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One of the most challenging aspects of selling a healthcare information technology company is coming up with a business valuation. Sometimes the valuations provided by the market (translation – a completed transaction) defy all logic. In other industry segments there are some pretty handy rules of thumb for valuation metrics. In one industry it may be 1 X Revenue, in another it could be 7.5 X EBITDA.
Since it is critical to our business to help our healthcare information technology clients maximize their business selling price, I have given this considerable thought. Why are some of these software company valuations so high? It is because of the profitability leverage of technology. A simple example is what is Microsoft’s incremental cost to produce the next copy of Office Professional? It is probably $1.20 for three CD’s and 80 cents for packaging. Let’s say the license cost is $400. The gross margin is north of 99%. That does not happen in manufacturing or services or retail or most other industries.
One problem in selling a small healthcare technology company is that they do not have any of the brand name, distribution, or standards leverage that the big companies possess. So, on their own, they cannot create this profitability leverage. The acquiring company, however, does not want to compensate the small seller for the post acquisition results that are directly attributable to the buyer’s market presence. This is what we refer to as the valuation gap.
What we attempt to do is to help the buyer justify paying a much higher price than a pre-acquisition financial valuation of the target company. In other words, we want to get strategic value for our seller. Below are the factors that we use in our analysis:
1. Cost for the buyer to write the code internally – Many years ago, Barry Boehm, in his book, Software Engineering Economics, developed a constructive cost model for projecting the programming costs for writing computer code. He called it the COCOMO model. It was quite detailed and complex, but I have boiled it down and simplified it for our purposes. We have the advantage of estimating the “projects” retrospectively because we already know the number of lines of code comprising our client’s products. In general terms he projected that it takes 3.6 person months to write one thousand SLOC (source lines of code). So if you looked at a senior software engineer at a $70,000 fully loaded compensation package writing a program with 15,000 SLOC, your calculation is as follows – 15 X 3.6 = 54 person months X $5,800 per month = $313,200 divided by 15,000 = $20.88/SLOC.
Before you guys with 1,000,000 million lines of code get too excited about your $20.88 million business value, there are several caveats. Unfortunately the market does not care and will not pay for what it cost you to develop your product. Secondly, this information is designed to help us understand what it might cost the buyer to develop it internally so that he starts his own build versus buy analysis. Thirdly, we have to apply discounts to this analysis if the software is three generations old legacy code, for example. In that case, it is discounted by 90%. You are no longer a technology sale with high profitability leverage. They are essentially acquiring your customer base and the valuation will not be that exciting.
If, however, your application is a brand new application that has legs, start sizing your yacht. Examples of this might be a click fraud application, Pay Pal, or Internet Telephony. The second high value platform would be where your software technology “leap frogs” a popular legacy application. An example of this is when we sold a company that had completely rewritten their legacy management platform in Microsoft.Net. They leap frogged the dominant player in that space that was supporting multiple second generation solutions. Our client became a compelling strategic acquisition. Fast forward one year and I hear the acquirer is selling one of these $100,000 systems per week. Now that’s leverage!
2. Most acquirers could write the code themselves, but we suggest they analyze the cost of their time to market delay. Believe me, with first mover advantage from a competitor or, worse, customer defections, there is a very real cost of not having your product today. We were able to convince one buyer that they would be able to justify our seller’s entire purchase price based on the number of client defections their acquisition would prevent. As it turned out, the buyer had a huge install base and through multiple prior acquisitions was maintaining six disparate software platforms to deliver essentially the same functionality.
This was very expensive to maintain and they passed those costs on to their disgruntled install base. The buyer had been promising upgrades for a few years, but nothing was delivered. Customers were beginning to sign on with their major competitor. Our pitch to the buyer was to make this acquisition, demonstrate to your client base that you are really providing an upgrade path and give notice of support withdrawal for 4 or 5 of the other platforms. The acquisition was completed and, even though their customers that were contemplating leaving did not immediately upgrade, they did not defect either. Apparently the devil that you know is better than the devil you don’t in the world of healthcare information technology.
