techslog

"I think we have reached the bottom in enterprise software... In the IPO market, I think there will be some software offerings for investors to get excited about..."

Paul Holland's words came like music to the ears of software investors. And Holland should know. As a general partner at the venture capital firm, Foundation Capital, he holds a grounded perspective on the software market. During the 1990s, he helped bring two software companies public: Kana Communications and Pure Software.

Though nothing like the action of the pre-bubble days, the software IPO market is actually picking up. A total of 14 software companies have gone public in the past 12 months - with mixed results - and new filings may be picking up as well.

The outlook for software IPOs is more positive than it has been over the past few years. As the M&A/LBO shakeout continues, there are several key trends which will guide new offerings for the coming year.

Recent Growth in M&A
Of course, when a VC invests in a software company, the goal is to achieve a high return from an "exit." Traditionally, the exit has been an IPO.

But, with the slowdown in the IPO market, software companies have been focusing on M&A as an exit.

Look at JBoss, which is a fast-growing open source company that develops middleware. Back in the 1990s, this would have been a red-hot IPO.

No more. This year, the company decided to sell out to Red Hat. Some other notable examples of M&A exits include:
EMC's purchase of VMWare
Symantec's purchase of Brightmail
Kronos' purchase of Unicru
CA's purchase of Wiley
Sybase's purchase of Mobile 365

There is also another trend: public software companies deciding to sell out. According to data from the tech research firm The451Group, a total of 89 public software companies have been taken out of the public markets by both strategic and private equity acquirers since 2004 (12 of the transactions had private equity buyers). The aggregate value of the transactions was about $67 billion.

Already in September, there have been two going-private transactions in the software space: Intergraph ($1.3 billion) and Embarcadero Technologies Inc. ($234 million).

The problem is that it is extremely tough to be a public software company. First of all, because of cutbacks on Wall Street, it is hard for companies to get analyst coverage. Next, there is the regulatory "tax." With Sarbanes-Oxley, the legal and accounting costs for public companies have skyrocketed. For example, if public-company costs are $3 million, then it will make it very difficult for, say, a software company with $50 million in revenues to post a profit.

Go Overseas?
With the difficulties in the IPO market, some U.S. tech companies are looking overseas. One popular spot is the London Stock Exchange's Alternative Investment Market (AIM). Its biggest selling point: there are no Sarbanes-Oxley regulations.

Yet, the AIM is a relatively new market - and has been subject to lots of volatility. According to a recent study from Innovation Advisors, there are some ominous signs:
After the third year, AIM company returns fell to -65 percent versus a -26 percent for NASDAQ.
U.S. tech companies that went public on AIM found that their stock was worth less than half of their IPO price after two years (a loss of 57 percent for AIM companies versus a 12 percent increase for NASDAQ).
After five years, all AIM tech IPOs traded 60 percent below their issue price, while on NASDAQ they traded 19 percent below their IPO price.

"The increased hurdles for going public in the U.S. are not necessarily a bad thing," said said Eric Gebaide, a managing director at the tech-focused investment bank, Innovation Advisors. "The result has been better quality in the public markets. After all, institutions got burned during the dot-com bust and do not want it to happen again. While I think we will see more software IPOs, things will not return to the heyday anytime soon. So, expect the M&A to continue."
A Look at Recent IPOs
There have actually been 14 software IPOs over the past 12 months. And recent filings show that a new wave of software IPOs may be coming.

The performance for these offerings has been mixed, with five IPOs below their offering prices. A look at Table 1 shows that the best performer was decision tools developer IHS Inc., up 89 percent. The worst performer, Traffic.com, saw its stock plunge 61 percent. The company develops technology to capture and deliver auto traffic information.

Table 1: Software IPOs of the Past 12 Months

IPO Trends for the Year to Come
New filings have been somewhat scarce. However three new offerings will hit the markets in the coming months.

Table 2: Recent Software IPO Filings

The recent IPO activity and filings points to some major themes:
Innovative Solutions: Wall Street wants unique approaches - in terms of business models and delivery methods. This usually means Software-as-a-Service approach; that is, a combination of hosted software and subscription fees.
Although, in some cases, the latest IPOs are using a hybrid model - involving a mix of subscription and transactional fees. An example is DealerTrack, which charges a fee for every loan application within its network.
B2B in Vogue: There is renewed interest in B2B marketplaces, as seen with DealerTrack (autos) and Loopnet (commercial real estate). These companies build competitive advantages from the "network effect." Basically, as more members participate in the marketplace, the more valuable it becomes.
Revenue Hurdle: "An IPO candidate needs to be a rocket," said Gebaide. "The revenue should be at least $50 million and growing at high double-digit rates. There must also be a diverse installed base of customers. There cannot be dependence on one customer."
Big Market Opportunity: The company must target an addressable market of at least $1 billion. What's more, the market must be growing at a healthy clip - or have lots of inefficiency.

For example, InnerWorkings's target market is the $367 billion commercial print industry. In fact, the market is growing about $8 billion per year and his highly fragmented, with about 39,300 printing plants in the U.S.

Or look at MEDecision. The company is focused on the massive healthcare industry, which is expected to account for $4 trillion by 2015 (which will be roughly 20% of GDP in the US). If you drill-down to MEDecision's addressable market, it is currently over $1 billion and growing at 15.8% annually.

Many software vendors are pursuing the above strategies above - to varying levels of success, no doubt. This drive to reposition companies combined with heightened levels of software investment will undoubtedly lead to a resurgence in software IPOs over the coming year.

Tom Taulli is the author of various books, including the Complete M&A Handbook . He operates InvestorOffering.com and writes a blog at www.taulli.com.