For those who haven’t seen the details of the deal, Matrix Capital Management is investing NZ$58 million and Valar Ventures NZ$24 million into the company. Their total investment of NZ$82 million includes a purchase of NZ$22 million of shares from Xero’s three largest shareholders. All the transactions are priced at the 20-day volume-weighted average price at the time the deal was negotiated – NZ$6.00 per share. An interesting aspect of this is the fact that two of the founders, and MYOB founder (and large Xero shareholder) Craig Winkler are cashing out. Over on BoxFreeIT, Sholto has pointed out that:

Matrix Capital Management is investing NZ$58 million and Valar Ventures NZ$24 million. Their total investment of NZ$82 million includes a purchase of NZ$22 million of shares from Xero’s three largest shareholders. All the transactions are priced at the 20-day volume-weighted average price at the time the deal was negotiated – NZ$6.00 per share.

Cashing out is always a difficult subject. In the past few months we have seen both sides of the debate. Early Groupon investors were eviscerated when the company’s IPO was seen as largely an opportunity for them to cash out at significant gain. The performance of the deal deals company post-IPO seems to have justified this criticism, it seems the founders were aware of the temporary nature of the business and enjoyed the opportunity to take the money and run. On the other hand, Evernote recently raised USD85, in part to provide some liquidity to early investors, this move was largely supported, in part because of the very up-front nature CEO Phil Libin explained it.

In explaining the justification for cashing out, Xero CEO Rod Drury said that:

The investors made the offer to buy shares from the three largest Xero shareholders in order to minimise dilution to existing shareholders. As a result of the new share issue and transactions, Matrix Capital Management’s shareholding will increase from 1.8% to 9.8% and Valar Ventures will increase from 3.9% to 7.0%. Director Craig Winkler’s shareholding will reduce from 19.5% to 15.7%, Chief Executive Rod Drury’s shareholding will reduce from 21.0% to 18.5% and co-founder Hamish Edward’s shareholding will reduce from 5.7% to 4.9%.

As with all of these things, the real discussion that occurred around the deal is hidden from public view – but the fact that the share price has increased since the funding, despite the fact that existing shareholders have in fact been diluted somewhat by the round, indicates ongoing support for the company – it seemingly can do no wrong, at least in the minds of it shareholders who, outside from the handful of large funds, are both small scale, and long term. The impact on the market cap of Xero can be seen below, this round has pushed the company past the NZD900M mark, this despite it, as yet, being unprofitable.

The investors have obviously determined that Xero, despite coming from a relatively modest based of some 100000 customers worldwide, has the ability to scale into the millions – it’s going to have to if it wants to make its later investors a return. While Instagram, a company with no revenue, recently sold for close to $1B, it is in a very different space and enjoyed the benefit of being in a highly competitive market where a number of massive properties could all have been considered potential buyers – while Facebook snapped it up, it could easily have been Twitter or Google who did so. A different situation exists for Xero, despite Drury’s assertions that they’re building the company as a long term hold, the sort of investors they’re getting now are going to want to see a big return – there’s two ways this may occur:

• Finding someone with deep enough pockets, and a strong-enough stomach to buy Xero. The list of potential buyers gets shorter as the valuation goes up – clearly Intuit is a potential buyer, but there’s not a particularly good cultural fit there and it would be a marriage borne out of necessity rather than love
• A re-listing on the US markets which have a new-found passion for B2B stocks. The recent success of the Workday IPO indicates this could be a potential model for the company

MyPOV

Xero should be proud of the fact that such canny investors have got faith in their ability to execute. But with this investment comes a new and heightened level of scrutiny that might prove uncomfortable to the company that, until now, has enjoyed almost unwavering support from shareholders. It is always interesting to see how a company which is the darling of a market place, handles the increasing overview and potential criticism that comes from higher-caliber investors. Clearly Valar and Matrix see lots of potential here – but these funds have a short to medium term horizon on that benefit – they’re going to need to see Xero scale quickly to see those gains. And that’s where the money comes in – Drury has already flagged the possibility of investing in a US based call center (which on its own is somewhat interesting since he has previously been very critical of high touch, and hence high cost, customer support structures). I’m still a little unsure of how Xero is going to really accelerate growth outside its home markets of NZ and Australia – it’s doing OK in the US, but this level of funding means they have to do superlatively – that’s not a given.

