OwnYourVenture.com has put together a pretty cool simulator that lets you model basic VC investments over multiple rounds to determine the relative equity shares of founders, investors, and an option pool for executives and employees.  You simply enter in a few variables and it spits out pro forma ownership stakes for all parties.  The tool provides an excellent way to visualize how founders’ shares get diluted over multiple rounds of financing.

Venture capital math is not that hard – but the results always tend to be the same.  VCs tend to end up with 70%+ of the company’s equity while the founders and option holders split the rest.  When it comes to the pot of gold at the end of the rainbow, investors get their original investment back first and anything that is left after that gets split amongst all shareholders on a pro-rata basis – unless the VCs have negotiated even higher liquation preferences (i.e. until they get all the money up to 3x their initial investment before the proceeds are split with all shareholders on a pro rata basis.)

It is important to note that Venture Capital is a high risk business – most investments never payoff and for those that do, they need a very high rate of return.  Conversely most entrepreneurs cannot fund the development of their startup on their own – they lack the personal wealth or bank credit.  It is certainly better to own a very small piece of a valuable company than to own 100% of something that has no value.  One fact of Venture Capital investment you cannot escape is that for a very successful company, the VCs will make 3 to 5 times as much money as the founders in any successful liquidity event.  If your company has better than average success you might be lucky to return the investors’ original investment which means that as founders you end up with practically nothing.  If you are not comfortable with this reality then funding a startup with venture capital is not for you.

Let’s consider a hypothetical example, MyReallyCoolIdea.com.  This is a company that you have been dreaming about for years and you are finally ready to take the plunge.  In addition to yourself, you have two co-founders, Jim & Sue.  In the beginning, you spit the equity up three ways – you get 40% and Jim & Sue each get 30%.  Once you have built your proof of concept and gotten a few early adopter customers you are ready to go chase some venture capital.  For the sake of simplicity let’s assume that MyReallyCoolIdea.com is an absolute killer in the marketplace and that you are able to raise $1 million in a seed round, $5 million in a Series B round the following year, and finally $20 million in another two years to blow the doors off of sales and marketing on a global basis.  The following table summarizes what this fundraising cycle could look like:

There are lot variables in these types of calculations – pre-money valuations, whether the option pool comes out of the pre or post-money valuation, liquidation preferences, etc.  The basic math, however, tends to be the same.  The following chart puts the founders’ dilution into a bit more perspective:

While this math might be a little grim for the aspiring entrepreneur, it is important to look at how valuable a successful exit could be.  Taking this example a bit further, we can see how a founding team could achieve the dream of ‘walk-away money’.  The following table illustrates the hypothetical growth of MyReallyCoolIdea.com and some exit valuation and payoff assumptions.  The funding assumptions are the same as in the prior example, except that the VCs have a 2x liquidation preference.  Valuation assumptions are based on the typical valuations for public SaaS companies as of early 2010.  There is a big difference between VC funding valuations and actual market valuations.  Technology companies are typically valued based on multiples of their revenue or profitability.  In the case of SaaS companies, average valuations for slightly profitable SaaS companies generating >$40 million in annual revenues is between 2.3x to 3.7x trailing twelve months revenues.

As you can see, in Year 5 the founders’ payoff finally exceeds the magic $5 million ‘walk-away money’ number.

A more humbling approach is to consider that MyReallyCoolIdea.com stalls out in the fifth year and drops to flat or no revenue growth.  Relative valuations can drop and in that case the payoff to the founders is practically nothing:

The moral of this story is that budding entrepreneurs need to spend some time understanding the true dynamics of Venture Capital financing before they plunge deeply into its waters.  While you can argue with the assumptions used in these models, at the end of the day, the results tend to be about the same.

Some interesting takeaways from the data:

• Out of 24 software categories, pure play SaaS companies are the third most valuable from an Enterprise Value/Revenue multiple, second most valuable from an EV/EBITDA multiple perspective.
• The pure play SaaS category had the strongest year over year revenue growth of any software category
• SaaS companies have posted a median 73% year over year stock market return.  Almost half of the companies have posted >100% return and three firms have posted >20% return
• There is significant variation in valuation metrics amongst the pure play SaaS companies – ranging from a high a 7.2X EV/TTM Revenue multiple to a low of 0.2x EV/Revenue
• SaaS firms are generally EBITDA profitable, with an average EBITDA % of 8.2%.  About a quarter of the companies have negative EBITDA margins. 
• Gross profit margins are lower than traditional license software firms, with a median gross margin of 68%
• Surprisingly, high ttm revenue growth rates do not correlate to high valuations or high year over year stock market returns.

