When an enterprise software company is set up the founders are probably not thinking about the exit strategy for the company, except in a vague "maybe we’ll get bought by Oracle one day" kind of way. People may encounter a problem, perhaps when working at a customer, and code a custom solution. They start to think: "Hmm, this problem is not specific to this customer at all, maybe lots of people have the same problem" and then thoughts turn to whether it makes sense to try and produce a commercial software solution out of that particular example. Of all the times this occurs, only a few make it from daydream into a real company. Setting up a software company requires imagination, determination, energy and money, and only a few people have access to all these. To actually turn a software product into a success requires much more: real customers prepared to pay a substantial sum of money, a decent market (as companies trying to sell in the aftermath of the 2001 crash discovered), code that actually works reasonably well, and fired-up people who can sell the idea.
Even if you get as far as real paying customers there are a plethora of obstacles: growth pains, competitors, the need to raise more capital, dealing with awkward customers, recruiting high quality people, finding an effective pricing model, the list goes on. Enterprises need there to be such start-ups, because very few genuinely innovative pieces of software come out of the industry giants that large corporations like to buy from. Bureaucratic corporate cultures rarely attract dynamic entrepreneurs, and although large software companies have strong sales channels to enterprise customers, they are rarely in touch with customer needs, and are frequently obsessed with protecting their current installed base in preference to dreaming up new solutions.
In order for there to be a healthy environment for enterprise software start-ups there need to be avenues for founders to exit, typically either via a stock market flotation or, more likely these days, a strategic purchaser, often a larger competitor. Venture capital firms invest in promising start-ups, but usually only after they have achieved some real customer sales, and they can help focus the minds of founders on growing a company rapidly to the stage where an exit makes sense. Of course few make it: a venture capital investing in 10 firms would probably be happy enough to see one big success and two good trade sales, with seven of those investments not making it. Of course they would like a higher hit rate, and carry out as much due diligence as they can to maximise the chance of success. However the obstacles are such that only a small proportion of promising companies really make it to serious revenues (say $50+ million annually) and steady profits, at which point buyers and stock markets beckon.
The mergers and acquisition market is different from the heady days of the late 1990s, but has steadily recovered from the horrors of the 2001 crash. According to bankers BerkeryNoyes, in the first half of 2013 there were 120 software acquisitions with an aggregate value of $12.9 billion. This was barely changed from the level of a year before. From the start of 2011 to mid 2013 there were 3,804 software company purchases where financial terms were disclosed, at an average value of $37 million. There were a slightly larger number where the terms were private. So how much is a software company worth? The median value in this 30-month period was 2.1 times revenues, and 12 times EBITDA (profits). Of course there is a wide range here, from small deals through to large purchases, such as the $2.2 billion purchase of ExactTarget by Salesforce.com Inc. Looking only at enterprise software companies, PeachTree Capital Advisors reckon the average value was four times revenues in 2012. Again there is a wide range e.g. Ariba was purchased by SAP at eight times its revenues.
These numbers give a rough idea of the likely range of valuations that an enterprise software company is likely to obtain these days. Clearly fast-growing companies with high margins will do far better than ones without, so these are just averages. Entrepreneurs need to be aware of their exit strategy, and enterprises need to at least consider the general market in order to judge the health of the market in which they are making software purchasing decisions – the negotiating position of a buyer in 2001 was very different from that in 1999 at the height of the boom. Large enterprises face no shortage of technology challenges in 2014, and will need all the help they can get from the young software companies that actually spur most of the innovative in our industry.