Remember all those venture-backed companies that promised to turn dreams written on the back of napkins into real businesses (my erstwhile colleagues at Robertson Stephens earned many shiny nickels supporting those arguments)? As you PE professionals correctly predicted, most of them went under or were absorbed into more established entities.
However, the most amazing thing has happened over the past several years: Many who were considered candidates for “the walking dead” in 2001-2002 actually made it as mid-market companies. High tech firms are generating free cashflow, attracting bank debt at attractive multiples and participating in the LBO marketplace. Software companies delivering enterprise applications are the most amazing example of this. As they said they would, many of them hit the magical inflection point where their revenues blew past their fixed cost base and their marginal costs remained low: voila, cashflow!
While valuing intellectual property is an art that the venture capital firms ostensibly mastered, cashflow positive technology companies are being valued on multiples of cashflow just like widget manufacturers. Effectively, private equity professionals didn’t have to do anything; the technology sector moved on its own into the sphere of the LBO valuation model and IP has become a secondary valuation metric. Admittedly, revenue multiples remain an important metric for technology companies that are experiencing rapid EBITDA margin improvements, but it’s all easily modeled with traditional LBO valuation tools.
Why does this matter to you? Because it will become a core capability for PE investors. We’re fairly active selling tech-enabled service companies. That’s mainstream tech buyout, right? Think Insight, Polaris, Primus, Summit, etc. Well, roll forward five years and “tech-enabled” won’t mean anything. All service businesses will be tech enabled. Well, let’s put that thought in reverse. All PE shops should be doing “tech-enabled” deals today because those companies are simply a step ahead of where all of industry is going.
So, take it one step further. There are only two constraints on doing tech transactions: Having the best valuation model/approach and industry expertise/value add. Well, the first constraint is effectively gone for the hundreds of cashflow positive tech investment opportunities that will come to market in 2007. The second constraint can be addressed by hard work or judicious hiring.
The first wave of cross VC/PE investing came with the so-called cross-over funds that invest in both asset classes. Think TA, Goldengate, Summit, Polaris, Battery, etc. Today, we’re seeing activity from both ends of the spectrum. A much-lauded pure VC investor asked us to come and speak next week about how they could build critical mass in tech buyouts. Silverlake is acquiring Shah Capital to participate in mid-market tech buyouts in addition to their existing mid-cap core business. More traditional PE firms such as Parthenon and Audax have built in-house tech knowledge. Media-focused funds such as The Wicks Group and Boston Ventures have broadened their mandates to include all “tech-enabled services”. It’s the “convergence” thing.
TO DO: Think about adding tech sector knowledge in 2007. Don’t be shy; it turns out you don’t need that VC secret sauce to play in tech. What else? Don’t even get me started on the surprising appeal of cross-border mid-market technology transactions (last year had me in the UK, Germany, Italy, and India and we expect ’07 to be more of the same)…