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The U.S. economy gained considerable momentum in 2003. Most notable was a significant improvement in Gross Domestic Product (GDP), a leading economic indicator, which reached its highest level since 1984. While third quarter GDP grew at the sizzling rate of 8.2%, the rate decelerated to a more sustainable 4.0% in Q4. For the year, GDP grew 3.1%, as compared to 2.2% in 2002 and 0.5% in 2001 (Figure 1).

Key contributors to the upturn in GDP were a

significant increase in business investments and

strong consumer spending, both of which surged in the third quarter. Business investments in equipment and software jumped 17.6% in Q3 and 10.0% in Q4. A weaker dollar and an improving global economy also drove the manufacturing sector, as demand for U.S. exports grew 19.1%, a seven year high, offsetting a 11.3% rise in imports. Consumers, who single-handedly kept the economy afloat in 2001 and 2002, continued to capitalize on decade low interest rates.

The Conference Board's Composite Index of Leading Economic Indicators, an important short-term forecasting tool, improved steadily the last three quarters of 2003, reaching the highest level in its history by year-end. Positive contributors included building permits, consumer optimism, new manufacturing orders for both non-defense and consumer goods, and stock market performance.

While the economic indicators were largely positive, there remained reason for caution. The number of unemployed was 8.4 million in December, 5.7% of the job force. While the number of jobless was down from the recent high in June 2003, the unemployment rate remained stubbornly high and reflected a drop-off in job seekers. The civilian labor force fell by 309,000 in December to 146.9 million; the labor force participation rate decreased over the month to 66.0%.

Entering the new year, consensus estimates put 2004 GDP at a sustained economic expansion rate of 4.5%, with business investments leading consumer spending. Consumer spending is expected to flatten or decline slightly as home sales weaken, interest rates rise and consumers begin to feel the impact of increased household debt and reduced savings.

Public Markets

U.S. markets ended a torrid year on yet another upswing in Q4, with the Dow, Nasdaq and S&P 500 climbing 13%, 12% and 12%. For the year, these same indices were up 25%, 49% and 26% (Figure 2). As a group, public software companies outpaced the broader market. For the year, the average market value of the SEG-Seventy, our index of public software companies, climbed 57%. The median market cap of the SEG-Seventy grew 78%. Other Q4 market indices for the SEG- Seventy compared to the prior quarter:

· Median revenue multiple for the group grew 11% to 2.8 times trailing-twelve-month (TTM) revenue.

· Median enterprise value (adding debt and deducting cash and cash equivalents) to revenue multiple increased 26% to 2.1x TTM.

· Median P/E ratio climbed 11% to 36.9x.

· Median multiple of EBITDA was 25.2x, up 20%.

· Average operating profit margin before depreciation, interest and taxes declined to 15.2% from 16.7% in Q3.

· Average revenue multiple for the SEG-Seventy was 3.6x (up from 3.1x in the prior period), and the corresponding confidence interval at 80% was 3.3x to 3.9x.

As expected, the markets continued to disproportionately reward the industry’s largest players – those public

software companies with the greatest revenue. Similar to last quarter, the 20 software companies in the SEG-Seventy with revenue between $200 million and $1 billion had a 2.8x median revenue multiple in Q4, as compared to 2.6x for companies with revenues below $200 million. Similarly, companies with revenue in excess of $1 billion recorded the highest median revenue multiple for the quarter, 5.0x. On an earnings basis, companies with revenue greater than $200 million had a7 median P/E of more than 40x, compared with 28x for those with revenue less than $200 million.

Public software company performance, however, did not keep track with escalating market caps and higher PEs. Median revenue of the SEG-Seventy actually declined 2.6% in 2003 from 2002 (Figure 3). Earnings of the group improved however, with the median growing 6.8% (Figure 4). Given the belt tightening that has occurred over the past three years, top line growth will likely be required to generate earnings sufficient to justify current market valuations.

Prospects for software company revenue growth appear better in 2004 than anytime in the past three years, but opinions vary. Both Gartner Group and IDC project a 5.0% increase in IT spending, but Goldman Sachs’ December survey of IT executives portends only a 1.5% increase in IT budgets (down from a 2.3% estimate in August, and a 3.5% estimate in June). Gartner also projects that IT spending will be greatest in the government and health care sectors during the next five years, each averaging in excess of 12% compounded annual growth. The financial services, education, manufacturing and communications sectors are each projected to increase IT spending by more than 6.5% over the same five year period.

