Our observations are now being posted on a new blog, Architect Partners LLC. We have lots of plans for where we're taking this, stay tuned.
It's funny how certain things stick with you. Growing up my parents had a small framed quotation, cited to be made by the Chinese philosopher Confucius. It hung on some random, out of the way wall in our home. Although we always had a variety of interesting framed art hanging on the walls, I'm pretty sure this was the only quote featured in our house. The quote was:
"A sage seeks opportunity in difficulties. A fool sees difficulties in opportunities."
Over the years, this bit of advice has come to mind thousands of times. I'm not really one that holds on to these types of phrases but this one stuck for some reason. Somehow it infiltrated my mind, became a part of my own idealized personal identity and has given me perspective and motivation throughout my life.
These days with the economic dark clouds over our head I've found the advice come to mind many times. In my professional world, M&A activity and equity financings have certainly been impacted by the uncertainty of whats next for the economy. Uncertainly equals very slow moving and cautious or outright frozen buyers and investors. Encouragingly, In spite of the general mindset that prevails today, I do often hear a variation of Confucius' quote by executives, board members and investors. It's more words than action at this point but it's a first step.
Blogs and podcasts (and likely soon video blogs) are being used by an increasing number of venture capitalists as their mouthpiece to their constituencies. Brad Feld is certainly one of the pioneers and he has begun to organize a blog network of venture capitalists via Feedburner.
One incredibly useful form of post is under the theme of best practices. Brad Feld has his Term Sheet Series of posts and now Pascal Levensohn and his partners at Levensohn Venture Partners has begun a series entitled VC Inside Out. I'm sure there are other examples as well, but the point is that the amount of sharing of insight and perspective gained from experience is unprecedented.
Thanks for all who believe sharing is better than hoarding knowledge.
This past week has been what may be a breakout week for technology IPO. Three IPO's in particular received an enthusiastic welcome by Wall Street.
CommVault -- CommVault has distinguished itself as a truly viable competitor in the data storage management sector competing head-to-head with giants such as CA, EMC and Symantec's Veritas line of products. Revenues over the past 12 months were $120.8mm and growth from fiscal year 2005 to 2006 (March year end) was 32%. CommVault's competitive momentum, emerging scale and growth rate make for an impressive offering. CommVault has been incredibly patient with its IPO, actually starting the process three years ago and biding their time as their business grew and the technology IPO market began to regain its footing.
Of particular note in this deal were two rather unusual structural elements; (1) roughly 45% of the shares sold were selling shareholders and (2) a large portion of the proceeds raised by CommVault will be paid to certain preferred stock holders.
With regard to selling shareholders, it certainly makes a stronger statement (and deal) when existing shareholders are NOT sellers in an IPO. Given the choppy nature of the IPO market in general, it is a bit surprising that the Company and underwriters were comfortable with such an aggressive structure. I posit that the answer lies in the fact that the vast majority of selling shareholders were affiliates of CSFB, one of the two book managing underwriters. Clearly the market looked through this "interesting" set of facts and focused on CommVault's business and prospects. Generally, underwriters and corporate issues strive to eliminate these types of distractions as they increase the risk of execution.
Another quite unusual "distraction" in this situation was the large cash payment ($101.8mm) being made by CommVault to satisfy obligations under the first five rounds of private financing. Typically preferred stock issued in private financings converts to common stock upon an IPO. In this case, in addition to conversion into common stock, the holders of Series A-E preferred stock (again CSFB affiliates) were also due a preferred return and accrued dividends. This is an extremely unusual occurrence in an IPO.
So, does any of this matter to the new investors purchasing the IPO? Only if you believe that the selling shareholders see this as an opportunity to liquefy as they have a tempered view of CommVault's prospects. In this case, the CSFB affiliates have been in this investment for up to 10 years (a VERY long time) and are continuing to hold a substantial equity position in the Company. Also, very importantly, management is only selling a modest amount, signaling confidence.
These transactions are encouraging and suggest that we may be seeing a more receptive marketplace for emerging vendors. Investment banker IPO activity levels are also reasonably high these days suggesting that with an open market, the technology IPO pipeline may begin to build. We'll be watching.
Brad Feld alerted me recently to a newly published book by William H. Venema, entitled Top Secret: The Strategic Guide to Selling Your Software Company, Essential Advise from a Veteran Deal Warrior. Mr. Venema is an attorney who has represented a number of software company executives with the sale of their businesses.
I applaud Mr. Venema for the effort and feel the book gives a good overview of the types of processes and issues that executives and boards need to navigate when selling a business. What this book fails to do, and to be fair, no book would accomplish, is to equip the constituents involved with a sale of a company with the depth of knowledge and judgment that only comes with years or decades of transaction experience. Mr. Venema, does make this point but it’s worth reiterating; sellers should surround themselves with deeply experience advisors including accountants, lawyers and in many cases investment bankers.
While its detailed military analogies fail to deliver better understanding and are a distraction, I recommend this book to any technology entrepreneur who is seeking a sense of the M&A process. The issues around intellectual property and where value lies (or not) are just as relevant to any technology company not just software vendors.
