Nellore Capital, the largest shareholder of Subordinate Voting Shares with 1.2mm and 9.99% of the shares, opposes Thoma Bravo's proposed acquisition of Magnet Forensics

• Proposed transaction, which is a structurally unfair, opportunistic and undervalued deal, can be blocked by a simple majority of unconflicted Subordinate Voting Shareholders
• Nellore Capital plans to vote AGAINST the deal with 9.99% of Subordinate Voting Shares
• Magnet Forensics' compounding opportunity ahead is worth significantly more than the CAD$44.25 being offered per Subordinate Voting Share. Nellore Capital conservatively estimates current intrinsic value to be CAD$60 – 70 per share and growing annually by CAD$13 – 20
• Nellore Capital estimates Magnet Forensics will earn USD$50 – 60mm FCF in 2024. Thoma Bravo is acquiring the business for just 20 – 25x FCF, at a highly opportunistic time as the company's margins are just recovering from a recent investment cycle
• Closest precedent transaction is Vista Equity's acquisition of KnowBe4 Inc. in October 2022 would value Magnet Forensics at CAD $51 on EV/NTM revenue and CAD $60 on EV/NTM FCF. Magnet Forensics is growing faster, has higher gross margins and cash flow margins than KnowBe4 and attempting to adjusting for this by applying KnowBe4's EV/NTM gross profit multiple would value Magnet Forensics at CAD $55
• Magnet Forensics' senior management and board chair must believe the long-term value potential is far greater than CAD$44.25, since they have negotiated only for themselves the right to maintain their interests, an opportunity being denied to the public holders of Subordinate Voting Shares

PALO ALTO, Calif., Feb. 9, 2023 /CNW/ - I am writing to you on behalf of Nellore Capital Management LLC (together with its affiliates, "Nellore" or "we"). Nellore owns 1,199,950 subordinate voting shares of Magnet Forensics Inc. ("Magnet" or "MAGT"). We are proud to be the largest outside shareholder of Magnet. We have been involved since day 1 of the company's public company journey. We have never sold shares, and in fact have been consistently increasing our position – including as recently as December 2022 at CAD$37.32 per share. Nellore obviously believes that the true value of MAGT is much greater than CAD$44.25.

The Magnet team has accomplished something truly extraordinary - it has scaled to USD$100mm of revenue, while still growing 30%+ YoY and with less than USD$1mm of capital burned. Only six other companies (that we know of publicly) have achieved this: Adyen, Atlassian, Paycom, Microsoft, Veeva and Zoom. For illustrative purposes, if you had bought shares (instead of selling as we are being asked to do for MAGT) when these companies, excluding Microsoft, first hit USD$100mm of revenue, you would be looking at a 19.3x return in 8.5 years, or 43% annual compounding¹. Therefore, our first, second and third preference is for Magnet to remain public.

We love Adam and Jad, we love Magnet's business and we even love the industrial logic of combining with Grayshift. What we hate is that public shareholders are being forced to part with their shares entirely, and for far too low a price. If it were up to us, we would restructure this transaction as a PIPE led by Thoma Bravo where they acquire 13.2mm shares for cash and contribute Grayshift into Magnet at currently agreed upon ratio and all parties, including subordinate voting shareholders, would participate in the future value creation and have exactly the same cash economics at stake. If that is not an option, then in order for us to consider voting in favour of the transaction, the board must change the deal terms and require that Thoma Bravo pay a fair price that can compete with probable standalone long-term returns of MAGT. Unfortunately, we, the Subordinate Voting shareholders, only have the power to block the current deal, not fill in the ballot for our preferred structure.

I was hesitant to publish this letter because of my admiration for and relationship with the exceptional management team. However, given my fiduciary obligation to my LPs and the accelerated shareholder record date published yesterday, I had no alternative but to voice my concerns publicly.

The transaction requires approval from a simple majority (50% + 1) of the subordinate voting shares, excluding the 368,522 shares held by Adam and Jad. Given the reasons outlined below, we will not support the proposed transaction. Given that Nellore will use its 9.99% ownership to vote AGAINST, we are already partway towards achieving our objective of voting down this transaction.

Red Flags

The structure is unfair, the timing is opportunistic and the offer price is insufficient.

Structure

The most concerning aspect of the deal is the differential treatment between the members of senior management and the board chair (the "Rolling Shareholders"), and the public shareholders.

As outlined below, we believe that the offer price to subordinate voting shareholders represents a dramatic discount to the present intrinsic value, and an even greater discount taking into account the probable future path for the company and the value creation to result from the combination of Magnet with Thoma Bravo's subsidiary Grayshift. That the Rolling Shareholders are taking less on their shares for cash does not address this unfairness – it highlights the value that insiders are placing on continued ownership. As proof, note that the interests of Chairman of the Board Jim Balsillie should be more akin to a financial investor than to a senior executive like Adam or Jad. Therefore, Jim should want the same thing as subordinate voting shareholders: the best financial outcome for his own shares. If the deal being offered to subordinate voting shareholders is equivalent, then why isn't Jim taking it? Instead, he too is rolling 55% of his shares.

