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Some Thoughts on Open Source Software in the Public Markets

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Catherine Klinchuch   October 12, 2017

This analysis was conducted by EquityZen Securities LLC.

Public market investors like to see [fill in the blank]. We could put many adjectives here. Very few seem to correspond with the adjectives often used to describe open source software (OSS) companies.

With several of these vendors gearing up for IPO, including MongoDB (filed S-1) and MapR (reported), we often get asked how OSS models fare in public markets. The challenge in answering this question is that it's somewhat unclear. There are not many publicly-traded companies whose business models are based on monetizing open source software. Only two — Red Hat (NYSE: RHT) and Hortonworks (NASDAQ: HDP) — have trading histories long enough to analyze. And how have those two fared? Well, differently…

Source: Google Finance, EquityZen estimates

With these data limitations in mind, we offer some preliminary thoughts on developing a framework for evaluating open source models.

What is open source? 

Open source is a model for developing software. It differs from traditional proprietary models in that open source software is distributed royalty-free along with its source code, which the user can view and modify. This model can be appealing for vendors as it enables both faster innovation to the source code through a community of contributors and faster customer adoption (in part because... well, it’s free).

If open source is software, what metrics are important for software investors?

For software companies, revenue growth is king. As mentioned in our newsletter on Tuesday, investors buy these stocks primarily on this metric. Note that we only look at SaaS companies here as their financial profiles more closely resemble OSS companies versus more established software players like Microsoft and Oracle. Other factors do matter. Indeed, Todd Gardner of SaaS capital developed a useful framework for thinking about SaaS valuations here that suggests other important metrics including size of total addressable market, retention rates, operating margins and capital efficiency. For now, at least, expected revenue growth seems to be the most important metric for investors, with ~70% correlation to P/S multiples.

Source: Google Finance, EquityZen estimates

How do open source companies fare on these metrics?

It depends. Pure play OSS distribution comes with a host of challenges. The first — and perhaps most salient — limitation is that revenue generation (and thus growth and also capital efficiency) is not inherent to a business model where software is distributed royalty-free. Retention rates can also suffer in this model. Accessible source code can make it more difficult to sustain product differentiation and ward off competitors. Further, OSS companies may require frequent capital infusions to fund adequate R&D.

But not all open source business models are alike.

Indeed, today’s open source vendors fall on a spectrum ranging from pure play open source to others that incorporate more traditional proprietary elements. We distill the main OSS business models into a few common buckets (though some companies add their own variations within each category):

  • Paid support: Here, the underlying software is distributed for free. The vendor charges for consulting, installation and support services to generate revenue. 
  • Open core: Definitions for open core can vary. Here, we are defining open core as companies that develop enhancements on top of the original open source code. These extra features are sold commercially. 
  • Hybrid open source: Hybrid models integrate proprietary modules with open source code. The proprietary code is commercialized. 

How do these models stack up? Each model has its merits. Paid support, which is the most pure play OSS model, generally encourages wider distribution as the core product is free. Hybrid models, the most similar to traditional software companies, do not share this advantage. However, this model does adhere more closely to a path that has already been successfully paved to robust revenue; i.e. building a compelling product and charging users for it.

What is the market telling us so far on OSS revenue models?

As mentioned earlier, analysis of open source valuations is far from conclusive given the small sample set of OSS companies and limited financial histories. Nevertheless, early signs seem to indicate investors prefer hybrid models, with multiples averaging in the low-7x range on forward sales vs RHT at 6.4x and HDP at 3.3x. Further, hybrids also clock in better than the SaaS sector overall (~6.5x). We note that this may bode well for companies with IPOs on deck — most notably, MongoDB which has a hybrid model and filed its S-1 last month.

Source: Google Finance, EquityZen estimates

Anything else to consider?

The fundamental law of corporate valuation is that a company’s worth must be equal to its cash flow prospects; i.e. revenue net of all cash outflows. Notably, only one of the vendors listed above is profitable: RHT. The other business models — though commanding higher relative valuations currently — have not yet been proven. Investors may have placed their initial bets, but it may be too early to call the race for open source.

