Following several years of strong performance in the broad software industry – driven by robust fundamentals and increased pricing multiples – spending constraints by corporate information technology (“IT”) departments and sustained economic uncertainty has exerted a slight damper on the sector. While systems software and custom designed or prepackaged application software have historically dominated the market, software geared toward individuals and mobile device applications, in addition to the proliferation of software-as-a-service (“SaaS”) and cloud-based products, have recently contributed to industry growth. Still, enterprise resource management (“ERM”), business intelligence (“BI”), and customer relationship management (“CRM”) suites remain mainstays of the industry.
Merger and acquisition (“M&A”) activity remains steady in the application and system software industry. Consolidation trends persist, driven by the enduring need to add functionality and deploy products meeting the evolving needs of customers. At the same time, accounting requirements for business combinations pursuant to Financial Standards Accounting Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations (“FASB ASC 805”), have led to increased scrutiny of valuations for identified intangible assets and deferred revenue in business combinations by auditors and the Securities and Exchange Commission (“SEC”).
This article highlights recent equity market performance and M&A trends in the application and systems software industry, as well as purchase accounting considerations and industry norms regarding the identification and capitalization of intangible assets and goodwill in business combinations.
Since the depths of the recession in 2008 and 2009, the application software industry has outperformed the overall equity market, while the systems software industry has underperformed. Since mid-2009, equities in the application software industry increased more than 125% while equities in the systems software industry improved only 37%, as compared to an increase of 47% for the Standard & Poor’s (“S&P”) 500.
Macroeconomic uncertainty contributed to industry volatility in the most recent 12-month period. As a general rule, negative economic conditions tend to adversely affect capital spending by organizations, including that for IT outlays. This, in turn, has a tendency to decrease the outlook for software developers, which negatively affects stock prices.
Trading multiples for the application software industry – calculated herein as the ratio of enterprise value (“EV,” which includes debt and equity) to revenue or earnings before taxes, interest, depreciation, and amortization (“EBITDA”) – peaked in the first half of 2011 and the first quarter of 2012, which corresponds to spikes in the equity markets as shown below. This trend indicates that market values for industry participants were increasing at a greater pace than revenue or EBITDA, which typically coincides with increased forward growth expectations. In the most recent quarter ended June 2012, pricing multiples contracted relative to the prior quarter, suggesting lower forward growth expectations. The observed trend in pricing multiples corresponds with recent research published by Gartner Inc., whereby 2012 growth expectations were adjusted downward for the enterprise application software industry to 4.5% growth over fiscal 2011, down from the previous estimate of 5.0%.1
Similarly, multiples for the systems software industry also peaked in the first half 2011, although equity market activity and pricing multiples have been far less volatile than for the application software industry, suggesting more stable growth prospects for this segment.
Since mid-2009, M&A activity has remained robust, but has generally failed to return to pre-recession levels. Most recently, deal volume in the second quarter of 2012 contracted to levels not experienced since the second quarter of 2010, but remains near the post-recession quarterly average. The median transaction purchase price has generally trended upwards since 2009, exceeding $30 million in the second quarter of 2012 for the first time over the last three years.
Stout analyzed the form of purchase consideration for transactions between 2008 and 2010 in which the acquirer was a public company and detail regarding the transaction was publicly disclosed. This research indicates that approximately 91% of transactions included cash consideration, 35% included stock consideration, and 24% included contingent consideration (i.e., earnouts). While earnouts can create earnings volatility and accounting complexities due to the requirements of FASB ASC 805, contingent consideration remains a useful way to align the expectations of buyers and sellers, especially for high-growth and early-stage companies. Since financial reporting requirements can often be onerous for public companies (as the contingent consideration asset or liability must be remeasured at Fair Value each quarter), and considering the increased flexibility for public companies to offer stock consideration, the percentage of transactions by public companies that included contingent consideration is likely lower than that for all transactions in the software industry.
Application software EBITDA and revenue multiples implied by M&A transactions in the industry indicate rising valuations from 2009 through 2011 before a contraction in 2012. Multiples in the systems software industry have been more volatile over that time period, although it is noted there are fewer transactions in the systems software space with sufficient disclosure to calculate pricing multiples.
Purchase Accounting Considerations
FASB ASC 805 provides that all business combinations shall be accounted for under the acquisition method of accounting. In particular, the acquirer must recognize and measure the Fair Value of any identifiable assets acquired, the liabilities assumed, and any noncontrolling interest of the acquiree. FASB ASC 805 requires that intangible assets are recognized as assets apart from goodwill if the asset is separable from the entity of which it is a part; that is, it is capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, regardless of whether there is an intent to do so. An intangible asset shall also be recognized as an asset apart from goodwill if it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity.
In light of the significant intangible value inherent in industry participants, Stout analyzed transactions in the systems software and application software industries consummated between January 1, 2008 and December 31, 2010 to assess industry norms regarding the identification and capitalization of intangible assets and goodwill. Specifically, we analyzed the most frequent types of intangible assets identified and capitalized in the context of the total purchase price.
