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Software M&A -- A Look at the Year Ahead
By Ken Bender and Allen Cinzori, Software Equity Group, L.L.C.
Can you feel the ground shaking beneath your feet? According to the industry pundits and prognosticators, the tsunami is almost upon us. It began two years ago as just another wave, the latest in an endless succession of new software industry waves. We called it application service provider then, but it grew in size and intensity to become software as a service (SaaS) and it threatens to become a tsunami. Yet the staunchest software ships are confident they can ride it. VCs and other private equity investors insist upon it. Industry pundits thrill to it. The Street loves it.
And why not? SaaS and subscription pricing take much of the volatility out of the software game, especially in the enterprise software arena. Revenue growth has long been the leading indicator of software company success, and new license revenue has been its most critical component. Public software companies, GAAP-savvy and share price-conscious, have historically strived to make sure their new license revenue was significant and quickly recognizable. Market caps depended on it. Their customers understood that all too well, often deferring new buys to the very end of the quarter and extracting major discounts and concessions. And those enterprise customers felt entirely justified doing so, abhorring the huge up-front costs of buying and deploying an enterprise suite, and the virtual imprisonment that followed.
In the face of so many overwhelming objections to the traditional software business model of packaged applications sold on a perpetual license basis for a significant up-front fee, the new business model of services oriented applications delivered on a subscription basis is surely a good thing. Right? It must be, otherwise why would there be such a groundswell of support? Right?
Not necessarily. Not for tens of thousands of privately held software companies that serve the enterprise and small-medium business markets.
Granted, the traditional model does not serve private ISVs especially well. By best count, there are some 40,000 privately held software companies in the United States. We estimate more than 90% have annual revenue of less than $10 million, yet many provide essential and superb point solutions and product suites to the Fortune 1000. The typical private ISV business profile: Average revenue per employee < $100,000; average CAGR 10% -- 20%; average margin on software sales 93%, but average EBITDA only 15% due to substantial software development expenses and high costs of sale. Most have less than $500,000 in balance sheet cash and cash equivalents. The paid-up license fees from new licenses are usually the only source of capital to invest in their next major releases. And the maintenance and support fees from existing licenses, priced at 20% of software list price, keep these ISVs alive. For most private ISVs, M&S revenue comprises about 30% of total revenue, often yielding margins of 70% or better, particularly for later releases. M&S revenue is the private ISVs saving grace, the one revenue source it can rely upon to stay alive in tough times.
It's not an especially pretty picture. Why, then, shouldn't private ISVs enthusiastically embrace SaaS and subscription based pricing? Won't the continuing and more level revenue stream ensure a more stable future? Perhaps, but can the ISV survive long enough? It's a matter of cash flow.
SaaS and subscription based pricing currently come in many flavors. If vanilla consists of an enterprise application licensed on a pay-as-you-go, month-to-month or annual term, with little or no up-front payment and variable pricing based on number of users, many private ISVs will not survive. Even if the recipe calls for periodic payments amortized over a two or three year initial license term, few bootstrapped private software companies will be able to stay afloat long enough for subscription model cash flows to equal cash flows from paid-up licenses, professional services and M&S.
With little cash on hand, and virtually no professional money available to it, where will a private ISV that adopts a SaaS business model find the capital to rewrite its application suite in JAVA or .Net, add major functionality, and deploy on new platforms? When chunks of cash from new paid-up licenses and annual M&S fees are replaced by smaller recurring payments, how will the ISV endure yearlong enterprise sales cycles and escalating operating costs? Many won't.
For those that do survive long enough for subscription / services revenue to ramp, solidify and recur, EBITs should soar and prosperity should reign -- at least in theory. It's a theory we subscribed to, but which may no longer apply. Subscription-based pricing used to ensure revenue predictability and reliability. Customers would quickly regard the smaller, recurring fees no differently from their rent. After some initial belt tightening by the software provider, the cash would flow, and flow...
Problem is, in today's environment, the subscription model may not be the long-term annuity many perceive it to be. Should technology trends such as open platforms, services oriented architectures and web services be widely adopted in the future, it will become much easier for customers to replace ISV applications, customize them using non-vendor resources, and eschew ISV-supplied add-ons and enhancements in favor of third party solutions from other vendors. We recognize that in such a technology environment, the converse holds true, as well. Some ISVs will be adroit enough to exploit these trends, providing product extensions and software services to enterprise customers of larger software providers. Those that can't or won't adapt, perhaps numbering in the thousands, will likely perish.
Will that be a bad thing? Many don't think so. In the past few weeks, the internet has been rife with articles from industry pundits and disgruntled enterprise CIOs, chiding software companies for their inefficiencies, touting the new software business models, and predicting a significant industry shakeout. Their post-tsunami vision resembles a brave new software world, with the role of Big Brother played by a mere handful of software providers (Microsoft, IBM, Oracle, SAP, Symantec, EMC).
Fear not, some of these pundits add, optimistically. There's always room for start-ups that are truly innovators, citing Google. Perhaps, for the very few with truly disruptive technology that are able to attract the paltry VC dollars available to start-ups. What about the rest of the privately held, bootstrapped software companies that won't survive the tsunami? Where will they find the capital, or cash flow, to innovate? The new revenue model makes bootstrapping all but impossible. Will we miss them?
Enterprise customers certainly will. In their current quest for flexibility, reduced cost of ownership and fewer vendors, CIOs take comfort in having lots of options, and the leverage those options provide. But if the current rate of industry consolidation continues or accelerates, and if the tsunami hits with full force, only a few very large enterprise software companies may be left standing. And those few will likely be an oligarchy, slow to innovate, invested in the status quo, and able to dictate terms and prices as never before (can you say oil industry?).
We suspect, over time, even the oligarchy members will miss the departed privately held software companies that couldn't weather the tsunami. Gone will be many of the private ISVs that could listen carefully and respond quickly with best of breed solutions to fill the product suite gaps of larger software providers. Gone will be many of the small players that provided their enterprise customers with viable alternatives and vital leverage. And gone will be many of the private software companies that enabled larger software industry players to innovate by acquisition.
Long live the privately held, self-funded software company.
Software Equity Group, L.L.C. (SEG), a mergers and acquisitions advisory firm serving the software, life science and technology sectors, prepared this report. SEG is solely responsible for its content. This material is based on data obtained from sources we deem to be reliable; it is not guaranteed as to its accuracy and does not purport to be complete. This information is not to be used as the primary basis of investment decisions. For more, please visit www.softwareequity.com, or phone (858) 509-2800.