Not All Revenue Is Created Equal: Revenue Composition Affects Valuation, Part I of II

Valuation is often quoted as a multiple of annual revenue. While this is a useful metric for understanding valuation ranges, it also can be misleading. Companies of similar size in the same market may have quite different valuations based on many factors. One such factor is the composition of a company’s revenue. 

Software companies generate revenue in many ways. Some examples include the sale of perpetual licenses, annual maintenance fees, professional services, hardware sales, software subscription fees, and long term licenses. Each of these has two characteristics that are relevant to a buyer’s valuation model: (1) predictability/risk, and (2) profit margin. 

Valuation is driven up by increases in predictability (and therefore reduction in risk) and profitability (and therefore higher ROI). Without putting a valuation multiple on each type of revenue, let’s examine how typical buyers look at different kinds of revenues. 

Hardware: Your customers may appreciate receiving a turnkey hardware/software solution, but revenue from hardware sales will typically be given little value by a software buyer because they consider hardware a commodity business. 

Services: The performance of services may be an important part of your solution sale and a key competitive advantage. Your services group may also be key to maintaining a tight relationship with your customers, which will pay dividends over the years. That’s a good story to tell an acquirer, but every hour of services revenue comes with an hour or more of direct cost as well. Typically, profit margins are not as high on services as on software sales, so don’t expect services revenue to be valued as highly as more profitable software sales. 

Licenses: The sale of software under a perpetual license has been the historical software business model. License sales can be large and very profitable. However, the sales cycle can also be long, and when large sales slip they can materially affect a company’s annual financial performance. Each year the revenue bucket starts empty and needs to be filled with new sales, which may or may not materialize. Buyers may have concerns about a company’s ability to continue to sustain large license sales after an acquisition. A solid pipeline analysis can mitigate this concern. 

Maintenance: Maintenance revenue, typically billed annually as a percentage of software license value, can provide revenue stability and profitability for companies that mainly sell software licenses. Buyers value that predictability. However, when maintenance revenue is a small percentage of total annual revenue, it may reveal that few customers purchase maintenance. Alternatively, if maintenance revenue is a high percentage of annual revenue, it may be because sales have stagnated and there is little growth. Another issue facing companies transitioning to the SaaS model is that traditional maintenance revenues evaporate quickly as your business moves to a recurring revenue model. 

Subscriptions: The sale of software under a subscription is increasingly common and is the business model for the sale of “software as a service” or SaaS. Valuations of companies like Salesforce.com clearly indicate that investors and acquirers highly value the predictability of this business model. The high valuations also stem from the fact that once SaaS companies reach a base of revenue that covers operating costs, the profit margin on all revenue increases is very high. Part II of this article will examine this issue in greater detail. 

Long term contracts: Software companies may sell licenses under contracts that extend over several years. Future amounts are contractually assured but will not show up on historical financial statements. This contractual revenue should be highlighted as an element of a company’s pipeline analysis. While a revenue multiple may not be applicable, contractual revenue can support a rationale for using the highest comparable market valuation metrics and a premium valuation. 

So, be prepared for buyers to ask for an analysis of your revenues. Don’t expect them to value all your revenue the same way. If your potential buyer is a public company, look to their business model, financial statements, analyst reports and market valuation to understand their perspective on valuation so that you can provide them sound rationale for the valuation that you want. As you describe your company's revenue models, help the buyer gain an accurate view of the risks in your business and recognize where they can drive future profits. 

A version of this article originally appeared in Soft•letter and Software Success.