There is no question that the advent of the Cloud has dramatically transformed the IT landscape, creating billions of dollars of value for IT incumbents astute enough to capitalize on the development (i.e. Amazon, Microsoft, Google) and destroying billions of dollars of value for those who missed the boat. While we have seen numerous strategic Cloud transactions (NetSuite, Concur, SuccessFactors, Ariba, SoftLayer, and Demandware, to name a few), hundreds of large independent players remain. And while traditional barriers to strategic M&A exist (e.g. entrepreneurial desire to remain independent, rich valuations), these do not seem to be sufficiently prohibitive to deter Financial Sponsor interest in the Cloud, with private equity firms executing recent notable acquisitions such as Marketo, Cvent, Infoblox.
All this begs the question: why hasn’t there been more strategic Cloud M&A, and will this change? At Spurrier Capital Partners, based on our extensive dialogue with senior decision-makers at the most acquisitive IT leaders, we have identified five structural impediments to strategic Cloud M&A: Cloud architecture, IT procurement, market composition, connectivity, and distribution. So, you will have a few of the potential answers the next time you find yourself thinking, “why can’t IBM recognize that if they plugged my product into their channel, they could quadruple revenue in a year?” More importantly, we can help you proactively plan for, and position against, each of these barriers to give your company the best chance of garnering a strategic multiple.
Architecture: Single-Instance Code Base Frustrates Technical Integration
Conditions: A single-instance, multi-tenant architecture is one of the primary competitive advantages of Cloud vendors relative to their on-premise predecessors, better enabling products to scale up and minimizing maintenance expenses. However, it can also be a liability in strategic acquisitions, as this implies either a separate instance or a massive re-write of the code base. True to form, Cloud-native players such as ServiceNow, Workday, and NetSuite have been much less acquisitive than their legacy cousins (i.e. BMC, PeopleSoft).
Effects: Beyond inhibiting M&A, SaaS architecture has created somewhat of a barbell in terms of strategic M&A, with strategic vendors preferring to either purchase very early-stage targets (potentially even pre-revenue, wherein a code rewrite will be trivial and not disruptive), or very late-stage targets with a large customer base to justify a re-platforming exercise. To wit, a common refrain from IT leaders is that “$5MM in recurring revenue is worth less than zero to us.” Of course, Financial Sponsors are all too eager to occupy the territory in between, either purchasing SaaS vendors as platforms (no integration necessary) or simply leaning on their portfolio companies to re-platform.
Remedies: In this case, there is not much that private vendors can do to market around this issue. Rather, this is a fact of IT M&A that should be understood and appreciated when making strategic and operational decisions, namely those around spending. Heavy expenditures on improving product to elicit the interest of an IT leader are unlikely to bear fruit, and can prevent a vendor from building a more sustainable business that would be attractive to a wider universe of buyers, including mid-market strategics and Financial Sponsors. SCP’s long-term, client-focused approach to strategic advisory ensures that we can be there with you every step of the way to counsel you through such decisions.
IT Procurement: Decentralization of IT Procurement Erodes Account Control
Condition: IT procurement in an on-premise world afforded great cross-sell opportunities to IT leaders, as many purchase decisions required capital expenditures and often ran through the CIO, who may have carried affinities for vendors that provided mission-critical products such as Database (e.g. Oracle) and ERP (e.g. SAP). This effect is referred to as “account control.” Given that Cloud services can be procured by line of business users with a credit card, and that those purchase decisions are small in number and dollar value, these do not represent similarly fertile channels for IT incumbents.
Effects: While the Cloud has had several effects on enterprise procurement and vendor go-to-market (detailed later on), the erosion of account control is the main reason why our aforementioned executive’s product doesn’t quadruple in a large strategic channel. As such, incumbent vendors have preferred to acquire anchor platforms where they have not previously held hegemony. Oracle’s acquisition track record serves as a perfect illustration, extending their position into new enterprise buying centers (e.g. CMO, as with Eloqua and Responsys), industry verticals (as with Textura in Construction or Opower in Utilities), and market segments (as with mid-market leader NetSuite).
Remedies: If your company is a leader in a large market, you are likely to get strong attention from the leading IT acquirers! For the rest, the most powerful way to demonstrate that your company’s products present strong cross-sell opportunities for IT leaders is by referring to specific customers who have requested deeper integration between the products, where your product’s mission-criticality has allowed you to influence purchase of a potential acquirer’s products, or by proving the ability to drive consumption of the incumbent’s key products. By partnering with Spurrier Capital Partners, you can leverage our strong relationships with IT leaders to make the case regarding customer demand for joint products directly to the executives who would sponsor a strategic deal.
Market Fragmentation: Reduction in Startup Costs Has Balkanized Software Categories
Conditions: The Cloud has wrought two major forces that are splitting what were previously multi-billion dollar monolithic markets into federations of multi-hundred million dollar markets stratified by target customer size and tailored for specific vertical / function. First, the aforementioned decentralization of IT implies that purchasing decision is driven by value to the end user, rather than value to the CIO. This prompts SaaS vendors to tailor solutions to various end users. Second, the Cloud’s ability to massively reduce startup costs allows disruptors to easily enter markets with differentiating characteristics once a first mover has validated that category.
