What is a custom software development shop worth?

A custom software development shop builds software to order for clients, so what it is worth rests on different things from a company that sells its own product. There is no product to license and no subscription base to count; the things to examine are the team that can keep delivering, the clients who keep commissioning work, and the paperwork that shows the shop can hand over what it built. Two shops with the same revenue can therefore be worth quite different amounts. A company that sells its own software is a different case, covered in what a software business is worth.

Signed work ahead is what a buyer pays for first

Backlog is worth counting only to the extent the work is signed, scoped and funded; conversations and a pipeline of prospects are not the same thing. A master services agreement with no committed volume does not guarantee the shop any work, and a client that can end an engagement on short notice makes the work behind it less certain, so the termination clauses are worth reading. Clients who come back for a second and third project show that the relationship survived delivery, which a run of one-off engagements does not show. That is the difference between recurring revenue and revenue that has to be won again every time.

Written assignments set the ceiling on what the code is worth

What a shop can promise about the code it has delivered depends on paper. Under the Copyright Act the author of a work is its first owner (section 13(1)), and the Act’s definition of a literary work includes computer programs. The exception is an author employed under a contract of service who made the work in the course of that employment: the employer is first owner unless there is an agreement to the contrary (section 13(3)). An assignment of copyright, or a grant of any interest in it, is valid only if it is in writing and signed by the owner or the owner’s duly authorized agent (section 13(4)). Every transfer of ownership in the chain that is not an employee’s work for an employer, such as from a freelancer to the shop and from the shop to the client, therefore needs its own signed writing. A project where a freelancer’s assignment is missing, or where the client contract is silent on ownership, is one the shop may not be able to deliver as promised, and the cost of chasing signatures, renegotiating or defending a claim may have to be reflected in the price. See who owns code written by a contractor.

The same paper cuts the other way. If a client contract assigns everything the shop produces, including its reusable tooling, the shop may not own what it thought it did. Whether pre-existing tools were carved out is worth checking, because tooling the shop owns outright is what the shop can reuse on the next project.

Recasting the earnings of a shop run by its owner

Reported profit is only a starting point. If the owner is also the architect or the main salesperson, the books may not charge that work at what it would cost to replace. Earnings can be restated as if every role the owner fills were paid a market wage, then adjusted for items that will not repeat, such as a one-off project or a personal expense run through the company. Fixed-price work needs special care. Revenue booked on a project running over its estimate overstates what the shop will earn from it, so the estimate to complete on each open project is worth asking for. Unbilled work in progress raises similar questions: how old it is, whether the client has accepted it, and whether it will become an invoice.

Scientific Research and Experimental Development (SR&ED) credits get their own line. The Canada Revenue Agency says an SR&ED claim is submitted with the income tax return to access two tax incentives, a deduction against income and an investment tax credit, and it publishes what to do when a claim needs review. If profit includes an SR&ED refund, whether the claim is supportable and will recur is a question for the shop’s tax advisor, and the refund should not be counted as settled earnings. See whether SR&ED credits survive a change of control.

Why two similar-looking shops price differently

• Bench depth. A shop where architecture, estimating and client management sit with one lead developer carries key person risk, which can lower what a buyer will pay.
• Who writes the code. Heavy reliance on subcontractors raises the question of what each of them signed, and whether it reaches the end client.
• Client mix. When one or two clients supply most of the work, the backlog is only as durable as their decision to keep outsourcing; see customer concentration.
• Contract type. Whether work is fixed-price or time-and-materials changes who carries the risk of an estimate being wrong.
• Privacy record. PIPEDA requires an organization to keep a record of every breach of security safeguards involving personal information under its control, and a buyer may ask to see it.
• The owner’s exit. The BDC notes that buyers may insist on a reduced price if the seller chooses to cut all ties; it lists vendor financing, an earn-out, a phased transfer of ownership and a role as an executive, board member or advisor as ways a seller can stay involved.

Multiples are shorthand, not a method

Treat any multiple of earnings you hear quoted for a business like this one as general industry discussion, not an appraisal. The BDC notes that the specific multiple used, and the type of ratio, vary greatly with the industry, market conditions and other factors. Ask what earnings figure a multiple was applied to, since the recast can move that figure further than the multiple moves the price. Hours billed to clients and a product licensed repeatedly are different kinds of revenue, so a multiple borrowed from product software companies may say little about a shop. A practical test is to list each reason a buyer might discount the shop, from a missing assignment to the largest client, and see how many you can close before a sale.