Click through the following presentation to get a detailed look at the data and trends.

CDC Software’s unsolicited offer represented a 21% premium to Chordiant’s stock price over the preceding 30 days – a premium that CDC cited as above the median 19% premium paid in the enterprise software space in the past few months.  CDC Software offered two options to Chordiant’s shareholders – 40% of the consideration in cash and 60% in CDCS stock, or 50% cash and 50% CDCS stock.  On the surface, it looks like a low-ball bid – with Chordiant having $49 million+ in cashon their balance sheet, CDCS is basically offering to buy CHRD with their own cash and some CDC stock, as shown in the following table:

This is not the first unsolicited offer CDC Software has made.  You might remember CDC’s attempt to acquire CRM provider Onyx Software in 2006.  In the end, Onyx went with a deal from Made2Manage Systems, a portfolio company of Battery Ventures and Thoma Cressey Equity Partners.  The deal chronology is pretty interesting and you can read the whole chapter and verse here in an abstract from the proxy filed along with the deal.  Onyx ended up going with M2M primarily because of the all cash offer versus CDC’s cash and stock offer and a pattern of ‘inconsistent statements’ and behavior from CDC throughout the process.  While the shortcomings cited by Onyx in 2006 may have been true, since that time CDCS has established their credibility as an effective acquirer and they have grown the value of their equity consistently.  The CDCS’ deal for Chordiant has a few similar undertones, the fact that CDCS walked away from the deal less than a week after starting it shows that things have changed in the past four years.

When you peek behind the numbers a bit, you will see that the CDCS offer is pretty much in line with the overall market.  To begin with, let’s contrast the financial fundamentals of the two companies:

CDCS’s revenues have been basically flat until 2009 while Chordiant’s have been in decline for a number of years.  While CDCS profits have grown significantly over the past three years, Chordiant’s EBITDA continues to decline.  Chordiant is suffering the same fate as a lot of mid to late stage enterprise technology companies – their ability to materially grow revenues in their core market has evaporated and regardless of how much money they invest in execution, they still can’t stop declining revenues.  They are also sitting on a huge pile of cash that they have been unable to deploy to drive organic or inorganic growth.  Chordiant took a stab at acquiring their smaller competitor Kana Software in December by trying to interrupt their deal with Accel-KKR, but failed to get the Kana board to take them seriously. 

As the following table indicates, the Street considers CDCS to be more valuable than Chordiant:

What is more interesting is that CDCS’ offer is very much in line with how the market values CRM, marketing, and sales companies in January 2010.  The Software Equity Group publishes monthly, quarterly, and annual analyses of enterprise software M&A and valuation trends.  In their January Flash report, they reported the following metrics for their CRM, sales, and marketing category:

While the Chordiant Board may not like it, the market considers unprofitable late stage CRM companies with a history of declining revenues and an inability to deploy large piles of cash to drive growth not to be that valuable.  Most strategists and bankers would agree that Chordiant needs to combine with a larger company that can leverage economies of scale to lower costs and a large, pre-conditioned customer base to cross-sell their offerings to, which is pretty much what CDCS is proposing to do.

It is hard for a management team and a board to decide to sell, and to sell at what might be considered to be a discount.  In the case of CDCS and Chordiant, the initial offer was just enough of a premium to get over the typical Revlon Rule-like fiduciary responsibility requirements.  Just this week alone, three other enterprise software companies agreed to acquisitions where VC and private equity investors barely broke even, much less made significant money on the transactions.  These deals included Progress’s acquisition of Savvion ($49 million in consideration versus $52 million in VC funding), CA’s acquisition of Oblicore (estimated $25 million consideration against $20 million in invested capital), and Lawson’s acquisition of HealthVision ($160 million in consideration versus $136.7 million in invested capital.  The investors did get a 3.5x return on their investment due to their creative use of leverage — check out this WSJ piece on the transaction).  Tech companies go through a predictable lifecycle – they are born, go through adolescence, become mature, and then eventually reach retirement age.  While I am not advocating ‘death panels’ for technology companies, I wish they were clearer standards that boards and management teams could use to honestly assess their options when revenue growth is no longer a viable option for the business.