My father, Ralph Risley, was an executive at General Electric in the 1960's and 1970's then was recruited to several successful start up (in one case going public) enterprises in the energy industry during and following the first "energy crisis" in the mid-late 1970's. Over the past couple of years he has become engaged with the topic of corporate governance. He provides the following thoughts: The business models of start up companies focus on product, markets, distribution, financing and technology development. Insufficient attention is placed on those governance and ethical oversight issues which will become critical as a company grows, especially when a public offering is considered. Early stage Boards of Directors have a much narrower interest spectrum than those of public companies where the shareholder base is more diverse, less knowledgeable of industry specifics and expectant of candid disclosure. When early stage investors and venture capitalists use the term "Adult Supervision" I doubt that they are referring to governance at the Board level but rather they are injecting the lixor of experience and insight on operational and budgeting elements. Regardless of the success of the business, initial investors will eventually seek liquidity. Without strong independent Board oversight an undesirable company culture can root itself so deeply that removal may be next to impossible.
My father, Ralph Risley, was an executive at General Electric in the 1960's and 1970's then was recruited to several successful start up (in one case going public) enterprises in the energy industry during and following the first "energy crisis" in the mid-late 1970's. Over the past couple of years he has become engaged with the topic of corporate governance. He provides the following thoughts:
The business models of start up companies focus on product, markets, distribution, financing and technology development. Insufficient attention is placed on those governance and ethical oversight issues which will become critical as a company grows, especially when a public offering is considered.
Early stage Boards of Directors have a much narrower interest spectrum than those of public companies where the shareholder base is more diverse, less knowledgeable of industry specifics and expectant of candid disclosure.
When early stage investors and venture capitalists use the term "Adult Supervision" I doubt that they are referring to governance at the Board level but rather they are injecting the lixor of experience and insight on operational and budgeting elements.
Regardless of the success of the business, initial investors will eventually seek liquidity. Without strong independent Board oversight an undesirable company culture can root itself so deeply that removal may be next to impossible.
John Newton has some insight into the consolidation within the content management sector. A bit of wild speculation by Seth Gotlieb, a content managment consultant and another take on the deal and the sector by IT Analysis.
Macrovision is leaping aboard the trend that we have highlighted several times in the past few months -- debt is playing an increasing role in software company capitalization.
Macrovision announced the offering of $175mm of convertible notes today. Of particular note is that they are also entering into a call spread arrangement (which we highlighted in detail in a previous post on Symantec's recent financing) and using a portion of the proceeds ($50mm) to repurchase common stock. Just like Symantec and CA, they are doing a leveraged recapitalization. Instead of turning to the straight debt markets, such as high yield or bank, they have chosen to use a convertible bond as the funding vehicle. Why? Lowest cost and execution risk.
Today CA announced earnings, a material restructuring intended to reduce ongoing expense levels and the expected initiation of their previously announced $2 billion stock repurchase program.
CA's Capital Structure Philosophy
CA has historically been the most aggressive user of debt within the software sector as a mechanism to finance its business. While the management team has seen much change in the past five years, the aggressive use of debt remains firmly in place. As we have seen with the recent Veritas financing as well as the financing of the Secure Computing acquisition of CipherTrust, debt has found its way into the mainstream of the software industry.
CA intends us the Microsoft technique and initiate a tender offer to repurchase $1 billion of its common stock. The Company expects to financing between 50% -75% of the purchase price with a bank facility and the balance with cash from the balance sheet. The net effect is that leverage ratio's will rise to the highest levels of the past several years. Today CA's debt / common stockholder equity ratio is 40%. Following the buyback that ratio will rise to between 57% - 67%, well above CA's previous debt levels.
NY Times DealBook published a short piece on Friday speculating that another bidder may be lurking in the shadows for FileNet. We place the probability as quite low.
We believe that FileNet has been receptive to a sale for quite some time and it's been very well shopped informally. I'm also certain that alternative logical buyers were approached as part of the recent transaction process. This is wishful thinking on the part of investors who are reacting to the 1% stock price premium offered by IBM. What they are forgetting is that the stock has moved upward 27% in the past month or so on acquisition rumors. See our recent assessment of the transaction.
Well, IBM is getting aggressive. In it's second large acquisition in a week, IBM announced that it is purchasing FileNet for $1.6 billion. This comes on the heels of another recent acquisition in the enterprise content management sector, the purchase of Hummingbird by Open Text for roughly $500mm.
Purchase Price: $35.00/share
Premium to Pre-Announcement Price: 1%
Enterprise Value: $1.2 billion
Enterprise Value / 2006E Revenues: 2.5x
Price / 2006E EPS: 30x
FileNet is an enterprise content management platform vendor. In other words, customers use FileNet's suite of products to build content management applications suited to their own needs.
Web pages, word processing documents, spreadsheets, HTML, XML, PDF, email messages and other digital content are all examples of the types of content that FileNet is capable of cataloging, organizing and making available as needed.
FileNet has been in a bit of the doldrums over the last several years, with stock performance being essentially flat since the beginning of 1994 and revenue growth sub-10% annually. While net income has increased nicely over the past several years, operating margins remain rather lackluster at 10% over the past 12 months. Many believe that FileNet, as an independent entity, was not particularly well positioned with tough competition on the high end from EMC/Documentum and Microsoft showing early success at the low-end with Sharepoint.
