AUTHOR: Andy Updegrove
With several hundred software companies as clients our practice frequently provides us with a unique opportunity to observe (and sometimes anticipate) industry directions and trends. In some cases this may relate to areas of evolution, such as electronic distribution of software, where we see many projects being launched. In other cases our vantage point permits us to observe the ways in which the software industry at large is reacting to diverse economic developments and conditions.
Although a large part of our practice comprises assisting clients in transactions of all types, the most frequent transaction currently being handled by this firm -- by a significant margin -- is the purchase or sale of a software company or product. We are presently seeing a dramatic rise in this type of activity over prior years. In almost all cases these are not distress sales, but planned divestitures by founders of successful, profitable companies with sales most often ranging from $3 to $15 million.
Why this uptic in merger and acquisition activity among our representative sampling of emerging software companies? There are several reasons that we have noted.
Cash Constraints. As always, most software companies remain underfunded. Bank loans often are unavailable for other than minimal working capital purposes, venture capital is offered only to companies with realistically large market opportunities, private investors and strategic partners are often hard to find, and even the handsome margins which good software product companies can earn are often insufficient to support the market launch of new products or ports. As usual, our clients have typically been able to fund the research and development of a product, but frequently fall short of the funds needed to mount a major marketing effort. As a result, although current product sales may be strong, a transition to future products requires cash resources which are not readily available.
Competition . Entrepreneurs who have built profitable businesses in discrete niches are increasingly finding that their successes have been noticed by more powerful players. Frequently, a vendor will be called on by a larger player seeking to fill out its product line, move from the mainframe to the PC market, or enter the open systems area. Faced with one or more cash-laden acquirers determined to build or buy a competitive product and market it aggressively, some software developers opt to play it safe and sell while a premium price buyer is available.
Lack of Diversification. The happy corollary to the dearth of financing which many software companies have endured is the concentration of equity which characteristically remains in founders' hands. More often than not, the companies which we are seeing being sold are owned entirely (or nearly so) by founders and employees. On the other hand, in order to bootstrap the company to its current stage of development, the founders often invested most of their personal resources in the business at the start-up stage, and have not drawn impressive salaries in the years that followed. At a time when companies as respected as IBM and DEC must reinvent themselves and the Wang family has had its control of the family company eradicated, entrepreneurs are acutely aware that what goes up most certainly can come down. Accordingly, where most of a founder's net worth is tied up in one volatile asset, diversification of risk becomes imperative.
Unacceptable Alternatives. In order to take a portion of a founder's equity out of the business, only a limited number of alternatives are possible, and not all are palatable or, in a given case, available. For some companies, venture capital is still not available due to the profile of the company, and venture capitalists only infrequently buy founder stock in any event. Some companies are not yet large enough to go public (at least with a quality underwriter), or management rightly fears that if they start down the road toward a public offering the market "window" may close after massive expenses have been incurred. Other companies which would be eligible for venture capital or public funding pass on the opportunity because the founders are not interested in inviting outside investors in or would not welcome public reporting obligations after having preserved management's independence for so long. Often, with regret, they conclude that the time has come to sell the company while the value of the founders' most significant personal asset is high.
TLB Comment : In most cases, good companies are finding good buyers paying good prices. Although selling the most significant professional achievement of one's life can be a wrenching experience, seeing that same project wither and die by underfunding or overpowering competition is significantly more painful. As is so often the case, timing is everything, and it is well worth remembering that software companies ultimately represent perishable commodities.
Knowing when to sell is only part of the challenge in maximizing the value received from the sale of a software company or product. The other key ingredient is knowing how to successfully negotiate and structure the sale. Our next issue will examine some of the more important strategies which may be used to achieve that end.