A challenge investors in companies like Chordiant face is determining how to effectively value the upside potential offered by a cash and stock deal, like the one offered by CDCS.  At the end of a conference call conducted by CDCS on Friday January 8^th there was an interesting Q&A exchange between CDCS’ CEO Peter Yip and a Chordiant investor.  At one point in the discussion, the Chordiant investor remarked:

“You’re trying to get me – convince me to sell to you. So I’m saying to you, great. I agree with you. You can run it better than them because you have run your company better.  But if you’re going to pay me, you need to pay me what the company’s worth because you and I both know that it’s very, very cheap here and that we are at an historical bottom in a cycle.”

The investor felt that the price should reflect the value CDC Software would create in the combined company after the restructuring and integration.  He wanted to be paid now for the value CDC Software would create in the future – value that Chordiant has not been able to generate on their own account.  Perhaps investors will come to realize that taking a bet on an acquirer’s stock will yield a significantly better return than letting a management team that has not produced continue to struggle on until their asset becomes worthless.

“Fund managers aren’t likely to get any help from the White House. President Obama has expressed support for raising the carried interest tax, and his budget would start taxing carried interest as ordinary income in 2011.

“Private equity will endure, but the draconian tax hike, if enacted, will unquestionably slow the flow of capital to companies struggling to get back on their feet during this very fragile economic recovery,” said Doug Lowenstein, president of the Private Equity Council, a trade group.

University of Colorado tax law professor Victor Fleischer, whose views caught the attention of Congress two years ago, agrees with this approach. He notes that profits earned by managers from their own money invested in their funds—typically a small percentage of the total fund size—are appropriately taxed at capital-gains rates. But he said the portion of pay managers get for investing other people’s money should be taxed at ordinary income rates, just like other forms of salary.

“It’s amazing to me that at the same time the U.K. is imposing a 50% excise tax on bankers’ bonuses, the private-equity guys aren’t even willing to pay the usual ordinary income rate,” Mr. Fleischer said. “You would think they would recognize a fair deal when it’s offered.”

Private equity firms generally earn money two ways:  management fees and carried interest.  PE firms typically charge their investors a 2% annual fee for funds under management, and then claim 20% of the profits (aka carried interest) when the investment is sold (the infamous 2 and 20 rule).  Historically, carried interest has been taxed as a capital gain in the United States since the profits are only realized upon the successful sale of an investment, not unlike what happens when you sell shares of stock you have held for more than a year.  The legislation bouncing around Congress now would change this historical approach and raise taxes on carried interest from 15% to 35%, the rate for ordinary income.  It is important to note that this change typically will not impact the returns received by operating executives of the PE firm’s portfolio companies.  Most executives are incented through stock options that vest on an exit event.  The proceeds from stock options are taxed as either short or long term capital gains – not ordinary income as in the case of PE firm carried interest.

Basically, this change will reduce the returns earned by a private equity firm by about 24%, as shown in the following spreadsheet.  If a private equity firm invested $100 million in your company 4 years ago, and sells your firm to a strategic buyer in 2011 for $600 million, the proposed change in the tax laws will reduce their return by $100 million or about 24% in comparison to what they could if they sold your firm before the tax change goes into effect.

So what does this mean for executives of PE firm portfolio companies?  Quite a few things.  If the tax hike goes through as planned, starting in 2011 a private equity form will need accept either a materially lower return for their investment, or seek higher sales prices to generate the same amount of returns they would have had under the old tax regime.  Seeking higher sales prices could result in much longer exit horizons.  Alternatively, PE sponsors may seek an interim return on their investment via dividends.  At the height of the recent private equity bubble the leveraged recap and dividend.  Under this approach, a portfolio company would take on new debt and pay a significant portion of the raised money to their private equity sponsors as a special dividend.  With the collapse of the credit markets in 2008 leveraged recaps have temporarily gone the way of the Dodo.  Sponsors could still fund dividends by having the portfolio company significantly ratchet up their profitability and then distributing the newly generated cash as a dividend on a quarterly or annual basis.  Using cash to fund dividends versus investing in growing the business is a hard trade off that boards of directors and management teams will need to make.

Perhaps the greatest issue for portfolio company executive teams is that in 2011 there will be a significant mismatch between financial incentives for private equity firms and their management teams.  If the plan is for your company to achieve some type of exit in the next two years, private equity owners are highly incented to achieve such an exit in 2010 versus 2011.  As shown in the following spreadsheet, owners can yield the same return in 2010 at significantly lower sales prices than they could in 2011. 

