Q: How To Evaluate Acquiring a Small Software Firm

We recently helped a client frame the exploration of an opportunity for acquiring a small software firm. Here are some questions to consider if you are contemplating the sale or acquisition of small software company.

Q: I have a technical background in both software and systems administration and currently act as a freelance sysadmin. I enjoy the work but have been approached by some long time friends about taking over their niche software company.

A: Let me ask a couple of high level questions:

  • How long have they been in business?
  • What’s their revenue look like?
  • Why do they want to sell?

Q: It’s been in operation for the better part of a decade and they are now both in their 60’s and looking to retire in the next five to ten years. They have dozens of happy customers that they don’t want to leave in the lurch and are interested in getting some value out of all of the sweat equity they have invested. The firm is doing about 500K in revenue, mostly maintenance renewals on licensed software by their existing customers.

A: OK, here are some questions to ask

Understanding Customers: some key questions you will need to answer

  • Why did they buy
  • Do they plan to continue to use for the next two to three years?
  • Can they be a source for a case study or testimonial
  • Can they be a source of referrals
  • Are they willing to ask as a reference
  • What does the product lack?
  • Where is the product unsatisfactory?
  • What other applications or services should you integrate to increase value?
  • What other problems can you solve for them?
  • Who are their key suppliers / partners? Can any become yours as well?

Key risk reducing milestone: can you sell the product?

  • Need to go on 20-30 sales calls to determine if you can sell the product
  • Where is the key opportunity to scale revenue 2-4x in 3-5 years.

Key assets that need to be evaluated:

  1. customer base:
    1. level of customer satisfaction
    2. quality of customer data
    3. signed contracts and license agreements
    4. what else can you sell them?
  2. Source code and related systems
    1. key risk: maintainability
  3. What is current business model, in particular
    1. Cost of sales
    2. Support costs
  4. Intellectual Property: trademarks and patents

Sell What You Have: In the near term you can sell what you have without any development unless it becomes clear you are losing business or unable to close new business without one or more missing features. Because of your technical background, be careful of looking at new features as a source of significant near term value.

Structuring the Exploration and Deal:

  1. 3-6 months: Exploratory Phase where you determine whether you can sell and you understand their business model, the market opportunity, and source code maintainability.
    Breakup – don’t ask for equity but are compensation for any new sales you help close and perhaps other work–technical, business development, operations–that increases value of business
  2. 2.5 to 4.5 years Formal Earnout where existing partners are paid for work and you pay for ownership from cash flow.
    Breakup in this time frame is complex and will require considerable planning and discussion. There are no hard assets to seize, customer relationship matter.
  3. You may also want to tie some of the value to having the existing owners help you increase revenue (perhaps on a declining or sliding scale over time) to give them incentive to help you grow business, on top of your guaranteed minimum valuation.
  4. What is your exit plan?

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