The following article originally appeared in the November/December, 1993 issue of M&A Today
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 acquirors 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.
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 (besides finding a buyer, of course) is knowing how to successfully negotiate and structure the sale.
Knowing Your Buyer motivations . Understanding the and objectives of the other party in a negotiation is always important, and in selling a business it is essential. Only by thoroughly understanding such elements as the strategic significance of your product to the buyer and the buyer’s corporate culture can a seller optimize the return on the sale. For example, if acquiring the talent pool of the seller is important to the buyer, then high salaries, bonuses and non-competition payments may often be obtained in addition to the at-closing amount to be paid. On the other hand, if the buyer is a large company, it may have rigid internal compensation and title steps, and the seller may find it nearly impossible to gain such additional payments.
It is obviously important to determine as much about a buyer as the seller needs to know before going too far into the process. All too often, parties learn only after much time and effort that the goals and objectives of the respective parties are too far apart to ever be satisfactorily bridged. In such a circumstance, either the sale still closes with one (or both) parties bearing the risk of being profoundly disappointed with the final outcome, or the process falls apart after much wasted time and effort. One way to avoid this outcome is for a seller to insist on a detailed letter of intent, as compared to the superficial two page type of letter which deals with little more than price, basic legal structure and accounting treatment. While time consuming in its own right, the negotiation of such a term sheet should either abort a transaction which is not meant to be, or dramatically shorten the negotiation of the final purchase and sale agreement for a deal that is in the best interests of both participants.
Although each transaction is unique and there are many transaction terms which are important, several areas of vital negotiation stand out in the sale of a software company:
Legal Structure . Many buyers strongly prefer to purchase the assets of a company, as compared to its stock. One reason for this practice is that all liabilities of a company automatically follow its stock, but the buyer in an asset sale can usually leave behind the liabilities which it does not want to assume. Where for tax purposes the seller is a “c corporation”, as compared to an “s corporation”, an asset sale results in the sale proceeds first being taxed to the corporation, and then being taxed to its stockholders when the seller distributes the sale proceeds to its stockholders by means of dividends or when the company is liquidated. Fortunately, many software companies are young companies with simple enough histories that buyers may often be persuaded to engage in a purchase of stock in order to avoid this severe double taxation.
Payment Schedule . No issue is likely to be of greater importance to buyer or seller than the timing and amount of the payments to be made by the buyer to the seller. In the software industry, payment terms have varied immensely in recent times. The result too often has been heated discussion and mutual dissatisfaction between parties.
Why is this so? In simplest terms, potential sellers have recently seen industry giants pay enormous premiums (relative to traditional valuation techniques) at closing, setting high expectations across the industry. When another company soliciting potential buyers receives a much more modest offer, payable mostly over time as a function of the sales which follow the closing, that seller often feels insulted, or assumes that a premium price will necessarily be found if it continues its search. In fact, the seller may have failed to understand those factors which resulted in premium prices in other transactions:
- Strategic Importance . In many other industries, most sales of companies are to “financial buyers” (i.e., companies or individuals who believe that they can run a company better than its old owners, or who can improve profitability by reducing and consolidating redundant areas of operations). Where this is the case, there is a limit to how much of an increase in profitability a buyer may achieve. As a result, traditional valuation techniques based on multiples of earnings or other factors are used, producing offers which tend to fall within a fairly predictable range. In the software industry, however, an unusually high percentage of buyers have been willing to pay high premiums to fill out a product line or acquire a new distribution channel, when fierce competition has driven them to buy quickly what they would otherwise have to build slowly. Unfortunately, such a well motivated buyer does not exist for every seller. Where this is the case, offers are based more closely on traditional valuation techniques.
- Method of Payment . Where a buyer offers to issue stock which is trading at a very high value, it can afford to be more generous than it can with cash. Conversely, where a buyer’s stock is trading at a price which the buyer believes is less than its real value (and especially if it is trading at a price below the exercise price of management’s personal stock options!), then the buyer will wish to pay cash instead of stock, since the seller will not usually be content to accept stock valued at a price higher than its current trading range.
