Professor Raiton’s Inside Perspectives: Entrepreneurship, Creativity, Innovation

By Scott Austin, WSJ

Last August, Hewlett-Packard Co. signed a letter of intent to pay $360 million cash for LeftHand Networks Inc., a venture-backed provider of storage systems. A few weeks later, Wall Street’s collapse sent the economy in a tailspin and threatened to knock the screws out of the deal.

But after a two-week pause the two sides got back together and in November closed the acquisition on the same terms. Asked how LeftHand was able to command the same price despite the uncertainty created from the financial markets, an investor in the company said, “Maybe it’s because every Sunday I went to church and lit candles. Faith and religion are very important in the sale process.”

Jokes aside, LeftHand was able to hold its ground because it had proven itself valuable well before Hewlett-Packard offered to buy it. H-P had been reselling LeftHand’s software on some of its servers for nearly three years, and realized it couldn’t do without it.

The deal signifies the importance of setting up strategic relationships with possible acquirers, especially in this environment, said the aforementioned investor, Matthew McCall, a managing director with Draper Fisher Jurvetson Portage Venture Partners.

“When your hair’s on fire as a corporation, you’ll try anything to make the pain go away,” he said. “Now’s a great opportunity [for start-ups] to enter partnerships, distribution agreements, and dialogues with larger corporations.”

McCall was on hand at the National Venture Capital Association’s annual meeting in Boston last week to provide some pointers on how start-ups can position themselves effectively for a possible exit. McCall, who says his firm has scored 10 exits in the past 18 months, offered a few “key elements” that have helped his portfolio companies exit the past couple of years:

-Form a strategic relationship with a potential buyer. “Companies that have been successful in this enviroment are great at identifying who the strategic players are out there that would rather see you alive versus dead. Some of our portfolio companies are aggressively approaching them as a sugar daddy, as a protector in the market place. They’re going to them and saying, ‘We’re going to get a production line out for you, but getting lease financing is very difficult, would you do that for us?’ And we’re seeing some of these guys come up with corporate lease lines for them or helping guaranteeing those lease lines.”

-Look at it from the acquirer’s perspective. “Too many people try and sell from the position of fear. Especially in this marketplace, instead of saying, ‘How can we sell this?’ you need to get into their shoes and say, ‘Why do they need to buy it?’ One of our most successful sales in the last year happened because this was a critical piece of the buyer’s portfolio. You could see this was a hot part of the market, that they didn’t have a strong position in it and there are two or three competitors. If you can identify that and position it accordingly, you’re in a great position.”

-Identify the alternatives. “If you’re the clear superior company in the market and there are no alternatives, you’ve got leverage. If you’re the No. 2 or 3 technology out there, you can push as hard as you want, but they’re going to push back on you. And then at the end of the day they could buy one of your competitors and could really put you in a bind.”

-Make sure at least two mortal enemies are bidding on your start-up. “We had a company that was looking to sell, and went to a potential acquirer and said, ‘If you don’t move now, so and so will.’ They said, ‘Go ahead sell to them, we’d love to kick their ass in the market.’ About three weeks later we engaged their mortal enemy - the two had a Coke/Pepsi type of relationship. Two weeks later, we signed a letter of intent and closed it in six [weeks], at twice the original bid.”

From Xconomy by Ryan McBride 

We know there’s been a serious decline in exits for venture capitalists and their portfolio companies for the past year or more. Now two separate studies—one from Dow Jones VentureSource and the other done by the National Venture Capital Association (NVCA) and Thomson Reuters—show just how abysmal M&A and IPO activities were in the first three months of 2009.

The two studies differ in methodology, making the deal totals a bit different, yet the general trends are the same. Today Dow Jones reports that just 68 M&A deals involving venture-backed firms took place in the first quarter. The value of those deals totaled $3.2 billion, down almost 65 percent from $9.1 billion in 104 deals counted during the same quarter last year. What’s more, the number of mergers and buyouts so far this year fell to the lowest level since 1999, and the value of those transactions was the lowest quarterly figure since 2003, according to the VentureSource study.

On the IPO front, the liquidity drought persists. Venture-backed firms did not complete a single initial public offering in the first quarter of this year, making it eight straight quarters without a VC-backed company completing an IPO, the VentureSource study says. When will the IPO dry spell end?

By Andrew Pollack, SiliconValley.com 

It is called a reverse merger. And for a failing public biotechnology company, it can represent one last roll of the dice.

The gamble is to merge with a privately held company with better prospects.

The private company takes over the public stock listing and management of the business. The money that the public company had left is then plowed into developing the formerly private company’s products. If those products succeed, the shareholders in the old public company can eventually benefit.

Reverse mergers can be used in other ways, as well. The deal that Merck and Schering-Plough announced last Monday, is being done that way to let Schering sidestep a change-of-control clause in a separate drug partnership it has with Johnson & Johnson.

The reverse mergers in biotechnology are meant to help private companies go public at a time when market conditions have made it virtually impossible for them to pursue conventional initial public offerings.

(Read More)

By Steve Johnson, Mercury News 

A wave of multibillion-dollar deals this week signals the acceleration of a deal-making frenzy that will likely reshape the life-sciences industry.

