What Software Companies Need to Know About Private Equity Investment
Software company founders and management teams looking to secure capital should look closely at private equity (PE) firms. Whether it is funding for growth, exiting the company, or taking on a strategic investment partner, PEs might be your optimal option. Whether that is the case is heavily dependent on knowing what a PE can offer, how to approach deal negotiations and creating the optimal framework for post-merger collaboration.
BDO has developed RETHINK to assist companies with their response to the global pandemic. Businesses can use the RETHINK resources to shape how to optimally react to the fallout of COVID, increase resilience to weather challenges, and position themselves to realise their full potential.
RETHINK and our global PE and M&A experts’ insights form the framework for navigating PE investment – and how to get the optimal result – presented in this article. A fuller, in-depth overview can be found in the full guide on PE investment for software companies.
Benefits of PE Investment
PEs have a strong track record with software companies. Analysis from BDO UK details how private equity-backed businesses’ business revenues rose by 53% and employment by 43% over a five-year period.
Technology – and by extension software - is solidly on PE firms’ radar. Almost 40% of all PE deals completed in 2018 – 2019 fell within the technology, media, and telecoms space. In 2017, around 43% of all technology M&A deals were funded by PE.
While the global pandemic has temporarily slowed investments, deal flow will likely return to high levels. One driving factor is the increased need and demand for software companies’ solutions to accelerate digital transformation.
However, PE investment can, if approached incorrectly, be a risky way of raising capital. Knowing how to prepare for and negotiating a PE acquisition or investment, and collaborating with the PE firm post-investment, is crucial.
Start with Your End Goals
Software company management teams and leaders may, particularly during a very eventful 2020, conclude that there is a need for external capital - and perhaps also business partners.
Finding answers to questions such as the ones below is an excellent starting point for deciding if PE is the optimal investment route to pursue:
- Are you looking for an exit or taking your company to the next level?
- If so, what is your timeline?
- How can funding help you build on strengths and mitigate weaknesses?
- Why should you choose PE investment over other kinds of funding?
- How much control are you willing to cede to an investor?
- How do you see your position as founder or management team post-deal?
Consulting your business advisors on developing answers to the questions above – and exploring if PE is the best way forward - will be a good starting point.
Understand PEs’ Strengths
Private equity firms are investing heavily in technology and software companies. One study found that PE’s investments in enterprise software companies alone surpassed US$ 121 Billion in 2019.
For software companies, PE’s strengths include:
- Market expertise: Experts at creating market growth.
- Access to new markets: Experience with identifying and engaging new customers groups.
- Streamlining operations: Organisational and financial collaboration to optimise processes and daily management.
- Objective insight: An outside, objective, and data-driven evaluation of your business.
- Higher profitability: As illustrated by the UK data, PE investment and assistance often grows revenue and profitability.
- Exit options: PE investment is a good avenue for technology company founders and management teams looking to exit their company.
It is also important to consider where a PE firm’s and your interests align – and where they may differ. Many collaboration issues arise due to interests not being aligned early in the negotiation process.
What PE Firms Are Looking For
PE firms have different focus areas and interests. Some are generalists and others sector specialists. Some prefer to run companies independently while others specialise in rolling up several companies into one.
Common for all PE investors is that they are looking to maximise investment returns within a set timeframe - often three to five years - through selling on their stake in the business. Profit and revenue growth are at the heart of their goals and expectations for your business. Therefore, PE firms will, when looking at investing in software companies, be focused on scalability. In other words, how your solutions scale either vertically or horizontally.
Software companies may prefer to work with investors focused on your industry. In some cases, it can be advantageous, but if, for example, your ambition is increasing international sales and optimising business processes, industry expertise is somewhat less important.
How to Valuate Your Software Company
Estimating your company’s value often relies on projections of future earnings and market growth. COVID-19 has made such projections more difficult. However, software companies can, with the help of their advisors, still produce good value estimations.
The process includes appraising material and immaterial assets, your code and software solutions, ongoing R&D, and future potential, among other things. Generally, revenue or EBITDA multiples are used as yardsticks.
Many other factors can affect your valuation, both positively and negatively. Below is an inexhaustive list:
- Industry trends
- Revenue to cash flow
- Growth potential
- Software stack
The valuation of each part is not solely based on current and past performance but will include analysis of what your material and immaterial assets (especially IP and software stack) could be worth over time.
Where PEs Focus Lies
Traditionally, PE firms set goal for an investment is a substantial return in three (double) to five (triple) years. Even before COVID, PE firms were preparing for longer holding periods, but likely not much beyond a maximum of seven years.
A time-constrained, returns-focused approach means that PE firms up to and during negotiations will focus on growth-defining areas such as:
- Products, services, IP, and R&D.
- Management/employees and their ability to grow the business.
- Succession planning ensuring talent in place for replacing key employees.
- Contingency plans to weather industry ups and downs – and macroeconomic trends.
- Market trend preparedness to meet changing demands and developments.
- Track record of cash flow growth over time by expanding sales.
- Investments strategy to achieve growth through the capital raised.
- Exit strategy with clear ideas about how and when you and the PE exit the company.
Prepare for Due Diligence Questions
Knowing PE’s focus points is critical to your due diligence preparations. A PE firm will closely examine and evaluate many different parts of your business, asking questions such as:
- Sales and forecasts: What are your sales channels? Do you rely on a few, large customers, or many smaller ones?
- Products, product strategy: What are your competitive advantages? How will they help you achieve growth benchmarks?
- Market situation: What is your current market? Where can you increase sales?
- Management team and employees: Do you have the right skill sets to guarantee growth? What is your growth track record?
- Technology: How do your solutions scale? Are there third-party dependencies?