- Timing of Payment . The most heated debate in many sales is reserved for the negotiation of so called “earn out” terms. In such a payment structure, the seller receives part or all of the proceeds of the sale as a royalty on the buyer’s sales after the closing, with the measuring period being typically up to five years. Such a structure may be agreed on mutually, as is the case where the buyer is unwilling or unable to pay as much in cash or stock at closing as the seller believes its company is worth. In other cases, the situation arises from the volatility of the software industry. For example, if the seller’s products or market are immature, but both parties believe the future opportunity is great, the seller will be reluctant to sell based on current revenues or profits, and the buyer will be unwilling to pay a price at closing based primarily on projections.
Where an earn out is agreed upon, the seller can be distressingly dependent on the performance of the buyer to maximize the ultimate return. A number of methods are available to minimize this vulnerability:
Continuity of Management . Another way in which the software industry differs from other areas is that many large companies recognize that they are not good at nurturing rapid, efficient development of new products. In some cases, the buyer is therefore willing to allow a significant degree of autonomy to the acquired company after the closing, in order to preserve the creative environment of the smaller company. Where this recognition is present, the sellers are more likely to be asked to make long term employment commitments to the buyer, and can negotiate a higher degree of control over those aspects of development and marketing which they believe to be most important to maximizing the earn out.
Performance Frame of Measurement . Even if management is able to retain a fair degree of control over its own evolution, it may realize a disappointing payout if the revenues or profit being measured are those of the seller’s entire company. Accordingly, the payout should relate most directly to the performance of the actual products and/or development team which was acquired. By way of example, a payout equal to a rather modest percentage of gross sales of acquired products may result in far higher compensation than one which is based on a larger percentage of fully burdened profits attributable to the same gross sales, where the acquiring company has a bloated infrastructure and pays high commissions.
Specific Commitments . It is frequently essential to insist upon a buyer’s making significant financial and other commitments to increase the likelihood of a successful earn out. This (again) is particularly important in the volatile software industry, where products demand large marketing budgets to ensure a rapid and successful commercial launch, and where products which are not robustly supported and maintained can rapidly lose market share to competition. Where the earn out period is short (e.g., one year) and products have just been completed, the first factor can have enormous importance. Where the earn out is long (e.g., five years), the second can be vital. In the best of all possible worlds, the buyer commits to adopting a detailed business plan, with budget, for part or all of the earn out period. In the real world, something less than this is usually obtainable.
Founder/Management Issues . While “people” issues arise in corporate sales in all industries, software mergers and acquisitions again play by somewhat different rules. Most often, it is the technical staff that the buyer is most anxious to acquire and prevent from competing in the future; the buyer may only need the business managers of the acquired company for a brief transitional period, if at all. Technical staff who hold stock in the selling company and receive significant payments as a result of the sale are often in for a surprise: in many jurisdictions, the courts will enforce non-competition obligations which have been paid for at time of sale for up to five years, in contrast to the much shorter period (or no period at all in States such as California), which would normally be enforced. Some buyers will seek to insure this result by structuring some of the purchase price as direct payments for non-compete covenants. The bright side to such a requirement is that only one layer of tax is involved for this type of payment even if the seller is a c corporation, since the payment is made directly by the buyer to the individual.
Tax Issues . The tax issues which a given transaction may present are sufficiently varied and complex that they preclude detailed discussion here. However, a single example from our practice may serve to underline the importance of determining all the possible tax consequences of a proposed transaction before a letter of intent fixes the structure of the deal. In this example, the holders of stock options in the selling company in a partial earn out transaction intended to exercise their options at closing to participate in the profit of the sale of their company. Absent special planning, they would have found that the distribution that they would have received at closing (which was several times the option exercise price) would nevertheless have been less than the taxes that they would become liable for. This would not only have been a severe blow to the option plan participants, but would have been detrimental to the existing stockholders of the seller as well, since the preservation of a motivated team by the buyer was essential to realizing the maximum possible earn out.
Summary: Although selling the most significant professional achievement of an entrepreneur’s life can be a wrenching experience, seeing that same project wither and die by underfunding or overpowering competition is significantly more painful. The good news is that there has probably never been a better time to sell a software company than today, with demand and valuations at an all-time high. However, each potential acquiror and each proposed transaction is unique. It is essential to structure a sale transaction carefully to maximize the profit to the seller, and to avoid untoward and unplanned tax impacts. As sellers often neglect to bring their lawyers into negotiations with a potential buyer until a letter of intent is about to be signed, business intermediaries can play a crucial role in guiding preliminary discussions with a buyer through issues such as those discussed above, in order to insure that a beneficial deal for the seller is negotiated and closed.