On Friday evening Wellington based company Xero released a prospectus and offer document with the intention of raising $15 million via a listing on the main board of the NZX. Xero is a startup company that is developing an online accounting software package for small and medium enterprises (SMEs). The company has an excellent team including founder and CEO Rod Drury and independent directors Sam Morgan and Guy Haddleton who each have outstanding track records with their own business. Valuecruncher has the utmost respect for these people and their achievements and believes that it is possibly the best team that could be assembled in New Zealand for this type of venture. Valuecruncher very much wants to see Xero succeed but feels there are some issues surrounding the IPO that need to be raised.

Valuation

The offer of 15 million shares at $1.00 per share implies a pre-money (prior to the IPO) value of $40 million and a post money value of $55 million. The valuation of a pre-revenue company such as Xero is a subjective exercise that often relies on the rule of thumb estimates of venture capital investors (see Valuecruncher’s April Newsletter). Valuecruncher recognizes the size of the global accounting software market but think its highly competitive nature and the projected time before Xero reaches profitably makes the pre-money valuation of $40 million expensive. Based on information contained in the prospectus it appears that the $1.3 million raised in March 2007 was raised at $0.25 per share, this is a quarter of the price that the public has been offered to invest less than two months later.
 

Capital Markets v Venture Capital

Companies at Xero’s stage (i.e product development / testing stage) typically raise capital via private equity (venture capital [VC] funds). Generally companies’ wait until they have established revenues and a track record of financials before undertaking a public listing. There are three primary reasons for pre-revenue companies not undertaking public listings:

1. Risk
   

At the pre-revenue stage it is difficult to determine which startup will be successful and which will fail. VC funds address this issue by holding a portfolio of early stage companies recognizing that a significant portion of the portfolio will fail. Investors in the public markets often do not have the same ability to diversify their exposure to startups and consequently require a significant discount to invest and can only justify allocating a small portion of their portfolio to startup companies.
 

2. Listing Costs
   

The Xero prospectus lists the costs related to the IPO at $1.02 million or 6.8% of the capital to be raised. For the majority of start-up companies the cost associated with a public listing cannot be justified for the amount of capital required
 

3. Continuous Disclosure
   

The continuous disclosure and quarterly reporting requirements of being listed on the NZX main board can be a costly and time-consuming exercise for an early stage company where resources are often limited. While we at Valuecruncher understand that losses are fine as long as value is being created. This is a difficult concept for ordinary New Zealand investors to grasp. Explaining to the market how substantial losses over the next few years is the plan will be a challenge.
 
Xero obviously believe the benefits of listing outweigh these issues but we at Valuecruncher believe that based on the skills and track record of the personnel Xero has assembled they could have raised the required capital in a private funding round and avoided these issues.  Having raised the capital privately the option of listing would still be available in the future. Given the projected cash burn and the anticipated time to reach profitability Xero may require a further injection of capital within two years.
 

SME Accounting Packages and Software as a Service

Extract from Xero Prospectus and Offer Document 
 
Competitive landscape The market for accounting systems for the SME market is large, but fragmented. Whilst there are established providers of traditional accounting software packages in Xero’s target markets, the Directors are not aware that any of the larger competitors to Xero have completely adopted a SaaS model. The Directors believe that the products offered by Xero’s most likely potential competitors are predominantly focused on traditional methods of software delivery encompassing an upfront licence fee, software upgrades and ongoing maintenance and services charges. SaaS is a fundamental shift from how software is traditionally delivered; it requires new technology architectures and the nature of customer relationships are different. The Directors believe that larger competitors are not as well placed to completely change their business models to the SaaS model which Xero offers. If so, this situation provides a good opportunity for Xero as a fast moving, unencumbered new entrant, operating from a low cost of sale environment to firmly establish
itself in the marketplace. The leading providers of accounting software packages tend to be large international companies, including MYOB (in Australia), Sage (in the UK) and Intuit (in the USA). These companies are listed on stock exchanges in their respective countries.
 
The product being developed by Xero does not represent a disruptive innovation; it focuses on taking an existing product and delivering via an online interface. The core point of differentiation appears to be the SaaS model. Although none of the major players appear to have fully embraced the SaaS model, there are a number of examples of similar products being developed. If significant demand for SaaS were to emerge, we believe the major players would quickly embrace the transition from software in a box to an online solution. These participants have established products, distribution channels and customer bases in place and will compete vigorously to defend their market share.
 
The initial feedback on the product suggests it is a high quality offering with a first-rate interface, the excellent team assembled and the size of the market suggests that there is definite potential for Xero. Realising this potential will be dependent on Xero’s ability to acquire customers in a market where the switching costs for customers are high. Valuecruncher finds it difficult to reconcile the current status of Xero with the pre-money valuation of $40 million but hope they will be successful.

This entry was posted on Wednesday, May 16th, 2007 at 1:37 pm and is filed under NZX, Xero. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.