HP Acquires SimpliVity – A Case Study on Why Headline Valuations May be Fake News

On January 17, 2017, Hewlett-Packard acquired SimpliVity, a hybrid IT services firm, for $650 million.  On the surface of it, the deal is unremarkable enough.   At $650 MM, the deal would be considered mid-market.  SimpliVity is a company you probably have never heard of before, and HP is, well HP.  Most of us know HP for their printers – some of us may know them for their underrated Omen computer line.  But, like so many “computer” companies, HP’s bread is increasingly buttered with IT services, so the rationale for the acquisition is fairly clear.  For the record, “hybrid IT” means IT services that are partially rendered on-site and partially provided in the cloud.

One could take a cynical view and ask whether this is simply the latest in a long line of HP acquisitions which have turned out to be tire fires.  There was Compaq in 2001 – thought to be HP’s path to sustainability in the PC space – the Compaq brand now lies in the dustbin of history. (Remember when Compaq had the coolest PDA’s? – for you kids out there, PDAs, or personal digital assistants, where smart phones that couldn’t make phone calls).  There was EDS in 2008, which turned out to be vulnerable to low barriers to entry in the enterprise computing support space – they were written down to half the purchase value in just four years.  There was Autonomy in 2011, written down by nearly $9 billion (of an $11 billion acquisition) in just a year due to allegedly dodgy accounting discovered after the acquisition and let to indictments of Autonomy’s executives.  These were all much larger acquisitions than this one.  This SimpliVity acquisition falls in CEO Meg Whitman’s playbook for relatively small acquisitions, less than $1.5 billion in price tag.  Such deals are, presumably, lower risk, easier to manage and assess, and are aimed at relatively marginal improvements for HP, as opposed to paradigm-shifting, shockwave transactions.  HP’s shareholders are likely holding their breath to see if this acquisition model fares better than those of Whitman’s predecessors.  Perhaps we’ll revisit this deal in a year or two and see how it’s working (or not).

The real story here is the valuation.  It turns out that SimpliVity was a venture-backed company, and, as recently as as March 2015 had joined the unicorns club with a $1 billion valuation on an investment led by Waypoint Capital.   On the face of it, within 14 months, SimpliVity lost 35% of its value or a negative return of 30%.  Ouch.  Like the Red Sox signing Pablo Sandoval to a long-term contract ouch.  That’s more than a little short of what venture investors are typically targeting.  On the surface of it, to be caught with that low a valuation relative to a recent round with a strategic buyer, and a buyer with a history of being a sucker, by the way, must be viewed as a disaster – like a Mariah Carey New Year’s performance kind of disaster.  Oh, and by the way, the deal was rumored to be worth nearly $4 billion just a few months ago.

What went on here? Here seem to be the most plausible scenarios.

  1. The latest (Series D) investors were banking on SimpliVity going IPO, but the IPO market dried up on them.  I think this is highly unlikely.  The markets are steadily climbing, and look set to continue to do so with a Trump Administration.  Further, venture capitalists who have raised enough money to make $175 MM investments are too smart to try to time markets like that.  Timing markets is generally a bad idea even in a fully liquid market.  Timing markets with privately held companies is financial Russian roulette with multiple bullets in the magazine.  That having been said, I do think the dried-up IPO market did motivate the deal.  I’ll explain a bit later why these statements are not contradictory.
  2. SimpliVity’s value fundamentals dropped by 35% (or more) in a 14-month period.  This could occur due to changes within the company – possibly losing key personnel or customers, or (more likely) intensified market competition as it is very hard for IT services businesses to create and sustain meaningful barriers to entry.  I think there is some probability that this is the case.  Market conditions change frequently and it’s not uncommon for businesses to sell only after they realize that their sales market conditions have turned against them due to “incumbency bias”, the concept that our psychology leads us to over-value the assets we already possess.  Hoarders are extreme examples of incumbency bias.
  3. The Series D investors blundered – and simply fundamentally mispriced the investment in SimpliVity.  I suppose that’s possible, but venture capitalists are pretty smart.  While venture capitalists are not as infallible as they often like to project themselves to be, a mistake of that magnitude in pricing a relatively mature company seems highly unlikely.
  4. The reported valuation of $1 billion was inaccurate.  Private companies are not obligated to report their valuations, and when they do, they are not strictly obligated to tell the truth.  I ascribe some probability to this scenario, but a relatively low one.  When companies do reveal their valuations, you can be they only do so because they think it is to their advantage.
  5. The $1 billion headline valuation was only nominal, not reflecting the terms of the investment that offer preferential returns to institutional investors.  I think this was very likely.

