January Newsletter – Commentary
The Report on Business (sourcing Bloomberg) reported that 2015 was another stellar year for M&A involving Canadian companies, with $281 billion of transactions completed, which represented a 34% year-over-year increase from 2014. Of particular note is the fact that fully $205 billion, or 73% of the dollar value, involved Canadian companies acquiring foreign entities. In the segment of the market that we service ($5M to $75M) the total number of transactions has been declining since 2009, with the hardest hit category being transactions under $5 million. Fortunately for us, 2015 turned out to be a good year, so no complaints here.
It’s easy to misinterpret reported M&A numbers given that reported numbers for the Canadian M&A market are highly influenced by a small number of mega-deals such as the CPPIB announced the acquisition of Homeplus Co. for $8.6 billion or the Brookfield Infrastructure Partners LP acquisition of Asciano Limited for $12.4 billion.
Interestingly, what we have not seen is a measurable uptick in M&A activity from the Baby Boomer founders of traditional businesses who should be looking seriously at making a move now. (You can read more on this on our website by clicking here.)
As always, the past twelve months saw some interesting developments:
Tier II Brokerage and Accounting Firms Come Downmarket
During the year we saw an increase in the number of larger Tier II brokerage and accounting firms participating in bake-offs for companies with less than $10 million sale values. As the result of continued stagnation in the public markets it was interesting to see Tier II and Tier III bankers – associates in tow – pitching for private company sale mandates and touting their firms’ deep experience in SaaS M&A transactions and the deep resources that they bring to the table.
Having spent almost 10 years working in Bay Street brokerage firms I know only too well the pressure that partners are under to “cover the nut” when public markets get bumpy. I also know the vast differences between working and successfully completing a private company transaction versus a public company transaction and patience has never been a virtue of investment bankers. And last I looked, their clients were not jumping up and down to buy or invest in small-cap private companies.
Preparation Continues To Be an Afterthought
Not surprisingly, I would say that without exception most of the business owners who approach us about selling their companies are not close to being prepared to start a sale process. Of course, that’s to be expected since these individuals are spending every day running their businesses and preparation for a sale is mostly an afterthought. Unfortunately, there are no positives to be gained from a lack of preparation so the sooner business owners understand the requirements necessary in time and resources to consummate a successful transaction, the better. (Again, you can refer to our website to learn more about our thoughts on this matter.)
Everyone is SaaSy!
With the continued shift to SaaS models and the valuation premiums awarded successful companies implementing this delivery model, it’s not surprising that we continued to see two developments:
- Small and mid-market companies misunderstanding publicly available information related to valuation metrics in the SaaS space. Unfortunately, there is a dearth of valuation information on private company capital raises or sale transactions, so sellers look to public company information as comparables. And while the information can be determined from a close and comprehensive review of data, most buyers and their advisers find it just too easy to use large, public, and liquid SaaS company metrics as the basis for their company’s valuation. I can tell you that there is a significant difference between revenue multiples applied to a public company generating $500 million in revenue and a private company generating $3.5 million!
- Some companies who receive monthly payments from customers as opposed to one time annual payments are attempting to classify these revenues as recurring and SaaS, as though they were one and the same. No matter how many times we point out that “monthly billings of revenue” is a revenue recognition methodology and SaaS is a software delivery model, the explanation falls on deaf ears.
Obviously, I’m missing the point: Monthly revenue billing equates to SaaS, which equates to a higher valuation, probably in the range of that attributed to Saleasforce.com. Yeah, now I get it. There’s the door.
Culling the Herd
I believe that 2016 is going to be the year of the “culling of the herd” and valuations for many tech unicorns are going to hit the ground with a very loud and resounding thud, but I’m guessing that’s not news to anyone reading this newsletter. Unfortunately, the eventual demise will not be pretty, although it will be very much less a public spectacle than the bursting of the 1997–2000 dot-com bubble.
Interestingly, I’ve come across a couple of articles recently stating that a significant devaluation of unicorns is nothing to worry about since, unlike in 2000 when market-crazed retail investors (my words) saw their dreams and savings vaporized, this time it’s really only wealthy venture capitalists who are going to take the hit. Yes, there is a difference but ultimately losses by venture firms directly impact returns to the Limited Partners who invest on behalf of pension funds, mutual funds, corporations, and ultimately individual investors. No matter how you look at it, eventually the poor returns flow downhill.
Secondly, venture firms that experience losses on their unicorn investments will become extremely gun-shy. In fact, we are already seeing a moderate pullback in early-stage investing as VCs start to think about keeping their powder dry for what could be a fundraising dry spell while GPs, LPs, and tech CEOs play a game of “pin the blame on the donkey”. With very choppy public markets and mixed results from recent tech IPOs, taking the companies public, particularly given that there are over 130 unicorns with massive valuations, is simply not going to happen. Unfortunately for the VCs there probably aren’t enough retail investors willing to be the “greater fool” to monetize their unsupportable valuations.
Furthermore, at current valuation levels, how many public company CEOs will be willing to step in and acquire the new disruptive tech leaders? Can anyone say “just one more time, let’s replay the AOL/Time Warner deal of the century?” NOT!
For technology companies looking to raise VC capital, the eventual fall of the unicorns will negatively impact the flow of investment capital not unlike mid-2000, the fall of 2001, and late 2007 through 2008. The cash taps get turned off while everyone retrenches. If you’re a company looking to raise growth capital, I would suggest doing it sooner rather than later.
While the tone of my comment may appear negative, I actually find many of the developments or trends quite amusing. Looking back on previous years we see the recurring themes of disruption, disbelief, scrambling, new business models, mining guys becoming tech guys, tech guys becoming mining guys…
Overall, I’m bullish on the state of M&A in Canada, especially for small and mid-sized companies. Demand for new acquisitions by strategic and private equity groups remains strong, not just based on what we read in the papers but from speaking directly with such acquirers in the course of our work on behalf of our clients.
If you have any questions about the state of M&A, please don’t hesitate to pick up the phone and give us a call.