LBO modeling for software companies

All the LBO modeling tutorials out there are for traditional companies (i.e. companies with tangible assets.) But there are more PE firms moving into tech and since they are usually not profitable, they use revenue multiples. So my question is, how do you model a software LBO? Other than using revenue multiples for entry and exit, are they focused more on expanding revenue? It would be great if someone can share a example.

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Comments (24)

  • Analyst 1 in PE - LBOs
Feb 5, 2020 - 10:56am

Not sure what apes are tossing shit at you, this is correct. Literally part of the main thesis of Vista and every other big enterprise SaaS investor.

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Feb 3, 2020 - 1:03pm

More and more lenders are willing to lend off of revenue (mainly recurring revenue) and EBITDA.

Software companies with high gross margin, solid growth, high recurring revenue and high retention are generally highly sought after businesses and many tech focused lenders would love to get a piece.

The underwriting case is going to depend on the investment. Is it an EBITDA or a growth story?

Feb 4, 2020 - 6:28am

This. Also not all software companies are utlra-scale negative cash flow whatevers. There are some gems which are well managed on a cost-basis and can be incredible buyout targets given the above with good roll-up potential etc. Look at some of Thoma's investments for example

  • 1
Feb 5, 2020 - 11:44am

How does this work in terms of debt paydown / interest coverage if you lend off revenue at a low or negative EBITDA business? Is there a lot of PIK used? If so, isn't that eating into returns significantly?

Array
Feb 4, 2020 - 5:28pm

Agreed. Much easier to see a path to profitability as a software company continues to grow. Harder to really influence COGs, but much easier to influence and grow Opex (mainly people based) at a slower rate than revenue.

For a high quality software company, lenders are able to get comfort around

  • path to profitability
  • attractive pricing - need to pay more for burning businesses
  • cash flow dynamics - high retention businesses who bill annual up front have great dynamics
  • because of all of this, these businesses are debt recap opps. which means more $$$ for lenders
Most Helpful
Feb 5, 2020 - 9:26am

Tech businesses should mostly be CF generative once they achieve a certain scale and dial back on the S&M because the unit economics of a software product (whether license/maint or SaaS) is incredibly profitable and highly sticky. Most LBOs (see Vista or Thoma Bravo's playbook) is predicated on some forward cash ebitda where they underwrite to a pro forma operating margin that sheds the cost of driving bookings growth through spend.

I do have a question for anyone with experience with recurring revenue loans. How do you price the risk if there's no CF? Is there usually a PIK component? Is opening cash over-capitalized such that creditors are essentially paying themselves cash interest (for some period)? Is there a warrant component? I'm assuming it's a combination but curious to what the debt structure look like for the most part.

  • Analyst 1 in Other
Feb 5, 2020 - 11:06am

Hey, OP here. I think you answered your own question. Recurring revenue loans are tied to your revenue so your CF is your revenue so they only fund revenue generating companies.

Feb 5, 2020 - 2:51pm

You price a little higher, and set covenants to make sure things don'tgo off the rails.

Lenders are getting comfort on the asset class in general. If Tier 1 sponsors like Vista and Thoma are in, they feel pretty good about the business their lending to not go belly up. A firm like Vista isn't going to allow one of their businesses go bust. They know what the they are doing and will get in front of such scenario early on. Worst case they put in an equity injection/cure if a company is breaching covenants, which is essentially default (but NOT bankruptcy)

Feb 5, 2020 - 4:36pm

But yes, for more venture type deals (typically smaller businesses, who may be B/B- companies vs. A/A- companies) warrants definitely come into play. Juices up the returns for venture lenders. They also can justify charging 10-12%. But also don't have covenants, typically, which is important for smaller companies 100% focused on growth. Good one's don't need debt, bc the existing investors should typically want to invest more into the business, or they can go out and raise more equity (this is a generalization of course).

I frankly don't have much experience on the distressed side, but i'm sure alot of it has to do with being able to more easily cut cost in software businesses than others. In software businesses, since gross margins are so high you have so much more flexibility in managing opex. Just RIF out cost, in sales, marketing, product, etc. Easier to show a "lender case" and get the debt you need.

Feb 6, 2020 - 11:08pm

Same way you'd price risk in any other deal, you're just looking at different metrics (ARR leverage vs. EBITDA leverage, retention stats, liquidity outlook). For our software deals, we focus on later stage companies that have a clear path to cash flow generation like you said, so the risk is the degree of conviction around the company hitting that forecast.

We have a strong preference for cash yield, but I can think of a deal or two where we've talked about doing 6-12 months PIK only. An alternative is pre-funding an interest reserve (what you described as paying yourself cash interest), which is pretty common in a cash-free buyout situation. Otherwise it's a fairly typical structure, just with a different set of covenants.

In our segment of the market, PE groups push back pretty hard against warrants, but we'll try to get an equity co-invest where we can.

Feb 7, 2020 - 12:55pm

In the SaaS deals that I have seen, the lenders are lending under the assumption that at any time you can "flip a switch" and turn off R&D and S&M spend and become cash flow positive.

Most of these companies have gross margins in the 70-80% range, so if shit really hit the fan, the idea is that you could rip out a ton of SG&A and cash flow (with little to negative growth) for a few years (or however long it took to repay the debt)

Feb 7, 2020 - 1:45pm

How are interest payments covered until the point where the company is profitable?

Array
Feb 6, 2020 - 11:15pm

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