| One of the most challenging aspects of selling a | | | | completed and, even though their customers that |
| healthcare information technology company is | | | | were contemplating leaving did not immediately |
| coming up with a business valuation. Sometimes | | | | upgrade, they did not defect either. Apparently |
| the valuations provided by the market (translation | | | | the devil that you know is better than the devil |
| - a completed transaction) defy all logic. In other | | | | you don't in the world of healthcare information |
| industry segments there are some pretty handy | | | | technology. |
| rules of thumb for valuation metrics. In one | | | | 3. Another arrow in our valuation driving quiver for |
| industry it may be 1 X Revenue, in another it | | | | our sellers is we restate historical financials using |
| could be 7.5 X EBITDA. | | | | the pricing power of the brand name acquirer. We |
| Since it is critical to our business to help our | | | | had one client that was a small healthcare IT |
| healthcare information technology clients maximize | | | | company that had developed a fine piece of |
| their business selling price, I have given this | | | | software that compared favorably with a large, |
| considerable thought. Why are some of these | | | | publicly traded company's solution. Our product |
| software company valuations so high? It is | | | | had the same functionality, ease of use, and open |
| because of the profitability leverage of | | | | systems platform, but there was one very |
| technology. A simple example is what is | | | | important difference. The end-user customer's |
| Microsoft's incremental cost to produce the next | | | | perception of risk was far greater with the little |
| copy of Office Professional? It is probably $1.20 | | | | IT company that could be "out of business |
| for three CD's and 80 cents for packaging. Let's | | | | tomorrow." We were literally able to double the |
| say the license cost is $400. The gross margin is | | | | financial performance of our client on paper and |
| north of 99%. That does not happen in | | | | present a compelling argument to the big |
| manufacturing or services or retail or most other | | | | company buyer that those economics would be |
| industries. | | | | immediately available to him post acquisition. It |
| One problem in selling a small healthcare | | | | certainly was not GAP Accounting, but it was |
| technology company is that they do not have | | | | effective as a tool to drive transaction value. |
| any of the brand name, distribution, or standards | | | | 4. Financials are important so we have to |
| leverage that the big companies possess. So, on | | | | acknowledge this aspect of buyer valuation as |
| their own, they cannot create this profitability | | | | well. We generally like to build in a baseline value |
| leverage. The acquiring company, however, does | | | | (before we start adding the strategic value |
| not want to compensate the small seller for the | | | | components) of 2 X contractually recurring |
| post acquisition results that are directly | | | | revenue during the current year. So, for example, |
| attributable to the buyer's market presence. This | | | | if the company has monthly maintenance |
| is what we refer to as the valuation gap. | | | | contracts of $100,000 times 12 months = $1.2 |
| What we attempt to do is to help the buyer | | | | million X 2 = $2.4 million as a baseline company |
| justify paying a much higher price than a | | | | value component. Another component we add is |
| pre-acquisition financial valuation of the target | | | | for any contracts that extend beyond one year. |
| company. In other words, we want to get | | | | We take an estimate of the gross margin |
| strategic value for our seller. Below are the | | | | produced in the firm contract years beyond year |
| factors that we use in our analysis: | | | | one and assign a 5 X multiple to that and discount |
| 1. Cost for the buyer to write the code internally | | | | it to present value. |
| - Many years ago, Barry Boehm, in his book, | | | | Let's use an example where they had 4 years |
| Software Engineering Economics, developed a | | | | remaining on a services contract and the last 3 |
| constructive cost model for projecting the | | | | years were $200,000 per year in revenue with |
| programming costs for writing computer code. He | | | | approximately 50% gross margin. We would take |
| called it the COCOMO model. It was quite detailed | | | | the final tree years of $100,000 annual gross |
| and complex, but I have boiled it down and | | | | margin and present value it at a 5% discount rate |
| simplified it for our purposes. We have the | | | | resulting in $265,616. This would be added to the |
| advantage of estimating the "projects" | | | | earlier 2 X recurring year 1 revenue from above. |
| retrospectively because we already know the | | | | Again, this financial analysis is to establish a |
| number of lines of code comprising our client's | | | | baseline, before we pile on the strategic value |
| products. In general terms he projected that it | | | | components. |
| takes 3.6 person months to write one thousand | | | | 5. We try to assign values for miscellaneous |
| SLOC (source lines of code). So if you looked at a | | | | assets that the seller is providing to the buyer. |
| senior software engineer at a $70,000 fully loaded | | | | Don't overlook the strategic value of Blue Chip |
| compensation package writing a program with | | | | Accounts. Those accounts become a platform for |
| 15,000 SLOC, your calculation is as follows - 15 X | | | | the buyer's entire product suite being sold post |
