how to value a software development company

When an entrepreneur starts their own software development company, they take an incredible risk. Before too long, the entrepreneur is working 80 hours a week or more to keep their fledgling business afloat. Then one day, it happens: the entrepreneur gets a call from someone who is interested in buying the business. Suddenly, instead of the long hours and hard work being attributed to building equity in their business, they are attributed to building a saleable asset. So when preparing to sell your software or Web development or e-commerce development business, you ask yourself "what's my company worth?"

Sales Multiple

Our sales multiple method does not consider the amount of capital employed, return on equity or goodwill. Sales multiples may be adjusted differently for companies with significant direct costs, such as purchased hardware, than for companies with more indirect costs. We use trailing, actual and forecasted revenue when computing sales multiples. Think about how you would feel if your company were for sale today.   What is your company really worth?  You should have an idea of what it would sell for.   Combing through financial statements and spreadsheets to determine this value is time consuming and complicated, which is why the sales multiple method has gained traction as a reliable estimation tool.   

Price Earnings Ratio

The price earnings ratio is the best valuation method for a company that has already proven its worth. This traditional method of valuation applies to companies in all industries, and is the most often quoted method of valuation for public companies. P/E multiples ranging from 5 to 50 are common in the software industry, with growth of company and growth of industry directing the selection of the multiple. A reasonable valuation is generally around 10 times net income.

Internal Rate of Return Method

The Internal Rate of Return Method is a classic financial methodology used in valuations, where projected profits are discounted back to the current period. The method is useful when valuing cash flows over many periods. However, Software companies would never use more than five years, and would employ a higher discount factor of twenty percent or more.

Free Cash Flow Model

A method of calculating the value of a company based on the cash it generates after expenses. The calculation can include interest payments, taxes and depreciation, but excludes capital expenditures and software development costs like Mobile Application Development. A Company's revenue or earnings alone do not make up an accurate picture of its performance. The company's free cash flow will provide a clearer picture of the company's financial situation.

Replacement Value

A startup that is growing quickly and can be immediately derived from the size of a market. The estimated value to investors and/or lenders is calculated by multiplying the number of units sold in one year by unit price, or risk value. This estimation of current value may be used to raise capital for growth or working capital in situation where a new invention does not have an easily predictable life cycle (for example, five years rather than the average ten years for a product).

Book Value Method

Book value is the amount of assets on the books in excess of the liabilities on the books. Although an important accounting concept and relevant in managing the business, book value is not generally very relevant in determining the true value of most software companies, since the value of the user base, recurring revenue stream, and cost to recreate the technology are largely ignored using this method.