That means that PE firms could accept up to 25% less for their properties in 2010.  While the PE firms returns are not impacted, portfolio company executives and other option holders would see a 25% reduction in their payoff for a successful exit.  The pressure to exit will certainly rise in the second half of 2010 as the inevitability of the pending tax law change becomes reality.

My first exposure to private equity was in 2003 when I became an operating executive for a portfolio company of Golden Gate Capital and Cerberus Capital Management.  This was at the beginning of the private equity boom that lasted through 2008.  At that point in time it was inconceivable that a serious private equity backed firm would ever go bust.  It was also inconceivable that a portfolio company’s debt would ever trade at a discount.  Such events would be considered professional suicide – a bankruptcy or downgrade would seriously impinge a firm’s ability to raise debt or equity in the future.  In 2010 the world has changed and the stigma of bankruptcy simply is not what it once was.

As shown in the following table the pace of PE backed bankruptcies in 2009 significantly accelerated in the first half of 2009 and then tailed off dramatically:

The types of firms filing for Chapter 11 protection should be no surprise:

Was there some economic miracle that started in May to slow down the pace of filings?  The answer is no.  As noted in the peHUB.com article:

“We can attribute the slowdown to a little thing called Amend & Extend (or, as Mark Patterson of MatlinPatterson called it, “Amend, Extend and Pretend”). Midway through the year, lenders realized they couldn’t be complete jerks about their loans if they didn’t want a tsunami of bankruptcy cases on their hands, so they relented, allowing sponsors and their companies to “kick the can down the road” (another buzzy phrase of the year) and extend debt maturities.”

I have some anecdotal evidence to confirm this trend as well.  In December I visited with a number of New York City based hedge funds doing some consulting on market trends in the supply chain management space.  During more than half of the discussions I had we were interrupted with news of a critical meeting to do another ‘amend and extend’ deal. 

You can download peHUB.com’s complete list of PE-backed bankruptcies here.

While most people consider supply chain management to be a mature and somewhat boring marketplace, the diversity of the types of exits that have occurred recently show how investors can obtain significant returns even in these tough times.  Generally, supply chain management companies are not considered to be too valuable in comparison to other software markets.  Take a look at the following table from the Software Equity Group’s 3Q 2009 Software Industry Equity Report.  Out of the 24 markets that SEG tracks, supply chain management is the 19^th most valuable market in terms of Enterprise Value/Revenue and EV/EBITDA multiples:

Advant-e $2 Million Dividend

Advant-e (Nasdaq:ADVC) is a $9 million revenue provider of internet-based hosted Electronic Data Interchange (EDI) and electronic document management software and services. The Company helps businesses automate manual, paper-intensive processes via expanded use of EDI or by integrating directly with ERP/MRP systems.  This profitable business has had steady growth in revenues and earnings over the past five years.  Recently, Advant-e announced a $2 million dividend to its shareholders.  Advant-e has been steadily building their cash balances.  A $2 million dividend for a $9 million revenue company is a pretty significant and positive event.

GXS / Inovis Merger

On December 8^th, B2B integration heavy weights GXS and Inovis announced their plans to merge.  GXS is owned by Francisco Partners and Inovis by Golden Gate Capital & Cerberus Capital Management.  (Disclosure: I am a former senior executive of Inovis)  While details about the transaction have not been released one can reasonably infer a few things.  First, this is a stock deal.  The companies will be combined and the current owners will continue to own the equity.  It also appears that the owners will get a dividend out of the planned refinancing of Inovis & GXS’s debt but it is nowhere near walk away money.  This deal is significant because the investors realized that neither company had excellent prospects for a near term high value exits on a standalone basis.  On a combined basis, however, the new company will dominate their industry and be much better positioned for either an IPO or strategic exit down the road. 

The new company will be the undisputed #1 player in the EDI Value Added Network market place.  Their EDI VAN business will be almost three times the size of the nearest competitor and ten to twenty times the size of the remaining players in the marketplace.  They will be the undisputed leader in EDI Managed Services – basically the outsourcing of EDI activities which happens to be the fastest growing part of the market right now.  Additionally each company will contribute something to the NewCo that offsets one of the other side’s weaknesses.  For example, Inovis will be contributing a significant licensed software business that GXS currently does not have any presence in as well as significantly expanding the hosted master data management business.  GXS, with their significant global presence, will offset Inovis’ relative historic weakness in Asia, Central & Eastern Europe.  The combined companies will be able to significantly increase profitability through the consolidation of operations, facilities, G&A, and the elimination of redundant management and headcount.  These new found profits in turn can be reinvested into the growth of each company’s existing as well as emerging growth opportunities.

