Divergence in Software Multiples Continues to Expand
Background
In recent years, software M&A activity has generally followed broader market trends in terms of both deal value (the total value of reported transactions) and volume (the number of deals). However, since the pandemic in early 2020, the software M&A market decoupled from the broader M&A market, soaring to all-time highs despite strong economic headwinds, as can be seen in the chart below:
Exhibit 1: Software as % of Overall M&A
From a buyer’s perspective, the software industry is attractive because of several key factors. Firstly, it is a large and growing industry that is driven by the vast adoption of digitization, leading to an industry growth rate of more than 10%[1] per annum. Many software businesses also feature a form of recurring revenue stream, such as an annual subscription or licensing fee that is paid on a recurring basis. Additionally, the software market is extremely fragmented, offering great potential for consolidation and for value creation via add-on acquisitions. As a result of all these attractive features, buyers have gravitated towards purchasing software companies, driving multiples higher as demand continues to outweigh supply.
Recent Trends in Software M&A Multiples
The software industry has proven to be one of the most resilient, with the pandemic only accelerating M&A activity and boosting valuations across the board. However, one trend that has been particularly noticeable is the rapid increase in multiples for deal sizes that lie in the top 25th percentile versus the increase in multiples for deal sizes that lie in the bottom 25th percentile. The diagram below outlines this phenomenon:
Exhibit 2: Software Revenue Multiples Over Time
As can be seen, from 2019 to 2020, valuation multiples for deals that fit into the top 25th percentile increased by 2.1x whereas multiples for deals in the bottom 25th percentile decreased by 0.6x – further separating the gap between large “blockbuster” deals and lower valued acquisitions. This trend normalized slightly from 2020 to 2021 YTD, yet the gap still remains significant.
What Are Some Reasons Behind This?
This divergence in multiples can be explained by three key reasons:
· The COVID-19 pandemic exposed the scarcity of companies that have both scale and promising growth prospects
· Smaller and / or struggling companies were being sold at distressed prices as founders / CEOs became desperate to sell their business amid the uncertainty of the pandemic
· Overall deal volume rose dramatically but only a small percentage was driven by large deals as excess demand and limited supply forced multiples to increase at an accelerated rate
Why the Top is Expanding: As software companies became more attractive, consolidation in the industry kept pace at an alarming rate, resulting in the rapid growth in size of many large businesses. As a consequence, the number of companies that have both scale and promising future growth prospects dwindled as large buyers continued to swallow competition to fund their own growth. As a result, valuation multiples soared at a rapid rate as the appetite for acquisitions remained constant but the supply of companies that fit the criteria immediately became more scarce. Although overall activity and valuation multiples declined at the start of the pandemic, we can see a large uptick in prices paid for businesses that significantly outpaces deal volumes as activity returned to pre-COVID levels. The graph below outlines this:
Exhibit 3: Median Post Valuation vs Median Deal Size
What’s Happening at the Bottom: On the other hand, many small software companies struggled as the pandemic created great uncertainty of the viability of their businesses and their future prospects. As a result, founders and CEOs looked to exit and were willing to do so at more distressed valuations. This is especially true of businesses that were losing lots of money and had access to the capital markets temporarily interrupted or those businesses exposed to depressed end-markets - such as travel & entertainment. This can be seen in Exhibit 1 as the median multiple for deals in the bottom 25th percentile dropped from 1.9x in 2019 to 1.3x in 2020. However, as economic conditions slowly recovered and businesses began operating similar to pre-COVID levels, we see a change in sentiment from founders and CEOs that reflects this as the median multiple jumped back up to 1.8x in 2021 YTD.
Overall M&A Activity: Since 2017, dollars invested in software M&A has increased year-over-year as financial and strategic buyers continue to leverage the scalability and profitability of software businesses. As Exhibit 3 shows, there has been a steady increase in investment into the industry over the last few years with 2021 expected to hit new all-time highs. More importantly, if we analyze the trend on a monthly basis as per Exhibit 4, we can see the dip in overall activity between February – August of 2020 and the corresponding rebound thereafter. In fact, M&A activity in recent months has surpassed pre-COVID levels, primarily due to increased consolidation of businesses operating in the lower mid-market spaces rather than large firms.
Exhibit 4: Software M&A Since 2014
Exhibit 5: Monthly Software M&A Activity
Final Thoughts
As we head further into the economic recovery and steer away from the troughs of 2020, we see software M&A activity continuing its hot run of form and surpassing milestones as deal volumes continue to increase. Additionally, due to the scarcity of large-scale companies that continue to generate strong metrics, we expect valuation multiples to keep blowing up as more and more bidders compete for a rapidly decreasing subset of businesses. How long will this trend last? We’ll find out soon enough.
Written by Chris Lor of Sampford Advisors
[1] Gartner
Photo by Ian Taylor on Unsplash