IBM, showing a bit of a "me too" mindset with EMC, is justifying this transaction under its "Information on Demand" initiative. No doubt, managing information assets within an enterprise is a challenging and high value effort which equals expensive projects with lots of services work to make right. Perfect for IBM's capabilities and strategy.
Architect Partners Assessment
IBM has shown it's smarts again with this acquisition. FileNet's products fit well within IBM's overall product set, albeit with some overlap, and importantly to IBM's strategy, FileNet products drive considerable service revenue as well. Although as we mention above, FileNet's software should be considered a platform, it does continue to move IBM up closer to the application category and as we speculated in our post on IBM's acquisition of MRO Software, we believe this add further validity to the notion that IBM's strategy around owning applications has shifted. Time will tell if our premise holds true.
One interesting dynamic worth mentioning is the lack of premium offered. Historically, on average, public company control premia have been on the order of 35%-40%. Clearly a 1% premium to pre-announcement stock price doesn't incent shareholders to act. The markets immediate reaction was to bid the price above the offer price by IBM, believing an alternative suitor will emerge. While it's possible, we believe that all logical purchasers had more than adequate time to consider this purchase and have likely chosen to pass on the opportunity. One also need to consider that FileNet's stock price rose over 27% in the preceding month or so, suggesting takeover rumors were rampant. We bet that shareholders will be disappointed when other bidders fail to emerge. We'll be watching closely.
Purchase Price: $25.80/share
Premium to Pre-Announcement Price: 19%
Enterprise Value: $586 million
Enterprise Value / FY 2006E Revenue: 2.6x
Price / FY 2006E EPS: 24x
Target: MRO Software
MRO Software provides software and services that allow corporations to manage the lifecycle of assets such as plant, equipment and IT systems. The vast majority of MRO's business is managing the lifecycle of non-technology assets which clearly complements IBM's Tivoli business focused on managing IT assets. The core IT management centric product inherent within MRO is their service desk offering (Product: Maximo ITSM), although the Maximo ITSM product set was released in 2005 and remains a very small business within MRO. MRO's business is service and support heavy with 69% of total MRO revenues coming from those two categories.
Architect Partners Assessment
MRO is a somewhat surprising acquisition for IBM. Historically IBM has focused on being a non-competitive partner to application vendors. MRO competes directly against the SAP and Oracle's of the world, albeit in a rather obscure category. This may signal a significant shift in strategy within IBM.
MRO does fill an obvious hole in IBM's IT management product set, an IT service desk product. Some have speculated that this was IBM's primary motivation for the acquisition. While this is a nice benefit, it makes for an expensive way to achieve the result.
Well, HP finally did it! After years of showing at best tepid support for its software business, HP finally showed some conviction. HP's purchase of Mercury interactive is a blindingly obvious strategic move with the only question being, what took them so long.
Target: Mercury Interactive
Mercury Interactive was founded as a software quality testing vendor. In simple language, Mercury created software that tested software. Mercury's software stress tested newly developed software products to catch bugs and performance issues before the software was released to the market or installed. Mercury dominated this niche, and still does, but as growth became harder to achieve Mercury was compelled to extend its product scope. Several years ago, Mercury began selling software to manage the performance of applications which were already deployed and running. Today Mercury Interactive competes quite effectively with companies such as IBM, CA, BMC, Symantec, Quest and even to a limited degree HP.
Enterprise Value: $4.5 billion ($52.00/share)
Premium to market: 33% above pre-announcement price
Aggregate Value / 2006E Revenue 4.8x
Price/2006E Earnings Per Share 34.0x
Strategically,this has been one of the most obvious transactions to not get done for years. HP has long had a strong reputation around its Openview product set but it's been perceived as strong at managing the network layer, alright but emerging at managing the systems layer and weak at managing the application layer. Mercury is the leading player at the application layer providing a perfect complement to HP's product weaknesses. Very importantly for HP, they are also acquiring an industry leading team of professionals which we are sure will be an important catalyst to reinvigorate HP software business.
Architect Partners Assessment
Timing is everything. Several events transpired to make this transaction achievable. First, the departure of Mercury Interactive founder, Amnon Landon, last year as fallout from the well described option dating scandal. Amnon was a fighter, not a seller. Second, HP's change in leadership has clearly resulted in a new level of respect for its software business, resulting in corporate resources now being allocated to building what had been an oxygen starved business under Carly's watch. Third, the loss of credibility and uncertainty caused by the senior leadership changes and accounting issues at Mercury Interactive brought its valuation down to earth, making it a relatively affordable acquisition for HP.
This is one of those deals where both sides win. The takeout valuation of Mercury is actually quite good at 4.8x revenues, particularly when one considers that revenue growth was expected to be only on the order of 12.3% from calendar 2006 to 2007 based on Wall Street analyst consensus. Assuming solid execution, not a given, we believe the business will thrive under the HP umbrella making the relatively hefty purchase price quite reasonable.
