If investing in companies is a game, then an exit — a company selling to somebody else, or going public — is like winning.
In that sense, there was a whole lot of winning going on in the gov tech market last year. Enough activity, in fact, that the gov tech market is starting to look more and more like any other market segment, with its challenges and triumphs on the path to maturity.
Start by looking at last year’s GovTech 100 list. No fewer than 11 companies on that list were acquired or merged into other companies since that list was released. 2018 was remarkable for the number of large, significant deals that reshaped the landscape, bringing the sometimes-fuzzy outline of how a gov tech company can be a profitable investment into clearer focus.
First, streaming media provider Granicus acquired government website builder Vision Internet. Then Tyler Technologies, a long-standing gov tech company offering software spanning many verticals, acquired open data pioneer Socrata. Then TriTech, Superion and Aptean all merged into one big company called CentralSquare. Not to be outdone, a full six gov tech companies merged into a single entity called GTY Holdings* in a “reverse IPO” meant to bring the firms onto the stock market all at once. Around the same time, another company working with traffic enforcement and tolling operators named Verra Mobility had its own reverse IPO.
It’s difficult to parse the meaning of so much activity and what it means for gov tech going forward. But one thing has been made quite clear in the past year — if one asks whether investing in a gov tech company can really be profitable, the answer must now be “yes.”
Certainly H. Lynn Moore, Tyler’s CEO, feels that way.
“Outsiders look on, we’re a publicly traded company, they see our growth in revenues, they see our free cash flow … and it certainly raises the interests of people who run funds like private equity firms,” he said.
Jay Nath, co-executive director of the City Innovate Foundation — which spends a lot of time getting tech startups to work with cities to solve problems — feels change in the wind as well.
“I think it’s getting the people on the sidelines to take a closer look at investing in this space,” he said. “Because if you’re looking at the metrics in this space, you’re going to see we haven’t seen many IPOs, we’ve seen a few acquisitions, and [now] you’re seeing momentum toward acquisitions.”
ANATOMY OF AN EXIT
But not all exits are the same. A company looking toward the traditional Silicon Valley mindset of raise-raise-raise-exit has a few options, and different roads to get there. Those roads might influence how the company approaches growth, how it invests its capital and what kind of work it pursues.
The two basic kinds of exit are public and private — a private exit is where one investor buys out another, or an acquiring company buys out previous investors. A public exit is where a company has an initial public offering and hits the stock market.
Private exits are much more common, but there are several versions. A private equity firm might buy a company, merge it together with other companies and then sell it to another private equity firm, or to a larger company. Or perhaps a larger company simply buys a smaller company outright, without the help of a private equity firm.
That’s been the case with Tyler Technologies, one of the oldest gov tech companies and a true veteran at mergers and acquisitions. The company was created through mergers, and has completed many of them since. The Socrata deal was simply one in a long line of mergers.
Moore said the company’s approach lately has been to acquire companies that can expand Tyler’s product portfolio, rather than to buy out competitors and consolidate markets.
“It’s a way to accelerate time to market with current technology,” he said.
Tyler is large enough that it can fund acquisitions on its own. But there aren’t many companies of Tyler’s size in the space. So if other companies want to pursue acquisitions, they’re more likely to go the route of Accela, CentralSquare and Granicus — join up with a private equity firm whose deep pockets can finance many such deals.
That can be a path to rapid growth, but like any other path, there are risks involved. New ownership and a new attitude has the potential to make some existing customers nervous, especially in the public sector where government agencies become “married” to the systems they use for decades at a time.
“If private equity comes in and buys one company or a few companies, but if their road map is they’re not going to own that company seven years from now, customers are going to be in tune with that,” Moore said.
But it’s hard to deny the market leverage such deals can create. The CentralSquare deal created easily one of the largest gov tech companies around, and one that has an especially broad reach into the public safety systems of jurisdictions large and small. The company’s CEO, Simon Angove, said they are now going to try to use the reach of the new company to enable data sharing between bigger cities and the smaller cities and suburbs surrounding them.