The market valuations of public software companies continued to vary widely according to principal product focus, although virtually all categories saw quarter-over-quarter and year-over-year increases (Figure 5). SEG-Seventy median revenue multiples by principal product category for Q4 were:

· Business Intelligence (BI): 4.2x (up from 3.4x in Q3)

· CAD/CAE: 2.8x (up from 2.2x)

· Customer Relationship Management (CRM): 2.0x (up from 1.5x)

· Developer Tools (DT): 2.5x (down from 3.2x)

· Enterprise Application Integration (EAI): 2.6x (up from 2.5x)

· Enterprise Resource Planning (ERP): 3.4x (up from 2.4x)

· Information / Data Management (IM): 3.0x (up from 2.5x)

· Security: 4.5x (up from 3.6x)

· Supply Chain Management (SCM): 2.6x (up from 1.8x)

As in Q3, publicly traded security software developers boasted the highest market values, with median Q4 revenue multiples increasing an additional 24% over the prior quarter. Business intelligence software companies posted a 25% increase in the quarter, even though Cognos guided down next quarter expectations after beating analyst expectations. Public software companies focused primarily on enterprise resource planning (ERP) and customer relationship management (CRM) posted dramatic gains for the year of 227% and 87%, respectively. The developer tools segment, which has held much of its value in the past two years was hardest hit in the quarter, declining in market value 21.6% to 2.5x.

Initial Public Offerings

The market for initial public offerings (IPOs) declined

in 2003 relative to 2002. Only 73 deals priced, raising

an aggregate $15 billion, making 2003 one of the slowest years on record (Figure 6). However 89% of these IPOs, and 92% of all proceeds, came in the third and fourth quarters. 19 companies made it to market in Q3 and 42 were listed in Q4, suggesting there may finally be light at the end of the IPO tunnel in 2004 (Figure 7).

Venture-backed IPOs accounted for 29 of the offerings (40% of total activity) and raised an aggregate $2.3 billion (15% of overall funds raised). Perhaps signaling a trend, foreign issuers garnered more than 40% of 2003 IPO proceeds. The financial services sector led the IPO market with the largest number of offerings at sixteen.

Eight software companies went public in 2003, with seven coming to market in the second half of the year (Table 1). By year-end, these software companies were up a group average of 21% from their initial offering price. This contrasts sharply with 2002’s five software IPOs which declined an average 26% in price from date of offering to year-end.

iPayment, a provider of credit/debit card-based payment processing services to small merchants, climbed 114% from its offering price. Not all 2003 IPOs fared as well. By year-end, DVD software developer Intervideo had declined 21% and online travel agency Orbitz was down 10%. Perhaps most curiously, Kintera, an ASP targeted at non-profit organizations, was up 58% from its offering price. Kintera’s IPO supported more than a $225 million market cap for a company with less than $6 million in revenue, in an underwriting that harkened back to the “good old days” of 1999.

Four of the eight “software” companies categorized as 2003 IPOs primarily sell services rather than traditional “shrink-wrapped” or packaged software. These “software as a service” providers, iPayment, DigitalNet, Orbitz and Kintera, performed well as a group. Orbitz was the only company posting negative returns at year-end. Callidus, a provider of incentive management software, and Open Solutions, a provider of software and services for financial institutions, were the only traditional enterprise software companies to come to market in the period. Given the relatively strong level of activity in Q3 and Q4, and the continued strength of the overall equity markets, 2004 looks promising for software IPOs.

Private Equity

Overall, U.S. venture capital investments continued to decline in 2003, but apparently found bottom. With $18.2 billion invested in 2,715 companies, the number of companies funded in 2003 dropped by 12% (from 3,035) and dollars invested fell 18% (from $21.4 billion) in 2002. The average investment also fell by 5%, to $6.7 million. On a positive note, Q4 showed some reason for optimism, with $4.9 billion invested in 679 entities. (Figure 8).

Software, once again, continued to lead all other

industry sectors in attracting VC investment, with

718 companies funded in 2003 (20% of the total).