| 3.6 = 54 person months X $5,800 per month = | | | | acquisition into an "installed account." It is far |
| $313,200 divided by 15,000 = $20.88/SLOC. | | | | easier to sell add-on applications and products into |
| Before you guys with 1,000,000 million lines of | | | | an existing account than it is to open up that new |
| code get too excited about your $20.88 million | | | | account. These strategic accounts can have huge |
| business value, there are several caveats. | | | | value to a buyer. |
| Unfortunately the market does not care and will | | | | 6. Finally, we use a customer acquisition cost |
| not pay for what it cost you to develop your | | | | model to drive value in the eyes of a potential |
| product. Secondly, this information is designed to | | | | buyer. Let's say that your sales person at 100% |
| help us understand what it might cost the buyer | | | | of Quota earns total salary and commissions of |
| to develop it internally so that he starts his own | | | | $125,000 and sells 5 net new accounts. That |
| build versus buy analysis. Thirdly, we have to | | | | would mean that your base customer acquisition |
| apply discounts to this analysis if the software is | | | | cost per account was $25,000. Add a |
| three generations old legacy code, for example. In | | | | 20% company overhead for the 85 accounts, for |
| that case, it is discounted by 90%. You are no | | | | example, and the company value, using this |
| longer a technology sale with high profitability | | | | methodology would be $2,550,000. |
| leverage. They are essentially acquiring your | | | | 7. Our final valuation component is what we call |
| customer base and the valuation will not be that | | | | the defensive factor. This is very real in the |
| exciting. | | | | healthcare information technology arena. What is |
| If, however, your application is a brand new | | | | the value to a large firm of preventing his |
| application that has legs, start sizing your yacht. | | | | competitor from acquiring your technology and |
| Examples of this might be a click fraud application, | | | | improving their competitive position in the |
| Pay Pal, or Internet Telephony. The second high | | | | marketplace. One of our clients had an outcomes |
| value platform would be where your software | | | | database and nurse staffing software algorithm. |
| technology "leap frogs" a popular legacy | | | | The owner was the recognized expert in this area |
| application. An example of this is when we sold a | | | | and had industry credibility. This was a small add |
| company that had completely rewritten their | | | | on application to two large industry players' |
| legacy management platform in Microsoft .Net. | | | | integrated hospital applications suite. This module |
| They leap frogged the dominant player in that | | | | was viewed as providing a slight features |
| space that was supporting multiple second | | | | advantage to the company that could integrate it |
| generation solutions. Our client became a | | | | with their main systems. The selling price for one |
| compelling strategic acquisition. Fast forward one | | | | of these major software systems to a hospital |
| year and I hear the acquirer is selling one of these | | | | chain was often more than $50 million. The value |
| $100,000 systems per week. Now that's leverage! | | | | paid for our client was determined, not by the |
| 2. Most acquirers could write the code | | | | financial performance of our client, but by the |
| themselves, but we suggest they analyze the | | | | competitive edge they could provide post |
| cost of their time to market delay. Believe me, | | | | acquisition. Our client did very well on her |
| with first mover advantage from a competitor or, | | | | company sale. |
| worse, customer defections, there is a very real | | | | After reading this you may be saying to yourself, |
| cost of not having your product today. We were | | | | come on, this is a little far fetched. These |
| able to convince one buyer that they would be | | | | components do have real value, but that value is |
| able to justify our seller's entire purchase price | | | | open to a broad interpretation by the |
| based on the number of client defections their | | | | marketplace. We are attempting to assign metrics |
| acquisition would prevent. As it turned out, the | | | | to a very subjective set of components. The |
| buyer had a huge install base and through multiple | | | | buyers are smart, and experienced in the |
| prior acquisitions was maintaining six disparate | | | | M&A process and quite frankly, they try to |
| software platforms to deliver essentially the same | | | | deflect these artistic approaches to driving up |
| functionality. | | | | their financial outlay. The best leverage point we |
| This was very expensive to maintain and they | | | | have is that those buyers know that we are |
| passed those costs on to their disgruntled install | | | | presenting the same analysis to their competitors |
| base. The buyer had been promising upgrades for | | | | and they don't know which component or |
| a few years, but nothing was delivered. | | | | components of value that we have presented will |
| Customers were beginning to sign on with their | | | | resonate with their competition. In the final |
| major competitor. Our pitch to the buyer was to | | | | analysis, we are just trying to provide the buyers |
| make this acquisition, demonstrate to your client | | | | some reasonable explanation for their board of |
| base that you are really providing an upgrade path | | | | directors to justify paying 8 X revenues for an |
| and give notice of support withdrawal for 4 or 5 | | | | acquisition. |
| of the other platforms. The acquisition was | | | | |