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| Home - Software M&A Review - May 06 Issue |
Software M&A – Q1 2006 was The Best Since '99
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Vertical Markets
Approximately 23% of 1Q06 M&A transactions involved software companies serving vertical markets, compared to 18% of all software M&A transactions in 4Q05. Healthcare software was once again the most active category, as acquirers sought to capitalize on valuations that remained depressed due to stagnant healthcare IT spending and strong pressure to reduce healthcare costs. Nevertheless, the largest vertical transaction of the quarter was in the healthcare vertical, with Allscript Healthcare acquiring A4 Health, a provider of clinical and practice management systems for hospitals and physicians, for $272 million (3.6x). Other notable vertical software deals included iSqFt's $50 million acquisition of Northstar Exchange (construction) and SS&C's acquisition of Cogent for $12.3 million (financial services).
Product Category Consolidation
Consolidation (the acquisition of a software company by a typically larger industry player to gain market share and eliminate a competitor) continued in 1Q06 at a pace consistent with 2005 and represented 11% of all deal activity. Deals within this category included Dassault/MatrixOne (3.4x), PlanitHoldings/Pathtrace (0.8x) and Allegiance/SilentWhistle.
Investment Acquisitions
More than one in three software company buyers in 1Q06 were private. Most were venture-backed private software companies spending VC and private equity investor cash. However, in six percent of software M&A transactions in 1Q06 VCs and private equity firms, awash in cash and under growing pressure to invest it, acquired directly – opting primarily for large, established and relatively safe companies. New to this category however, are Special Purpose Acquisition Companies (SPACs), which can be thought of as publicly traded VC firms that offer an accelerated path to liquidity for privately held companies. SPACs have traditionally stayed away from technology until recently. Deals within this category include CEA Acquisition Corporation's merger with eTrials Worldwide a provider of clinical trial management software; and Israel Technology Acquisition Corporation's merger with IXI Mobile, a provider of mobile communications devices, services and software. The most notable deal within this category was Hellman & Friedman's acquisition of Activant, a vertically specific enterprise resource planning provider with approximately $266 million in revenue. In June 2005, Activant filed to raise $200 million in an IPO.
Software As a Service: Implications, Benefits & Ramifications
It appears VCs, private equity firms, the trade press, public market investors and industry pundits have found the true Holy Grail, and this time it's called Software-as-a-Service, better known by the acronym moniker of "SaaS". A growing number of VC's now eschew investing in any software company that has not implemented a SaaS delivery platform and subscription revenue model. Using Salesforce.com as the benchmark, investors laud the business model, which portends faster growth and significantly greater recurring revenue, free cash flow and earnings. Customers love SaaS as well, because their initial investment can be markedly smaller and they're seemingly free to go elsewhere if the solution or its provider proves inadequate.
SaaS also offers the first cost-effective software delivery model for penetrating the SME market, which has neither the budget nor the IT staff to acquire, install and deploy costly enterprise software. SME and large enterprise resistance to having mission critical and sensitive data reside on a third party's server has abated over time with the widespread use and acceptance of Yahoo, eBay, Amazon, Google and online banking. And technical advances such as services oriented architectures (SOA), metadata models and AJAX have vastly improved the user's web-based application experience.
IDC Research estimates the worldwide SaaS market will reach $10.7B by 2009, up from $6.8B in 2006, and that SaaS makes up 10% of all software sales – growing to 25% in the next 5 to 10 years. Perhaps, but we always take these prognostications with several grains of salt. Among enterprises, we see SaaS gaining considerable traction in the non-mission critical horizontal app arena, primarily with apps that don't require significant integration or customization. Good examples are sales automation/CRM, corporate purchasing, HR benefits management, travel and expense management, email/message management, payroll/time & attendance, website marketing/analytics and web conferencing. We also predict small and mid-sized businesses (SMBs) will harken to the SaaS call in ever-growing numbers over the next 12 – 24 months. Other factors that will drive SaaS market adoption include the growing trend to allow line managers to acquire IT solutions without IT department approval, and the ability of the SaaS model to provide ISV's with improved customer intelligence and usage patterns, enabling them to be more responsive to market requirements.
That said we believe SaaS adoption will be slow where use of the SaaS app requires extensive integration with an enterprise's on-site, server deployed, perpetually licensed apps and databases. And despite the fact many large enterprises have overcome privacy and security concerns about providing a third party access to sensitive and proprietary information, many others remain very reluctant to do so.
The SaaS model remains very problematic for a great many private ISVs. Perpetual licenses, though difficult to forecast, generate a significant amount of up-front cash most software companies rely upon, together with annual maintenance and support, to fund ongoing development and meet payroll. When perpetual license and annual M&S revenue are replaced with considerably smaller monthly or periodic payments, many ISVs will struggle mightily to cover operating costs while providing state-of-the-art solutions and infrastructure, 24x7 world-class support and complex implementation and integration assistance – to say nothing of implementing a new sales model. It's been estimated that early stage SaaS companies require 70% to 100% more capital to fund to breakeven, and it takes two to three times longer to get there. VCs are beginning to factor this into their funding model, but many bootstrapped SaaS providers, as discussed in our 2005 Software Industry Annual Report, may not survive until subscription cash flow reaches historical perpetual license levels.
We also anticipate the revenue growth and earnings accretion of today's more visible SaaS providers will not be sustainable over time. A key value proposition of SaaS is the flexibility and risk reduction it offers end-users, but that may well be a double-edged sword for the SaaS provider. In some cases, the SaaS model can drastically reduce the customer's switching cost in the event the ROI is disappointing or a better solution from another vendor becomes available. We suspect many of these SaaS vendors will be abandoned, after incurring substantial up-front costs but before the recurring revenue exceeds the perpetual license fee. However in many cases, the ease of switching may be more perception than reality, particularly where there is significant integration, customization and end-user training involved.
For now, many enterprise ISVs will opt for a dual revenue model consisting of customer hosted perpetual license solutions with annual M&S, and vendor hosted web-based solutions. It won't be easy. Prospects may be confused about the best option for them, adding further delay to sales cycles. The dual model will place additional burdens on the ISV/SaaS provider's customer support, professional services and development teams, and especially on the sales organization. How will the ISV/SaaS provider sufficiently incent a sales rep accustomed to earning $10K on a $100K perpetual license sale to sell a $2K/month SaaS subscription? Should the ISV bifurcate the sales team into SaaS and perpetual? And what if the ISV utilizes VARs to distribute its traditional software? Rolling out a SaaS model could create significant channel conflict.
For those who are able to navigate the rocky shoals and survive the ramp-up years, accelerated revenue growth and greatly enhanced profitability are the likely reward. Perhaps as important, the SaaS model should greatly enhance the provider's liquidity and exit prospects. Today's software IPO market, such as it is, clearly favors SaaS businesses. Of the 10 software and web businesses that went public in 2005, only SSA Global, an ERP provider, and Emageon, a provider of software within the healthcare vertical, lacked a true SaaS offering (Figure 24).
Similarly, in the current equity funding market, pure play, enterprise-focused SaaS providers may well receive from VCs three times the valuation of their traditional license model counterparts. The same holds true for M&A valuations, as buyers place inordinate value on the SaaS providers" recurring revenue streams. SaaS providers acquired by strategic buyers can receive as much as pay five to seven times revenue from the appropriate candidate. Figure 23 lists select SaaS deals from 1Q06.
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.
 
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