Recently we commented on a post by Tom Evslin regarding how underwriters profit from an IPO. We felt that Tom's post was an unfair assessment of underwriter motivations and incentives. Let us try to explain simply how and where underwriters make money on an IPO.
Gross Spread -- The Easy Part
First the easy part, underwriters earn a commission (known as a gross spread) calculated as a percentage of the capital raised for the issuing company. As a rule this is 7%. When all is said and done, on average about 70% of the gross spread is actually kept by the underwriters and split amongst themselves in a very disproportionate manner. Where does the balance of roughly 30% go? To pay the salespersons' (employees of the underwriters) commissions who sold the shares and the underwriters' expenses of the deal (legal and travel mostly). These fees are quite lucrative, for example a $75mm IPO will net roughly $3.7mm in fees to the underwriters as a group. If your a lead, book running underwriter (managing the deal) you get a big chunk of these fees. If your a co-manager, not quite so interesting, but crumbs are better than no crumbs. If the deal is large enough, those crumbs tend to be large also.
Aftermarket Trading -- A Bit More Tricky
Okay, now lets get to the part that is a bit more complex, the aftermarket. This is the area there there seems to be some misconception that underwriters stand to profit handsomely. Let's look at exactly where and how underwriters make money in the aftermarket. There are two ways that underwriters can profit in aftermarket trading of an IPO, (1) trading and (2) inventory profits.
Trading: First underwriters act as a market maker and essentially match buyers to sellers. In doing so, the underwriter is buying shares from willing sellers at the "bid" price and reselling them to willing buyers at the "ask" price. There is a small difference between these prices and the underwriter pockets that "spread" for every share which is purchased then resold. So, how much do these profits represent in a typical IPO? Well in the first 10 days following an IPO (a rough approximation of the stabilization period following an IPO) these profits average only about 9% of the gross spread that we described in the paragraph above. This equates to about $473,000, again assuming a $75mm IPO. This statistic is according to the research paper, When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket published in June 1999 which studies 306 IPO's completed between September 1996 to July 1997.
So trading can be a decent business but is hardly a gold mine. This business has actually become far less attractive with the advent of decimalization in 2001 as spreads used to be at minimum increments of 1/16 ($.625/share) because that was the smallest fraction available. Now average spreads are more on the order of $.01-$.02/share as decimal-based quotation has enabled competition to drive spreads down.
Inventory Profits: The second way for underwriters to profit in aftermarket trading is to actually make a bet on the direction of the stock by either owning the stock (holding inventory and being long) and speculating that the stock goes up or being short the stock (naked short) and speculating that the stock price will decline. In my direct experience, holding material inventory positions, either long or naked short, in an IPO during its stabilization period (again lets assume the first 10 days) is NOT a position underwriters intend to be in. Any inventory held is usually the result of the underwriters' attempt to stabilize the issue following pricing, not an attempt to make a bet on direction. In fact, the same research paper as referred to above, also evaluated profits generated from inventory positions following the IPO. Their findings were that on average underwriters generated NO net profits from inventory positions during this stabilization period.
So, IPO underwriting is a lucrative business but the vast majority of profits are generated via the gross spread that is paid by the issuer to the underwriters. The aftermarket activities of the underwriters are certainly generally additive to profits but do not represent a mother lode.
Another security deal was announced with Secure Computing announcing an agreement to acquire private software vendor, CipherTrust. This represents another in a long line of promising software IPO candidates who have elected to take the M&A exit prior to public debut. What is most striking about this transaction however are two other elements (1) a significant portion of the purchase consideration is expected to be financed with a syndicated bank facility and (2) Secure Computing announced concurrently a huge Q2 miss vis-a-vis expected financial performance.
The Future is Debt my Son
While that is certainly an overstatement, this transaction is another example of how debt has become an important component of software company capitalization. Why is this happening? A few factors:
1. Bank are aggressively looking to deploy their capital. Ironically, software vendors used to be radioactive to the credit folks in big banks because of the unpredictability of revenues and product obsolescence risk. No longer, software vendors are seen as reasonably good credit risks with high switching costs combined the support and maintenance revenue annuity.
2. The 2000-2004 technology capital spending drought proved that well managed software companies can manage to maintain significant positive cash flow from operations even through a down cycle.
3. Private equity firms have "socialized" the concept of debt as a prudent component of a software company's capital structure via how many buyouts are financed. In this case, Warburg Pincus is a large shareholder in Secure Computing.
4. Large software firms have also taken a leadership role in integrating debt as a permanent part of their capital structure. Firms like CA, Oracle and Symantec have relatively significant levels of debt on their balance sheet, a big change from as recently as 5 years ago.
5. Debt has a lower cost of capital thereby, at prudent levels, enhances returns on shareholder equity.
The other unusual feature to this transaction is that Secure Computing simultaneously announced a major miss on Q2 number. They are now expecting Q2 revenues of between $38.5mm - $39.0mm vs. previous guidance of $43.0 - $45.0mm. The excuse? Slipped deals. We've heard that one before. What this means is that at the 11th hour Secure Computing introduced this fact to the CipherTrust board and management team and still got the deal completed! Given that roughly 30% of the consideration is being paid in stock, I'm sure that made for some interesting conversations. Kudos's to someone for holding this deal together.