JDA & i2 Debt Financing

On December 7^th, JDA announced that they had successfully priced $275 million in senior secured notes to finance their acquisition of i2, which closed on December 10^th.  As you may recall, this is the second time JDA has attempted to acquire i2.  The first attempt at the end of 2008 blew up when JDA was unable to close on the financing for the deal due to the meltdown of the credit markets.  This time around JDA structured the deal as a combination of cash, stock, and limited new debt.  The deal value is in line with the current general supply chain management valuation metrics – 1.7x ttm EV/Revenue and 6.3x ttm EV/EBITDA.  As in the case of GXS/Inovis the combination of JDA & i2 will create a significant powerhouse in the supply chain management licensed software marketplace.  It was also interesting to note that JDA’s debt sale was extremely successful.  According to a few hedge funds I spoke to last week there was significant interest in the debt and many funds could only get a portion of what they wanted to buy.  Most of this was due to the excellent leverage metrics and the very high confidence the funds had in JDA’s ability to execute.

Descartes Raises $38 Million via Secondary Offer

Descartes Systems Group (DSGX) launched and closed a successful secondary stock offering that grossed about $38 Million in late October.  Descartes is a $ 65 million/year provider of SaaS-based logistics and global trade management solutions.  While this is not an exit per se, being able to raise a substantial amount of cash in today’s market is quite a feat.  In the past three years Descartes has done a number of small, highly accretive acquisitions to help expand their customer base and logistics/global trade management services.  They put some of that newly raised cash to work right away with their announced acquisition of Belgian-based Porthus on December 14^th.

SPS Commerce IPO

Also on December 7^th, SPS Commerce, a $40 million provider of EDI-centric SaaS services, filed an S-1 to sell $46 million in shares.  SPS is a specialist that serves mid-market and small to medium enterprises that need to use Electronic Data Interchange (EDI) to do business with their customers and suppliers.  They have consistently grown revenues in the past few years and are track to hit $40 million this year and make money at the same time.  While GXS/Inovis may be the king of large scale EDI, SPS is undoubtedly recognized as the leader in the small to medium enterprise EDI space.  SPS has raised more than $50 million in venture capital and the IPO will provide a decent, but not oversized exit for the investors.  This deal represents the first EDI company of any size to go public in the past five years. 

RedPrairie IPO

RedPrairie, the Wisconsin-based provider of licensed software and SaaS solutions to enable manufacturers, distributors and retailers to synchronize and optimize the management of workforce, inventory and transportation, filed for a $172 million IPO in late November.  Red Prairie is a portfolio company of Francisco Partners, who acquired the firm in May 2005 for $236 million, $120 million of which was financed by new debt.  Since the Francisco investment the company has grown revenues from $125 million to almost $260 million this year and they have closed two small and one large acquisition as well.  This IPO will represent the second supply chain management investment that Francisco has been able to monetize recently, with the other being the GXS/Inovis merger described earlier.

The details and an assessment of the initial lawsuit were covered in an earlier post entitled “Suing Gartner Won’t Solve Your Magic Quadrant Problems.”  Basically, ZL Technologies got fed up of being binned in the ‘Niche’ quadrant year after year.  ZL Technologies has been in business for 10 years and included in the MQ since 2005.  After being pigeon-holed in the ‘Niche’ quadrant for the fifth year in a row, ZL Technologies decided that Gartner and their analyst Carolyn DiCenzo were so biased against them that their only recourse was to sue Gartner.  ZL made seven claims against Gartner in their original lawsuit.  These included defamation of character, false statements about Gartner’s products/services, and false statements about Symantec under the Lanham Act, as well as false advertising, unfair competition, and negligent interference with prospective economic advantage under the California Business and Professions Code.  After the initial lawsuit was filed, Gartner filed a motion to dismiss.  A hearing was held on October 23^rd and on November 4^th the Court ruled in Gartner’s favor on all claims.  As noted in the order:

“This Court declines ZL’s invitation to expand the principles of Lanham Act standing beyond those recognized by the Ninth Circuit.  Finally, even if the Court were to apply the prudential standing approach, ZL fails to explain in its opposition how its allegations of fact support the first statutory factor – that the alleged injury “is the injury of a type that Congress sought to redress in providing a private remedy for violations of the Lanham Act.” Phoenix of Broward, 489 F.3d at 1163-64, citing Conte Bros. Automotive, Inc., 165 F.3d at 233.2. . . . ZL asserts six additional claims under California law. Each claim is dependent upon a conclusion that the Alleged Defamatory Statements are false or misleading statements of fact.  Because it concludes that all of the statements are non-actionable opinions, the Court will grant the motion to dismiss as to each of the claims.”