3. Another arrow in our valuation driving quiver for our sellers is we restate historical financials using the pricing power of the brand name acquirer. We had one client that was a small healthcare IT company that had developed a fine piece of software that compared favorably with a large, publicly traded company’s solution. Our product had the same functionality, ease of use, and open systems platform, but there was one very important difference. The end-user customer’s perception of risk was far greater with the little IT company that could be “out of business tomorrow.” We were literally able to double the financial performance of our client on paper and present a compelling argument to the big company buyer that those economics would be immediately available to him post acquisition. It certainly was not GAP Accounting, but it was effective as a tool to drive transaction value.
4. Financials are important so we have to acknowledge this aspect of buyer valuation as well. We generally like to build in a baseline value (before we start adding the strategic value components) of 2 X contractually recurring revenue during the current year. So, for example, if the company has monthly maintenance contracts of $100,000 times 12 months = $1.2 million X 2 = $2.4 million as a baseline company value component. Another component we add is for any contracts that extend beyond one year. We take an estimate of the gross margin produced in the firm contract years beyond year one and assign a 5 X multiple to that and discount it to present value.
Let’s use an example where they had 4 years remaining on a services contract and the last 3 years were $200,000 per year in revenue with approximately 50% gross margin. We would take the final tree years of $100,000 annual gross margin and present value it at a 5% discount rate resulting in $265,616. This would be added to the earlier 2 X recurring year 1 revenue from above. Again, this financial analysis is to establish a baseline, before we pile on the strategic value components.
5. We try to assign values for miscellaneous assets that the seller is providing to the buyer. Don’t overlook the strategic value of Blue Chip Accounts. Those accounts become a platform for the buyer’s entire product suite being sold post acquisition into an “installed account.” It is far easier to sell add-on applications and products into an existing account than it is to open up that new account. These strategic accounts can have huge value to a buyer.
6. Finally, we use a customer acquisition cost model to drive value in the eyes of a potential buyer. Let’s say that your sales person at 100% of Quota earns total salary and commissions of $125,000 and sells 5 net new accounts. That would mean that your base customer acquisition cost per account was $25,000. Add a 20% company overhead for the 85 accounts, for example, and the company value, using this methodology would be $2,550,000.
7. Our final valuation component is what we call the defensive factor. This is very real in the healthcare information technology arena. What is the value to a large firm of preventing his competitor from acquiring your technology and improving their competitive position in the marketplace. One of our clients had an outcomes database and nurse staffing software algorithm. The owner was the recognized expert in this area and had industry credibility. This was a small add on application to two large industry players’ integrated hospital applications suite. This module was viewed as providing a slight features advantage to the company that could integrate it with their main systems. The selling price for one of these major software systems to a hospital chain was often more than $50 million. The value paid for our client was determined, not by the financial performance of our client, but by the competitive edge they could provide post acquisition. Our client did very well on her company sale.
After reading this you may be saying to yourself, come on, this is a little far fetched. These components do have real value, but that value is open to a broad interpretation by the marketplace. We are attempting to assign metrics to a very subjective set of components. The buyers are smart, and experienced in the M&A process and quite frankly, they try to deflect these artistic approaches to driving up their financial outlay. The best leverage point we have is that those buyers know that we are presenting the same analysis to their competitors and they don’t know which component or components of value that we have presented will resonate with their competition. In the final analysis, we are just trying to provide the buyers some reasonable explanation for their board of directors to justify paying 8 X revenues for an acquisition.
Dave Kauppi is the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale healthcare and technology based businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.
The following suggestions have probably been considered or attempted by others. However, the potential lies in your ability to capitalize on your clients not having the time to complete the tasks for themselves. In the case of the Digital Photo Album business, there are thousands of people who are very familiar with converting paper photos to digital files but only a handful really have the time to engage the process. Hence, potential clients! Next, be sure to seek business guidance! This can be hard at times considering the amount of books and tapes sold on the subject. Just remember to look for information from people who have a similar business model as yours.