CipherTrust, backed by Battery Ventures (Thomas Crotty), Greylock (Asheem Chanda), USVP and Noro-Moseley, is an appliance based email (and instant messaging) security vendor. The consideration is $185mm cash ($115mm financed via a syndicated bank facility), 10mm shares of Secure Computing stock (worth $50mm after today's stock price drop of 38%) and a $10mm note which will be paid (or not) upon achieving certain benchmarks. It looks like CipherTrust was on something like a $60mm revenue run rate off of Q2 2006 numbers. So $245mm in total consideration at today's Secure Computing stock value translates into a 4.1x revenue multiple. Frankly, we would have thought that CipherTrust could do better.
Here's Mike Rothman's (Security Insight) take. Maurene Caplin Grey also has some good perspective on the sector and recent competitive dynamics.
Scott Bolick, George Gilbert and Rahul Sood of Tech Strategy Partners have assessed the economic model of software as a service (SaaS) in their recent post on Sandhill.com. It is worth reading. Their conclusion is the the SaaS model is likely a superior economic model, particularly once scaled. They estimate that SaaS vendor operating margins will range between 34%-40% in its mature manifestation. These margins are superior to the traditional model as evidenced by SAP with a 27% operating margin and Oracle at a 34% operating margin.
Mercury Interactive has been one of the darlings of the software industry for the past five years. Their darling status collapsed last year when the Company announced the forced resignation of its founder and CEO, Amnon Landon, its CFO Douglas Smith and General Council Susan Skaer.
This week, Mercury Interactive filed its long delayed 2004 10K which describes what turned out to be 54 instances of stock option grant backdating. Mercury certainly isn't the only company who engaged in this ethically unacceptable and perhaps illegal activity, but they are certainly the software industry poster child.
We've personally worked with companies where, in retrospect, it was discovered that certain executives conducted themselves unethically and in some cases illegally. These have been disappointing and disheartening experiences as we were lied to and deceived directly. It's incredible discouraging to have the covenant of trust broken by someone whom you respect. The only consolidation we've found is to try to learn lessons from the experience.
Mercury Interactive has many lessons to teach on how greed and hubris can break people and even fundamentally change a companies course. Enron may be the most striking example but there are many other examples to learn from. Jack Ciesielsky posted an excellent analysis on Mercury Interactive today at SeekingAlpha. We encourage all to read carefully.
Tom Evslin reminded us of a potent theme today, disruptive pricing. Within the telecommunications industry it's a core strategy for many vendors. In our world, software, pricing certainly plays a strategic role but perhaps more is to come.
Disruptive pricing is certainly a theme that we've seen on the consumer side fairly consistently since Netscape used "free" as a weapon to proliferate its browser. In fact, "initially free" has seemed to have become the de riguer pricing strategy on the consumer side.
Within the enterprise software world, however, the aggressive use of pricing as a weapon has been somewhat muted. While there are certainly examples, including open source and hosted applications sold on a low monthly cost subscription basis (aka Salesforce.com), widespread disruptive pricing is not a big industry theme. We've often contemplated how pricing will begin to play a more prominent role within the enterprise software sector. We suspect that we will see a day, not too far in the future, where disruptive pricing will become a more prominent strategy.
Well it looks like the technology press is starting to let the old word "software" slip into their stories about Google. Here's c|net's recent review of the Top 10 Google Apps. Please see our last post on this subject, Google's a Software Company.
Google is the dominant hosted software vendor. What makes Google different is it's revolutionary revenue model driven by highly-targeted advertising.
EMC continues it acquisitive ways with the announcement of the intent to purchase RSA Security today.
Target: RSA Security
RSA, while reasonably modest in size at $322mm in revenues, has an outsized impact on the security industry. The RSA encryption standard, created by RSA, has become the de-facto standard for authentication to ensure secure access to corporate computers (SecureID Authentication) and is widely used to ensure secure on-line commerce. RSA also hosts the security industry at it's annual RSA Conference. RSA, while dominant in its niche, has not really been able to break out of a rather slow revenue growth mode. Revenues only grew by 1% from 2004 to 2005 although top-line is projected to grow by 20% from 2005 to 2006.
Total Consideration: $2.3 billion ($28.00/share)
Premium to market: 45% above pre-rumor price
Aggregate Value / 2006E Revenue 5.7x
Price/2006E Earnings Per Share 44x
EMC is wrapping it's "managing the lifecycle of information strategy" around the transaction. EMC's spin is that they already manage the information via their suite of storage products and Documentum, the document management application they purchased a couple of years ago. Now the are simply managing "secure access" to that information via the RSA Security product set.
