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Software Firms Feel Urge to Merge

Ivy Lessner

Rackspace, the second significant tech IPO of 2008, fell 20% on its first trading day. The sour reception effectively put a detour sign over the IPO exit for private firms and their venture investors.

We won't see more tech IPOs this year because of the way Rackspace was "roughed up," predicts Brenon Daly, mergers analyst with The 451 Group.

As a result of the chilly IPO market, companies like Compuware(CPWR), which has delayed the public spinoff of its Covisint division, will have to find buyers or sit on their hands until the IPO market picks up.

Merger activity, meanwhile, has picked up, despite the sluggishness of private equity players who a year ago were engineering big mergers.

For instance, on-demand software host Salesforce.com(CRM) said Wednesday it bought privately held developer InStranet in early August for $31.5 million.

InStranet supplies call centers with information-management software at companies such as Comcast (CMCSA) and Verizon(VZ).

Halfway through the third quarter of 2008, the M&A market in software is running slightly ahead of last year with 379 deals since July 1, compared with 373 mergers for the same six weeks of 2007, according to the Software Equity Group, an investment bank specializing in software-industry mergers. The bank tracks all software mergers quarterly.

Allen Cinzori, managing director of Software Equity Group, predicts that the merger environment for software companies will be strong through the remainder of this year, with an average of 380 to 400 buyouts a quarter. The sector will continue to see acquisitions of developers of security, Web analytics and corporate performance-management software, he says.

What has changed is the size of the deals, with startups or microcaps being mostly the targets. Big companies are actively buying software developers with annual revenue , generally, of well below $500 million.

For example, speech-software developer Nuance Communications(NUAN) bid $40.4 million last week for Zi Corp.(ZICA), a company expected to generate $14.5 million in revenue this year.

Zi, though, rejected the offer of 80 cents a share, which represented a 150% premium over Zi's share price of 32 cents.

In the second quarter, 99% of target firms in deals had enterprise values below $500 million. The average deal size in the sector was $57.8 million and included three mega-deals, according to Software Equity Group. That's down 7% from a deal size of $62.3 million for the second quarter of 2007.

Worldwide, the average deal size of mergers across all industries in the second quarter fell 37% year over year, according to Dealogic.

"On average, we are seeing fewer mega-deals," Cinzori says.

Leveraged debt just isn't available to private equity firms at the scale to carry out the type of "platform deals" they engineered in the past - the merger of mid-sized software companies in which financing also provided for add-on acquisitions, Cinzori says.

For private equity deals, debt is now 3 to 4 times earnings before interest, taxes and amortization, from a ratio of 7 or 8 two years ago, Cinzori says.

"We've seen some deals that have gotten software companies into new markets, but those deals are riskier in the current climate," Daly says. "Wall Street's only paying for growth" and wants a quick return. That means deals must consolidate market share, not create new business strategies, he adds.

"I don't think we're going to see a lot of roll-the-dice, bet-the-company M&As," Daly says. "The market is not going to give a company the benefit of the doubt."

With leveraged financing scarce, large deals are beyond the grasp of all but the few companies with strong cash flow. Oracle(ORCL) just swallowed BEA Systems and continues to make smaller, private acquisitions, as CEO Larry Ellison predicted last September.

These are precisely the market conditions that Ellison said would help the company find new growth on the cheap through acquisitions.

"Strategic buyers have been very active," Cinzori says. Many large software companies have greater cash flow than a year ago, says Cinzori, noting public companies now account for 48% of buyers, up from 44% a year ago.

But public companies in some niches have seen their deal hopes dry up along with financing options in a down market. Cadence Design Systems(CDNS), which sells chip-design tools, cited financing Friday in the withdrawal of its mega-deal bid for Mentor Graphics(MENT).

While holding steady in number, deal sizes are shrinking. Average software-company deal valuation dropped recently to 2 times revenue, from 2.2 in the third quarter of 2007. "That's what you would expect" with a 13.5% decline in the market cap for the sector (excluding on-demand software companies) since the beginning of 2008, Cinzori says.

The market cap for Software Equity Group's index of 17 public on-demand software companies has dropped 26% year-to-date.

When the IPO window was still open, tech companies paid hefty sums for the future value of their targets because private companies could threaten to take the IPO route, Daly points out.

But the dual exit track "is an empty threat these days," Daly says.

A significant number of software companies are still "sitting in the IPO pipeline," says Cinzori. "You'll see the majority let their filings expire."

For example, on-demand supplier Convio withdrew its registration Aug. 5, shortly before it was to expire.

And those that expire are ripe for buyouts.