Our research found that, on average, approximately 60% of the “intangible gap” (i.e., the difference between the purchase price and net working capital plus tangible assets) is accounted for as goodwill in the systems and application software industry. The remaining intangible value was allocated to various identified intangible assets, including trade names and trademarks, customer backlog and other customer-based intangibles, technology and software, in-process research and development (“IPR&D”), and non-competition agreements, among others.
Technology and Software
Unsurprisingly, technology and software represent the largest and most frequently identified intangible assets (apart from goodwill), accounting for a median of 21% of the acquired intangible value. In fact, several transactions reported technology and software values that exceeded the purchase price due to negative working capital balances (because of deferred revenue balances). In addition, we noted an average reported remaining useful life for software and technology of six years, which represents the duration of time over which current software or technology is expected to contribute to the acquiring entity’s operations. Software or technology in development are often recorded as IPR&D until certain criteria are met. As shown, IPR&D was recorded in approximately 15% of transactions but only represented a median of 5% of the intangible gap.
Customer-based intangibles include customer lists, contracts, and/or relationships, which were recorded in approximately 56% of transactions and represented a median of 18% of the intangible gap. Customer backlog, which was recorded in only 2% of the transactions, represented a median Fair Value equal to 2% of the intangible gap. For software companies, backlog often represents professional services revenue that has been contractually agreed upon but not yet completed, whereas customer relationships or contracts typically represent future revenues to be generated from license and maintenance revenue streams (but for which deferred revenue has not yet been recorded). As SaaS software becomes more prevalent in the industry, we expect customer relationships to become an increasing percentage of the intangible gap due to the recurring cash flow streams resulting from these pay-as-you go relationships.
Trade Names and Trademarks
Trade names and trademarks were identified in approximately 42% of the transactions disclosing purchase accounting
detail, but only represented a median of 3% of the intangible gap. Trade names tend to be less valuable in the software industry due to the short operating history of many acquirees, in addition to rebranding that is often completed post-transaction. Additionally, software code is often integrated into preexisting platforms, eliminating the need for the acquired
Non-competition agreements were recorded in approximately 20% of transactions observed, but accounted for only a small percentage of the intangible gap. Non-competition agreements are often assigned minimal value in business combinations due to the limited ability of a selling shareholder to compete absent the non-competition agreement. It is often argued that the parties entering into the non-competition agreement would face difficultly competing without access to the software code. In addition, the frequency of stock-based consideration or contingent consideration would disincentivize an individual from competing if the non-competition agreement did not exist. As such, although non-competition agreements are fairly common, they typically do not maintain significant value.
Goodwill was reported in more than 95% of the transactions we analyzed, and represented approximately 60% of the intangible gap on average. Goodwill can represent synergy value, new platform opportunities, new technology to be developed (beyond IPR&D), and a trained workforce, among other items. A high proportion of goodwill value is common in software acquisitions due to the early-stage nature of many companies acquired. Because these companies are often growing quickly, much of the value cannot be attributed to existing products, existing customers, and other identifiable intangible assets at the transaction date.
In addition to determining the Fair Value of identifiable intangible assets, deferred revenue must also be remeasured at Fair Value in a business combination, with the difference in book value and Fair Value commonly referred to as a “carve-back.” Because of revenue recognition requirements in the software industry, many companies maintain deferred revenue liabilities representing a future obligation to provide software or services, although cash has already been received. These liabilities create a negative working capital balance for many software companies, which serve as a form of synthetic financing for research and development and other operating purposes. In other words, software companies often receive cash up front for users to license software over a set period of time. Although accounting rules delay the recognition of cash as revenue (which creates the deferred revenue balance), the cash has been received by the software provider and therefore can be used to fund operations. This dynamic has been tested recently due to the growth of SaaS-based agreements. Under SaaS agreements, users pay as they go and therefore are not required to front all of the cash at the onset of the agreement, although we note that software providers can often generate more fees under a SaaS agreement than a license agreement, all else equal.
In order to determine the Fair Value of a deferred revenue liability, one must contemplate the present value of the actual costs to perform the license, maintenance, or professional services performance obligations, plus a reasonable profit associated with the performance effort. Typically, software licensing fees primarily compensate the licensor for past software or technology development efforts, resulting in minimal actual costs to perform the requisite service over the deferred revenue period. Thus, carve-backs for licensing revenue can be significant. Maintenance deferred revenues typically require a greater degree of future costs to perform the requisite service, resulting in a smaller carve-back resulting from the Fair Value measurement. Due to the somewhat labor-intensive nature of many service-based deferred revenue obligations, the carve-back is typically minimal.
The data presented herein provides a brief snapshot of the current equity and M&A markets for the software industry, as well as a great starting point for high-level or preliminary estimates of assets acquired in a software company transaction. However, an acquirer must perform due diligence on the potential tangible and intangible assets acquired to ensure that differences do not exist between the overall industry and the specific target. Further, the evidence presented herein indicates significant identified intangibles are often recorded in acquisitions of software companies, and that deferred revenue liabilities must be carefully analyzed to determine carve-backs resulting from Fair Value accounting.
1 Petty, Christy and Rob van der Meulen, “Gartner Says Worldwide Spending on Enterprise Application Software to Increase 4.5 Percent in 2012,” Gartner, Inc. Press Release, June 20, 2012.