Of late Xero has started to attract some investment analyst commentary and this has largely been cautious of Xero’s valuation and prospects. Notwithstanding the immediate share price benefit that this latest funding round has had on the company, these fundamentals haven’t changed and Xero is exceptionally highly prices given it’s low liquidity and financial performance – it’s all about potential gains which increases the risk of investing significantly.

Perhaps the most accurate, if somewhat coarse, analysis came from a friend of mine with a history of investment banking. When discussing the market cap and opportunity that lies ahead for Xero, he joked about the dubious nature of the business model but added:

All due respects though. Rod found a way into the US money machine and really, if they can keep customer acquisition up, they are bound to be taken out by some bozo, just by sheer dint of their size

It’s not an elegant approach – but in the thrust and parry of technology investing, this $80M stands as a real validation that Xero might just be able to achieve the lofty goals its founders and early investors have set it.

$20M Raised from Existing Shareholders

Existing shareholders have reinvested to the aggregate tune of $20M. Sam Morgan, Sam Knowles, Craig Winkler and Peter Thiel’s fund Valar Ventures have all taken part in the round. This is interesting as I was picking a major investment from a US based fund. While admittedly Valar is US based, I am a little surprised at the modest quantum and the Australasian focus of this round. CEO Rod Drury has spent some time recently talking with VC funds in the US and I would have expected a much larger round from an assortment of US funds. I see two possibilities – first that this $20M is an interim step to fund growth in US prior to a major round for a mass US attack. Secondly there is the possibility that Xero has made a strategic decision to keep a modest pace to their US operations (growing, but not seeking meteoric growth), if this is the case the $20M will see them able to deliver this growth.

At the same time Xero is offering a shareholder purchase plan to existing Xero shareholders under the same terms as the new round – namely $2.75 per share (a slight discount on what they are trading at currently). This will appease any existing shareholders concerns around dilution and shareholder equality.

Acquisition of WorkFlowMax Completed

18 months ago Xero made a strategic investment in what was then project management vendor WorkFlowMax. This investment was in my assessment a reaction to the announcement of a tight partnership between Xero competitor Saasu and former Xero partner Acclipse (the deal came less than a month after the Saasu/Acclipse hookup was announced). Xero has long told the story of the modern practice which sees client side and practice side operations occurring over a common ledger. In order to delvier on this vision, Xero needed a strong practice management offering and with Acclipse having gone elsewhere, Xero had to run fast to find this. While WorkFlowMax wasn’t primarily about practice management per se, they have since built out sufficient functionality to deliver upon this single ledge vision.

Xero made the decision that since the single ledger is central to their strategy, full ownership of WorkFlowMax was critical and hence has acquired the company for $2M in cash and $4M in shares.

I’m surprised that Xero has made the full acquisition, my earlier view was that the strategic investment gave them enough control over WorkFlowMax to achieve their aims, obviously having a separate entity didn’t sit comfortably with the Xero board and the benefits of bringing it in house with total control were worth the cost of acquisition.

It’s fair to say that, in Australasia at least, accounting practices are in a state of flux, unwilling to pay for a practice management solution that is growing ever less functional (when compared with modern approaches). Xero aren’t alone in trying to capture this latent demand, Acclipse is also doing well with its iFirm product – it’ll be interesting to see how the two of them grow.

Disclosure – I am involved in an initiative, LiveMigrate, that aids end users and practices moving from varying accoutning solutions. Our initial product being launched at Xerocon is an MYOB to Xero conversion service.

Last year at Xero’s partner conference many payroll providers were a little dismayed to hear that Xero was developing it’s own payroll solution – albeit a very very simple one that was rudimentary to say the least. Customer and commentator feedback indicated that this was a sub-optimal approach – and the announcement today is a tacit admission of that fact – once integration with Paycycle is complete Xero will have a fully integrated offering that, with time, I would imagine being rolled out in New Zealand also.

What this means for the existing payroll partners is unclear, in the blog post announcing the deal Xero moved to ease their fears saying that;

We have, and will continue to promote, a best-of breed approach whereby a number of Add-on Partners offer our customers payroll solutions

I would imagine however that some payroll providers, having got a fright from Xero twice already, would take little comfort in this statement.

