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Something Ventured: May 13th

Insight For BC Technology Entrepreneurs

By Brent Holliday

Sierra Systems Stirs Up The Services Sector

Take another look
At what you see
'Cause you may find
That it's all right - Little Village, Take Another Look

That loud snap that you heard the week of April 20th was the whiplash of technology investors as they cranked their heads and watched Sierra System's initial public offering take off. The stock price has grown 85% in two weeks.

Another Internet technology, you might think? A red-hot, biotech play perhaps? No, Sierra Systems is a computer software solutions provider. They are a service-based organization trading at three times revenue! (roughly 152 times earnings) I, like many others, was intrigued.

I have not spent a lot of time looking at systems integrators and other technology services companies because I was under the impression that, like any service-based company, you could only sell your time. And how much is that really worth?

Well, apparently technology services companies have found a lot of value and investors in the publicly traded companies are bidding up their valuations to dizzying heights. Two other Canadian, public, technology services companies are Mortice Kern Systems and The CGI Group. Mortice Kern is valued at 8 times revenue and CGI at 5 times revenue.

Looking south of the border, (have a look yourself at http://www.upside.com/texis/mvm/stocks/sector.html?key=13) it is apparent that Sierra is not an anomaly at all. Are technology service companies a good opportunity for investment?

Perhaps, but it depends at which stage the company is at. Is this an important issue? You bet. There has been and will continue to be a rapidly growing trend in all industries towards outsourcing parts of the business and consulting where expertise is needed.

Here is a breakdown of technology services to help show the diversity and size of the industry:

1) Professional services - these are the systems integrators that solve the complex installations of products and the business consultancies that offer expertise and process reengineering. Sierra fits here.

2) Distribution services - these are the resellers (VARs for value-added) that help grease the sales channels for technology companies

3) Outsourcing services - Placement, public relations, legal, financial (VCs?) and accounting firms that focus on technology would be included here. It's a loose definition of infrastructure that would also include services such as call centers and content production.

4) Information services - These are the content aggregators like direct marketing, credit checking and related companies.

Where there may be an opportunity for early stage venture capital investment is in the professional services area. The framework for this discussion is that of, naturally, a venture capitalist. We look for opportunities that have three main criteria: A massive market opportunity, a superb management team and a sustainable competitive advantage.

There are many fine business opportunities that we do not fund, mostly because we must have the potential to get a huge return (We are just being honest with ourselves, knowing that most of our investments donít live up to their advanced billing). Until recently, VC's in general have been passing on service-based companies because, although they made good businesses, they did not generate the returns.

Service-based companies have it doubly tough because banks have also had an enormous amount of difficulty lending them money. Of the three aforementioned criteria for early stage venture capital investment, the fact remains that service-based companies have a fundamental problem. They do not have a sustainable competitive advantage. They don't have patents, they canít form standards and they canít build huge switching costs. These are the things that smartly managed products can have.

It turns out that the technology services market opportunity is so big, that competitive advantage may be attainable by simply staking out a niche and building good relationships with customers. The competitive advantage may actually lie in the brand of the company and its perception in the larger customer community.

Professional IT services was a $126 billion industry in the U.S. alone last year. And it's projected to double in 5 years. The Year 2000 problem is helping this growth immensely. It's no wonder that the public market thinks highly of service companies reaping profit from the massive pain that information systems have created.

Back to the issue of funding these companies way before they go public. Very early stage technology services companies probably donít need financing because they are living off the cash flow from their contracts. At some point they will want to expand the market and would require a cash infusion. Or, as is often the case, a product idea has emerged from the repetitive solutions being provided to the clients.

It may look attractive to have a hybrid company that is bringing in revenue from services and can then sell their product to their client base. But building a product and selling it are monumental tasks for any management team, let alone one that is also running a service business.

De-coupling product from service is usually a wise choice. Which still leaves the service-based company. For a VC to consider a professional technology services company there must be a large, happy client base, a track record of success and a vision of how to capture a much larger piece of this huge market.

Is there another Sierra Systems out there? I need something to take away the pain in my neck...

Random thoughts - Attaboy Glen! Get out there and make some noise about Ballard! This week Mr. Clark visited Alabama and asked Daimler-Benz (Chrysler) if they would build buses in BC. A good start, but you see the kind of jobs he's thinking of creating here...

I saw an interesting story on something called "charter schools" in California that are funded partially by high-tech companies. The massive shortage of high-tech workers (190,000 high-tech jobs unfilled today in the US, growing to 1,000,000 by 2002) has led to radical changes in school.

The kids are taught from an early age about science, entrepreneurship and how to use technology. Sound scary? I find it much more appealing than the BC schools, where teachers are told not to have spelling bees because competition is not good for self-esteem...

It's good to see the public hearings happening about the Employment Standards Act. But, I'd be interested in a poll of HR directors in BC's high tech companies that asked, "Do you really think that there will be any changes or exceptions made for high tech?"

I thought my "Hot Technologies Column" would generate some queries. Instead it was a bit of a yawn. Guess I'll shelve the "Hot Technology Fashion Trends For The 21st Century" column.

What Do You Think? Talk Back To Brent Holliday

Something Ventured is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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