Architect Partners Assessment
This was a very expensive deal for EMC for, at best, a moderately attractive asset. The other rumored bidders may have lost the battle but may be better off for it. EMC will will no doubt rationalize the purchase price by claiming that growth will accelerate substantially under the EMC umbrella but by all measures we believe RSA shareholders are the winners here. We've pondered EMC's rather unorthodox software strategy many times. While acquiring RSA, from a very big picture perspective, can be rationalized, we wonder how much real synergy exists with their existing businesses. We frankly felt the same way about the Documentum acquisition and EMC has apparently made it work, at least financially. We're still not convinced that was a great strategic fit either unless the strategy is really just a revenue growth strategy. While the strategy has been rather confusing to us, we do take our hats off to EMC for their excellent execution post-acquisition on their software acquisitions. BusinessWeek did a good article on EMC's acquisition success. Dave Dewalt also recently posted an interesting piece on this very subject. Here is a good summary of Wall Street's reaction by Steve Hamm at Business Week.
Novell. Not a name that elicits much excitement. For god sake, it bought, a technology consulting company, Cambridge Associates, in 2001 under the logic that "Cambridge accelerates Novell's adoption of a solutions-selling model that supports customers and partners transforming their businesses" In other words, they were saying loud and clear that their software requires lots of handholding to sell and implement. Tough model for a software company! This was when Eric Schmidt was running the company; boy did he get lucky to find the exit to Google.
But wait, in 2003, Novell made a bold and impactful move by purchasing SUSE Linux, the #2 provider of a "certified and supported" Linux operating systems, behind Red Hat. We believe the strategy was, and is, sound. That strategy being: the world needs an alternative provider to mitigate the threat of Red Hat becoming the new Microsoft. IBM jumped on board symbolically by investing $50mm in Novell to show their support.
Okay, good move strategically, but as we all know, strategy is nothing without execution. So, its been three years, what has execution looked like? Hmm, the promise hasn't really been realized. SUSE Linux market share (on the server) has probably stayed flat or declined slightly (from 15% market shore or so) under Novell's stewardship. With Red Hat at 60% market share, the strategy isn't working if Novell cannot nip away at that dominance.
So why even mention Novell? We are very interested in the Novell's (and the Borland's, see our previous post) of the world. The reason is to answer the question: can dinosaur's survive by adapting? We believe technology companies can make material transitions to their business, with the right leadership and commitment. Novell announced today a significant leadership transition, we hope this re-energizes Novell and puts them on track to thrive.
Michael Fields, CEO of Kana, highlights his real-life, in the trenches perspective on outsourcing software development work to India. Sometimes cheaper isn't cheaper at all. Worth reading. Thank you Sandhill.com
In our first post, we mentioned that Symantec entered into a form of derivative transaction, widely known as a call spread, which was structured to compensate for the dilution that would occur if convertible bonds holders exercise their right to convert into common stock.
So, what the heck is a call spread? In this case it was the the purchase of a call option at one exercise price and sale of another call option at a higher exercise price. Symantec did the following:
1. Purchased a Call: Symantec purchased a call option (from one or more of the underwriters) that gives Symantec the right to buy its own shares at a price 22.5% above the current stock price. That is $19.12, the same conversion price as the convertible notes. The number of shares underlying the call option was likely the same that would be issued if the convertible converts, 104,590,200 shares. This component is what Symantec refers to as "convertible note hedge transactions" in the press release.
2. Sold a Call: Symantec also sold a call option ( again, to one or more of the underwriters) that gives the purchasing underwriter(s) the right to purchase Symantec shares at a price 75% ($27.32) above the current stock price. Again the number of shares would have likely been something close to 104,590,200 shares. This component is what is referred to as "separate warrant transactions" in the press release.
Transaction Impact on Potential Equity Dilution
So what does all that accomplish? It allows Symantec to eliminate all equity dilution resulting from the conversion of the convertible up to a stock price 75% above the current price (again $27.32). Even if Symantec's stock price is above $27.32, it still protects against equity dilution somewhat as the proceeds paid to Symantec from the exercise of the sold call option (#2 above) could be used to repurchase common stock in the market.
Let's illustrate equity dilution with several scenarios:
Scenario One, Stock Price $18.00: Convertible bond holders elect to get repaid as bond value ($2 billion) in more valuable than value as converted into common stock ($18.00/share x 104,590,200 shares = $1.9 billion). Result: No equity dilution.
Scenario Two, Stock Price $25.00: Convertible bond holders are incented to convert to common stock ($25.00/share x 104,590,200 shares = $2.6 billion as converted value vs. $2 billion bond value) and receive 104,590,200 shares. Symantec exercises purchased call (#1 above), purchasing 104,590,200 shares. Result: Purchased call exercise offset convertible bond conversion 1:1.
Scenario Three, Stock Price $35.00: Convertible bond holders are incented to convert to common stock ($35.00/share x 104,590,200 shares = $3.7 billion as converted value vs. $2 billion bond value) and receive 104,590,200 shares. Symantec exercises purchased call (#1 above), purchasing 104,590,200 shares. As in Scenario #2 above, the purchased call exercise offsets the convertible bond conversion 1:1. But, in this case, the purchaser(s) of the sold call (#2 above) are now incented to exercise their right to purchase 104,590,200 new treasury shares at $27.32. Symantec receives $2.9 billion in cash from the sold call exercise which is then used to repurchase 81,640,122 ($2.9 billion sold call exercise proceeds / $35.00 stock price) shares in the open market. Result: Net 22,950,078 shares issued instead of 104,590,200 without the call spread in place.