In other news, Xero gave some guidance as to their US market entry strategy – something I’ve asked for previously. Xero indicated that, while it would work on finishing its US specific version, true market entry in the US would be throttled back. As they told NBR;

Xero now had over 1000 customers in the US – where its CTO recently relocated – but would not “really put our hammer down” until a major partnership was secured similar to Xero’s marketing alliances in Australia with Telstra (which promotes Xero through its business portal) and ANZ in Australia, or BT in the UK (which pushes Xero on its BT Business site

I’m sensing a couple of things here – firstly that we’ll see the fully featured US version of Xero released imminently (weeks instead of months) and secondly that we’ll very shortly see the announcement of some significant funding for Xero. A few things make me think this;

• The stated strategic shift away from driving for profitability but rather to target growth
• The Paycycle acquisition shows that Xero isn’t overly concerned about spending money where it deems necessary
• The fact that CEO Rod Drury has been spending significant time in the US lately
• The seed funding that Peter Thiel put in – this needs to be leverage for the next round

While Drury is saying that it’s a marketing partnership that the company is waiting for – my pick is that it’s more related to a funding question and I predict that the next couple of months will see Xero raise significant funding to cover the costs of US market entry. Their research will have shown them just how much this is likely to cost and I’m picking a $50M-$100M fundraising round to give them the breathing room to grow to scale in the US.

The unknowns are how the market will react to the putting back of the profitability target, and how markets may react to the possible share-value dilution that a subsequent fundraising round may create. I’m picking that shareholders, who are strongly supportive and loyal to Xero, will regard both those factors positively and there will be no short term share price impacts.

So it’s been interesting to see some developments in Xero’s US initiative. Some of these issues have been discussed in an NBR article which, unfortunately descended into an opportunity for some people to approach the issues from a perspective of ad hominem attacks. That does nothing for the level of conversation and really should be avoided. Notwithstanding the immaturity however there are some really interesting issues raised in the comment stream. Anyway, back to Xero’s US market entry. Some highlights;

Investment Dollars – Some Guy Called Thiel

Six months ago Xero has perhaps their biggest international validation to date when Peter Thiel, co-founder of PayPal and angel investor in Facebook, invested a small amount in the business. True Thiel can afford to lose significantly more than he invested in Xero, true Thiel invests in companies every day but nonetheless it was a validation and one that Xero will leverage for its US market entry.

Startup Bus

In something of a contrast to the approach in their other markets, where they’re all about partnering with institutions nd being seen as “top shelf”, Xero took a stab sponsoring the Statuup Bus event that put a bunch of developers into a bus and drove them from around the US to the SXSW festival in Austin. It was a good way to build a degree of awareness as Startup bus was covered by many tech blogs and it was a reasonably high-profile event for the web esigners/developers that are a traditional arly adopter customer base for Xero

The Small Business Web

While attending SXSW I was impressed to see Xero CEO Rod Drury hustling hard at a Small Business Web networking event. While other vendors were happy to chill out, have a few drinks and chat with their peers, Drury was hard out demo-ing the product. I had some concerns about how the Xero culture would translate to the US, in their home market, and primarily through the credentials of Drury and investor Sam Morgan, Xero has great credibility. This could easily have translated into Drury coming into the US full of bluster. I was pleased to see a humble approach (well, humble in the rarefied tech sector anyway) from Drury and the team.

Partner Positivity

I read a blog post recently from US accounting firm The Sleeter Group. Sleeter is a group that has 600 consultants throughout the US and Canada serving around 120000 businesses. If you consider Xero’s current customer base is somewhere north of 30k – that’s a pretty significant partnership. In the post Sleeter talks about something that one would have expected to be old hat for people in this space, the ability for connected web applications to reduce data entry and allow practitioners to focus on high value work. As I said, that should be a theme that accounting practices have understood for years now, he act that it appears to be an (in their words) “A Ha moment” indicates just how immature the market is, and why whoever gets to scale first in the massive US market will gain real stickiness.

Having a partner evangelize this message is significantly more valuable than Drury yet again telling his story – and it justifies the investment which I’m assuming Xero has made to on-board partners such as Sleeter.

It’s true that Xero is burning money incredibly fast and, while making good progress adding customer count, is arguably not doing so at a rate commensurate with its valuation. The indications are however that the growing momentum in the US will pay off in the next 12 to 18 months and we’ll start to see the graph move in a positive direction. Watch this space.

