e-discovery 2.0

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.

As companies use Clearwell’s e-discovery solution on more and more cases, I often find myself speaking to their litigation support service providers. Other than being in the same industry, these service providers have nothing in common: they vary from small shops to large, national companies; from unprofessional cowboys to highly principled professionals. But despite these differences, they all say the same thing: theirs is a very tough industry.

Perhaps everyone says that, but in their case there are good reasons for believing it to be true. It is very hard to differentiate litigation support services, other than by price; law firms make for demanding customers; barriers to entry are low so there’s constant price pressure from new entrants; and, it can take a long time to get paid, given that you are at the end of a long chain (enterprises must first pay law firms who then pay service providers).

That led me to wonder, “What would I do, if I were in their shoes?” The answer is that I would seek to differentiate my service by leveraging technology to swim upstream.

Neither of these ideas (leveraging technology, moving upstream) is original in its own right. Every litigation support service provider leverages technology in some way or other, and many have even built their own in-house review platforms. The larger ones have also sought in one way or another to swim upstream, meaning sell to their customer’s customer (the enterprise) directly rather than to law firms who then sell their services to enterprises.

But what service providers historically have not done is combine the two ideas: i.e., use technology as the means by which they can more easily sell to the enterprise. To paraphrase what the bright, forward-looking CEO of one service provider recently told me: “If I can get technology into the enterprise behind the firewall, then that makes my corporate accounts more “sticky”. It makes it easier for them to export data into my review platform and more likely they will use my services on any given case.” This technology does not have to be developed in-house; service providers can partner and integrate with providers of corporate e-discovery solutions to achieve the same effect.

My respect for litigation support service providers has only increased as I have come to appreciate the severe market pressures under which they operate. So has my excitement for the opportunity before them. Litigation support services is a large, fragmented, growing industry –- a level playing field in which service providers who innovate can see large returns.