Ben Kepes for Forbes writes: This week it was suggested to me that cloud accounting vendor Xero could be in the early stages of measuring up a potential acquisition in North America. Xero now has well over 200000 paying customers globally but, much like its other markets, New Zealand, Australia and the UK, growth in the US doesn’t seem to have built rapidly. While Xero hasn’t published specific customer numbers for the US, at its recent series of conferences it boasted of customer growth and numbers in its other regions, potentially indicating slow uptake. This is to be expected for a few reasons. First, as stated before, Xero has taken time to build momentum in other markets. Secondly, and perhaps more importantly, in the US it faces an incredibly strong competitor in Intuit INTU +0.65% with its QuickBooks franchise utterly dominating the SMB accounting space. Thirdly Xero follows a sales approach that targets accounting practices as channel partners. Accountants tend to be slow to adopt new technologies and hence despite the fact that Xero is unquestionably an excellent product, its uptake is, to an extent, out of its own control.
This slower growth wouldn’t be a problem but for the incredible growth Xero has seen in its share price. While the CEO has stated that the company pays little attention to the share price, at a market capitalization of close to $5B in New Zealand dollars, there is incredible pressure on the company, still doing relatively tiny revenue (currently around $70M annualized), to justify this price. The company announced a fundraising of a massive $180M only a couple of weeks ago led by Matrix Capital Management and the Peter Thiel-backed Valar Ventures. Since then the share price rise has been incredible as shown by the stock chart below:
It has to be said that this price rise is, in part at least, a reflection on the very low liquidity of the stock. Current shareholders are holding their stock and very few parcels actually come up for sale, distorting the price upwards.
While this sort of market capitalization is a great validation for the company, it also puts them under incredible pressure to perform and achieve the growth that is factored into the current price, which is where the acquisition suggestion that I heard comes in. Given that Xero is likely experiencing a similar velocity of sales growth in the US as it has elsewhere, an acquisition that could short circuit the growth lag is a plausible suggestion. Two companies that have been suggested as targets are Wave Accounting and FreshBooks. Let’s look at them both.
Wave Accounting
Wave (further information on them here) is an interesting company. Set up with the intention to offer free accounting software for SMBs it follows a similar approach as personal financial management product Mint.com (now owned, coincidentally, by Intuit) and monetizes by delivering highly targeted ads to users. In Wave’s case, this might take the form of special offers for customers – say I buy toner cartridges every six months, Wave can infer that information from the data it holds and offer me a special deal on cartridges the next time it assumes I’m ready to buy. It’s an interesting approach but questions remain as to whether business customers will trust a free accounting product or whether they’ll be turned off by the advertising.
Wave has raised around $25M in venture funding, most recently another $6M last month. Interestingly enough, despite being adamant that the accounting product will remain free, Wave has introduced peripheral paid services. One assumes this is a reaction to slower than anticipated revenue growth through advertising, potentially as a result of slower than anticipated customer uptake of the product. If this is in fact the case, then despite the recent funding round, Wave could look positively at a potential short to mid term exit.
From Xero’s perspective the deal would be relatively simple, they can certainly afford to buy Wave (either in cash or stock) so that wouldn’t be a barrier. However there is something of a disconnect between Wave’s dogmatic approach towards free and Xero’s more traditional model. The customer numbers and/or channel partnerships would have to be very appealing for Wave to be a good target, but even then Xero would have a hard time explaining the free to paid story.
FreshBooks
Freshbooks (more here) is also an interesting company. It’s arguably the most well known and popular invoicing application with over five million “users”. Unfortunately the company gives no information about the two most important things around customer count: how many of those users are regular (ie what churn they’re seeing with customers dropping off) and how many of those users actually pay for the service. My sources tell me paying customers are a fraction of total users.
Interestingly while FreshBooks started as an invoicing application, last year it re-positioned to start calling itself an accounting application. While one could argue whether a product without true double entry accounting can really be called an accounting application, the company has been broadening out the functionality it offers within the application.
FreshBooks has done an excellent job of penetrating the market, they have a quirky culture and focus on exceptional customer service. Founder Mike McDerment is a well respected entrepreneur and over the past year or so he’s built an A-grade management team around him. Little details exist publicly as to either revenue or profitability figures an article on Bloomberg last year stated that:
FreshBooks, which now has 110 employees… has achieved success without the help of venture capitalists, the lifeblood of startups for the past half century. While the company doesn’t disclose financials, FreshBooks has paying users in 120 countries and its product has been used by more than 5 million people since its inception
Interestingly some back of the napkin calculations by one experienced SaaS executive last year suggested that FreshBooks might have an annualized run rate of around $22M. This is a significant figure and would mean that any valuation that FreshBooks obtained for either funding or a buyout would be significant, in Xero’s case a cash purchase wouldn’t be viable. In an email conversation with McDerment he reiterated that FreshBooks is #2 in the US for paid customers after Intuit – given Xero’s ambitions, that’s certainly fighting talk!
Acquiring FreshBooks would give Xero a massive customer base – globally but with an all-important huge presence in North America. However FreshBooks sales approach is different to Xero’s they are primarily a direct to consumer product and how well this would fit with Xero’s culture, managements team and core approach is unknown.
Summary
I need to reinforce that the acquisition suggestion was simply a hunch by someone who, while well au fait with the industry, has no specific inside knowledge. However, even if the hunch is unfounded, it does raise the question about how Xero is going to achieve the growth to justify the share price rapidly enough to keep shareholders happy. Given that many shareholders bought stock at $1 per share, the return in only a little over six years is incredible. There’s not a shareholder who purchased at IPO who shouldn’t be extremely happy right now. But the markets being what they are, everyone is looking for continued growth, given that analysts are fairly adamant that current pricing takes into account expected growth and you have a situation where the company has to do even better than expected to deliver results. That’s a difficult situation to be in and one that calls for significant action beyond “business as usual”.
It’s certainly an interesting ride and it will be fascinating to see how the next few months pan out for the company. I reached out to Xero to comment on these suggestions but at publication time had no response to my email. Watch this space.
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