The comments on the Xero blog were, as expected, overwhelmingly positive – Xero has a hardcore bunch of users, fans and shareholders and many of the comments seemed to naively suggest that this is all that it would take to knock Intuit QuickBooks off its perch – people seem to forget that in the US market, Xero will be up against other similar products – inDinero, IAC-EZ, Kashoo, Less Accounting and many, many more. CEO Rod Drury himself is upbeat that the investment is a validation but would never be so bold as to suggest that the hard work is over.

Yes, Xero has had great success at home and, to a lesser extend abroad. Yes, Thiel’s cachet will definitely help with exposure. However it’s arguably still going to leave them coming from behind when compared to the hyper-buzz that inDinero and its 19 year old founder Jessica Mah gained after the funding they received only months after launching and even further behind the sheer momentum that four million customers (Quickbooks) brings to a product. Dennis points out why the Thiel investment, although a validation, won’t do much to accelerate uptake int he US market.

Anyway – I don’t want to dwell on the funding, I do however want to look at some of the more critical comments that were left on a TechCrunch post talking about the Thiel deal (rhyme intentional). A commentator, remarking on the fact that Xero is still cash flow negative and is paying its execs and directors well, commented that:

…the company is a cash black hole, because management’s interests are misaligned with shareholders’. The directors pay themselves fat, six-figure fixed salaries even as (or as a result of which) the company is making mounting losses. Every time they lose money, they ask shareholders to pony up to cover opex. Meanwhile the bigwigs bear no risk. I hope Thiel will introduce some Silicon valley thinking to these guys. The directors should be paid in equity with very low fixed salaries. That will change their incentives and focus. I’d hate to see such a great product in the deadpool due to greedy and wasteful management.

The comments are fairly aggressive especially in light of the fact that Xero has always been open about an approach to business that is the antithesis of bootstrapping. As CEO Rod Drury says:

We’ve done underfunded start ups before and this time we’re building a well resourced sustainable business

It is however interesting to note that a number of the directors and executives who are being paid what the commenter called “fat salaries” are some of the same people who get employee share purchase deals, or loans to buy shares, or are in fact significant shareholders from pre-IPO allotments themselves. As such, one could argue that paying “key management” 35% of revenue, and directors a total of 17% of revenue is a little unfair to shareholders. One could argue that the directors are in effect hedging their bets – making great returns by way of salaries, but also potentially being in line for great capital gains from a possible future sale.

Another Xero watcher reflected on this saying that:

the more I think about it the more I wonder why are the directors are paying themselves such big salaries….

On a simplistic level, they’re doing so because they can. their investor base is (or at least was pre investments by Craig Winkler and Peter Thiel) New Zealand based. Many of their initial investors were newcomers to the stockmarket, having jumped on board primarily because of the credibility of Drury and other founders. However, after a few years post listing, I wonder if those same initial Ma and Pa investors don’t start to ask questions about the appropriateness or otherwise of the executive remuneration.

Drury has said on a number of occasions that breakeven will occur this year. Alongside that Xero has a six monthly report due out in the next couple of weeks. Current numbers indicate 100000 active users (I quizzed Drury on this and he advised that an active user is one who has signed in over the past three months), note however that Xero charges per business so paying customers are significantly lower than active users. Either way, unless the news on both those fronts is positive, I’d expect more murmurings of discontent rom the rank and file Xero shareholders – watch this space.

After spending a few days with a bunch of boot-strapped start-ups at the Office 2.0 conference I have to agree to a certain extent with his thoughts although I’d extend them further to include spending generally – not just C level remuneration.

But first a disclaimer – I’m not suggesting that startups should scrimp and save every penny – it costs money to build a brand and sometimes there are things you just have to do (spending up to go to tech conferences for example) – but startups that let go of the reins – paying themselves high salaries and hosting lots of launch parties – run the risk of burning through their cash before they have a product.

The fact is that a startup should act like a startup – leave the top shelf partying to those who’re actually making the revenue.

My role model for sensible expenditure is a SaaS business that I’ve been following for awhile – rather than being located in high rent silicon valley, they’re domiciled in a much more affordable location. Rather than big ticket offices with plush sofa and carpets, they’re working out of a converted garage. They’re also scaling pretty fast, making good revenue and deriving profits from their endeavours – while their startup brethren are out partying on their investors dollars.

I wonder who will still be around in a few years time?

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