e-discovery 2.0

I knew the rumors about FTI’s acquisition of Attenex were true when we received a call in early May. It was from a large Attenex partner, who said: “We need to switch out Attenex no later than the end of June.” There have been many similar calls since then; as one service provider told us the other day, “I cannot imagine any Attenex partner not looking for other alternatives.”

The reason is obvious: Attenex Advantage partners – such as BDO Seidman, Deloitte & Touche, DiscoverReady, DTI Global Document Technologies, Forensic Consulting Solutions, Navigant Consulting, SPI Litigation Direct, VMAX Consulting and 10-15 others – compete directly with FTI. If they must now rely on FTI for their Attenex technology, it puts them at a massive disadvantage when competing for business. FTI could easily undercut them on price, since it no longer pays usage fees to Attenex; or, FTI could promise additional features in the Attenex product that its competition cannot match. It could certainly claim to be the world’s greatest Attenex experts (after all, who knows Attenex better than Attenex itself?). Perhaps worst of all, every time an Attenex Advantage partner works on a client using the Attenex product, it has to inform FTI at the end of the month so that it may be invoiced for usage, thus enabling FTI to track its client engagements.

Yes, FTI will likely make all sorts of promises about “Chinese Walls” and continuing to support other Attenex Advantage partners. But those promises are impossible to enforce (ask the editor of the Wall Street Journal!), and FTI could change its mind at any time, leaving service providers which depend on Attenex in the lurch. I don’t know anyone who would take that risk.

So the single greatest impact of the FTI-Attenex deal is that every other “Attenex Dis-Advantaged” partner needs to find an alternative e-discovery solution – and fast!

A second impact can be surmised from the market’s reaction to the deal. As the chart shows, FTI’s stock immediately popped 10%, adding about $300 million to its market capitalization. Partly, that’s because FTI negotiated such a great deal. It purchased Attenex for only 3.5x revenue, in a transaction that is neutral/accretive to earnings. Partly, it’s because FTI has a great track record with software acquisitions. For example, it acquired RingTail (a hosted review platform) in 2005 for $34 million, and today RingTail generates over 3 times that amount in revenue. Personally speaking, I have always been impressed by FTI’s team which is without doubt among the best in the business.

The interesting thing in this acquisition, unlike many others, is that the value will not come from selling the acquired product, since FTI is doing that already. In fact, FTI has been selling Attenex for years, and has even integrated it with RingTail. Rather, my guess is that FTI will use Attenex to grow its consulting business in several ways, such as:

1. By convincing clients to switch consulting firms, not technology. Let’s take a hypothetical example and say Ford is presently using Attenex through LECG. If LECG now uses a different e-discovery solution, then Ford is left with a choice: keep LECG and lose Attenex, or change from LECG to FTI and keep Attenex. Ford’s decision will, of course, be driven by many factors, and it will be interesting to see what happens in scenarios like this.
2. By winning a greater share of e-discovery dollars. Today, companies primarily engage FTI on life-threatening issues: stock option investigations, merger 2nd requests from the DoJ/FTC, and so on. By leveraging Attenex’s brand, FTI might extend that to also cover everyday e-discovery issues like run-of-the-mill litigation and regulatory inquiries.
3. By building an e-discovery footprint behind the enterprise firewall. Attenex has struggled to sell its product for on-premise deployment at enterprise customers in the past. Its website has no customer logos and I’m only aware of a couple of installations, neither of which is publicly reference-able. FTI’s strong consulting business might help change that and make it easier for enterprises to adopt Attenex.

I am sure there are other ways for FTI to get value from the deal that I am not smart enough to think of. My point is that, given FTI’s leadership talent and the scope of its consulting engagements, there are lots of things FTI could do with Attenex to create shareholder value far in excess of the acquisition price. That’s why I believe the second impact of the deal is that it will have a positive impact on FTI’s core business.

Assuming that you can buy each company for the same price, which would you acquire?

Company A has been in business 3 years, has 25 customers, no brand to speak of, and did about $5 million in revenue in the prior year; or,

Company B has been in business 7 years, has over 100 customers, a strong brand in its market, and is doing $25 million in annual revenue?

“No brainer,” you say, “obviously, Company B.” So it is that FTI looks to have got a great deal buying Attenex (Company B) today for $88 million, whereas Seagate looks like it grossly overpaid for Metalincs (Company A) which it bought for $82 million in December 2007. But things are not always as they appear, and there are good reasons why Attenex has sold for a paltry 3.5x revenue, a multiple well below the 16x commanded by Metalincs or even the 5x revenue that Iron Mountain paid for Stratify.