Effects: One need only to observe the number of “Box for X” monikers (Enterprise, SMB, Financial Services, Healthcare, Government) that emerged in the wake of Box’s success, to appreciate the impact of these trends. While vendors can still win large markets, they face the constant threat of disruption, TAM erosion, and pricing pressure as newer vendors flock to their hard-won pots of gold. As such, IT leaders are having difficulty identifying uniform markets that are sufficiently large enough to “move the needle” for them and adequately insulate from competition. This hinders those companies from being able to justify multi-billion dollar outlays with long payoff periods.
Remedies: As with previous concepts, creation of enterprise value begins with a practical assessment of a Company’s potential. Serving a single vertical, function, or customer size within a broader category does not imply that your TAM is equal to that of the entire category, and spending decisions should be made accordingly. When considering an exit, the strategic landscape should include not only the traditional software vendors in that category, but also other services / solutions providers that target your Company’s end market. SCP’s long-term approach to advisory and relationships with senior decision-makers across the IT landscape ensures that our clients have the time, the forum, and the insight to engage in meaningful dialogue with potential corporate buyers in order to cultivate strategic interest.
Connectivity: APIs Mitigate the Value of Pre-Integrated Bundles
Conditions: In the on-premise world, integration between adjacent systems invariably required expensive, time-intensive integration efforts that often yielded inconsistent performance. As such, a pre-integrated suite of solutions from a single vendor typically carried significant cost and performance advantages over stitching together best-of-breed modules. However, with the evolution of integration software, including the advent of APIs, customers have come to expect easy integration of best-of-breed SaaS solutions from different vendors.
Effects: The competitive advantages of a suite yielded a wave of M&A, as leading Application Software vendors such as Oracle and SAP embarked on efforts to deliver every module of a platform, growing wallet share of each customer and improving customer experience. However, APIs have diminished the advantages of suites as customer preferences shift away from single-vendor platforms and toward best-of-breed point solutions from multiple providers. As such, it has become more difficult for IT leaders to make the business case for M&A.
Remedies: As with so many other corners of IT, the value of data is having a massive impact on this development. While APIs enable sharing of data between systems for purposes of workflow execution and recording transactions, advanced analytics spanning multiple data siloes requires deeper integration. For the growing population of vendors that are seeking to aggregate and analyze data across customers to deliver benchmark-based insights, native integration is required. As such, SaaS vendors seeking to transact with providers of adjacent systems should (1) ensure that their customer contracts enable broad data rights (that can be assigned to an acquirer), and (2) be able to clearly demonstrate the unique set of data that their SaaS solution generates, how they are currently analyzing that data to provide insights to customers, and how these insights could be enriched by merging with the acquirer’s solution. SCP’s relationships with senior decision-makers facilitate client access to make this case directly to executives that sponsor transactions. Our patient approach to advisory allows the time to partner with strategics to test data sharing, ultimately providing acquirers empirical evidence to build the business case.
Distribution: App Store Model Allows Strategics to Easily Monetize Third-Party Services
Conditions: Prior to the advent of the Cloud, IT leaders who experienced heavy demand for complementary / adjacent solutions often opted to purchase vendors offering such solutions. The upfront costs of training and integrating third-party products inhibited partnerships and encouraged IT leaders to acquire in order to access all the revenues associated with third-party product sales in an effort recoup upfront costs. However, the emergence of the app store dramatically reduces such partnership costs, putting the integration burden on the third-party vendor – taking advantage of the massive reduction in distribution costs associated with online procurement. This reduction in expenses enables IT leaders to monetize demand for complementary services simply by offering those services in a cloud-based app store and collecting 15-30% of the subscription.
Effects: The success of these app stores has significantly diminished M&A. Needing to offer the service is no longer the same thing as needing to own the service. This can make it extremely difficult to determine which markets a strategic buyer will pursue. With more and more IT leaders looking to fill out their app store offerings, the value of the private company partnership has diminished.
Remedies: First, rely on an advisor who has firsthand knowledge of a strategic buyer’s intent based on direct interaction with those buyers, rather than one who can only speculate on the value of the combination of complementary products. Second, avoid committing development resources to app stores / platform integrations if you do not see clear demand in the market for such an integration. Third, if you do offer your service on a Cloud leader’s platform, and the joint offering is flourishing, ensure that it is properly messaged to senior decision-makers within the organization. SCP’s deep relationships with all Cloud leaders allow us to evangelize on behalf of our clients with regard to joint product efforts.
In conclusion, the Cloud’s impact on strategic activity is clear, and the impediments are multifold. Understanding these obstacles is the first step to ensuring that your company is making the right decisions regarding product roadmap, budgeting, and strategic interaction is the key to maximizing value over time.
At Spurrier Capital Partners, our senior relationships, deep domain expertise, and transaction experience ensure that we can help you across all these areas. Further, our long-term flexible approach to strategic advisory means that we can be supporting the Company over its lifetime, providing patient counsel at each decision point. If you have any questions about market dynamics or how to navigate around them, please do not hesitate to reach out.
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