The Thousand Yard Stare

I work at an asset management firm. The investment assets we manage are diverse and the skills required among our managers are diverse. Many times the managers will sit and talk shop about what they see, what they might be sensing around the market, their projects or something like this. These are illuminating conversations.

Many times I may be asked about this portfolio company or that portfolio company, its performance and the inevitable, "What do you think it is worth?" Since so many of our positions are in software, I am regularly quoting some multiple of revenue. This conversation generally results in a facial expression trying to conceal the listener's disbelief (i can feel the "thousand yard stare"). The suggested value appears to have no rational connection to earnings or cash flow of the subject company. The listener then politely leaves the room trying to spare my feelings from what he is really thinking.

When a software company is acquired by another software company...the rationale is generally in one of two camps: (a) the acquirer is trying to grow something they already own, or (b) the acquirer is trying to preserve something they already own. When the buyer is trying to grow something they already own...they are generally doing more speculating than not - they believe the product set is previously incomplete and that the addition of something else will finally be the thing that causes things [sales] to really take off (I am not sure I have ever seen this work). When the buyer is trying to preserve something they already own...my belief is that they are doing less speculating than in case (a). They have seen the acquisition target have a negative impact on the thing they already own and are worried about about its further negative influence on this thing (which they value so much). So what is the thing they already own that they value so much?

Investors in software early-stage software companies incur a lot of risk to get to a place of comfort and confidence. The possibility of operating leverage resulting from scalability in license sales influences this confidence. BUT...the end is not scalability of license sales per se but rather scalability of the maintenance stream (that license sales produce) and the recurring cash flow stream it produces.

The maintenance stream is really "the gift that keeps on giving." It is a pool of "insurance payments" that customers make for years after their initial product purchase. It guarantees them the right to all future advances of the software product. As customers become increasingly dependent on a particular software product the reliability of this "annuity" increases. It becomes extremely valuable to shareholders of software companies as a funding source for future product development and even more "annuity". It is when this annuity stream is put at risk that acquiring companies seem to go into action. The greater the risk to the existing annuity stream...the more they are willing to pay for the target company.

So...lets say you are a $20 million/year software products company. You are growing at a nice rate and you currently make $1 million per year in operating profit. Life could be worse. You get a knock on the front door and XYZ software giant wants to buy you. Nobody at XYZ software giant is going to tell you how scared they are about their annuity stream...they are going to say something like you are a meaningful complement to their solution set and that this is a build-vs-buy evaluation. If this is in fact true and you belief it is true...this will likely be a short negotiation and you should probably take the second offer they make. You will close the deal at 1.5x revenues.

However..let's say that XYZ software giant is calling because they see you as a threat to the maintenance stream on their "time travel" software. You go to their annual report, look deep in the footnotes and you see that maintenance revenue from "time travel" software was $600 million last year. You deduce that your product set is creating risk around this annuity stream and four years out could cause great problems for it. As a result...you have significant negotiating leverage. They are not focused on your annuity stream and speculating about what it could be. They are focused on their annuity stream and what it "is". They are taking some of the insurance payments made to them by their customers and, in turn, taking out insurance of their own by acquiring you. They are buying an extension of their own annuity stream It is the nature of the beast.

By way of example lets say that XYZ software giant estimated you had permanently impaired 1% of their annuity stream and that by next year this was going to reach 2%. Without considering any escalation thereafter XYZ anticipates that your existence would kill off $12 million maintenance per annum of say $7.2 million after-earnings. If ZYX trades at 10x earnings...then it might be worth $72 million (10 x $7.2) to stop the risk of greater damage occurring. So in this setting with this perspective layered on top...your little $20 million software product company might be worth 3.6x revenue ($72 million/$20 million).

And this is the story of how a fair number of software companies trade at something that bears absolutely no planetary resemblance to the rest of the world.