- Taxes and legal: What are your non-income-based taxes? How is your company incorporated?
For most companies, it is advisable to undertake a vendor due diligence process ahead of negotiations to identify and mitigate any potential issues.
Understand PE firms’ Software Concerns
PEs’ interest in software companies can sometimes be tempered by perceived challenges and risk factors influencing the industry.
Respondents in BDO’s 2019 private equity study point to growth opportunities (42%) and finding and retaining management teams (33%) as some of the biggest challenges when acquiring target companies. Something that also applies to the software industry.
PE’s may have concerns regarding your intellectual property (IP), solutions, and patents - for example, if your IP is reliant on third-party systems and solutions.
Technology is another area that PE’s may view with some trepidation. Your company should have a clear strategy in place for how your existing solutions may take advantage of emerging technologies like the increased data transfer speeds of 5G networks.
Sine PE firms are locked into a time-limited exit strategy such uncertainties can lead to valuation issues and a less advantageous deal.
Mitigating IP Issues
Who owns the rights to your software and patents? The answer may not be as straightforward as you think.
Your code, and the products and services it supports, will be the main reason why a PE firm is interested in your company. Code and solutions are part of your IP. Valuation of IP plays a pivotal role in valuing your company and includes looking at revenues, royalties, license fees, IP-related patents, trademarks, and certification marks.
Your software and IP will be focal points during due diligence. A PE firm will want to ensure that an acquisition includes IP, associated rights, and software solutions free of future extra charges or litigation risks. As is the case for legal matters pertaining to IP, you and the PE firm may want to hire outside independent third parties to analyse the IP situation to ensure insight without risk of perceived bias.
Understand COVID-19’s Impact
The global COVID pandemic has impacted parts of M&A negotiations and specific contract terms.
For example, software companies need to pay close attention to Material Adverse Effects (MAE). MAE cover situations where a buyer’s obligation to close a deal no longer applies because of substantial threats to future earnings potential. As regulatory approval is taking longer and market and business conditions remain volatile, there are increased risks of unforeseen changes to your potential earnings.
Other areas which may be affected by COVID-19 include:
- Due diligence: Projections, business plans, continuity plans, and potential liability exposures.
- Risk exposure: Increased privacy, HR, supply chain, and cybersecurity risks.
- Negotiation process: Populating and updating data rooms can be more time-consuming.
- Interim Operating Covenants: Deal terms should allow for fast response to rapid changes.
- Earnouts: Targets may be changed and timelines prolonged.
Define Earnout Goals and Targets
If your goal for a deal is an exit, PEs are an excellent option. However, you will want to prepare for earnout clauses. Fixed part(s) of earnout clauses are usually paid upon completing the deal while variable parts are delayed and delivered in segments over time.
Without proper planning, you risk earnout-related post-closing disputes. One reason is calculation methods where indicators like EBITDA (earnings before interest, taxes, depreciation, and amortization) are often used to define targets. However, EBITDA-based metrics can be difficult to calculate if your company does not continue as a stand-alone basis, post-acquisition.
Earnouts can also result in material tax consequences to both seller and buyer, which are heavily dependent on terms and applicable legislation. In other words, your decisions regarding payment form for earnouts will have an impact on your future tax liabilities.
Start Sales Preparations Early
Most software companies will, once due diligence and negotiations begin in earnest, be surprised by the detailed granularity of some of PE investors’ requests.
To establish the best possible starting point for the sales process and preparing documentation, your company will need to start well in advance. If time allows, beginning preparations a year in advance is recommended. Preparing for tomorrow, today, most definitely applies to both preparations themselves – and for getting documentation ready ahead of time. It starts on the data level and includes how to structure and present data, information, and documents to PE firms during negotiations.
PE investors will also want to know details about how you plan to deploy raised capital. Detailed plans for the use of raised funds will be a requirement – and likely an area where the PE firm will want influence.
Plan for Your After-Acquisition Life
Signing on the dotted line is not the end. It is the beginning of a new chapter for you and the PE firm. Establishing the fundamentals of post-deal collaboration starts at the negotiation table.
Collaboration will differ depending on the goals of both the PE (will your company remain independent or rolled up with several others) and yourself (are you looking for an exit or to remain in charge).
PE firms spend a lot of time studying a company and how and when they will divest to achieve the optimal result. A PE’s exit can take various shapes, including repurchase, secondary sale, trade sale or an IPO. Working proactively with the PE firm towards a defined exit goal is a core aspect of your collaboration.
PE firms often desire involvement in the day-to-day running of your company. However, the level of that involvement will vary.
Set Clear Collaboration Targets
Communication and collaboration issues often arise from misaligned expectations and goals.
Keeping your targets and goals realistic is pivotal for all aspects of a deal. Unrealistic plans and goals for sales and lack of foresight regarding future challenges will be a red flag for PE firms that casts doubt on your management team’s business acumen.
Shaping the conversation and collaboration starts during the negotiation process, but in a rapidly changing world – and in an industry where technologies move fast - it should be a continuous effort.
While the exact structure, form, and regularity of communication between you and the PE firm will vary, there are guidelines which apply to almost any situation, including:
- Be proactive instead of reactive
- Define the decision-making process
- Ask for help when you need it
- Set up and update communication schedules
- Avoid surprises
Get the Right Advice – and Advisors
This article is an overview of some of the aspects that a software company should look to cover during deal preparation and negotiations. The key takeaway is that preparation is vital. The same goes for setting clear goals.
Even during less tumultuous times, an acquisition process is a long-lasting undertaking and involves many novel tasks for software company leadership teams. The good news is that there is little reason to undertake all of it on your own. By working with a good advisor team during the entire process, you will likely achieve a better result – and have a better acquisition process – than if undertaking it on your own.