“We believe that investors who are looking beyond just traditional [business-to-business] tech categories such as CRM, for example, which have limited and predictable growth patterns and where extreme competition has beaten out profits, will see that public-sector software has tremendous upside and opportunity for growth,” he wrote in an email. “Also, revenue streams tend to be more reliable in the public sector since they are based on state and local taxes.”
Though IPOs are rare, the GTY Holdings and Verra Mobility deals present an intriguing hybrid model that other companies could look to in the future. The “reverse IPO” in these cases worked like this: First, investors created a shell company. They carried out an IPO for the company, raising money that they then used to acquire their target companies. Voila, those previously private companies became public.
In the case of GTY, it was six companies: CityBase, Questica, OpenCounter, Sherpa Government Solutions, eCivis and Bonfire Interactive. None of the companies were particularly large, and according to CityBase CEO Mike Duffy, none were actively looking for an exit before they were approached about joining GTY Holdings.
The deal means the companies all now have access to much more capital and resources than before.
“The capital that is contained within the entity is in effect permanent, as long as we have effective uses for it,” Duffy said. “And that timeline is much better suited to our industry than, let’s say, traditional venture … in venture, you’re often asked, ‘Well who would you sell to in three years?’ right after you get done saying ‘generational transformation.’”
THE PRICE TO PLAY THE GAME
The venture capital/private equity/exit mindset is not for everybody. Some companies prefer to take things slow, self-funding businesses or taking out loans.
It’s a longer road, but there’s good reason some people choose to take it. Among other things, taking private investment means the company needs to eventually look for an exit, and some worry that distracts from the mission of the company.
“When you go into the VC track, you have to continue raising funding until you have an exit,” Nath said. “You cannot get off that treadmill easily.”
In gov tech, where so many people jump in because they see an opportunity to help the public, that could be a problem.
“You run the risk of misaligned incentives … trying to grow revenue, trying to reach a higher valuation mark, which is like a fleeting score in an interim quarter of the game, not an outcome in and of itself,” Duffy said.
Another source of market tension lies in the ebb and flow of consolidation and competition over time. The gov tech space is renowned for entrenchment; big legacy companies hold onto customers for decades and it becomes difficult for the customers to move on. So competitors die.
Still, there are smaller companies finding footholds in the space.
“When my co-founders and I first started Mark43 in 2012, some investors told us that it would take a decade to get our first major city police department on board,” wrote Scott Crouch, CEO of the public safety tech startup Mark43, in an email. “In six years, we are fortunate to already work with Washington, D.C., Seattle and Boston, along with dozens of other departments.”
In 2018, the story was largely one of companies gradually moving into competitive spaces with one another. Oracle jumped into the permitting and licensing space, putting it in competition with Tyler and Accela. Accela partnered with Microsoft for cloud services, which Oracle is also set on increasing its presence in. The predictive policing arena, fresh off the entry of CivicScape, gained newcomers in the form of CentralSquare and ShotSpotter.
Basic economic principles imply that that competition could lead to reduced prices and increased innovation for government as those companies fight to stand out from each other.
Not all feel that way, though. Many are worried that the very market forces that gave young companies a path to existence might simply circle back toward domination by individual vendors.
“We don’t believe that these mergers prove anything beyond the fact that the industry is becoming more consolidated and less competitive, which is by definition bad for government organizations,” Crouch wrote. “These legacy vendors will now feel even less inclined to innovate and improve the lives of the first responders who rely on them.”
Nath thinks more companies are heading down the venture capital path, which is bent toward mergers and acquisitions.
“You seem to be seeing more and more companies going down the VC track as you see more companies come into the space, more investors come into the space and the market changes,” he said.
To Duffy, that’s ultimately a good thing.
“The more entrepreneurs that we can incent into this space, the more mission-driven people we can have educating people …. and the faster [we] evolve the government tech stack, the faster we realize and the faster our champions realize the outcomes that this modern technology can unlock,” he said.
This article originally appeared in Government Technology.This article originally appeared in Government Technology.