"Failing to Plan is Planning to Fail" Chinese Proverb"
Business plans are pervasive in ICT and Software businesses. In the M&A area, and at least on the buyer side, business plans are prepared for two main reasons: for valuation purposes on one hand; and to quantify how the acquired software company could be further developed and create value for the ICT buyer. The valuation model will need to show and incorporate possible synergies on the cost side, cross-selling opportunities, the ability to enter new markets and other ways to increase the value of the ICT or Software business.
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Information technology buyers need to know how much the business is worth today, to them, as a key input to price negotiations with the seller. Many buyers employ 'Multiples' for the industry and the market they operate in, especially Revenue, EBITDA, and EBIT Multiples. These multiples are of course available both for information technology (ICT) overall as well as for the software industry more specifically.
But the true source of value in the information technology business comes from cash, and its ability to generate free cashflows (FCFs). They are then discounted to the present to generate the Net Present Value (NPV), which provides a useful crosscheck that the Multiples used to value the business make sense. Especially in the software industry with normally high margins it is important to forecast with the right level of detail, as the key revenue and cost drivers will have a large impact on the free cashflow generated by the information technology or software company.
At least as important as valuation, the acquiring company needs to prepare a plan early on showing (and quantifying) what they would do with the acquired software business. This includes in particular the following issues:
First, you need the right level of detail. More often than not, the templates for software company valuations are much too detailed. In those horrible templates, you really wonder who might ever read the hundreds and thousands of rows that try to forecast what could happen 10 years down the road….
Hence, to get a good idea of the value of your information technology or software company you need to have a structure that is detailed enough to make a robust valuation. On the other hand the valuation model needs to stay at a sufficient high level so that it is easy to understand for decision makers and captures the right revenue and cost drivers for the ICT (software) company. Below you find a screenshot of the template that we use as starting point for the valuation:
Second, when looking at an existing business, the financial projections should also take the recent past into account. This is what you see in the valuation printout for the software company above. Too often, the templates provided by others don’t seem to care about what happened in the last couple of years. If you haven’t analysed the recent performance and value drivers of the company, how can you pretend that your 7-10 year forecast is realistic?
Third, forecasting ‘costs’ can be hard, but forecasting 'markets' and 'revenues' is really a lot harder. One way to address this challenge is to forecast the market in two different manners: by regions / countries on one hand, and by product lines / products on the other hand. And then reconcile them so that the two projections are aligned. In the following exhibit you find a market forecast by regions for the software company. Preparing forecasts from different perspectives makes the free cashflow projections and valuation more robust.
Fourth, the financial plan must look good. It must not only support the story that you are trying to sell (to your management, or to investors), but it must also be visually appealing.
Last but not least, the template that you use must be relevant to your business and its specificities. A valuation model needs to be tuned to the industry it relates to. Hence, the valuation model above shows software, maintenance, professional services and hardware revenues.
In the ICT industry, there are quite a lot of software and service businesses (as well as hardware, for sure), with the added charm that gross margins can be (very) high, and working capital requirements low (who doesn’t love prepayments or annual software / service fees paid upfront?). So we have reflected these salient features of the ICT industry in the template below. All these items need to be incorporated in your valuation model for the ICT (or software) industry.
The ideal case, at least from an EBIT margin point of view, seems to happen when the target information technology company has a say in the 'hardware' business and 'control it' in a sustainable manner for the mid and long term, but has outsourced the hardware none-the-less, so that the complex issues surrounding hardware are for others to solve (e.g. low margin; obsolescence; low cost competitors etc).
This typically happens through R&D, Design, IPR and Software activities. If you control the IT interface, or the software, then in many cases (but not all) you won't have to build the hardware yourself.
At the end of the day, it is very hard for a company to have a complete DNA of 'Excellence in Service', 'Excellence in Software', and 'Excellence in Hardware'. It's really hard to be best in class on all fronts, because the mindset, skills and key success factors are different. The specific focus and strengths of the ICT business need to be integrated into the valuation model so that it becomes entirely relevant for your company.
The Excel information technology valuation template is provided in a PDF format below, with screenshots of selected and key areas. If you would like a copy of the Excel file of the valuation model, please contact CFIE.
The Excel template has been developed and provided by Pierre Lurin, an M&A consultant specialising in the ICT industry and member of the CFIE network. Pierre can help you in adjusting the model for your specific information technology company needs.
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