It's time to put up or shut up in cloud software.
One of the hottest recent themes in technology has been the rise of young companies such as Workday and Zendesk that sell Web-friendly software to businesses for subscription fees. Those cloud software firms are the ones that have been going public -- back when technology companies were actually holding IPOs -- and cloud software startups have emerged to fill nearly every imaginable technology need in corporations or among Main Street businesses.
There are signs, however, that we're on the cusp of a cloud shakeout.
An index of cloud software firms maintained by Bessemer Venture Partners has fallen about 8.5 percent this year through Friday, far worse than the S&P 500 and other technology stock indexes during the same period. And in the last six weeks, five deals have been announced for young cloud software firms valued at $500 million or more each.
The takeovers include Tuesday's deal from marketing software firm Marketo, which agreed to sell itself to private equity firm Vista Equity Partners for a headline price of $1.79 billion. Vista also recently added Cvent, which sells software for corporate event planners, to its stockpile of software buyout targets.
There have been predictions for several years that independent software firms focused on specific business tasks like tracking marketing spending or running payroll would get consolidated by one-stop-shopping software titans such as Microsoft, Oracle or SAP. The giants have been making selective purchases of cloud software firms, but it's interesting to see a private equity firm getting into the mix, too. It may mean the cloud software business has entered a phase in which the companies that are growing -- but not at hyperspeed -- have to prove they can churn out profits, or capitulate to new owners with different expectations.
Villi Iltchev, a longtime software executive who is now a partner at venture capital firm August Capital, wrote recently that it's not easy for big software companies to wring value from acquisitions of subscription-software firms. And that means cloud startups can't necessarily rely on a windfall from a big corporate buyer. The sugar daddies, in other words, won't hand out rich multiples for everyone. Marketo's sale price works out to about 5.5 times the company's estimated revenue for 2016, according to Bloomberg data. During an early 2014 market peak for many cloud software firms, Marketo was trading at about 7.5 times its expected revenue.
For Vista, its recent software purchases don't immediately seem to fit the classic private equity blueprint of buying profitable but slow-growing companies, piling on debt and milking them for cash. Marketo and Cvent are posting healthy sales growth of 35 percent and 27 percent in the first quarter, respectively. Marketo isn't profitable and it has negative free cash flow -- a measure of the cash generated by the company's business minus its capital spending. Cvent has posted positive free cash flow inconsistently.
The PE firm's interest is a test of whether cloud software has the same "set it and forget it" characteristics of dinosaur firms like Oracle, IBM and Microsoft. Once a company buys database software from Oracle, it becomes incredibly tough to ditch. Oracle can rely on software renewal or maintenance fees forever. If subscription fees for cloud software prove as predictable as Oracle's maintenance contracts, more PE buyouts will come to the sector.
It's unclear whether private equity will be good news for investors in cloud software firms. Vista's $35.25-a-share bid for Marketo is 64 percent above the company's closing share price on May 9, the day before Bloomberg News first reported that Marketo was exploring a possible sale. But the company's shares had traded as high as $45 in early 2014.
If cloud software firms can prove they're dependable streams of cash, more private equity buyers may be poised to pounce. That may prove to be painful for investors who bought into the cloud when share prices and growth expectations were lofty.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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