Common Exit Strategies for Software Companies, Explained
When building a software business, most entrepreneurs are solely focused on delivering a product their customers can’t find anywhere else. If the company develops mission-critical software solutions and happy customers stay loyal, a successful business can grow, and that growth creates new challenges. Entrepreneurs thrive on meeting the increasingly complex demands of a flourishing company, but eventually there comes a natural time to start thinking about exit planning.
Whatever your goals for exit may be, each circumstance is unique. It can be challenging to balance the best outcomes for ownership, management, employees, and customers alike.
In this post, we’ll examine the pros and cons of the most common exit strategies. First, it’s important to understand what makes selling a software company different from a traditional business.
What Makes Software Company Valuations Unique?
A software company’s primary asset is intellectual property, which can present advantages and disadvantages for valuation. Traditional businesses, such as those involved in agriculture, manufacturing, transportation, or retail, all have tangible assets. These tangible or physical assets can include real estate, machinery, vehicles, and/or inventory that help determine the company’s value. When these companies experience more demand for their products, they make new investments in raw materials, manufacturing, and transportation to scale up production.
Software companies can generate higher profit margins than companies that rely on tangible assets since their products typically have no transportation costs, they do not take up any shelf space, and they never spoil. Software can also be deployed to countless customers without a corresponding rise in production costs. As a result, software companies creating superior products for their particular market can be well-positioned to create strong recurring revenue that can sustain for a long time.
These advantages of not relying on physical assets are very beneficial when running a business, but can make it difficult to find a buyer who understands the long-term value of what you’ve created when you’re ready to exit. Putting a proper value on intangible assets like patents, trademarks, leases, computer code, customer lists, franchise agreements, domain names, and industry knowledge requires a unique understanding of the business and industry being served.
The simplest way to sidestep a sale process is to skip the sale entirely, choosing instead to pass the company on to a child or other family member. Plenty of traditional companies—from tiny mom-and-pop convenience stores to massive retail giants like Walmart—have chosen to remain family-owned businesses. Even if the heirs aren’t fully acquainted with the specific industry, a business degree can equip them with a baseline understanding of accounting, marketing, and management so they can learn the rest as they go.
Unlike traditional companies, the software industry requires more specialized knowledge of coding and development for a successful transition to successors. Vertical market software businesses have the added requirement that heirs have a deep knowledge of both the software being offered and the industry being served. Seasoned business owners know that responding to their customer’s needs can make or break a company. Owners of software companies serving niche markets have charted a unique course to arrive at their specialized expertise, an experience that is difficult to replicate.
Management or Employee Buyouts (MBO or EBO)
While it may be possible for software companies to successfully pass the business down to a new owner through inheritance, the management team that has been supporting a product for decades is often a more viable option when picking a successor to manage the company’s product and intellectual property. An owner may feel more comfortable leaving the company in the hands of a trusted protégée, but this option can create a difficult path to payment.
If the company’s owner wants to realize the financial benefits of selling the business they’ve grown, the new managers need to raise enough outside money to fund their purchase. Even if the company has strong recurring revenues and a loyal, diversified customer base, the specialized understanding required to evaluate a software business can be beyond a typical lender’s expertise.
Because software company valuations are higher than average compared to traditional companies, and the businesses hold a lower-than-average proportion of tangible assets to guarantee them, traditional banks may see too much risk in lending to software companies. With no tangible company assets to guarantee a bank loan, management or employee groups attempting an MBO or EBO may be faced with the prospect of personally guaranteeing the loans to raise the necessary capital. Such an arrangement could potentially put the company on unstable ground if it has to weather a down year or two under overleveraged ownership.
Taking the Company Public
When the management team is solid but not in a position to buy the business outright, taking a company public is another option some owners investigate as a possible exit path. In an ideal scenario, a business applies to be listed on a stock exchange and underwriters set the price for an initial public offering (IPO). This ideal scenario might see the existing management team staying in place, while the company raises new capital when investors buy the stock, and shares held by the owner could become a potentially lucrative way to cash out of the business whenever they choose to sell.
For companies with huge user bases and nearly universal brand recognition like Facebook and Twitter, public interest in their IPOs can generate enough capital to make the venture worthwhile. But for software companies serving niche markets and very little brand recognition outside the industry they serve, a successful IPO can be far less likely, and going public can make the business vulnerable to an unsolicited takeover.
For a smaller company, the possibility of being bought out by a competitor with no recourse could be catastrophic for the business. Even tech giants have found that IPOs can be a gamble that results in losing control of their business. Twitter’s 2022 change in ownership shows how vulnerable a public company is to a hostile takeover from anyone with enough cash on hand to buy a large stake, and that can spell disaster for a company’s corporate culture, business model, and relationship with its customers.
Even a successful IPO free from takeover attempts comes with a long list of regulatory requirements and inherent uncertainty in the stock market. Owners looking to stay with the business as the stock price appreciates may find that an IPO makes sense. But for an owner looking to exit soon, the risks of an IPO can greatly outweigh the potential rewards.
Selling To Private Equity
Given the longer time horizons of other traditional exit options, many software company owners consider selling their business to a private equity (PE) firm. PE firms are uniquely positioned with a deeper understanding of the software industry’s particular operating model and enough funding to pay what a business is worth when other financial institutions won’t. But when it comes to creating liquidity for an owner exiting the business, the PE model raises concerns worth noting.
PE firms typically invest in companies for the short term, with many hoping to extract a significant return on investment in 3-5 years. Generating a large return in that short of a timeframe can often mean cutting costs through layoffs or making changes to existing products that could damage a company’s relationships with customers. In a niche industry where reputation and consistency are everything, a disruptive change in ownership can endanger the recurring revenue that forms the foundation of a company’s long-term success.
For owners who have spent decades building the relationships required to make their business a success, handing over their company to people whose agenda is focused on a short-term payday can feel like surrendering control of their legacy.
A Balanced Solution
Volaris Group provides a unique solution that leverages the shared strengths of hundreds of software companies without endangering what makes every company unique. With more than 150 acquisitions to date, Volaris has a deep understanding of how software companies operate. But unlike PE firms, we never sell the businesses we buy.
Volaris invests in its companies for the long term, taking the time to build a foundation that positions the business to succeed for years to come. Our decades of experience benchmarking software businesses allow Volaris to help its companies identify opportunities to grow right away. The strong financial backing of our parent company, Constellation Software, Inc., gives Volaris companies access to investment capital to fund initiatives without the need to meet outside financing requirements.
As a buy-and-hold-forever acquirer, Volaris understands investing in a company’s employees is the key to its long-term success. Joining our group presents new opportunities for career growth within the company, with our other companies, or even within the Volaris corporate team.
Owners of our acquired companies have discovered entirely new career trajectories when they choose to stay with the business after joining Volaris. Many owners continue to run their businesses the same as before, only now with more support from a financially strong parent company. Others have become portfolio leaders after discovering a passion for the M&A side of our business. And for those looking to retire or move on to a new venture, Volaris provides a transparent path to selling the business and comfort in the knowledge that their company is secure in responsible, capable hands.
We’ve successfully supported the growth of software businesses for more than 25 years and we're always happy to discuss possibilities for new companies to join us. Wherever you are in your company’s journey, we’d love to talk about your business and your plans for the future. Feel free to drop us a line!