High purchase prices paid for software companies during COVID-19 and the debt used to fund those transactions is creating an interesting competitive dynamic for the industry, particularly when compared to the less-levered balances sheets of their public peers, said two software investors.

The more levered balance sheets may limit those companies’ ability to invest in artificial intelligence and the transactions they can make, these investors noted.

Many balance sheets of privately held software companies hold debt exceeding the current enterprise values of many publicly traded software companies, as calculated by Mergermarket.

Publicly traded Monday.com, a workflow management and collaboration platform, is selling for an enterprise value of 1.4x its last-twelve-month revenue (LTM), with a market cap of USD 3.5bn.

Security company Tenable trades for 2.3x EV to LTM revenue with a market cap of USD 2.3bn, enterprise financial software company Blackline trades for 2.8x and a USD 1.9bn market cap, and cloud infrastructure company Nutanix sells for 3.9x and an USD 11bn market cap.

These valuations contrast sharply with some of the larger deals completed earlier this decade.

Coupa, a procurement software platform, was taken private at 9.8x LTM revenue by Thoma Bravo in 2023 for USD 8bn. Avalara, a tax compliance solutions platform, was purchased by Vista Equity Partners for USD 8.4bn, or 10.6x LTM revenue, in 2022.  A number of other deals were completed at lofty multiples.

Today’s valuation gap is fueled by public investors believing that new AI technologies will eat and potentially replace the application software as we know it today, said Scott Berg, senior software analyst at Needham. A similar gap occurred with previous technology disruptions, he noted.

But the leverage may not necessarily create a competitive difference. Debt at software companies is often used to acquire and less so to fund new projects and growth investments, noted Berg.

Levered companies can be better positioned in the short term because the leverage implies the company is generating cash and may be able to pivot that cash toward R&D, said Berg.

Jonathan Ho, a technology analyst at William Blair, said software companies are measured by a combination of factors, not just the amount of debt on their balance sheets. Other factors include confidence in management, broader platforms of products, data moats, and the ability to execute, he said. To have staying power, companies need durability at the platform level, with disruption coming from the AI model vendors themselves.

A key issue for software companies, Ho said, is whether they have sufficient cash to sustain operations and invest in growth to achieve higher valuations, or whether existing private investors will continue to underwrite them despite the lack of a clear exit path.

Less-levered publicly traded companies, though, are not immune to pressure.

Ho said that the contracting terminal values of publicly traded companies, driven by the rise of AI, have eroded the attractiveness of stock-based compensation. Additionally, the emergence of “vibe coding,” a form of AI-generated programming, along with faster feature development by larger platforms, could lower barriers to entry and continue to weigh on valuations.

Private companies try to hold their value

Daryl Lansdale, vice chair at Norton Rose Fulbright US, said he had expected a more competitive environment to result in a sharper valuation reset in private markets, but that has not materialized.

Companies are still searching for deals at what sellers consider fair prices, rather than undergoing the broader repricing some had anticipated, Lansdale said. While some opportunistic buyers are seeking bargains, it does not appear to be an environment in which they will have the upper hand, he added.

Private markets are not experiencing the same degree of immediate repricing seen in parts of the public markets, and many sale processes remain competitive, according to Lansdale.

Public companies may be more selective in pursuing private targets due to existing valuation gaps, as well as the need to invest in their own businesses, Lansdale said. Many are allocating significant capital expenditure internally to “AI-proof” their operations rather than pursue larger acquisitions, which may also limit their appetite for bolt-on deals, he added.

The amount and speed at which publicly traded strategics need to make investments in AI, infrastructure, and energy upgrades may impact the amount of capital they may have for acquisitions, Lansdale said.

William Blair’s Ho noted that there are limited exit options for private companies at elevated multiples given the public markets aren’t rewarding companies right now for high growth rates. Companies must either grow into their multiples or lower their expectations, he said.

The excessive valuations paid to take software companies private during COVID-19 are starting to show up in the bond markets. A group of creditors at CDK Global, the auto dealer software company, are working with Houlihan Lokey as the company’s debt plunges, Debtwire reported this week. CDK was taken private by Brookfield Business Partners in 2022 for USD 8.2bn.

Meanwhile, customer and employee experience management company Medallia, purchased by Thoma Bravo in 2021 for USD 6.4bn, is nearing an agreement to be handed over to its lenders, according to news reports.

Ho said the best private companies will need to demonstrate a clear benefit from AI while avoiding disruption, though such cases are likely to be rare. “The bar has certainly been set higher,” he added.