Last week the announcement came that Xero had secured a huge investment round from US venture funds Valar Ventures (backed by Facebook founder Peter Thiel) and Matrix Capital Management. I’ve spent time talking with these US investors about Xero’s prospects and areas I thought the company would need to improve to make their investment pay off. Given these inside discussions I didn’t want to comment publicly about the round but readers have requested my thoughts so here goes.
For those who haven’t seen the details of the deal, Matrix Capital Management is investing NZ$58 million and Valar Ventures NZ$24 million into the company. Their total investment of NZ$82 million includes a purchase of NZ$22 million of shares from Xero’s three largest shareholders. All the transactions are priced at the 20-day volume-weighted average price at the time the deal was negotiated – NZ$6.00 per share. An interesting aspect of this is the fact that two of the founders, and MYOB founder (and large Xero shareholder) Craig Winkler are cashing out. Over on BoxFreeIT, Sholto has pointed out that:
Matrix Capital Management is investing NZ$58 million and Valar Ventures NZ$24 million. Their total investment of NZ$82 million includes a purchase of NZ$22 million of shares from Xero’s three largest shareholders. All the transactions are priced at the 20-day volume-weighted average price at the time the deal was negotiated – NZ$6.00 per share.
Cashing out is always a difficult subject. In the past few months we have seen both sides of the debate. Early Groupon investors were eviscerated when the company’s IPO was seen as largely an opportunity for them to cash out at significant gain. The performance of the deal deals company post-IPO seems to have justified this criticism, it seems the founders were aware of the temporary nature of the business and enjoyed the opportunity to take the money and run. On the other hand, Evernote recently raised USD85, in part to provide some liquidity to early investors, this move was largely supported, in part because of the very up-front nature CEO Phil Libin explained it.
In explaining the justification for cashing out, Xero CEO Rod Drury said that:
The investors made the offer to buy shares from the three largest Xero shareholders in order to minimise dilution to existing shareholders. As a result of the new share issue and transactions, Matrix Capital Management’s shareholding will increase from 1.8% to 9.8% and Valar Ventures will increase from 3.9% to 7.0%. Director Craig Winkler’s shareholding will reduce from 19.5% to 15.7%, Chief Executive Rod Drury’s shareholding will reduce from 21.0% to 18.5% and co-founder Hamish Edward’s shareholding will reduce from 5.7% to 4.9%.
As with all of these things, the real discussion that occurred around the deal is hidden from public view – but the fact that the share price has increased since the funding, despite the fact that existing shareholders have in fact been diluted somewhat by the round, indicates ongoing support for the company – it seemingly can do no wrong, at least in the minds of it shareholders who, outside from the handful of large funds, are both small scale, and long term. The impact on the market cap of Xero can be seen below, this round has pushed the company past the NZD900M mark, this despite it, as yet, being unprofitable.
The investors have obviously determined that Xero, despite coming from a relatively modest based of some 100000 customers worldwide, has the ability to scale into the millions – it’s going to have to if it wants to make its later investors a return. While Instagram, a company with no revenue, recently sold for close to $1B, it is in a very different space and enjoyed the benefit of being in a highly competitive market where a number of massive properties could all have been considered potential buyers – while Facebook snapped it up, it could easily have been Twitter or Google who did so. A different situation exists for Xero, despite Drury’s assertions that they’re building the company as a long term hold, the sort of investors they’re getting now are going to want to see a big return – there’s two ways this may occur:
- Finding someone with deep enough pockets, and a strong-enough stomach to buy Xero. The list of potential buyers gets shorter as the valuation goes up – clearly Intuit is a potential buyer, but there’s not a particularly good cultural fit there and it would be a marriage borne out of necessity rather than love
- A re-listing on the US markets which have a new-found passion for B2B stocks. The recent success of the Workday IPO indicates this could be a potential model for the company
Xero should be proud of the fact that such canny investors have got faith in their ability to execute. But with this investment comes a new and heightened level of scrutiny that might prove uncomfortable to the company that, until now, has enjoyed almost unwavering support from shareholders. It is always interesting to see how a company which is the darling of a market place, handles the increasing overview and potential criticism that comes from higher-caliber investors. Clearly Valar and Matrix see lots of potential here – but these funds have a short to medium term horizon on that benefit – they’re going to need to see Xero scale quickly to see those gains. And that’s where the money comes in – Drury has already flagged the possibility of investing in a US based call center (which on its own is somewhat interesting since he has previously been very critical of high touch, and hence high cost, customer support structures). I’m still a little unsure of how Xero is going to really accelerate growth outside its home markets of NZ and Australia – it’s doing OK in the US, but this level of funding means they have to do superlatively – that’s not a given.
Of late Xero has started to attract some investment analyst commentary and this has largely been cautious of Xero’s valuation and prospects. Notwithstanding the immediate share price benefit that this latest funding round has had on the company, these fundamentals haven’t changed and Xero is exceptionally highly prices given it’s low liquidity and financial performance – it’s all about potential gains which increases the risk of investing significantly.
Perhaps the most accurate, if somewhat coarse, analysis came from a friend of mine with a history of investment banking. When discussing the market cap and opportunity that lies ahead for Xero, he joked about the dubious nature of the business model but added:
All due respects though. Rod found a way into the US money machine and really, if they can keep customer acquisition up, they are bound to be taken out by some bozo, just by sheer dint of their size
It’s not an elegant approach – but in the thrust and parry of technology investing, this $80M stands as a real validation that Xero might just be able to achieve the lofty goals its founders and early investors have set it.
(Cross-posted @ The Diversity Blog – SaaS, Cloud & Business Strategy)