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| Home - Software M&A Review - Nov 05 Issue |
Software M&A - Robust Q3 Deals Despite Katrina
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 Vertical Markets
At the forefront is Oracle, having awoken from a deep slumber, leading the consolidation charge. According to Oracle President, Charles Philips, "Many companies have concluded they need to sell out or suffer the consequences. They are coming to us now, thinking if they're not the one bought, they will have a hard time." Former Veritas CEO Gary Bloom agrees: "It has already happened in hardware. There are now only four or five server vendors, four or five operating system vendors, and four or five storage vendors. When you get into the software that manages all that infrastructure, there are still thousands of vendors. That's the consolidation we're in right now, and it's about reducing complexity for users." Marc Benioff, the outspoken and sometimes controversial CEO of Salesforce.com, offers a different perspective. "I don't think the whole industry is consolidating. I think part of the old industry's dying off because client-server computing is starting to die. My opinion is that eBay and Yahoo and Google are not about to merge. There's a whole generation of companies that are merging. In our world of on-demand computing, I don't see a huge consolidation trend at all."
Who's right? Is this the same consolidation the software industry has known for decades, or is this a paradigm shift in software industry mergers and acquisitions? If there are significantly fewer buyers in the software M&A market today, one might expect to see far fewer deals, which is certainly not the case. Q3 saw a whopping 472 software and services transactions, a 15% increase over the prior quarter. The increased deal activity is attributable primarily to a sharp increase in acquisition activity among those public software companies left standing, as well as a sharp increase in private buyer activity (Figure 20).
The more intriguing development has been the extraordinary increase in the number of software M&A acquisitions featuring private buyers. Let's put it in perspective. In 2003, private buyer transactions accounted for 23% of the total. In 2004, the number of private buyers averaged 35% of the total. While the percentage declined somewhat in the first half of 2005, the number of software industry acquisitions by private buyers in 3Q05 increased to a whopping 42%. Most were private, venture-backed software companies.
Today's Three Most Important M&A Valuation Drivers: Category, Category, Category
We've often enumerated the many disparate factors that drive software M&A deal volumes and valuations, including the overall state of the economy, NASDAQ performance, and the quarterly revenue and earnings growth of public software companies. First among equals, however, is corporate IT spending. The allocation of those limited IT dollars is having a profound downstream impact on software industry M&A activity and valuations.
IT spending accounts for 40% of total US corporate capital spending1. While some $600 billion is expected to be spent in the United States on IT in 2005, most CIOs have carefully prioritized their shopping lists. Enterprise resource planning, supply chain management, customer relationship management and CAD are among the CIOs" lowest priorities. Conversely, security, storage management and internet tools have, for the past three years, claimed the lion's share of most CIO budgets and continue to do so.
Unsurprisingly, public software companies in the low IT spend sectors are barely growing and their median enterprise valuations are depressed and relatively stagnant. Conversely, public software companies in the high spend IT categories are growing far more rapidly and have significantly greater enterprise valuations. Figure 18 depicts software category valuations relative to category revenue growth rates. For purposes of our analysis, and in light of IT capital budget stagnation, we consider categories with revenue growth less than 12% to be low growth, and categories growing at greater than 12% to be high growth.
What is less obvious, however, is the clear and direct correlation between software category performance (based on median TTM revenue growth of the SEG-100 companies comprising the category) and M&A valuations (Figure 19). Software company sellers in high growth categories are far more likely to receive a higher valuation than sellers in low growth categories.
Granted, a plethora of other factors affecting valuation of a privately held software company come into play- product functionality and platform, revenue size, recurring revenue, installed base size, makeup and size of the addressable market and profitability. That said, the prospective seller's software product category is today the single most important indicator of salability and valuation. Even a high growth company operating in a low growth product category will have difficulty in the current market attracting a software industry median exit valuation. Prospective buyers will likely argue that the company's growth is attributable to stealing market share from competitors and that future growth has a well defined upper limit.
So what is a seller to do? First and foremost, understand the valuation drivers in the product category. Buyer motives are a key determinant of exit valuation, and buyer motives differ considerably between high growth and low growth product categories.
Of the 1088 software industry transactions we analyzed in the past twelve months, 37% were in high growth categories and 63% in slow growth categories - not surprising for a maturing industry. Buyers within low growth categories are typically seeking to increase critical mass, functionally enhance and strengthen their product sets, generate incremental revenue, add predicable reliable recurring revenue from a large maintenance and support base or subscription model, gain new distribution channels or territory, and enhance profitability.
Examples of Q3 transactions in slow growth categories include SSA Global / Epiphany, Oracle / Siebel, and BEA / Plumtree. Prospective sellers in low growth categories can also expect fewer software company buyers, more financial buyers seeking rollups, an insistence upon target market compatibility, an excruciating focus on the installed base, extraordinary financial diligence, and of course - a modest valuation.
Different factors dominate buyer thinking in high growth product categories. That's not to say these buyers eschew revenue, profitability and customers, but the clear emphasis here is on growth. A careful analysis of the 37% of Q3 transactions in high growth categories reveals a buyer quest for new products to accelerate growth, empower competitive differentiation and enable the buyer to better serve - and capitalize upon - its customer base. Software companies that offer best-of-breed niche solutions are particularly attractive to these buyers who seek to capitalize upon the shift in customer preference from point solutions to integrated suites. Recent examples include Symantec / Veritas, Business Objects / SRC Software and Symantec / Sygate.
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