ServiceNow Founder and Investor Offer Lessons in Startup Growth

After Fred Luddy founded ServiceNow in 2003, he was still a little shell-shocked from his experience as the CTO of San Diego’s Peregrine Systems.

Luddy had spent 13 years developing Peregrine’s asset management product before the high-flying enterprise software giant collapsed in a corporate accounting scandal in 2002. When a new management team finally calculated the extent of the fraud as part of Peregrine’s bankruptcy reorganization, Luddy said his Peregrine fortune was “zero.” He estimated that his stake in the company had amounted to $35 million just a few years earlier, when he was 40.

Now Luddy is 60, and he has a pretty good comeback story—which he told last week in a special presentation to the San Diego Venture Group. It was a relatively rare public appearance for Luddy, and was billed as “a fireside chat” with Paul Barber, the San Diego-based managing general partner of JMI Equity, the investment firm (and related entitites) that provided the initial $9.3 million in startup funding to ServiceNow.

In the 13 years since Luddy started ServiceNow, the company has grown into a software industry juggernaut, with roughly 3,400 employees and a current market valuation of nearly $12 billion. At the time of ServiceNow’s initial public offering in 2012, Luddy owned a 9 percent stake in the company (about 13.4 million shares), and Forbes estimated his net worth at $400 million.

ServiceNow’s software, like Peregrine’s, helps big companies and organizations manage their help desk and IT services.

But where Peregrine installed its enterprise software on its customers’ internal networks, ServiceNow was among the software companies pioneering cloud-based, software-as-a-service. The company has expanded over time into more of a platform-as-a-service, and now provides Web-based software used by big organizations to manage their human resources, legal, and financial services. The company also enables customers to easily develop their own forms-based workflow applications.

Much of that growth has occurred since 2011, when ServiceNow named ex-Data Domain CEO Frank Slootman to succeed Luddy as CEO—and Luddy shifted into a more familiar role as chief product officer. But Luddy said that making the transition was one of the most stressful periods of his life.

Before Slootman joined the company, Luddy said he was initially unsure whether he should continue as CEO, or shift to a more familiar role in software development. He recalled that Sequoia Capital partner and ServiceNow board member Doug Leone took him on a tour of several Silicon Valley software companies, so he could meet CEOs and talk with them about their jobs. The process helped him realize that he didn’t have the kind of CEO skills that ServiceNow needed, “and I had no interest in acquiring them.”

Fred Luddy of ServiceNow

Fred Luddy

It may sound funny, Luddy told the audience, but “I wake up every morning, and all I want to do is write code.” Nevertheless, it was still hard to hand over control of the company to Slootman.

“When Frank came in, we had some famous fights,” Luddy said. Yet he conceded that the corporate culture at ServiceNow “had to become Frank’s culture. Our culture was very collegial, but it wasn’t really a culture of excellence and execution.”

Making that transition was a fractious and stressful process.

Barber, who is a longtime ServiceNow board member, said Luddy was calling him almost daily, saying, “I just can’t do it. I want out.”

Barber said he told Luddy, “You’re probably going to have the hardest 90 to 120 days of your life.” The startup founders who are good at innovation often don’t succeed as CEOs when companies move to the growth stage, and they often don’t last in a subordinate role. But he encouraged Luddy to stick it out. “In JMI’s experience, we’ve never been able to keep an innovator as long as Fred.”

In the end, though, Luddy agreed that moving aside for Slootman was the right thing to do. As he put it, “My skillset is to think about where the market might be going. Frank’s skill is in performance and execution, and in building large, highly functional organizations.”

Barber added, “We were growing by 100 percent year-over-year, and Frank said we weren’t growing fast enough. Frank brought in an HR executive from Data Domain, and together they built a hiring engine that enabled them to grow to scale fast.”

Luddy added that while he was CEO, “Nothing we were doing was being questioned,” at least partly because revenue growth was so strong at the time. “But we probably would have peaked out at a couple hundred million a year,” Luddy said.

Luddy and Barber also disclosed that ServiceNow received numerous buyout offers before Slootman took over.

“We got a number of unsolicited term sheets to sell the company,” Luddy said. “They went from the tens of millions to the hundreds of millions, and I was ready to sell every time.” However, Barber persuaded him against selling each time. In retrospect, Luddy said, selling ServiceNow “would have been a $10 billion mistake.”

How—or why—did ServiceNow resist the buyout offers?

Barber said one reason was that ServiceNow was extremely “capital efficient”—stretching JMI’s $9.3 million investment over a roughly six-year period. Luddy said that with just a few senior developers and a small number of experienced sales people, ServiceNow landed business with Qualcomm, Deutschebank, UBS, and Johnson & Johnson. The business was cash flow positive within a few years after Luddy founded the company.

As Barber put it, “Fred got the company to a $100 million run rate with 100 employees.”

With each buyout offer, Barber said he believed that ServiceNow’s valuation was substantially higher than whatever the offer was—and each time, ServiceNow’s investors, board members, and senior executives eventually agreed to reject the offer.

They were unified, Barber said, because ServiceNow was so capital efficient—and because Sequoia Capital and Greylock Partners made at least $70 million in private equity investments in 2009 and early 2012—enabling JMI and all of ServiceNow’s employees to cash out part of their ownership stake.

There were no internal conflicts or insider pressure to sell, Barber explained, because all the stakeholders’ interests were aligned. In other words, everyone could afford to hold out for a better offer because they had profitably sold some of their shares through the private equity deal.

When ServiceNow made its IPO debut in mid-2012, the company’s shares soared by 37 percent on the first day of trading (climbing from $18 to $24.60 a share), which yielded a market valuation of nearly $2.2 billion. Today, ServiceNow shares are trading around $76 a share, giving the company a valuation of more than $11.7 billion.

In 2013, Slootman moved ServiceNow’s headquarters to Santa Clara, CA, which increased the company’s visibility among industry analysts and tech journalists. That has been good for the company, Barber said, even though it means that San Diego has lost some unicorn bragging rights.

Luddy said he expected the move to Silicon Valley also would yield a bonanza of talented software developers. But in this respect, he said he’s been disappointed.

“It’s a very mercenary environment,” Luddy said. “In Silicon Valley, people will spend an inordinate amount of time telling you how brilliant they are—so much so, that they don’t spend any time doing work,” Luddy said. “The talent [in Silicon Valley] is not nearly as exceptional as it thinks it is.”

In general, it also has become much harder to persuade employees to move to another city for a job offer, Barber said. As a result, ServiceNow has established a sizable software development group in San Diego, as well as in Seattle, Waltham, MA, and other U.S. cities, and overseas in the Netherlands, Israel, Singapore, and elsewhere around the world.

Luddy agreed, saying, “I’ve lived in five different countries, and I don’t see any reason why you can’t build software companies anywhere in the world.”

Bruce V. Bigelow was the editor of Xconomy San Diego from 2008 to 2018. Read more about his life and work here. Follow @bvbigelow

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