As more and more companies look to technology to bolster their offerings, M&A activity in the tech-enabled space is in - creasing. Mergers & Acquisitions convened a special round- table to discuss the role tech-enabled companies play in the market today. Abacus Finance hosted the event and the excerpted discussion that follows provides a range of perspectives on what middle-market dealmakers can expect from these companies going forward. Participants included private equity investors, a senior cash flow lender and an investment banker.
Danielle Fugazy, Mergers & Acquisitions (moderator): How do you define a tech-enabled business?
Michelle Noon, Riverside Partners (pictured): It's a term with a meaning that's morphed over time. Technology-enabled means an injection of technology into a process-that was otherwise manual or capital intensive-to reduce capital intensiveness and increase operating leverage, which will help the business scale more efficiently. It can lend itself to a variety of different industries and companies.
Jonathan Barnes, Halyard Capital (pictured): To us, a technology-enabled business services company provides a corporate efficiency or productivity solution to its customers beyond simple labor outsourcing - the "this is not your core competency, it's ours" - by introducing a technology application into the solution, substituting technology for labor to some extent. At the same time, tech-enabled services companies don't differentiate themselves exclusively on the basis of technology per se. We like to invest in technology companies that have services "wrappers" around them, such as recurring, managed services or professional services around the technology.
Fugazy: What is the difference between a tech-enabled business and software as a service (SaaS) company?
Matthew Carroll, WestView Capital Partners (pictured): The terms have become more intermingled over time so there is overlap. Oftentimes, software as a service is positioned as a subscription "service" and it is sold to business or operational people. One of our investments, eSolutions, is a true SaaS model in the healthcare revenue cycle sector but its customers view it as a service that is provided to them by eSolutions. It just so happens that it is a highly automated one-to-many service because behind the scenes it is powered by proprietary software.
Noon: SaaS is an amorphous term that has changed meaning over time. We have a portfolio company called Pilgrim Software; it's a software company that helps companies comply with FDA and audit procedures. It's deployed in two ways. It's either delivered as your traditional licensed model, or it's delivered in a SaaS model. The point is the term can be nebulous.
David Joncas, Aeris Partners (pictured): There are fundamental differences between traditional tech-enabled services companies and true SaaS companies. Traditional tech enabled services companies sell a service and the extent of technology enablement can vary widely. Tech-enabled service consumers are generally less interested in the enabling technology used behind the scenes. In contrast, the first "S" in SaaS stands for software - so the emphasis is on the software. SaaS users consume software and make purchase decisions based on software features, functionality, performance and cost.
Devin Mathews, Chicago Growth Partners: The last "S" in SaaS is the most important one, and that is the service. When you sell to the lower end of the market it's all about the service. Small companies really don't care about what's behind the browser or the device; they just want it to work the way they expect. A truly tech-enabled service would be a SaaS model -- a subscription-based service that is delivered through a browser or a mobile device where you are paying a monthly or annual fee.
Fugazy: What industry verticals do tech-enabled businesses or SaaS businesses lend themselves to?
Joncas: SaaS is relevant to almost any industry that consumes software. Industry verticals that are complex or dynamic, especially where there's a lot of demanding significant domain expertise or change is required, benefit from SaaS. Healthcare, finance and insurance are great examples of complex industries benefiting from SaaS applications. Vertically-focused SaaS companies gained early momentum by capitalizing on industry complexity and expertise, and have proliferated. Salesforce.com is a classic example of a functional, horizontal SaaS play that transcends industry lines.
Carroll: Tech-enabled services and/or SaaS tend to fit best in the industries with one of the following two characteristics: really archaic and disjointed legacy infrastructure or an operating model that is both cost conscious and even more capital expenditure conscious. And those problems have tended to be in government and healthcare. Entrepreneurs are smart. They look for a problem, as niche as it may be, and they develop a service or a software to solve it. They can be in niche businesses that can be grown into billion dollar companies.
Noon: I would also add that verticals that never even had legacy technology could use tech-enabled services as well. For example, it can work well in industries where there's a lot of manual or paper-based solutions like education and big media. I like to use the analogy of telecom development in Africa. In many countries, they didn't install landlines; they leapfrogged straight to a wireless solution. There's a lot of tech-enabled service opportunities for companies that have fallen behind the technology curve because those companies or institutions don't have the IT resources or know-how, never had them and they don't want to build them.
Tim Clifford, Abacus Finance Group: We're a niche cash-flow senior lender and we exclusively focus on sponsor-backed transactions in the lower middle-market. We define the lower middle market as companies with Ebitda of $3 million to $15 million. We looked at over 500 unique opportunities in 2012, and roughly a third of the deal flow was in business services, and the majority of those had a technology-enabled aspect to their business model. In total, almost half of our deal flow was from technology or software businesses. When you put it all together, these sectors are becoming a meaningful industry focus for our clients.