(1.) Start a business converting family paper photo Albums to digital photo albums. If you have a computer and a scanner you’re ready to start. If you use a mac, get iPhoto from Apple.com. I start with this application because iPhoto has the most complete process I’ve seen with a very low learning curve. Plus after you have finished scanning in all the photos and cleaning them up, for an extra charge to your client if you decide to do so, you can layout a hard cover photo book in iPhoto, and send it directly to Apple to be printed and mailed to you or the client for very little expense. If you’re on a PC consider Picasa 2 by Google, online at google.com for FREE. Did I say it was for FREE? I give a tutorial overview of Picasa on my site at theanthonyreport.com in the free tutorials section. It works similar to iPhoto but without the service of going directly to a book format. Still, the learning curve is low and the software is free. Both of the above require minimal computer system configurations ($500 e-machine or $1,200 iMac ) and scanner/printers run about $80.00
2.) Start a business trouble-shooting and upgrading computer systems. Now this may seem high tech but it’s really not. When on service calls I only have my knowledge of the PC and the Mac, an external hard drive to backup the clients documents, (even if they said they have done so), some software to run some tests and a screw driver. Clients are literally 2 doors to your left or right, if they have a computer. In fact the easiest clients in the world to get are computer clients. People ALWAYS need help with their computers. Trust me, once you announce just to your family and friends that you now fix and upgrade computers, you’ll be busy from that moment on. Don’t know how to charge? Just look at the price list the “Geek Squad” has. They charge $200 to setup a home network, excluding equipment! It really only takes 30 minutes, if that, to setup a home network, so under bid them. I would charge a $100 and be on my way to my next stop in 20 minutes.
3.) Setup a business configuring and loading iPods with music and video. It never ceases to amaze me the amount of people with iPods that don’t use them or haven’t added music to them since their friend first put a few tracks on there for them. People WILL pay you to setup their iPod. What tools do you need? The know how and transportation to the client. Or, you can have them drop off their music, movies and their iPod to your home and charge a package fee or a per hour fee. When it comes to movies I have had people give me a couple of DVD’s and asked if I could get them onto their iPod. All you need is some DVD ripping software and a compressor software then transfer the files onto the iPod.
Where do you get your customers in your area? Advertise in the local online newspaper, post a flyer at Starbucks, tell a friend, who’ll tell a friend. Trust me, word will spread.
Once again, its not that people don’t have the technology to do these things, they just usually don’t want to take the time to get them done.
4.) Start a business creating forms for businesses. I know a guy who delivered a product to a client without an invoice detailing the exact amount of items to be delivered. An argument followed between the two regarding the amount. The person delivering the product wanted to keep the client so they just conceeded and brought the client more product at a loss to himself. A friend of mine let him know that all he needed was an invoice with his business logo and information on it with a carbon copy sheet attached. He had no idea as to how to do the above so he asked my friend to create the documents and get copies. My friend did so at a cost. There are a great many people who need all types of forms which can be downloaded from the internet and customized to fit the clients needs. What’s required? For this you don’t even need your own computer, use theirs! Google the type of form, download it, copy the text from it, bring it into MS Word and adjust! Or, depending on how complex it is, download a free trial version of photoshop and alter it there. Don’t know how to use photoshop, I have a great tutorial on my site that’ll get you up and running in no time.
5.) Create a Cell Phone Media business. On a flight to Atlanta I had a lady sitting next to me who decided to pitch me on a multilevel marketing product. I wasn’t interested in the product, but I was impressed that she had the promo video on her Treo cell phone. I asked her if everyone in the company had the same setup, she said no, her son had compressed the video to go on the phone. Now imagine your company that can take a corporate promo video and format it for the top PDA smartphones available on the market today! Most major corporations only use 1 type of phone but there are smaller companies with sales people that have the Treo, the Blackberry, the iPhone and other smartphones. Most phones can run either an Mpeg 4 (.mp4) video clip or a 3G compressed video clip. Download a free or very inexpensive video compressor like Movavi, (www.movavi.com) and you’re ready to go.
In part 2 to this article I’ll give you 5 more businesses and I give you some more marketing ideas as to the promotion of your businesses using digital technology. In the meantime I sugggest you stop by theanthonyreport.com and familiarize yourself with some other technologies that are available and how to implement them to accomplish everyday tasks in life.
As a Digital Technology Consultant and publisher of THE ANTHONY REPORT ([http://www.theanthonyreport.com]), Anthony Stewart specializes in Media Content Production. He has over 10 years experience in Graphic Design, Video Production, Web Design, Interactive CD-ROM and DVD Authoring. He is fluent on both Mac and Windows operating system platforms and has built and serviced computer systems for clients since 1996.
