Software Deals Make a Tasty Vintage

Published: Friday, July 23, 2004

Merger activity in Silicon Valley expected to help fuel the software industry


Software companies are using mergers and acquisitions as a way to both survive and grow their business, albeit cautiously, experts say.

Weakening earnings and a chilly market for initial public stock offerings (IPOs) have signaled a new wave of merger-and-acquisition (M&A) activity among software companies, which is likely to increase during the second half of 2004, says Ron Lissak, managing partner and founder of M&A advisory firm Catapult Advisors LLC, based in San Francisco.

“We are absolutely seeing more M&A activity today,” Lissak says. “While we see very few blockbuster-type deals, we are seeing a lot of the smaller, private deals under $100 million by tech companies to stay competitive in the marketplace.”

In a study conducted last month, business consultant Bain & Company found 65 percent of software companies are not profitable, although most with more than $1 billion in revenue are.

“And when this fact is coupled with customers’ continued rationalization of their vendor bases and slowed [information technology] spending, that makes organic growth more difficult. The result is that small and medium software companies are increasingly prime [acquisition] targets for the large software vendors,” according to the Bain & Co. study.

The front edge of the consolidation may already be forming, according to Bain. Software M&A deal volume is beginning to rebound and, although valuations are no longer fueled by “bubble” equity, the proportion of software deals by value is greater than one third.

“The writing seems to be on the wall,” says Simon Heap, Bain partner and co-author of the study. “There are too many unprofitable players selling too many niche products in a slowing market where customers want fewer vendors, and that’s a recipe for consolidation.”

Catapult’s Lissak agrees and says many companies that received venture backing early on found customers and proved solid business strategy, but now are looking ahead to future growth plans.

Lissak currently is working on a $60 million-plus deal between a Bay Area company and one of the top three software vendors — he didn’t drop any names. But the software vendor executive was hinting at having second thoughts about the deal, Lissak says.

“He really believes in the company and feels that it’s a great choice,but he told me that given enough time, he is not convinced that his engineers could not develop the technology themselves,” he says.

Lissak says while the software executive at the larger company has the clientele, he lacks the software needed to propel his business.

“The company I’m working with has already done the hard work. They have undergone a million process steps to embed every piece of code and worked with their customers to learn what they want,” Lissak says. “I told the CEO I knew his engineers could do the same job eventually, but he could accelerate the process today by working with this particular company. His response was, ‘how much?'”

During the first six weeks of 2004, there were 205 deals worth $9.1 billion, compared to 350 deals worth $7.98 billion in the entire first quarter of 2003, according to Thomson Financial.

M&A dollar volume fell from a peak of $15.5 billion in 2000 to $8.1 billion in 2001, then to $6.4 billion in 2002, according to a Bain & Company report.

During 2003 and the first half of 2004, the industry again witnessed mega-deals such as IBM and Rational ($2.1 billion), PeopleSoft Inc. and J.D. Edwards ($1.7 billion), EMC Corp.’s acquisition of Legato ($1.3 billion), Documentum ($1.7 billion) and VMWare ($635 million), as well as the proposed Oracle-PeopleSoft deal ($7.7 billion), the Bain report says.

A stream of deals in the mid-range has taken place as well, including Business Objects SA and Crystal Decisions ($840 million), Veritas Software Corp. and Precise Software Solutions ($500 million), IBM and Candle (about $350 million) and Serena Software Inc. and Merant ($303 million).

It will be harder for software companies to access the IPO market for the rest of this year and maybe the beginning of next year, which leaves many tapping into the M&A market, says John Newell, partner in the San Francisco office of law firm Latham & Watkins.

“The IPO market is choppier than in the past,” Newell says.

“Companies won’t be acting out of desperation,” he says. “Most companies that have survived so far have adequate cash flow. They are just looking to expand and grow strategically.”

Becky Bergman is a free-lance writer based in Antioch. You can reach her