Relative to 2002, the number of software industry VC

investments declined 17%. In dollar terms, $3.6 billion was invested in software businesses in 2003, compared to $4.5 billion in 2002 and $8.8 billion in 2001. However Q4 showed a 13% improvement over Q3, with 145 software companies financed. Notable IT fundings included Grande Communications ($45 million), Vonage ($35 million), Alereon ($31.5 million) and Egenera ($30 million).

By comparison, two adjacent industry sectors,

Biotechnology and Medical Device companies attracted a combined $4.89 billion, or 27% of all venture capital. 69% of that amount went to biotech, with the balance invested primarily into medical devices. VC investments in telecommunications, networking, and semiconductors continued to decline in 2003, dropping to 11%, 9% and 6% of total investments.

In terms of the life cycle stage on companies

funded, 2003 mirrored 2002 for much of the year,

but hinted at change by year-end. VCs continued to

flock to relative safety, investing $4.7 billion in later

stage companies (26% of total) in 2003, the highest percentage for that category in the past 20 years according to MoneyTree (Figure 9). The average investment for later stage companies was $9.4 million. However, VC funding of less mature, expansion stage entities declined 22% in value from 2002, with $9.9 billion invested in 1,339 companies. Early stage company financing followed suit, declining 20% from 2002, to $3.3 billion. Funding for the youngest, seed stage entities leveled off at $354 million for the year, after plummeting 800% since 2000 (Figure 10). Viewed on a quarter-by-quarter basis, however, seed stage financing was erratic throughout the year, with Q4 declining 53% from Q3’s surprising $126 million windfall.

Across all industries, 624 companies received first-time funding totaling $3.4 billion, a decline of 27% from 2002. However Q4 first-time financings were 35% greater in amount than in Q3. Software was the leading sector for first-time financings, with 156 companies receiving $691 million. The closest competing segment was biotech, with 71 companies raising $462 million.

On a bright note, VCs raised $5.2 billion from limited partners in Q4, almost half the $10.8 billion raised for all of 2003. According to industry tracker VentureOne, nearly half the VCs surveyed said they expected to raise more money from limited partners in 2004.

Mergers & Acquisitions: The Trends

What drove this deal? It’s a question we ask every day as we review the most recent software industry transactions. To understand trends in software M&A, it’s essential to understand buyer motives, which shift over time to reflect fluctuations in the economy, changes in IT spending and new technologies which presage widespread market adoption. As those motives shift, so do the types of companies buyers target, and the prices they’ll pay. What were the deal drivers in 2003, and how did they impact valuations and purchase prices? How did buyer thinking evolve in 2003, and what does it portend for 2004?

A deal-by-deal analysis of transaction analyzed in 1H03 reveals fully 65% were driven by buyers, primarily public software companies, seeking small and mid-cap companies with strong financials, a suite of products, technology/market leadership and a significant installed base. Most were unwilling to stray far from home. Buyers sought an almost perfect strategic fit, acquiring companies which targeted the same market with highly complementary products and compatible technology. Examples abound, including JDA’s purchase of Vista Software for 1.0 times trailing-twelve-month (TTM) revenue, Serena Software’s acquisition of TeamShare for 1.4x, and FileNet’s acquisition of Shana for 1.1x.

Simply put, buyers in Q1 and Q2 sought incremental revenue at bargain basement prices. Median revenue valuations for software deals in Q1 and Q2 were 1.1x and 1.2x, respectively. There were few buyers, and most paid cash rather than use deflated stock as deal currency. Acquired companies had to have sufficient recurring revenue to pay for themselves in two or three years. Slightly higher prices were paid for companies which could generate incremental revenue almost immediately by cross-selling the buyer’s products into the seller’s installed base, and vice-versa.

In Q3, however, we began to discern a shift in buyer thinking. While the majority of transactions reflected the safe bet / incremental revenue rationale of Q1 and Q2, buyers proved more adventurous and less risk adverse in some 25% of the transactions. Public software companies were buoyed by sharply rebounding tech sector stock prices. The improving economy suggested increased corporate IT spending might follow shortly. For the first time in two and a half years, public software companies felt pressed to respond to competition and changing market requirements by acquiring proven solutions which would enhance the buyers’ offerings. We call these “strategic technology” buyers. Examples: Proprietary storage software vendor EMC acknowledges it must offer open platform storage technology and acquires Legato for $1.24 billion, a 4.4x TTM multiple; web content management provider Interwoven, losing deals to Documentum’s end-to-end knowledge management suite, pays $136 million, a 3.2x TTM multiple, to pick up iManage, a leader in content collaboration and document management to fill in the gaps.