The Court also noted:

“As discussed at length above, the Court concludes that the Alleged Defamatory Statements as such are non-actionable statements of opinion, and obviously no amendment can change the statements themselves. Other courts have denied leave to amend under similar circumstances, concluding that amendment would be futile. Partington, 56 F.3d at 1162 (affirming the district court’s dismissal without leave to amend of defamation and false light claims when the alleged defamatory statements were held to be nonactionable opinions protected by the First Amendment); Browne, 525 F.Supp.2d at 1255 (dismissing plaintiff’s claims of defamation and libel without leave to amend after concluding that defendant’s evaluative rankings were non-actionable opinions protected by the First Amendment). Because the statements are at the core of all of ZL’s claims, it appears very unlikely that even additional allegations of bias will enable ZL to state a viable claim, particularly given the fact that even under the liberal pleading standard of Fed. R. Civ. P. 8(a) a claim must be “plausible on its face,” Twombly, 550 U.S. at 570 (2007), see also Iqbal v. Aschroft, __ U.S. __, 129 S.Ct. 1937, 1950-53 (2009), and in light of the constraints imposed by33 Fed. R. Civ. P. 11. However, in keeping with the strong policy in the Ninth Circuit favoring amendment, leave to amend in part will be granted here.” (emphasis added)

The Court did throw ZL a bone, however.  In Gartner’s motion to dismiss, they asked the court to dismiss the claims with prejudice and to not allow ZL to amend their original complaint so they could get a second bite at the litigation apple.  During oral arguments at the October 23^rd hearing, ZL’s attorney raised some new points that the Court considered:

“ZL contends that through its “continuing investigation” it has discovered facts that lend further support to the allegations in the complaint. Opp. MTD at 25, n. 7. In particular, ZL claims that “a former board member of Gartner was also, until very recently, a board member of Symantec, and also…a co-founder of a significant Gartner shareholder” that according to a recent SEC filing by Gartner “‘may be able to exercise significant influence over matters’ of significant importance at Gartner.” Id. ZL also purports to have discovered that Gartner maintains business relationships with at least some of the IT companies that it rates in its MQ Report, “some of whom pay Gartner hundreds of thousands of dollars per year for Gartner services, promotion, and participation in Gartner trade shows.”

The Court allowed ZL to amend their complaint, but noted an important caveat:

“Because the Court can discern no way in which additional factual allegations could cure the deficiencies in ZL’s claims under the UCL or FAL or for negligent interference with prospective business advantage, leave to amend will be denied as to these claims.”

In summary, the Court ruled that the ZL suit was without merit and had no chance of succeeding.  They left open the door that if ZL could prove some crazy conspiracy theory about how Gartner was really out to get them they might be able to amend their initial lawsuit and actually make it into court.

It will be interesting to see if ZL tries to take this lawsuit any further than they already have.  As the Court noted several times there is practically no chance that ZL could prevail on any of the claims they have made.  It was good to see how Gartner backed their analyst, Carolyn DiCenzo.  It is never a positive thing to be sued individually as a result of your work but it was gratifying to see Gartner mount a robust and successful defense on her behalf. 