Because of the inherent conflict in the go-forward interests of the Rolling Shareholders and public shareholders, we question whether:

• there was a full and robust sale process run as if the entire company was being sold; and
• CIBC, the independent advisor to the Special Committee, was provided with information that fully captures the existing and potential value, or whether it was given more conservative information than what was provided to Thoma Bravo.

Timing

The timing of the deal seems odd. Why sell at a moment when things are going so well? Magnet has the right team (Thoma Bravo seems to agree, as an article published by The Logic rumored that Adam will be CEO of the combined entity), the right business strategy, accelerating revenue growth, rapidly increasing EBITDA margins and strong product velocity. Companies typically sell to private equity when things need fixing, why would MAGT sell after its incredible Q3 results?

The timing of the transaction announcement, before Magnet reports Q4 results on March 10^th, also seems odd and highly opportunistic. We are currently in a period of maximum opacity about the next twelve months. If we had Q4 2022 results, we would have:

• official company guidance for 2023 revenue and EBITDA. This would lead street analysts to update their currently stale models, especially 2023 EBITDA margins which are far too low at 20% despite management's guidance of at least at 23% during Q3 earnings,
• evidence of another quarter of ARR growth, ~50% YoY driven by Private Sector ARR, and
• proof of EBITDA margins inflecting further as the company exits the investment cycle it entered in Q3'21

Lastly, why does the press release mention a 41% premium on the 90-day VWAP, 87% premium to the day before Thoma Bravo's non-binding proposal for the company, and a 160% premium to the IPO price? The most important VWAP is after the company announced their stellar Q3 results on November 9^th and the fundamentals changed to the upside. The 49 day VWAP since that day is CAD $37.66 and the offer price of CAD $44.25 is a paltry 17% premium. Guess how much ARR has grown since Q3 results and today? 17% by our estimates.

Offer Price

We are voting AGAINST the deal because the price of CAD$44.25 is simply too low.

CAD$44.25 values Magnet at USD$1.28bn enterprise value, just 20 – 25x CY'24 free cash flow of USD$50 – 60mm. This is for a business that we project will be growing top line 30%+ and EBITDA 50%+. We believe if the company were allowed to stay public, it would trade above CAD$60 in 6 – 9 months and the market would very likely pay 30x NTM FCF by September 2023 for a stock with these growth, profitability and business quality characteristics. More importantly for long-term shareholders, Magnet will continue to add roughly USD $40mm of incremental revenue and USD $20mm of incremental EBITDA every year for the next 3 years with roughly 85% of that converting into incremental FCF. The incremental FCF will translate to CAD$13 – 20 per share of incremental value each year.

Our appraisal of value does not rely on precise growth rates or incremental margins in a given year. Rather, we are very confident in the durability of the company's 30%+ top line growth as well as its ability to convert that into significant cash flow margins over the forecast horizon. Most importantly, we are confident in the company's terminal value underpinned by the strategic pole position that Axiom occupies in the digital forensics workflow.

To arrive at current intrinsic value, we primarily perform a simple discounted equity value analysis using our rough, conservative forecast of USD$35mm of incremental revenue in 2023, growing by USD$10mm per year with incremental EBITDA margins in the ~50% range. Assuming a 12% discount rate on CY'26 FCF of USD$95mm (fully burdened for stock based compensation and taxes) and a 25 – 30x exit multiple, such that it would allow for the buyers at exit to still generate a return >15%, we come up with an intrinsic value estimate in the CAD$62 – 73 range today.

To supplement our discounted equity value analysis, we have also performed a precedent transactions multiples analysis using recent and relevant software transactions on a EV/NTM revenue multiple basis. The vast majority of targets looked much worse than Magnet – they typically grew revenue less than 20% (Magnet at 35%+), had gross margins in the 70%s (Magnet at 93%), were not EBITDA or FCF positive and were especially FCF negative after burdening stock based compensation. The one company that came closest to Magnet's financial characteristics was KnowBe4 Inc. However, KnowBe4 was growing slower by 5%, had lower gross margins by 6% and lower FCF margins by 5-9%. KnowBe4's NTM revenue multiple which we believe should be the absolute floor for Magnet and that results in a value per share of CAD $51. We actually think KnowBe4's NTM gross profit multiple makes the two companies more comparable, which would result to a value per share of CAD $55. Applying KnowBe4's NTM FCF multiple makes the two companies most apples to apples and that results in a value per share of CAD $60.

Lastly, we replicated the simple discounted equity value analysis but by using multiples and discount rate disclosed in a recent fairness opinion by one of the advisors on this transaction. The advisor chose a discount rate of 12.7% and applied 6.0 – 9.0x forward revenues on CY'25 projections and applied 30.0 – 40.0x forward free cash flow (unburdened by SBC) on CY'25 projections and discounting back to today. This resulted in a range of CAD $40.79 – 58.39 using revenue multiples and CAD $64.99 – 84.80 using FCF Multiples. This actually proves our point – Magnet's unique growth and free cash flow profile are simply not captured by revenue multiples. Not every dollar of revenue is the same – it has different growth and margin characteristics. But every dollar of FCF is the same – it makes the shareholder wealthy by exactly that amount. 