Mathews: We look at where technology is converging across the education, healthcare and financial technology and information services sectors. And we like companies with predictability. At the end of the day, strategic acquirers and the public market want predictable business models more than they want a "hot" opportunity. So we bought Marathon Data Systems because it has a business model you can set your watch to. They sell to 90,000 U.S. small business targets. They have 6,500 customers and they close dozens of new customers a month and each year their existing customers spend more money with them.
Barnes: In addition to thinking about the applicability of these models by industry vertical, we also spend time thinking about it by functional areas within the corporation. In other words, where there are outdated, labor-based and paper-intensive processes that are best laid off to a third-party who can do it better and help make the corporation more efficient? For example, our companies EducationDynamics and Datamyx bring tech-enabled solutions to the marketing function, while OneSource Virtual uses technology and services to improve the corporate human resources department.
Fugazy: What are you looking for in the tech-enabled companies you invest in?
Mathews: We start with growth. We want to see 20 percent annual organic growth or more. Then we look at just the four industries where we have pattern recognition and experience - technology, healthcare, education and industrial. We also look for high-quality revenue, which for us means recurring or highly-visible models. Then we get down to defensibility of the product, because that speaks to margin profile - the higher the margins the more likely that the product has a good niche. Lastly, does the management team want our help? We're not trying to fix their operations, we are trying to help scale their growth, so we bring our in house operations team focused on technology and sales to partner with management. The team has to want us to be part of the solution.
Barnes: We start with growth, but we tend to be Ebitda multiple oriented from a valuation perspective. We focus on predictable and recurring revenue streams, customer renewal rates and the overall scalability of the company's solution. I think that a company's ability to demonstrate its customers' ROI on their spending is key.
Clifford: Growth is very important to us, as well, but it's really about the stability of the cash-flow. The quality and diversification of revenue and earnings is a big component. The less concentrated it is the better, obviously. The other attribute we look for is differentiation. What makes this business different? What advantage does their technology provide? How do we know that Ebitda is sustainable?
Joncas: We're asked to evaluate and value companies on a regular basis in the context of M&A processes. With respect to tech-enabled services companies, growth is a key consideration but we also consider the nature and extent of technology enablement, revenue visibility, scalability and margin expansion, and whether or not the enabling technology is proprietary. Each of these attributes informs our view of valuation.
Noon: Topline growth is not always the foremost criteria for us. We only invest in growing companies, but they don't all have to be 20 percent plus growth. We're looking for fundamentally sound businesses. We're often investing in founder or management-run companies that are profitable, that have gotten to a certain level of success, but working with Riverside will help them get to the next level. And sometimes that means it might be growing top line 10 or 15 percent, but we see an opportunity to increase equity value.
Fugazy: Is there anything specific you look for when backing a management team?
Mathews: There are three key things we look for. First, what type of team is it, and are they a good match for CGP's approach and given the company's evolution of where the company is in its life cycle. For example, is the CEO more sales-oriented; is he or she strategic or maybe operationally focused; what skills does he or she need around the table? Secondly, domain expertise. Does the team have deep experience in the industry? That's obviously critical. The third one is operating expertise. How do they manage their business - by gut or by data?
Carroll: We have companies that grow 10 or 15 percent and some that have grown 30 percent. We tend to gravitate to managers that are of the profitable growth mentality. Over the years we have come across a lot of companies in these sectors that overspent on sales/marketing and never reached scale and profitability. So, sometimes that means it's okay to not grow quite as fast, but they will be very focused on having excellent operating metrics combined with profitability.
Fugazy: Do you ever conduct serious due diligence on the CEOs?
Clifford: The total number of transactions we reviewed last year came from almost 200 different private equity sponsors, so we are in a position to see how each private equity firm conducts its due diligence. Both our partner sponsors and us conduct detailed diligence on management teams. For example, we had two transactions last year that sponsors had under LOI and at the end of the day we and the sponsor ultimately passed on the deals due to background checks on the management. It baffles me that the investment bankers didn't do preliminary background checks before they took the companies to market.
Mathews: We quickly pass on at least 80 percent of the deals that we see. We're pretty selective, which is a nice position to be in. At the end of the day, we're paid on success, so we want to make sure we are backing the right people in the right market at the right time. We need to be sure.
Fugazy: How do you expect the market to perceive these companies when it's time for the exit?