So in conclusion, the call spread works to either eliminate or mitigate the equity dilution resulting from the conversion of the convertible notes.
Symantec had to pay $ for the "convertible note hedge transactions" and got paid $ for the "separate warrant transactions". So what are the numbers? According the the 8K, Symantec paid $592 million for the purchased call (#1 above) and received $326 million from the sale of the call (#2 above).
So, the net cost to Symantec was $266 million to create the call spread. $266 million amortized over the average life of the bonds (6 years) is $44 million per year. That equates to a 2.2% annual cost. Tack this imputed cost to the coupon on the convertible (.75% and 1.0% depending on the maturity) and you have an imputed annual cost of roughly 3%. So, simplisticly, Symantec is borrowing $2 billion and paying a 3% annual pre-tax cost. Not bad terms.
Andy Hayler, a software entrepreneur and generally thoughtful guy, reminds us of one of life's Ironic truisms, 20% means more than 80%.
Andy points out that Microsoft is methodically making inroad into the business intelligence application category. Andy's core thesis is as follows: Microsoft may never field a product offering that offers the depth of features and functionality as do Cognos and Business Objects, but it really doesn't matter as "most users only take advantage of a fraction of the features of a BI tool anyway."
This is the exact same dynamic that is occurring all over the software sector. Think Salesforce.com vs. Seibel (Oracle), Google spreadsheets vs. Excel, MySQL vs. Oracle, Linux vs. Unix, Writely vs. Word, ... The fact is that 20% of the functionality provides 80% of the value. Put another way, 80% of the market only needs/wants 20% of the functionality. The irony is that software vendors are notorious for adding features over time. As a rule, it's function that most users don't want, need or care about. Further, the additional features are not typically monetizable! If anything, its a strategy to keep pricing from eroding, not pull more $ from the client.
Perhaps all software entrepreneurs, VCs and big company corporate executives should consider their strategy within the 80/20 rule. Is the software industry product/business model all wrong?
Nobody gets it. Symantec issued $2 billion of convertible notes on Monday. That in itself is notable news but there are a couple much more interesting elements to this transaction.
This financing is really in essence a recapitalization of Symantec. $1.5 Billion of the proceeds are being used to finance the purchase of Symantec common stock. In other words, Symantec sold bonds to pay the cash to shareholders. Why are they doing this? Well, finance theory states that the cost of debt is less expensive than the cost of equity (up to a certain point). The direct manifestation of this is that following this deal, Symantec will have fewer shares of common stock outstanding, which will increase their EPS, even when factoring in the carrying cost (interest cost) of the debt. Higher EPS = higher stock price, excluding other factors that impact stock price. So simply put, this is Symantec management working to enhance shareholder returns by placing prudent amounts of debt on the balance sheet. This is the continuation of a fairly nascent trend toward optimizing capital structure within large software vendors (and frankly has implications across the entire technology sector). Computer Associates was a pioneer in the use of debt and Oracle, Veritas, RedHat, Mercury Interactive and Symantec among others have begun to rethink their historical aversion to debt. MANY more technology companies are considering this move now.
Why a Convertible Bond?
The second extremely interesting element of this transaction is that they issued a convertible bond instead of high-yield debt. In other words Symantec actually issued a security that gives a right to buy Symantec stock at a higher price in the future. Well, that certainly isn't consistent with the recapitalization argument stated above. But wait, Symantec also entered into a derivative transaction, know as a call spread, which was structured in a way to compensate for the dilution that would occur if holders of the convertible bonds wanted to exercise their right to buy the common stock. Its sort of a complicated way to get to the same place but what Symantec and their underwriters did was create synthetic high-yield debt. Why would they do that when the high-yield market would have voraciously snapped up Symantec high-yield bonds? Well, the convertible bond market, combined with a complicated derivatives trade were a better deal. Us outsiders will never know the real data, but I can assure you that Symantec was thrilled with the outcome.
Underwriters LOVE these deals because the fees are very high. Bankers and issuing company executives also feel good because effort put into structuring a rather complicated deal (satisfying in its own right) results in superior terms for their shareholders. Believe me, every technology company over $2 billion in market capitalization is getting bombarded by bankers selling this same technique. Investment bankers get giddy sometimes.
So lets get back to our opening statement, nobody gets it. The real story here is what I outlined above. In my check of press reporting and blogging, their is no mention of the real significance of the deal or the rationale which motivated it. Striking. Here is the take from Stock Market Beat. All the bonafide press just regurgitated the press release.
Jerry Weissman is a legend. During the 1990s he was a required stop for all aspiring technology IPO management teams. That is if they were smart (and could get a slot in his schedule). Jerry is a presentation coach. He's a bit formalistic, but when your formula works, it means its a good formula. His formula works. One great example of his technique that I remember well is he advised that when asked a question, rephrase it back to the questioner before answering. It's a wonderfully effective technique to show that you understand the question, get clarification if required and gives you time to formulate a crisp answer.
Well, yesterday Guy Kawasaki's blog brought Jerry back into our minds. It turns out that he is prolific blogger! That made me smile as apparently an old dog (take that as an respectful term in this case) can learn new tricks (technologies). His post on being a great panel moderator is terrific.
