Webhosting Magazine (April 12, 2001) By Jack Ferguson --
Around Infotonic's Worldwide Headquarters, a question has arisen regarding the value of shared hosting shops that use outside providers, such as Hostopia and Alabanza. Specifically, what are the effects of using a wholesale hosting shop on valuation if a virtual provider yearned to sell in today's market? It is an excellent question that, unfortunately, lacks a precise answer.

In an industry that consistently over-whelms even the brightest participants with its rush to evolve, attempting to grasp the effects disparate operational environments have on a company's valuation now and in the future can lead to a mental breakdown. However, as hundreds of companies contemplate an jump to outsourced hosting, it makes for a worthy, albeit equivocal, discussion.

What are the issues?
Like any other business, virtual hosts must stand up to the typical measures that determine worth: size, revenue, gross margin, cash-flow margin, average revenue per unit, etc. Buyers and sellers must also understand the capability for wholesale providers to improve a company's cash-flow position, today and two years from now. By avoiding a large capital outlay now, are significant returns surrendered in the future? On the other hand, the build versus buy analysis has pointed the wrong way for a great number of overly aggressive IP providers. We're all familiar with the guys who overbuilt, couldn't wrangle up the necessary customers and faced "unforecasted" competition. In the shared hosting space, is capital better spent on marketing rather than facilities?

Approaching the significance of the considerations above, and understanding of the customers' attachment to custom software tools that allow automated control over web sites, email, billing and commerce is vital. Can would-be acquirers efficiently move customers off a wholesale platform onto their own? Or does this lead to substantial customer flight? Under current conditions does it even make sense to try? Like hauling fish from the pet store, will sensitive hosting subscribers survive the car ride home? Does the new tank provide a comfortable, productive environment? It's all about control-who actually owns the sites, how easily a site can be transferred and psychologically, how hooked are customers on a certain interface?

The answers to these questions affect valuation. Sites that are easily transferred with minimum churn will receive higher valuations. Sites that remain on the same platform will also receive a premium, comments Graham Anthony of Cheval Capital. While these micro-issues swirl around each other in an ever-evolving dance, they are unavoidably driven by the mood of the market's varied beat.

Speaking of the market
Showing beeps of life recently, M&A inside the shared marketplace has remained in stable condition over the past 12 months - if you consider hovering around flat-line stable. Multiples have orbited around one-and-a-half to three times annualized revenues for small to medium hosts, posting average revenue per unit (ARPU) between $15 and $30. The public market is making a slow, shaky comeback and private equity players seem to be lifting their collective head off the floor. Hostcentric recently raised a $33.5-million second round, lead by Thomas Weisel Capital Partners. For all intents and purposes, however, shared hosting has been stuffed in the bottom of the footlocker as investors chase high-end shops. So, as we ponder the maning of life and virtual valuations, there's not a lot of market activity to analyze. Will this change, as hosting becomes an increasingly software-intensive business, demanding scale to achieve financial success?

"Everyone is talking about high-end providers being the 'real' play in hosting, while predicting shared providers will inevitably face the same fate as the dial-up guys," says Dean Mann of Rampart Associates. "However, if you look around, the dial-up guys - at least in the private market - continue to make money. Similarly, a shared host, if it has made the proper decisions about infrastructure and software, has probably established a reliable stream of cash flow."

Mann believes that as shared hosts continue to show growth and decrease costs through automation, investment dollars will find their way back into the space. "The bottom line is that cash flow creates opportunities," says Mann.

Cash flow is king
Providers, such as Hostopia and Alabanza, focus on their ability to save partners time and money. For companies that have no facilities, or their servers reside on bread racks next to leftover Chinese carry out, the savings on start-up costs are naturally huge. Based on 5,000 hosting subscribers, Hostopia estimates it would cost a company $3.85 million to develop a similar level of infrastructure, administration, automation software and bandwidth (to that of Hostopia) - services that the company can provide for as low as $7.50 per account with no set-up fees. However, a company using Hostopa must sill provide marketing, administrative support and front-line technical support to customers. For companies that already have an investment in facilities and support staff - ISPs, CLECs, web providers - the question becomes one of the ability to scale using current resources and access to capital when and if additional resources are required. How big can we get with what we got?

The expected cash flow generated from providing in-house hosting services must then be weighed against using a wholesale provider. Whatever the outcome of one's analysis, as the market evolves from valuing business on revenues toward values, based on a company's cash flow, it will be the most efficient, profitable shops that receive the premiums.

Automation steals the show - and subscribers
For buyers and sellers, the numbers are always critical. In fact, the remainder of our discussion is about cash flow and how operations determine its existence. As wholesale providers create their own private Idahos through the use of custom site-management tools and interfaces, will subs be wed to a particular environment, unwilling to move? Do virtual hosts hawking a specific interface lock themselves in forever, drastically cutting down the number of interested buyers and thus demand? On the other hand do these custom environments become de facto standards that actually attract attention as an efficient and profitable back-end system on which to scale through marketing, acquisitions or a combination of both?

"From a process standpoint, it [moving a site off Hostopia] is no different than the process that would be required to move accounts between any hosting company. We do not imbed anything within the web sites that makes them non-functional on other services," says Hostopia President Franc Nemanic. (To this point, not a single Hostopia partner, or " Hostopian," has left the service.) Nemanic believes buyers will become increasingly interested in subscriber bases hosted with leading wholesale providers. "They know exactly what they are getting when they purchase an organization using our services. The risks the acquirer faces are greatly reduced."

Indeed, the ability of an acquirer to consolidate 15 companies using a wholesale provider like Hostopia, compared to a similar number of incongruent stand-alone shops, should be considerably less complicated and costly. In a new era of cash-flow conscious companies, acquisitions that are accretive to cash flow and relatively painless to digest will win management and the money's approval. This begs the question, is anybody doing this?

"There's no question people will continue to explore acquisition and consolidation in the hosting space. A major obstacle in the current market is the absence of a sufficient arbitrage opportunity. Public valuations are depressed, but private multiples have not come down far enough. Capital is worried that there is not enough of a return in the arbitrage," notes Rampart's Mann. Nemanic says he is unaware of any rollups taking place inside the Hostopia environment. It seems there are players making a concerted effort to consolidate a number of Alabanza customers, but details are sparse.

Are there any answers?
Admittedly, there remain many more questions than answers; however, there are a few lessons to be learned. First, it's difficult to proscribe specific valuations without market comparables. At the moment, there's little data on what buyers have paid for virtual hosts because there have been few deals. Second, it's all about the cash flow. Companies must understand whether a wholesaler provider can increase cash flow. In many instances, wholesale shops seem very capable of drastically increasing a partner's bottom line.

Additionally, as the shared marketplace becomes increasingly commoditized, wholesalers will be required to present real solutions that allow their virtual partners the ability to offer increasing functionally and efficient to end users. "If you rely on people rather than technology to run your business, then, eventually, you will be forced into a niche business in order to justify your higher prices," points out Hostopia's Nemanic. As a gaggle of wholesalers, software and hardware vendors and regular hosts go after the market, it's difficult to predict who will provide the best solutions years from now.

Finally, as we move toward beings of pure energy and reason, equipment becomes less important. It's less important today because so many folks went crazy and now need to fill the space. This is not to say a small, near carrier-grade facility hosting mostly shared subs will be completely discounted, but as more facilities come online, their value decreases.

The bottom line? Questions about equipment, custom interfaces, customer stickiness and automation always boil down to cash flow. Manage these elements wisely and the cash flow they create will render them nearly transparent.