Having no facts other than what is publicly available, the following scenario seems highly plausible:  I think there was a deliberate effort by all parties in the Series D transaction to manufacture a $1 billion headline valuation.  There are good reasons to do so, beyond ego (the ego was certainly present in the calculus).  First, being part of the unicorn club is great publicity.  Being one of the startups that is worth 10 figures is something of which customers, employees, vendors and investors take notice.  Second, being part of the unicorn club can create a mindset in the market of a company’s value, generating excitement among investors, bankers, and potential acquirers.  Third, being in the unicorn club can be a great too for recruiting top talent – combining the stability of a relatively large company with the return of a high-flying venture-backed startup.  There are plenty of great reasons to make the market believe you are worth a billion dollars.

But wait – why would investors play this game?  Why would investors subsidize this facade – creating a Potemkin unicorn?  The answer almost certainly lies in the terms of the investment.  Not all valuations are created equal.  I haven’t seen a term sheet, but it’s a good bet that the Series D investors thought the appropriate value of SimpliVity was around the $550-$600 million range on a plain vanilla terms basis.   The investors agreed to the $1 billion valuation but made darned sure that their own return on exit would be as if the the company were valued in that $550-$600 million range.  This split personality of value is accomplished through terms such as liquidation preference, participation multiples, and full-ratchet anti-dilution rights.  All of these terms mean that the later investors secure their returns first in any liquidity event, and receive a disproportionate return (i.e. better than simply a one-for-one share basis) relative to the junior shareholders, and the threshold for making any return at all for the common shareholders is quite high.  Thus, investors exchanged the unicorn valuation for preferential returns – the early shareholders would only benefit from an exit if the exit actually realized matched or exceeded the headline valuation.  The early investors and founders assumed nearly all of the financial risk.

In this case, where the exit was effectively a down round, the Series D almost certainly drove the transaction through their board seats and voting rights, and the common shareholders felt like Charlie after being read the riot act by Willy Wonka.  If you’re wondering why the founders/common shareholders agreed to this, the answer is they may not have had a choice in the matter.  By the time you get to Series D investments and beyond, it can feel a little like you’re making a contract with Darth Vader.  And that feeling can be somewhat justified.

Even if the founders did have a choice in the matter, they may have gone along anyway.  The founders may have had employment agreements that paid out cash bonuses for a successful exit.  SimpliVity’s founders may have cashed much of their respective shares out in previous rounds and were ready to do something else.  The founders may have realized that the $650 million was as good a real valuation as they would get due to changing financial and customer market conditions.  As a founder or early executive, putting a 9-figure exit on the board all but ensures good press, lucrative employment in your next opportunity, and/or relatively easy financing for your next venture.  Note that none of these considerations are part of a fair value discussion – the founders might have been acting on personal considerations unrelated (well, loosely related, anyway) to shareholder value.  If this is the case, one can make the argument that the conditions of fair value did not exist for at least a segment of SimpliVity’s shareholders.

As a decision-maker, it’s important not to put too much stock in headline valuations.  They may not be telling you what you think you are, and may be a grave mistake to decide to sell (or not) based on the published valuations of so-called comparables, unless you know a good deal more detail about the transaction than is generally widely known.  While it’s possible the SimpliVity transaction reflected sharply deteriorating market conditions for the company at the time it was sold, it’s more likely that the headline $1 billion valuation was a mirage all along.  Not exactly Fake News, perhaps, but not gospel either.

What do you think? Do you agree that headline valuations can be Fake News?  Or is the whole thing overblown?  Leave a comment and join the discussion!  Not only does it help us, but it raises your own social media profile!

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2 Comments

  1. Great points, Michael. How do you account for these non-headline factors (liquidation prefs, ratchet down, etc.) when using reported valuations in a comparable analysis? You might assume that all venture/series D rounds have similarly bad terms, but a 35% discount to headline valuation seems high.

    • Lorrin – there is math that helps you compensate for these features, but, of course, you have to know what those features are so you can assign the correct math inputs. I wouldn’t be inclined to assume that all Series D rounds have similarly onerous terms. Rather, I would tend to assume that, on average, Series D investments tend to have similar, market terms. To make more educated guesses, it would be necessary to perform research on the circumstances surrounding each transaction and make a judgment call in terms of who had more leverage in the transactions.

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