• M&A metrics

    Discover what software companies need to know

Blog:

Les mesures de fusions & acquisitions que les entreprises de logiciels doivent connaître

20 January 2021

Software companies may be surprised by the metrics used to gauge their value and growth potential during M&A. Knowing what investors look at is core to the deal negotiation process.

M&A negotiations are a novel experience for most software company founders and management teams. The same can apply to structuring data and information tied to specific company metrics.

Companies and potential investors, such as private equity (PE) firms, often have different expectations concerning metrics. Sometimes misalignments involve how granular data is needed. Other times issues centre on what metrics are the most important in defining a company’s value.

BDO advises companies across industries on deal preparations, negotiations, and how to get the optimal results. Our experience is that solid groundwork can address these issues before deal negotiations, which starts with knowing the metrics investors commonly use to value a software company.

Under the Metrics Hood

One of the central metrics issues is that companies and investors often view them differently. A PE investor may also want surprisingly granular historical sales and revenue data. That data forms the foundation for many of the models that PE’s prepare to gauge your current situation and future growth potential.

PEs may differ in their approach to calculation methods and resulting metrics for areas like net retention rate or recurring revenue. Further complicating the issue is that estimations and views may depend on sub-industry, geographic location, solutions, and company size. Consulting with financial advisors can often inform you about specific PE firms’ preferences.

However, there are certain aspects of a software company that will always influence how it is valued. The recent BDO guide for software companies considering PE investment presents a good overview. In this article, we want to look under the hood at the details of some of the financial and customer-related metrics that are invariably important to PE deals.

What Revenue Metrics Say

Revenue metrics are central to PE firms’ calculations of a company’s value and growth potential. Recurring revenue, composition, and sources are among the essential aspects.

Revenue source concerns customers’ industry and size. Centralised industry focus may be viewed as a risk factor. For example, anything relating to hospitality is currently seen as risky. However, your growth strategy, post-investment, may also be more apparent if you have a clear-cut revenue source focus.

Composition involves the concentration and length of customer contracts. Few, large or many smaller contracts each creates specific challenges and opportunities. Many small contracts lessens the impact of losing one, but your customer base may be less resistant to macroeconomic risks. The opposite applies to larger customers, who, on the other hand, tend to hold the cards when negotiating contract renewals.

Other revenue metrics PE investors look at include consistency (smooth distribution vs ‘lumpy’ or seasonal) and revenue growth over time. This is very dependent on what phase your company is in, as start-ups generally grow faster than scale-ups and so forth.

PE investors often set a goal based on ‘the rule of 50’ for their portfolio companies where your EBITDA margin percentage and revenue growth percentage should equal 50. If, for example, EBITDA margin is 15%, then revenue growth should be 35%. VCs and PEs differ in this aspect, as VCs are primarily focused on the growth of their portfolio companies, often at the expense of profitability, while PEs prefer a combination of margin and growth.

Annual Recurring Revenue

Annual recurring revenue (ARR), or the related monthly recurring revenue (MRR), is one of the most important financial metrics for software M&A with PEs. It is generally calculated by aggregating the total contracted revenue at a particular point in time.

ARR’s importance to PEs is partly linked to its potential effect on how much a PE can borrow as collateral from banks. In turn, it can influence what valuations they are willing to meet. MRR is the exception rather than the norm in enterprise software. It is used when contracts are billed monthly, and customers have either the explicit or implicit right to cancel at any given month.

When looking at recurring revenue, a PE investor will likely be focusing on specific aspects and vectors that influence final valuation – and whether your revenue is recurring.

If you primarily have volume or usage-based revenues, or perpetual licenses, investors will often not consider it as recurring revenue. Examples may include customers paying a base fee and then a per-use price for a service or solutions. A fix for such nonrecurring usage-based revenues can be to try and migrate toward higher contractual minimums, to minimise the component of nonrecurring revenue. If a solution relates to processing transactions, particularly with customer bases subject to seasonality, that may be difficult as customers will prefer to minimise fixed costs.

Software companies can utilise changes to subscription and pricing structures to engage with customers. Options include working on increasing contractual minimums, using tiered pricing and, for example, foregoing minimum billings if the customer agrees to an upsell of the minimums.

Renewal and Retention Rates

The rate at which customers renew upon expiration (or renewal option) is the renewal or retention rate. It is measured by listing how many customers renewed over a given period. Other factors may also influence renewal rate metrics - for example, contract length and pricing over time. If your average contract length or value grows or falls over time, it indicates customer loyalty levels.

