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.