Carroll: When companies are focused on measured profitable growth, it actually can be a bit of a hindrance on valuation right now. So the more profitable you are the higher your implied revenue multiple can get. So just to make up math, eight or 10 times might actually be a nice place to invest in a healthcare revenue cycle business, but the fact is, if you are well scaled and profitable you can start to bump into four and half or five times revenue, and at that point folks start to feel like valuation is pretty full. Revenue multiples have always been a part of corporate finance, but I think they're becoming much more prevalent as a front and center valuation tool in these sectors, particularly the SaaS models.
Noon: As I look at the revenue multiples in the public markets, and to a slightly lesser extent the private markets today, to validate current valuations those companies need extremely fast growth. Some of the SaaS or tech-enabled services companies are growing fast and warrant higher valuations. But, at some point that growth in revenue needs to translate to profitability. Ultimately, it needs to convert to cash. So right now we're seeing a major disparity between high revenue growth and low profitability with a high multiple valuation.
Mathews: When you have a highly profitable SaaS business, people are going to say the market must be small and you're the dominant player that's why you're so profitable. We invest in a lot of education and selling into the K-12 segment. There are a finite number of K-12 schools in the U.S so you need to build the market leader - not the second best - and you have to find ways to expand the market with complementary product offerings.
Carroll: These capital market dynamics make it hard on management teams and their private equity partners because in the end you want management simply serving the customer need not reacting or evolving their business model based on what's getting high values, yet you can't help but take notice. It takes guts to turn to management and say let's take the profitability down because I know that's the better and faster way to get from 20 to 40 million in revenue, and at $40 million of revenue we can pick our head up and focus on profitability.
Mathews: The public markets really haven't rationalized the gap between revenue and Ebitda multiples. They are rewarding growth more than profitability right now. But there aren't many public SaaS businesses growth 25% plus with 30% plus profit margins, though there are plenty of private companies with those profiles.
Fugazy: What are the viable exit strategies for investors in tech-enabled/SaaS companies?
Joncas: Roughly 85 percent of our technology clients companies are acquired by strategic buyers. We frequently advise most of our clients to selectively invest in key strategic relationships, especially within their buyer ecosystem. Strategic buyers don't always have perfect visibility into the range of available alternatives when it comes to M&A - corporate development teams are busy and prospective M&A targets aren't always "visible" to them. Waiting for the phone to ring isn't an optimal exit strategy and the best technology doesn't always "win" or get acquired.
Carroll: I think it's good when you have a CEO that gets out of the seat, goes out and meets the potential buyers. You're going to find partnerships, alliances and resellers, along the way. You're going to start to build a network even if you are not even trying to do it, but that can lead to building your ecosystem of buyers. Your company or business model might not have been on their strategic priority list, but the next thing you know, when they write up their M&A hunting list next year, they have your company, and your sector on the brain, and you get a little more attention from them.
Fugazy: Do you encourage your portfolio company CEOs to meet the larger strategics in the sector as a way to help find exit opportunities?
Mathews: If we, at CGP, don't personally know the buyers at the top five or 10 strategics, that's a complete failure on our part. We can't be meeting the head of strategy or the head of business development of a public company for the first time during a sale process. That is our job to know these people well. That's No. 1. No. 2: We want investment bankers in that industry segment to swing by and meet the CEO, and I want our CEO having the conversation because he has to learn how the outside world thinks about his business long before he is in a process selling it. And I want him going to some investment banking conferences where the CEOs of his big competitors are speaking because I want him to hear how his competitors talk about their businesses, what's driving them, where they're spending on growth initiatives and what acquisitions they have done.
Noon: We tend to invest for five to seven years. And in that period of time we're growing a mid-sized, profitable business to larger, strategically-relevant and professionally-run business. You can't do that if you're constantly focused on the exit. We don't want the company management to focus on that. They need to build the business. We think it's important to maintain relationships with the banking community, but we don't want pitch presentations to consume our CEOs time because fundamentally we are backing them to build a company and their focus is critically important to having an ultimate exit produce itself. You do have to think ahead, and we at Riverside Partners manage most of the exit process along the way so management can focus on growing the business every day.
Barnes: We tend to be the corporate development arm of our companies, particularly in the first few years. We're doing the first screen of all the acquisition opportunities. We're the ones who are trying to get a sense of who the most expert, plugged-in bankers are in the sector and after we meet with them first, we will make an introduction with the CEO at the right time. In the last year or two of our hold, absolutely the CEO needs to be viewed as a thought leader in the space, speaking at the conferences, on the panels, respected by his or her peers and aware of all the likely acquirers.
Joncas: Building relationships with a targeted group of prospective strategic buyers, in advance of a sellside process, is critically important. Relationships promote trust and can materially increase M&A interest, valuation and certainty of close.
Fugazy: What are the biggest challenges facing tech-enabled companies going forward?