Dollar-based retention rates are in many ways similar in scope to renewal rates. They measure how customers expand their purchases from your company over a given time by investing in product upsells or expanding their user base or number of solutions purchased, net of customers reducing their scope of usage.

Investors will often look at the relationship between different, related metrics. The most relevant retention/churn type of metrics are:

  • Customer retention rate: this is based on customer numbers. The downside is that this does not capture customer upsells or scope reductions. 
  • Customer churn: the inverse of customer retention rate.
  • Net retention rates (dollar-based): this takes the YOY (generally recurring/contractual) revenue for existing customers compared to those same customers one year prior. This captures upsells and downsells.
  • ARR from new customers: This is often useful as a complement to net retention rates to show the composition of revenues from new vs existing/retained customers.

Growth Rates

For PE investors, who are often looking to double investment within three years or triple it over five, growth rates are a core metric.

When examining growth rates, investors will look at details about where growth comes from and how stable it is over time. PE firms often look at more mature companies and will be more comfortable with lower growth rates than VCs if there is provable, stable growth over time. This is often referred to as the average annual growth rate (AAGR).

Growth rates apply across many different parts of your operations, including profits, cash flow, expenses, etc. PEs’ main focus tends to be revenue and profit growth. It is worth noting that you will generally be expected to show double-digit growth, as this is a general trend across much of the software industry. For example, Salesforce, the largest SaaS company with over $14 billion annual revenue, saw almost 30% year-on-year growth in the second quarter of 2020. That was before adding Slack through the recent acquisition, which could help increase revenue growth even further.

Other areas that affect the growth evaluation include growth from new customers vs existing customers and revenue growth by product or service line items.

Sales and Marketing Metrics

Your growth and revenue rates are often linked to your marketing and sales efforts. High marketing spend often equals sales growth. However, high marketing spend can also hamper your growth rates and future potential for profitability, not to mention influence your burn rate.

PEs will look at how your marketing and sales efforts are distributed, including specific industry or sales channel prioritisation. While it may vary, data analysis shows that certain combinations of channels and spend vs revenues often lead to the best results. If you are far from the median values, investors will want to understand your strategic reasoning.

Other core metrics include sales cycle length compared to time spent in a specific sales stage. This metric regards how long it takes for a new, potential customer to move through different phases to a closed deal. The metric can help identify bottlenecks and minimise deal slippage. The latter covers the number of customer committals that fail to close within a forecasted period. There is a misconception that any slippage is negative, but few companies avoid deal slippage. Average slippage rates will help inform you – and a potential investor – of any customer onboarding issues that may need to be addressed.

Customers and Customer Acquisition Costs (CAC)

Examining customers, their situation, and prospects necessitates detailed data covering many different vectors. From this foundation, you have a platform for telling a metrics-driven story about how you have built your customer base, their value, and future potential of existing and prospective customers to entice investors.

One of the core metrics is customer acquisition cost (CAC). Often it is described as your total marketing and sales expenses for a period divided by the number of customers acquired during that same period. Other metrics can help form a deeper understanding of your CAC, including how much you can expect to make from a customer over time.

CAC will vary over time. At the start-up stage, it will likely be high. Investors will want to see decreasing CAC over time, as it indicates that you are gaining market traction.

Target customer groups and how you have succeeded in engaging them will also be central. This metric shows your ability to grow specific customer segments and increase revenue through targeted efforts. As previously mentioned, your customers’ industry, size, and growth prospect are also of interest to a PE investor.

Other Central Investment Metrics

At the end of negotiations, you get to sign on the dotted line and will have new capital injected for your growth plans. The exact amount of capital injected often depends on the metrics described above. Other metrics and other parts of your company also play a big role. The same goes for avenues of growth, capital expenditure requirements, debt, and tax structure, to mention just a few areas.

For younger software companies, one of the core metrics will be your burn rate. This is by far the most critical KPI metric to track internally for start-ups and scale-ups. The burn rate is the amount of cash spend per month that exceeds your monthly revenue divided into the amount of capital you have available. So, if you have capital reserves of $1 million and a burn rate of $100,000, you have ten months left to either improve performance, raise additional capital, or risk going out of business.

Gross margin and R&D as a percentage of revenue are other metrics that PE firms will look at during deal prospectus. The same may apply to the cost of revenue, which can be measured in many ways.

In all cases, consulting with advisors can help inform you of what metrics and calculation methods a potential PE investor will pursue and how you can get the optimal result of deal negotiations.