The key assumptions we make in building our forecast are:

(i)  durable growth rate over forecast horizon of >30%,
(ii)  ability to convert incremental revenue into incremental EBITDA at roughly 50%, and
(iii)  a belief in Magnet's strategic position securing the terminal value

Regarding (i), the company has provided enough to detail to dissect the ARR growth rates of Public Safety and Private Sector. Private Sector is growing ~60% YoY and thus will continue to actually put upward pressure on ARR above the current 50% YoY growth rate. Further, Public Safety has continued runway in the 25-35% growth range given the MDIS suite is just starting to take off (underpenetrated at 2% of accounts) and the core Axiom product is still priced at ~1/3^rd of Cellebrite.

Regarding (ii), we observed incremental EBITDA margins of 77% in 2020 and would expect at least 50% going forward as the company comes out of an investment cycle that started in Q3'21. Further, hiring has slowed down materially starting in October 2022 per the company's LinkedIn page. Payroll is ~75% of the overall cost structure and thus, there should be a fairly tight follow through to margins. As confirmation, EBITDA margins have inflected from 12% in Q1'22 to 23% by Q3'22, in just 9 months.

Regarding (iii), the company has built a significant scale artifact library over 10 years that is difficult to replicate, especially for prior versions of applications. Additionally, over 20k forensic lab analysts have been trained on and now live in Axiom on a regular basis. Further, there are many point solutions for extraction based on device type and application type but only one single pane of glass to aggregate all the sources and analyze. Thus, no extraction tool (including Grayshift) is an existential threat to Magnet's business.

Conclusion

Nellore Capital intends to vote AGAINST the proposed transaction, given the reasons outlined. The transaction can be blocked by a simple majority of Subordinate Voting Shareholders, of which Nellore represents 9.99%.

Importantly, if the transaction proceeds despite our effort, then shareholders who voted against have the right to dissent through the dissent and appraisal process, and to receive fair value for their shares. If this deal reaches that stage, we will consider exercising those rights.

Further information about Nellore's investment in Magnet and our long form analysis can be found at: www.secureMAGT.com

No Solicitation

This press release is for informational purposes only and is not a solicitation of proxies. Any proxies solicited will be solicited by Nellore as permitted by Canadian corporate and securities laws.

Advisors

Goodmans LLP is serving as legal advisor to Nellore.  Carson Proxy Advisors is acting as strategic shareholder and communications advisor to Nellore.

Disclaimer for Forward-Looking Information

Certain information in this news release may constitute "forward-looking information" within the meaning of applicable securities legislation. Forward-looking statements and information generally can be identified by the use of forward-looking terminology such as "outlook", "objective", "may", "will", "expect", "intend", "estimate", "anticipate", "believe", "should", "plans", "continue", or similar expressions suggesting future outcomes or events. Forward-looking information in this news release may include, but is not limited to, statements of Nellore regarding  the meeting and  how Nellore intends to vote on the resolutions proposed by Magnet.

Although Nellore believes that the expectations reflected in any such forward-looking information are reasonable, there can be no assurance that such expectations will prove to be correct. Such forward-looking statements are subject to risks and uncertainties that may cause actual results, performance or developments to differ materially from those contained in the statements.  Except as required by law, Nellore does not intend to update these forward-looking statements.

A copy of this news release may be obtained on Magnet' SEDAR profile at www.sedar.com. The head office of Magnet  is 2220 University Avenue East, Suite 300, Waterloo, Ontario, N2K 0A8. The address of Nellore is PO Box 1237, 855 Jefferson Avenue Redwood City, CA 94063-9992.

About Nellore Capital Management LLC

Nellore Capital Management invests in entrepreneurially managed, competitively advantaged technology businesses globally for the long term.

Footnotes

(1)

Illustrative analysis assumes investor could invest at Adyen's private round led by General Atlantic at ~48 EUR per share (28x, 8 years), Atlassian's private round led by Accel in 2010 and 2014 at an average of ~$10 per share (18x, 10 years), Paycom's IPO at $15.00 per share (21x, 9 years), Veeva's IPO at $20.00 per share ( 9x, 9 years) and in Zoom's private round led by Sequoia at $3.74 per share (21x, 6 years). Assumes investments would be held until February 8^th, 2023 and stock prices are based on February 8^th, 2023. Multiple of money of 19.3x, holding period of 8.52 years and CAGR of 43% are all based on simple averages of each investment.

SOURCE Concerned shareholder of Magnet Forensics Inc

Sakya Duvvuru, Founder & Portfolio Manager, Nellore Capital Management LLC, Ph: 501-551-0128, Email: [email protected]; Christine Carson, President and CEO, Carson Proxy Advisors, Ph: 416-804-0825, Email: [email protected]