At the end of the day I am pretty sure ZL Technologies is no better off than where they were before they decided to sue Gartner.  Certainly they have had a chance to air their grievances in a public forum and they have generated some sympathy from other vendors and pundits who share their views about the evil Gartner.  The facts behind Gartner’s fundamental assertion in the MQ that ““ZL is primarily a product and engineering-focused company. To remain viable vendor in the market, the company must gain greater visibility and more aggressively expand its sales channels” have not changed.  Technical prowess only carries an enterprise software vendor so far.  Marketing and sales execution are the key drivers to revenue growth.  As I noted in my prior post on this topic, ZL would have been better served to invest the $300,000 to $500,000 they probably spent on this lawsuit hiring away one of Symantec’s top sales people.  Alternatively they could consider the advice from Jon Gatrell, a veteran product management executive who has a tremendous track record of moving from being a Niche to a Leader in Gartner’s Magic Quadrant.  Here are a few suggestions from Jon:

• IBM total Q3 revenues declined 6.9%
• SAP’s new license revenue declined 31% and total Q3 revenues declined 9%
• Oracle’s new license revenue was down 17%, and total revenues were down 5%
• Microsoft’s revenues declined 14%

If these tech heavy weights are having a hard time growing revenues it would not be too surprising if your company was struggling as well.  One of the most common complaints cited by sales teams and sales management is that prospects simply cannot appreciate the value a company’s offerings bring to the table and the significant economic benefits they could achieve if they simply implemented your solutions.  Often, the root cause of these problems is that product managers and product marketeers lack the financial literacy skills needed to express compelling value equations for their products and services.

Being able to express the value of a product or service using financial and operational metrics that make sense to prospects is tough.  Most product managers have some academic training in basic financial and operational analysis techniques.  As a result, they tend to rely more upon technology feature/function benefits to communicate value equations versus well thought out business cases.  To gauge the relative financial literacy of your product management team, have them complete the following exercise in less than 60 minute:

1. Pick 3 of Your Customers/Prospects That are Public Companies. We want to make this easy for your test subjects.
2. Give Them 30 Minutes to Answer the Following Five Questions:
   1. For the last 3 fiscal years what have been the trends in Company A, B, & C’s total revenues?
   2. What was Company A’s Gross Margin for the past three quarters?
   3. How much Operating Profit has Company B generated so far this year?
   4. How much did Company C’s cash change so far this year? Are they building or burning cash?
   5. What are Company A, B, and C’s enterprise value?
   6. Give Them 30 Minutes to Answer the Following Five Questions:
      1. Which group of customers is the most profitable for your company and which are the least profitable?
      2. For the three largest deals that have closed this year what was the return on investment each customer should have expected to receive from the purchase of your products and services?
      3. For companies with SaaS offerings, what was the number and dollar value of customers who attritted in the most recent quarter, and the number and dollar value of new customers in the same period?
      4. For companies with maintenance revenues, what is the year to date attrition rate and dollar impact?  How much maintenance was generated from new customer licenses?
      5. What were the top three types of sales transactions that generated more than 50% of sales to new customers on a year to date basis?

I have conducted these types of assessments on over 50 product management organizations that I either managed directly or assessed as part of various M&A projects in the past 10 years.  Generally, the results are poor – most product managers simply do not have the skills or experiences to answer these types of questions and frequently they do not have access to the internal data needed to complete these types of analyses.

Here’s a simple case in point.  A service provider had a long standing relationship with a company where they provided a value added outsourced solution that cost over $1.5 million a year.  After a change in management, the customer decided to re-examine their investment in the outsourced solution.  A new executive wanted to bring the solution in house.  To do so, this company would need to invest over $750,000 in equipment and software, plus set up a group of employees to do the processing/value added services the service provider had been doing.  If they brought the business in house they believed they could save $500K a year.  The sales person on this deal was petrified that the customer was going to take the solution in house.  As a result he thought of offering to cut the monthly fees by 50% so that the customer would not even consider taking the solution in house.  Fortunately one of his team members did a little research on the customer.  Even though it was a large company with greater than $200 million in revenues, it had some serious financial challenges.  At the time they were ‘considering’ insourcing the solution the company only had $5 million in cash on their balance sheet and a limited revolving credit facility.  Once the sales team realized that the company would have to invest about 20% of their existing cash balance to make the project work, they came to the conclusion that they were not serious about insourcing.  Instead they were really looking to get a massive price reduction.  Armed with this knowledge they were able to structure a win-win deal for all parties that did not result in a 50% revenue reduction.  This is a classic example of how financial illiteracy can directly impact your top and bottom lines.

Here are a few posts that can help your product management team close their financial literacy gap:

• Cost of Financial Illiteracy: How to Calculate Enterprise Value
• How to Calculate the Enterprise Value of Your Private Company
• Financial Literacy: Money Wheel Analysis
• SaaS Revenue Primer: Tiering Analysis
• SaaS Revenue Primer: Flux Analysis
• How to Build an M&A Strategy
• How to Build an Exit Strategy

If you are looking for some help in developing your team’s financial literacy, check out this structured consulting offering, Product Management Financial Literacy.

