaving the target company with only the “lowest common denominator” employees
- A smaller universe of potential acquirors
- May be less intellectually interesting for a young, enterprising entrepreneur to pursue
Thesis #5: The “Microcap” Deal
- Acquisition Multiple: Usually a low-single-digit multiple of ARR
- Transaction Financing: Often leans towards all equity, but can vary
- Cash Funded to Balance Sheet After Closing: Usually material, often to fund future investments required to pursue additional scale
- Historical Revenue Growth Rate: Varies, but often low
- Historical EBITDA: Varies, but often high
- Age of Seller: Mixed
- Age of Technology Stack: Mixed
- Required Revenue Growth Rate Moving Forward: Often material, especially if acquiror wishes to benefit from multiple expansion on exit
- Value Creation Levers: Many
- Relative Execution Risk & Complexity: Medium-to-high, often due to “zero-to-one” considerations (explained further below)
Acquirors pursuing this thesis tend to target software companies that are a) very small (<10 employees, usually with <$2M in annual revenue), b) growing slowly (<5-10% annually), c) very profitable (EBITDA margins > 50%), and d) quite founder-centric.
The basic investment thesis here tends to revolve around the idea that the founder/seller has created a “lifestyle business” and has not actively pursued growth, instead electing to extract cash from the business every year to finance their desired lifestyle. These founders are often technical in nature, in many cases having built the initial version of the product themselves 10+ years ago.
There are some advantages to pursuing this thesis, including:
- A lower revenue multiple relative to several of the other theses presented, usually driven by the smaller size of the company
- A smaller dollar value of equity that needs to be raised
- A less competitive acquisition environment
- Buyers can put more of their personal touch on the operations of the acquired company
As usual however, these benefits don’t come without their associated risks, including:
- Sometimes, acquiring companies of this size is more akin to purchasing the Founder/CEO’s job than it is to acquiring a true going-concern business
- Assuming that the new owner is interested in pursuing growth, high pre-transaction EBITDA margins may be unlikely to persist, due to the negative correlation between growth and profitability
- Companies like these often under-invest in their people, tools, processes and systems. The profitability profile that buyers see on the current set of financial statements may not represent the true profitability profile that the business will yield under new ownership
- Despite high EBITDA margins, targets often present a dollar value of EBITDA that can be insufficient to finance future growth initiatives, which is why cash often needs to be funded to the balance sheet at closing
- Sometimes, these businesses are still small for a reason. Though it is possible that the owner is satisfied with the current size of the company, it is equally possible that the market is small, competitive, saturated, or contracting
- Often, the financial and operational data available to an acquiror of a small company is in considerably worse shape than the information available to an acquiror of a comparatively larger company
- Sellers of these types of companies are more likely to use unsophisticated or inexperienced transaction advisors (if they use them at all), which often acts as an impediment to getting a deal done
- Key-person risk specific to the founder/CEO is more common within this thesis
- Required revenue growth is often materially high. Buyers must be confident that they can grow the business to a size that is large enough to attract a large universe of potential acquirors at exit: A $3M revenue business purchased today, even if it grows revenue at a compounded rate of 20% per year (which is quite a feat), is still only a $7.5M revenue business five years later.
For more commentary on the merits and risks of pursuing a similar thesis, you can read my other blog post, Busting the Biggest Myth About Purchasing and Operating Small Companies
The five theses that I’ve presented above are just a few of the strategies that enterprising buyers can pursue in their search for a software company to acquire. No thesis is perfect, as the benefits presented within each one comes with a commensurate set of costs that buyers must be willing and able to pay. Different approaches are likely to resonate with different buyers depending on their access to capital, their contemplated hold period, where their intellectual interests reside, their operational and value creation strategies, and countless other variables.
The real world is rarely as neat and organized as analyses like these seem to suggest, but that notwithstanding, I hope this way of framing the software acquisition opportunity was a useful one for you to consider.