His Media Design and Video Production clients have included, multi-platinum rappers Nelly and Lil Wayne, NBA superstars Carmelo Anthony and Marquis Daniels, MichCon, Blue Cross Blue Shield, and Daimler-Chrysler. He has also done extensive work for Loose Cannon Entertainment, the company behind recent NBA All Star Weekend Celebrity Main Events and Nelly & Jermaine Dupri’s Celebrity Weekends. Anthony has directed and produced several television shows, which include Everyday Cooking, Showreel, and the Digital Bridge. He is currently developing two shows for network cable in the areas of technology and health.
A technology business, in today’s society, can be very successful. It seems like everywhere you look, all businesses use some sort of technology in order to complete their daily tasks. It doesn’t matter if it’s a bank, a coal mines, etc; all businesses use some sort of technology.
A technology business can help others to achieve their daily goals whether it is for personal reasons or for business reasons. But when developing a business along these lines, you must know what you are doing in all aspects to the form of technology business that you have opened, so that one believes that you are capable of handling their situation. When it comes to business operations and technology, trust plays an important role.
Professionalism is also a key factor. What if you were working for a company that had viable data that needed to be handled and if they couldn’t trust your company, you, or your employees to handle that? Professionalism, privacy, integrity, and more should at all times be maintained.
You will also need all of the tools, whether it’s machines or software programs, that will allow you to operate sufficiently and efficiently. You will want to offer your customers everything possible for the type of service or business that you are performing/conducting. For instance, just logging into a system to retrieve lost information is fine, but what if you could offer them more?
A technology business must also stay up-to-date on all areas of their field. Technology changes fast and that means that your business will too. You and your employees will have to stay up-to-date on all new processes, programs, and anything along those lines in order to be able to offer your customers the latest and possibly the best for them or their business. Technology is helpful; but it is also demanding.
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Fueling the high growth rate for Retailers, Manufacturers and Distributors is a flurry of mergers and acquisitions. In today’s world of mergers and acquisitions, and heavy usage of the Web, companies are facing a new reality. Software that meets the company’s needs now will not be effective after a new acquisition takes place, or if sales substantially increase as a result of using the Web.
While meeting with a prospective client — a CEO of a large cleaning supply company — about purchasing new software, he told me that he was planning to grow his business by end of the year from 300 million to 500 million dollars by acquiring competitors he was negotiating with. When I asked him how he planned to integrate his company’s software with the new companies he was planning to acquire, his response was: “You hit the nail on its head. The software we are using cannot support our future acquisition plans. We will have to let the companies we plan to acquire keep using their current software until we find software that can meet our new needs. Not having the right software will result in a substantial increase of our operating cost. The unfortunate part is that we did not have the foresight to think ahead of the fact that our current software would not be able to support our acquisition plans. Nobody expected that we would grow at this rate and now we have to pay the price.”
Here are 4 unforeseen business disruptions that are likely to happen when your business environment changes:
1. Quite often companies engaged in e-commerce, experience an unexpectedly high volume of sales’ transactions that the current software cannot handle efficiently, resulting in the need for additional labor and excessive operating costs.
2. Frequently, the current software cannot provide the desired analytical information needed, resulting in the downloading of large amounts of data to spread sheets and more complex data manipulation to get the needed reports.
3. When mergers and acquisitions take place, the number of users along with the transaction volume will substantially increase, resulting in the possibility that the current computer system will not be able to handle this sudden change.
4. The acquired company might not have the same business practices as the company doing the takeover, resulting in the possibility that the current software may not be able to handle the new business demands. This can result in multiple software platforms being used creating higher operating costs and additional complexities in the computer infrastructure.
When planning future expansion, steps should be taken to ensure smooth business growth.
Software effectiveness evaluations should be performed the same way as evaluating old equipment in a factory. When evaluating the current software functions, the focus should not be on how well the software meets the business needs today, but whether it can meet the business growth of tomorrow when the company moves to the “next level.” In today’s business reality, which is changing at lighting speed, lack of planning can be a very costly proposition.
Nobody likes change, but not facing the fact that a company’s current software is outdated can result in substantial business disruptions and expenses down the road. The question that should always be asked is: “if the business reality changes drastically resulting in an unexpectedly large amount of new users or volume of data transactions, could the current software be able handle it?”
Since 1980, Dan Kaplan has worked with corporate executives to improve purchasing, increase warehouse and distribution efficiencies, and implement software solutions that result in substantial savings and productivity improvements.