3 Ways Searchers Can Still Buy Software Businesses
October 08, 2020
by an investor from University of Pennsylvania - The Wharton School in Washington, DC, USA
As an investor in self-funded searchers (and also 3X exits of GovTech SaaS businesses), I'm meeting more and more searchers these days that are looking to acquire software businesses.
It makes sense - software businesses are great businesses - they have high gross margins, recurring revenue, and often low customer concentration.
The bad news is the secret is out - from famous investors like Constellation Software to Vista Equity Partners and hundreds of private equity shops - there are billions of investor capital going into software companies and they are going down market and bidding up deals.
Which begs the question - "Can Searchers Still Buy Software Businesses"?
Here are 3 areas where I think Searchers still have a shot at buying software businesses:
1 - Small TAM - Most large investors care a lot about the total addressable market. You can have a great financial software business but if TAM is perceived as too small (anything <$1B is often seen as too small), investors will walk away. Searchers can focus on the uber-niche, small TAM markets.
2 - Software: Service Mix - The standard rule of software companies is you don't want more than 20% of your revenue from professional services. Businesses that don't fit those ratios (maybe they are 50%+ services) can be great businesses but don't fit investor criteria. Searchers can focus there and can either just enjoy the additional revenue or work on changing the mix of revenue over time.
3 - On-premise software - Private equity investors are generally looking for cloud-based software. If the business is large enough, they are willing to buy on-premise profitable software companies and migrate them to the cloud. However, PE investors often are unwilling to make an on-premise to cloud migration at the sub-scale level. Searchers should look for sub-scale software businesses that are already partly through the journey and clear path to cloud.
Are you a searcher looking at software deals? What's your experience - where do you agree / disagree with above?
As always, let me know if I can help - DM or redacted - Sign-up for my monthly musings at bit.ly/etamusings
from Harvard University in Omaha, NE, USA
If you want to go this route, I'd offer a few more items for consideration.
1. Your investor base will matter -- a lot. Different investors have different IRR and time horizons, tech knowledge, investment appetite, etc. If you buy a business like the type outlined above, you can keep it as is and professionalize where you can. This path means maximizing cash flow/EBITDA over time vs. Revenue growth. If you buy a business to transition it to the cloud, your IRR horizon will be pushed out longer. Cloud transition is expensive, takes time to execute, and takes time to adopt. It also means that you'll likely be foregoing distributions for several years to fund the R&D. You have to do that while paying down debt and living within your covenants. It feels like only a sliver of R&D can be capitalized on your balance sheet, so you need a bank that will agree to your R&D efforts for cloud migration as an add-back. Finally, while you're doing this cloud transition, you need to still manage your existing software and clients by serving them well. But get to the cloud, and Revenue Growth will be the priority.
2. Talent acquisition can be challenging because you're likely in a niche market. It takes time for find good people and onboard them. It also means they may be expensive, but the upside is once they're in, their market options may become limited. Every employee makes above market in my company. They're hard to replace, but there are not many places they could go to in my geography.
3. You need discipline and focus to manage the existing business while managing the cloud migration R&D, go-to-market, and adoption. It's a marathon. Back to Point #1, you need patient investors who understand the process, are willing to forego distributions for a while, and don't have an expectation of XX% IRR by Year 5. They're more realistic about this type of business and set their return horizons appropriately.
4. Along with Point 3, it's a grind. But as things happen, it's awesome.
I've lived this for six years and am still living it. I've released two cloud products, and am about to release my third. I've grown my software revenue from 38% of revenue to 72% of revenue (the rest is professional services). I've done that while managing existing legacy software solutions and debt. Thank goodness that I have great investors who understand, are patient, and are just as excited as I am about what we're doing.
from Carnegie Mellon University in San Jose, CA, USA