Q3 also saw a sharp increase in vertical software acquisitions with more than 20 deals, particularly in the health care, financial services and legal markets. There were some 10 security software company sales in Q3, and almost as many wireless software company M&A transactions. There was a sharp decline, however, in financial buyouts, which is not surprising, given the median valuation multiple increased again, this time to 1.6x.

Q4 saw the number of buyers seeking bargains close to home decrease further, to about 40% of total transactions. The number of “strategic technology” buys, however, ramped sharply in Q4 to 48% of total transactions. Increasingly, buyers sought to add incremental technologies to materially enhance their core products, improve the end-user experience, and compete more effectively. Buyers beefed up help desk offerings with e-communications management (Primus / Amacis Group), web-publishing products with e-learning (Macromedia / eHelp), and online content with mobile media (InfoSpace / Moviso).

Some of Q4 remained standard fare. We counted four rollups, which we define as combining companies with functional components to comprise a full-fledged, standard category offering (e.g., HR + Accounting + Manufacturing +Supply chain + Logistics = ERP). We also saw four software companies taken out by direct competitors, and four buyouts by private equity firms or their proxies. 10 pure vertical software companies sold in Q4, down from 19 in Q3.

But Q4 also revealed a marked change in acquisition strategy for a surprising number of buyers. About one out of five buyers decided to venture well beyond their traditional space. In many cases, buyers acquired an entirely new software category, as they sought to diversify their revenue base, and in some cases reinvent themselves. A leading enterprise systems management provider added help desk software for SMEs (BMC / Magic Solutions). The behemoth of storage management added the leading content management developer (EMC / Documentum), and the leading Linux provider added storage management to its product line (Red Hat / Sistina). A market leader in security software expanded into enterprise infrastructure management (Symantec / ON Technology), and a healthcare ecommerce provider picked up a developer of object-oriented infrastructure software (Quovadx / Rogue Wave). The median M&A valuation multiple increased once again in Q4 to 2.1 times TTM revenue, driven in large part by higher multiples paid by these new software category buyers, as well as strategic technology buyers.

Mergers and Acquisitions: The Numbers

Overall, U.S. merger and acquisition activity showed noticeable improvement in 2003, halting a steady two year decline (Figure 11). For the year, domestic M&A activity for all industry sectors increased 10% to 8,198 transactions, and dollar value, at $529 billion, was up 20%.

Software mergers and acquisitions continued to lead all other industry sectors in number of transactions, with 1,325 deals, almost identical to 2002’s tally (Figure 12). After a very slow start in Q1, software M&A activity increased 10% in Q2 and 27% in Q3, but was flat in Q4. In terms of M&A dollar volume, software placed third behind banking & finance and insurance, but the $44 billion spent on software company acquisitions was 52% greater than 2002 (Figure 13). The sharp increase in aggregate purchase price can be chalked up to both improved valuations and a greater number of “mega” deals, including Peoplesoft / J.D. Edwards, EMC / Documentum, EMC / Legato and Business Objects / Crystal Decisions. In contrast, IBM / Rational and Microsoft / Navision were 2002’s only billion dollar deals. Software company exit valuations improved

steadily throughout 2003 (Figure 14). As noted above, the median software company M&A valuation (based on the equity purchase price) reached 2.1 times trailing-twelve-month (TTM) revenue, almost two times the M&A median valuation in Q1. For the year, the median software company M&A valuation, measured as a multiple of TTM revenue, was 1.6x.

As in prior years, software M&A valuations varied widely by product category (Figure 15). Categories which enterprise customers perceived as high investment / questionable return, such as ERP, CRM and supply chain software, lagged well behind lower investment / measurable return categories, such as storage management, systems management and developer tools. Valuations were

also higher in categories where leaders played catch-up with key competitors or redefined themselves by moving aggressively into a new category. Median revenue multiples by software product category were as follows:

· Accounting/Finance, 2.6x

· Business Intelligence, 1.5x

• Content/Document management, 1.4x

• Customer relationship management, 1.2x

• Data management, 1.3x

• Developer tools, 2.9x

• Enterprise resource planning, 1.0x

• Security, 2.5x

• Storage management, 5.0x

· Supply chain management, 0.7x