Before we get too far into this analysis I’d like to plug the team at Software Equity Group and their monthly, quarterly, and annual Software Industry Equity Reports.  SEG is an investment bank and M&A advisory serving the software and technology sectors.  They publish the some of the industry’s most comprehensive analyses of software technology company valuations and M&A transaction forensics.  I’ve liberally used information from their latest 3Q09 Software Equity Industry Report which you can access here.

Before jumping into the details of SaaS company valuations, it is important to set some overall context.  The following table describes the relative valuation performance of 24 different software categories.  The categories are sorted based upon Q3 2009 Enterprise Value/Revenue multiples which appears to be the best metric these days for assessing the value of software companies.  If you need to brush up on your understanding of Enterprise Value and EV/Revenue multiples check out this quick post.

This table shows the changes in EV/Revenue and EV/EBITDA multiples for each of the 24 categories between Q3 2008 and Q3 2009.  As the data indicates, Security and eCommerce, Software have the highest EV/Revenue multiples.  The next tier are companies that have >2.0x EV/Revenue multiples – Healthcare, Financial Services, HR & Workforce Management, Enterprise Application Integration, Storage & Storage Systems Management, etc.  On an overall basis the enterprise value of software companies has declined about 12% on a year over year basis.  Surprisingly, 8 categories have shown valuation growth – those are the ones highlighted in italics.  One of the more surprising pieces of information is that some categories have seen significant declines in EV/EBITDA multiples, but not much decline in the EV/Revenue multiple or valuation.  In other words, even though profits were down, valuations did not decline in lockstep.  This leads one to believe, for now, that revenue multiples are a better way of valuing these categories than EBITDA multiples.  Another potential takeaway is that increasing profits during recessions does not necessarily lead to improvements in valuations.  It is almost a Biblical fact that tech companies will cut costs and increase profits during recessions to build shareholder value.  These numbers potentially indicate that profit growth at the expense of revenue growth may not be a solid strategy in today’s market.  I’m sure we’ll explore this concept in another post some time.

Now we’ve set an overall context on software company valuations, let’s take a look at SaaS valuations.  The Software Equity Group maintains a SaaS Index that is composed of 15 companies.  The following table shows the relative valuation trends for these companies.  The companies are sorted from the highest to lowest Enterprise Value.

As this table shows, the median 3Q09 EV/Revenue Multiple for these SaaS companies is 2.6x, which in comparison to all other software categories would be #3 behind Security and eCommerce.  Median EV/Revenue for SaaS companies declined 14% YoY, slightly more than the median software category.  SaaS companies that have achieved revenue scale (>$100 million) enjoy a significant valuation advantage over other software categories averaging a 3.6x vs 1.7x EV/Revenue multiple.

When it comes to exit valuations, SaaS companies are performing significantly better than their software peers.  As this chart indicates, software company EV/Revenue exit multiples have been slowly increasing over the past 4 quarters for traditional software companies:

SaaS companies are performing at almost twice the level of their software peers:

While these numbers are definitely trending down, they help to demonstrate the ongoing maturity of the SaaS space.  Of the 15 companies in the SEG SaaS Index, 10 have more than $100 million in revenue.  It is inevitable that as software companies grow past $100 million, their revenue growth rates will decline.  Valuation metrics will eventually revert to the mean of other software companies.

Another sign that SaaS companies may have hit a bump along the road to continuous growth is the apparent significant decline in a key metric:.  Max Bleyleben, a VC with London-based Kennet Partners recently did entitled “Why SaaS sales productivity is collapsing.”  Max analyzes a post from Bessemer Venture Partners Philippe Botteri.  Here’s an excerpt from Max’s post:

Philippe Botteri has put together an interesting analysis of his 13-member index of public SaaS companies (see here for the full spreadsheet).  Essentially he has applied the same sales productivity metrics we use to evaluate private SaaS companies to public companies and charted their evolution over time. 

The resulting graph provides a stark picture of the recession’s impact on these companies: an 85% decline in the productivity ratio (incremental gross profit / sales & marketing cost), which is now running at 0.10 vs a target of 1.00.  These companies are struggling to add new customer revenue and are surviving primarily on their existing recurring revenue base.

The rate and scale of the productivity decline are telling, but the absolute ratios should be taken with a grain of salt.