Carroll: Businesses have to continue to innovate and develop their technology and services. A certain level of tech-enabled service companies are going to fall off the back of the bus because in essence they are good solid service businesses, but they are using other people's technology to drive their service and eventually others will have that same technology to drive their service and water seeks its level. So I think we all have to be very careful about our valuations in relation to where along the tech-enabled to SaaS continuum they truly are or we run the risk of overvaluing these businesses at our entry.
Barnes: I think over-leveraging these types of businesses can be a risk. I don't think these are businesses where you can get too aggressive on debt financing.
Clifford: As a result, many of our portfolio companies are rapidly growing. The challenge for these businesses is to ensure their technology and infrastructure can efficiently handle the growth without a negative impact to their value proposition. Most of what we do isn't necessarily at the top end of leverage, but the beauty of tech-enabled businesses-particularly software businesses that have a high recurring revenue component-it allows us to provide more leverage than what you can offer for other types of businesses. Nevertheless, for most tech-enabled businesses outside a SaaS business model, revenue can be lumpy, which can make putting too much leverage on it at close a challenge.
Noon: Some of the challenges we face are company-specific. For example, one of my companies traditionally delivered its software as a perpetual license model and has transitioned over time to SaaS. That is a huge challenge for a business, in part because you, as a company, face an identity crisis and an infrastructure and organizational crisis of sorts as you transition. You need to be able to transition your sales team and articulate the new sales proposition. But you also have to deal with a transition from a revenue recognition standpoint, moving from upfront revenue recongition for license and services to one where the whole SaaS/subscription is recognized over time. Are acquirers going to understand that while revenue and Ebitda did not grow for this year or next, it's because the revenue quality has gone up and these are now SaaS customers with greater lifetime value? Within a five year investment horizon, if we spend two or three years transitioning a business from a licensed model to a SaaS model, are we actually going to get credit from the outside? It's a leap of faith. That's a real challenge we're facing.
Carroll: A lot of software executives are being told, sometimes by customers but certainly by capital markets and some private equity participants, that SaaS companies are worth this and traditional licensed model software companies are worth that. They are all feeling this nag to be a SaaS model. But if you serve the customer that will generally serve you well in your value and growth.
It takes guts from a financial perspective to change an entire company's delivery and economic model, because we all have people we report to, our partners and our limited partners, who might only see the interim P&L decrease. We are paid to make the investment return, but when we put up a bar chart that doesn't look necessarily pretty, the fact is, we're all sensitive to what our constituents will say.
Mathews: It's much more enjoyable to own a SaaS business with recurring revenue every month than a perpetual licensed business where the revenue can be incredibly lumpy. I do think there are lots of businesses that aren't ready for SaaS, but want to be.
Fugazy: How does buying into a tech company impact returns?
Carroll: One of the risks in these sectors more typically associated with higher multiples is that you might invest in a company that does quite well, but your return can turn out somehow to be just okay, and part of it is because you paid too high of a multiple.
Mathews: Our issue is if you're in a high multiple environment like we are today and you don't highly lever companies then you have to buy businesses that you feel can double or triple Ebitda during your ownership by scaling the growth and improving the company. If you can grow from $5 million to $15 million of Ebitda and you have multiple contraction from 10x to 8x, you're still going to do just fine on the investment even if you make no improvements and don't pay down debt. It won't be a blowout, but it's still 2.5x your money. So, if you see a company that is right down home plate, and you've got a ton of skills around the table and pattern recognition to make a difference, you can't come in second, you win and then you get to work.
Your investors don't care that you come in second a bunch of times because you weren't willing to pay more than eight times for a business. You're not going to own a lot of good companies if that's your strategy, so it's knowing where you want to invest, know what you're going to do with a company before you buy it, and then quickly execute that plan after the transaction.
Noon: Conversely, we have to maintain discipline. If a deal is squarely within an organization's area of expertise, it can make sense to move aggressively to try to get the deal done. But we are in a high-multiple environment today and I think that it is easy for us to get caught up in it because we are deal people. We want to do the deal. If it looks like a great deal, but it's not really, we have to step back, because you can't bet on double digit multiples or on multiple expansion five or seven years out, so we have to have enough confidence and enough leeway to either wait for the next pitch or to have enough alternative ways of creating value if the multiple expansions don't pan out. We're not investing in a VC model where we hope for one or two big homeruns. It is a balance.
Jonathan Barnes, Halyard Capital
Matthew Carroll, WestView Capital Partners
Timothy Clifford, Abacus Finance (sponsor)
Danielle Fugazy, Mergers & Acquisitions (moderator)
David Joncas, Aeris Partners
Devin Mathews, Chicago Growth Partners
Michelle Noon, Riverside Partners