e-discovery 2.0

In the past couple of weeks, I have spoken to several people close to the Iron Mountain-Stratify deal, and it has been interesting to hear their different perspectives.

The one thing they all agree on is that, as a business, Stratify was doing well. From a combination of news reports, Iron Mountain’s statements, and my various sources, I learned that Stratify’s revenue grew from $24M in 2006 to $30M this year. That is below the $40M+ it forecast earlier in the year, but healthy growth all the same. Gross margins are an impressive 60-70%, which is great for a services business, and profit margins are 20-30%. The vast majority of its 110 customers are law firms but – I know from personal experience – it has had some success in the enterprise. Net net: Stratify was in pretty good shape.

But at that point, opinions begin to differ. I heard 2 competing interpretations of the acquisition:

1. It’s a good deal for all sides

This was my initial reaction and the topic of a blog post written on the day the deal was announced. It has since been echoed in the press and by the analyst community. The story goes something like this:

Everyone wins from this deal. Once you factor in assumed stock options and retention packages along with the $158M that goes to existing shareholders, Stratify gets a multiple of 5.5X current year revenue, which is high for a services business. It also gets to operate autonomously under the Iron Mountain umbrella, with (supposedly) minimal interference from back East. For its part, Iron Mountain gets a growing, profitable business which it can grow more quickly, by selling into its installed base, and more profitably, by leveraging its existing sales force.

2. Stratify sold too cheap, too early

Why sell a profitable, growing business, especially one in a rapidly growing market like e-discovery? Given its growth trajectory, won’t an independent Stratify be much more valuable in 2-4 years time than it is today? Why repeat the mistake made by shareholders of VMWare and MySpace, who sold billions in value for a few hundred million?

The answer, say people who hold this view, has nothing to do with Stratify’s business and everything to do with its shareholders. On the one side, Mobius, the venture capital firm which owned 70% of the company, wanted out – the firm is winding down, some of its partners are raising a new fund and wanted an outcome to boost their VC track records. On the other side, the founder was tired after 8 years slugging it out and wanted a payoff. The business is not suitable for a financial buyer (sales are too lumpy and unpredictable, making it hard to take on large amounts of debt), so an acquisition was the only option.

With the benefit of more time to digest the deal, I have come to feel that both views are in fact correct. It’s a good deal for all sides, even though there’s a strong case that Stratify sold too early. Regardless, there’s still a lot for the Stratify team to feel good about – and, following the MySpace example, they can always go back and ask for a pay rise.

After months of rumors that Iron Mountain was going to do “something”, the grandfather of records management announced today that it is acquiring Stratify for $158 million in cash. My best guess is that Stratify will do about $30 million in bookings this year, making the purchase price about 5X revenue – a pretty good multiple for a services business with gross margins of 50-60%.

Iron Mountain’s motivations are not hard to guess. It stores oodles of electronic data for large corporate clients. Whenever those clients have a case, they retrieve a subset of that data and send it off to a service provider like Stratify for processing. Through this acquisition, Iron Mountain now has a chance to up-sell its customers on Stratify and capture that service provider revenue for itself. This will be compelling to customers if (and this is a big “if”) Iron Mountain is able to integrate Stratify with its archive, making it easy to pass data from one to the other. As one Iron Mountain customer at a major Wall Street bank told me, “Iron Mountain is great about getting data in; it’s awful when you want to get data out.” If Stratify can help solve that problem, even if it’s only in the case of litigation, then every Iron Mountain customer will cheer.

Given the obvious potential of this deal to Iron Mountain, the question is less about why they would want to acquire a service provider in general, and more about why Stratify in particular. E-discovery services is a large, fragmented market, and there is no shortage of players to choose from. That said, I think they found Stratify a compelling target for 3 reasons:

• Good Technology: Unlike many service providers, Stratify (or Purple Yogi, as it was originally called) started life as a product company. It went through several incarnations: starting out in 2000 to “personalize the internet” for consumers, it soon moved on to knowledge management for corporations, before finally settling on e-discovery services for law firms. To fund all this, it raised over $30 million in venture capital and invested a good chunk of that in product development. The result is a sophisticated product that goes far beyond the review platforms that most other service providers have built.
• Right Size: Many acquirers like companies in that $20-30 million in revenue range. On the one hand, they are big enough to provide a solid platform for growth; on the other, they are small enough to be affordable. When Iron Mountain analyzed the market, it will have found the vast majority of targets either too big or too small, leaving it with only a handful of players to consider, like Stratify, Cataphora and H5.
• Willing Seller: It is no secret that Stratify’s largest shareholder, the venture capital firm Softbank, is winding down and was looking to sell its stake in the company. That, together with the inevitable fatigue that sets in after 7 years of slugging it out, most likely made Stratify a willing seller.

So, on paper, this is a good deal for both sides. Stratify gets a decent return for many years of work; Iron Mountain gets the chance to capture more revenue from its customer base. My congratulations to the Stratify team – I have huge respect for entrepreneurs who weather the dark days, re-invent their company, and lead it to a successful outcome. I wish them well on their new adventure.