We believe venture capitalist Seth Levine of Mobius is right on in his post entitled "What DON'T You Do?" As he points out, most effort is made to define a company's focus, which is essential, but turning the question inside out helps to define the line between okay and not. Isn't this subject the essence of probably 70% of the conversations that go on within an organization, particularly a young organization which is still defining itself? Whether it's sales, product, marketing or management, the same question is always being considered; where do we spend our money and more importantly our time. Seth's approach is a good tool to keep in mind.
We realize this may not be the "politically correct" thing to say but let's not forget what Google really is, a software company. Search is software; period.
In fact, Google is the most software of all major "Internet" companies. Let's compare: (be nice, we are quite cognizant that we are being ridiculously simplistic with the following analysis)
Amazon sells stuff via its virtual store and manages the entire customer and supplier process with software. Makes money by buying stuff cheaper than it sells it.
EBay created a virtual flea market with software that allows buyers and sellers to communicate on all pertinent issues associated with a purchase/sale. Makes money by charging a fee for the right to use the marketplace.
Yahoo of course started with search (pure software) and has become one of the great aggregators of content on the Internet; a new media company. Makes money by selling advertising.
Microsoft's real business today is selling software that sits on PCs and servers. We all know that their feeling pretty vulnerable right now, rightly so, and are trying to become the next Google, Yahoo, Amazon, EBay. Oh yeah, let's not forget their burning desire to be the next Oracle, SAP, EA, Nintendo, Sony, Disney, ... (Is this a focus issue or is it okay not to have focus when your huge?)
Google is search, search and more search. Or in other words software, software and more software. Of course, their revenue model is strikingly different, they sell highly targeted advertising. It's the traditional media revenue model applied to the software business.
What's next for Google? Well, more software. We laughed out loud when we heard that Google announced its spreadsheet product today. We laughed even louder when we see some interpreting this as Excel light, implying its not a threat to Microsoft's core business. Wrong! Google's out to lay waste to Microsoft and while their at it, taking on the entire traditional software business model. They, not Software.com, are the masters of the software as a service (SAAS) model.
Sometimes something just strikes you with truth. I had that experience today.
Time Magazine recently published the Time 100: The People Who Shape our World. The profile of Steven Levitt, of Freakonomics fame was written by Malcolm Gladwell, author of The Tipping Point and Blink. I was struck by a simple but profound comment in this profile:
"This is not a great moment for listeners in American society. The public conversation is dominated by those whose minds are unalterably made up, and we have come to view the man or woman whose views remain steadfast, even in the face of overwhelmingly evidentiary assault, as a kind of moral hero."
If one is looking to pursuade, is it most effective to strongly present and defend a viewpoint or engage in an two-way, open minded conversation?
CEO’s make lousy fundraisers.
Okay, we acknowledge that’s meant to be a provocative statement. CEO’s are critical to successful fundraising but should they go it alone? Historically, the venture capital community has been highly reticent to engage an investment banker to assist with raising capital. The usual arguments come out something like this:
1. Don’t want to pay a fee
2. Part of the CEO’s duties
3. Why hire an advisor for a job we can do ourselves.
4. Existing investors are funding their pro-rata share, we certainly don’t want to be charged a fee for putting our own money to work.
5. Our LP’s are paying us implicitly to get our portfolio companies funded.
6. We have lots of VC relationships, our “club” will fund it.
7. Always done it ourselves, it works, why change.
8. Agented deals are tainted.
Value Creation Filter
Well, let’s look at this issue from a perspective that places value creation as the sole decision criteria. We believe that’s a fair filter as VC’s and entrepreneurs are fundamentally seeking to build value as job #1.
Understand. Question really is whether the investment bank adds more value than they take as a fee.
Successful CEO’s delegate aggressively. The fund raising process doesn’t create value, however building the business does. CEO’s should use their precious time for the latter. The CEO, and other senior executives, are critical to the fund raising process but what if 20 hours a week was freed up via an advisor?
So, fund it yourself. The reality is that external capital serves an important role. It bring external validation, mitigates financial risk, sets valuation and terms eliminating internal arm wrestling, allows a step up (hopefully) in book carrying value and can even reduce execution risk with the right investor. The new investor(s) are the catalyst of the funding. Creating and negotiating the catalyst is the value, not how the round is divvied up.
Perhaps on the extreme margin this is an accurate statement but lets get back to what LP’s really pay VC’s to do … make them money. This takes us right back to point #2 above. Is this the highest and best use of a VC’s time? We bet the answer is no.
Now be honest with yourself, how often did your buddies end up being the next round of funding? In your hot companies, perhaps more often than not but buddies generally do not represent an “efficient” market. What about the vast majority of your portfolio, promising but experiencing typical growing pains and executing a bit below expectations. Do you want to invite your closest friends to share the frustration?
We hope a VC never uttered this, it sounds awfully bureaucrat like. Yikes!
Given all the compelling reasons to hire an agent that are outlined above perhaps we should reject this groupthink.
We’ll speak more on this issue in the future.