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Some Thoughts Regarding ForeScout's S-1

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Catherine Klinchuch   October 05, 2017

This analysis was conducted by EquityZen Securities LLC.

ForeScout filed an S-1 earlier this week, marking its first step towards completing an IPO. ForeScout expects to list on the NASDAQ under the ticker “FSCT”. The S-1 was (long) expected as the company had reportedly filed confidentially early this year.

We believe comps point to a $1.1-1.7B valuation for ForeScout

ForeScout’s expected pricing range is still TBA. Comparable public companies trade at a mid-to-high single digit multiple on sales, as shown in the table below. Note that ForeScout generates revenue from hardware & software sold on a perpetual license (vs subscription); as such, we would expect its relative valuation to fall below companies with SaaS models. Our valuation estimate uses a P/S range of 5.0x-8.0x and assumes 2017 revenue growth continues at its YTD pace of 30%. Note that ForeScout’s last funding round implied a $1.1B valuation.

Source: Google Finance, Company Filings, EquityZen estimates

Some of our key takeaways from the filing:

(+) Revenue growth is robust.  Revenue growth is a key component of valuation, particularly for software companies. ForeScout has posted strong revenue growth numbers over the past several quarters. Note that while 4Q16 growth doesn’t look great, the number reflects a difficult comp in 4Q15, when multiple years of revenue were recognized on a non-standard contract [relevant excerpt from S-1 below]. Coincidentally (?), the revenue boost from this non-standard contract occurred immediately prior to ForeScout’s Series G funding round in January 2016. Nevertheless, 30%+ growth so far in 2017 suggests the business continues to see strong demand growth.

Excerpt from Forescout S-1 (with non-standard contract wording highlighted):

Source: Company Filings, EquityZen estimates

(+) Customer service retention rates remain solid.  ForeScout has maintained retention rates on its support and maintenance contracts of well over 100% since 2014. The strength of these numbers suggest the company may be well positioned to drive top-line growth by capturing additional revenue from its existing customer base (e.g. upgrades, other services). Existing customers typically carry lower acquisition costs versus new customers.

Source: Company Filings, EquityZen estimates

(+) Sales productivity stacks up favorably.  Sales productivity here is estimated as incremental revenue less costs to generate that revenue over prior period sales & marketing spend (ForeScout notes its sales cycle is typically 6-12 months). The company stacks up relatively well to higher-growth peers that also sell software on a perpetual model. Note in chart below that 2015’s outsized ratio probably “borrowed” from 2016 (and perhaps even 2017) given revenue recognition item mentioned above.

Source: Company Filings, EquityZen estimates

(-) Net margin still stubbornly negative, though may be some nascent signs of improvement.  Net margins are still very negative. Gross margin compression partially to blame (see below), while R&D expenses also seem to be creeping higher as a % of revenue. Note that there appears to be a seasonal pattern to margins (with the exception of 4Q15...again remember the item above). Looking at Y/Y trends, margins do seem to be showing some small improvement...emphasis on small for the moment.

Source: Company Filings, EquityZen estimates

(-) Gross margin has slipped.  ForeScout has seen a little over 400bps of margin contraction since 3Q15. Definitely a trend to keep an eye on. An unfavorable mix-shift is partly to blame. Chart 7 shows that the percentage of revenue that ForeScout earns from product sales (vs maintenance & other services) has declined. The drop may be attributable to seasonal/cyclical factors. Product sales typically carry higher gross margins compared to services.

Source: Company Filings, EquityZen estimates

What else caught our eye?

ForeScout sells its products under a perpetual license versus the subscription model employed by most next gen software companies. While there are many valid reasons for perpetual license models, subscription has gained popularity among software companies and investors alike as they typically afford greater cash flow stability and visibility. Perpetual licenses could also impact ForeScout’s ability to expand with smaller and medium-sized companies, which tend to prefer the flexibility of subscriptions. Additionally, S-1 notes that ForeScout underperformed bookings targets in 2H16. No update provided on bookings trends in 2017.