Three forces reduced Attenex’s acquisition price. The first is that FTI accounted for a large proportion of Attenex’s revenue. That gave FTI leverage over Attenex since it could say, “sell to us for $88 million, or we will take our business elsewhere, your revenue will plummet, and the value of your business will be greatly reduced.” This power that FTI had over Attenex made it the only logical acquirer, so there could be no pressure from other bidders to raise the purchase price.

The second force depressing Attenex’s valuation is that its revenue will likely decline post acquisition as Attenex’s partners (who compete with FTI) switch from Attenex to other solutions. Software investors value growth above all else – and are willing to pay up for it. For example, Bladelogic, an unprofitable software company, went public last year at a $500 million valuation with less trailing revenue than Attenex. But it did $62 million in revenue the following year (Bladelogic sold to BMC Software for $800 million in April 2008). Attenex, by contrast, will see declining revenue in the next 12 months.

Finally, acquirers worried that, since Attenex’s revenue comes almost entirely from its hosted offering via service providers, its revenue was more volatile than enterprise-oriented e-discovery software companies. This is due to the fact that customers (typically, law firms) purchase Attenex-powered services on a case-by-case basis and can switch away at any time. Enterprises, in contrast, purchase long-term software contracts that will not vary based on short-term changes in case volume.

Once these factors are taken into account, the price and the multiple start to look a lot better. Attenex’s founders, who are some of the pioneers of the e-discovery industry, get some well-earned liquidity; the venture investors make a decent return; and, employees get to join a professionally-run company that compensates its people well. My congratulations to the Attenex team, and to FTI which has negotiated a great deal.

Of course, all this says nothing about the deal’s impact on the broader e-discovery market. That will be the subject of my next post.

There are two independent analyst reports identifying the top e-discovery software vendors.

The first, published in June 2007, is the Socha-Gelbmann Annual Electronic Discovery Survey. The authors, George Socha and Tom Gelbmann, probably know more about e-discovery than anyone else you are likely to meet. As someone who has filled out their 178-page survey, I can tell you it is excruciating in its detail and incredibly rigorous. According to the report, George and Tom contacted nearly 1,000 individuals and collected detailed data from 115 organizations.

The second analyst report is Gartner’s MarketScope, which is published today (December 2007). Its author, Debra Logan, is fast emerging as one of the leading lights of e-discovery and has great instincts about the market. For her report, Debra tells me that surveyed 30 vendors and checked over 90 customer references.

The results from the two reports are as follows:

(1) Companies listed as “Top Electronic Discovery Software Providers Based on 7 Criteria” (Table 19 and 20), listed in alphabetical order. (2) Companies awarded ratings of “Positive” or “Strong Positive” (Figure 1), listed in alphabetical order.

Why are the lists so different? Primarily because of two main factors:

1. Gartner’s list mixes service providers and software companies whereas Socha breaks them out separately. The Socha report has an entirely separate list for service providers.
2. Socha’s report was completed 6 months earlier than Gartner’s. In that intervening period, several new players entered the e-discovery market. For example, Kazeon was ranked by Gartner earlier this year a “niche player” (lower left quadrant) in the enterprise search market, and has not been in e-discovery long enough to participate in the Socha study (or, if they did participate, they did not have enough e-discovery customers to gain a high ranking).

Conclusions

The first conclusion to draw from these lists is that any vendor not in them is probably not worth considering for e-discovery. If neither Socha nor Gartner ranked them highly, then the vendor either could not provide compelling customer references or has lost competitive bake-offs to someone who is on the list. Either way, they are best avoided.

The second thing that stands out is how different these lists are. Of the 21 vendors identified by Socha and Gartner, only 5 are ranked as top e-discovery software vendors by both of them. Those 5 are Attenex, Clearwell, FTI, Guidance, and LexisNexis. So, if you are an enterprise looking for an e-discovery solution, it is clear who you should call first.

Finally, it is worth noting that both these analyst reports are relatively new. This is the third annual survey for Socha, and the first MarketScope for Gartner. That speaks to the fact that e-discovery software is a new, fast-growing product area. More and more enterprises are adopting e-discovery software solutions, and asking analysts about them, because they offer such a compelling ROI.