In the two latest, South San Francisco-based Genentech on Thursday finally agreed to a $46.8 billion deal with Roche, while Foster City-based Gilead Sciences moved the same day to snap up Palo Alto-based CV Therapeutics for $1.4 billion. Earlier this week, pharmaceutical giant Merck agreed to buy Schering-Plough.

Failing in large measure to develop their own new medicines and facing a slew of generic competitors as their drug patents expire, companies like Roche — often dubbed Big Pharma — increasingly are bolstering their product lines by swallowing up biotech and other drug companies with hot products.

And Bay Area biotech companies are especially attractive takeover targets. Aside from Genentech and CV Therapeutics, companies whose names pop up as possible acquisitions for Big Pharma or other biotech suitors include Affymax of Palo Alto as well as Exelixis and Theravance, both of South San Francisco. Affymax is working on treatments for kidney diseases, Exelixis focuses heavily on combating cancer, and Theravance is developing medicine for respiratory disease, bacterial infections and gastrointestinal ailments.

Some experts fear the trend might blunt the innovative, research-oriented cultures that long have been the hallmark of such legendary biotech firms as the venerable Genentech. Others say Big Pharma may stop work on some promising but expensive-to-develop drugs at the companies they buy or could so dominate certain drug markets they could foist higher prices on consumers.

But others discount such concerns, noting the merger trend has been growing for nearly two decades without stifling biomedical research, and they predict that a lot more deals are likely to be in the works.

“I don’t see any end in sight for the next two to three years,” said Mark Edwards president of Deloitte Recap of Walnut Creek, which tracks these deals.

There were 31 such mergers and acquisitions in 2008, a record number, according to Edwards’ company. That compares with 19 in 2007, 24 in 2006 and 23 in 2005.

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From Get Venture by Mark Davis

An important trend is taking place in the venture marketplace – it is taking longer for VCs to exit their investments.

In 1995 (before the Internet boom), the average software acquisition occurred 48 months after a company was launched. Initial public offerings were made at an average of 56 months into a venture. In 2007, M&A happened on month 65 and IPOs on month 67. That’s a significant change – 35% and 20% later, respectively.

What’s unclear to me is whether or not this trend will reverse over time. If the time to exit continues to lengthen it could have a number of consequences. Some of the potential impacts include:

• Longer LP Commitments: Venture funds are designed in such a way that their limited partners are required to commit capital for about 10 years. However, with an average five and a half years to IPO, there are bound to be companies that don’t exit for up to a decade, meaning that LPs may be required to commit their capital for a longer period.
• Increased Liquidity Premium: LPs agree to lock-up capital in a venture fund for up to 10 years due to the expectation that the risk they taking in having the capital tied up (which may mean they miss future investment opportunities) is compensated by higher returns. If the lock-up period increases, LPs will likely demand a higher return (or they’ll invest their money elsewhere such as with hedge funds or leverage buyout firms).
• Lower Valuations: If VCs across the board need to generate higher returns (and they can’t increase their time to exit) they will likely require greater ownership of their portfolio companies, translating into lower valuations of startups and greater dilution of entrepreneurs.

This scenario is a losing situation for everyone and I am optimistic that the market will evolve back to shorter exit times as the M&A and IPO markets enter future legs of their cycles. However, it’s important to continue to watch these dynamics as they could have industry-wide consequences.

From Get Venture by Mark Davis

The average company exiting through a public offering is more mature than a company that exits through an acquisition, at least since 2000.

There is good reason for this extra maturation. Public investors are often seeking to buy shares in companies that will continue to operate independently long into the future. In contrast, corporate acquirers may buy companies when they are very young before the company has demonstrated its ability to sustain itself. There are a variety of reasons why a company might be bought without demonstrating financial sustainability; a fledgling company might be acquired for its assets (technology, customer, contracts or management) or it may be acquired as a defensive maneuver – to eliminate the opportunity for the company to become a long-term threat.

It could also be argued that Sarbanes-Oxley legislation, which requires additional internal process documentation and oversight by public companies traded on U.S. exchanges, has delayed public offerings. Companies must ensure they will be compliant with Sarbanes-Oxley regulations, and that they can afford to pay the associated costs, before they can issue public stock for the first time.

From the period of 1996 to 2008, the average company that IPO’d was 8 months older than the average company to be acquired. It’s worth noting that this pattern didn’t hold true during the Internet boom. In the period of 1996 to 1999, the average software company making its initial public offering was five months younger than the average company being acquired (according to Dow Jones Venture One data).

The general trend of IPOs taking longer to realize than acquisition also puts pressure on investors to push for larger exit values. VCs are judged by their investors based upon a number of metrics, one of which is call the Internal Rate of Return (IRR). An IRR is an accurate way of measuring the average annual rate of return on invested capital adjusted for the timing of cash flows. A simple relationship that comes from this math is the fact that longer times to exit reduce the effective annual return. Returning 200% of invested dollars in 1 year implies a higher average annual increase in value than returning 200% of invested dollars in 10 years. As a result, the delay in exit time drives VCs to require higher exit values to adjust for the delay. While in theory the increase in value can be justified by the company’s ability to expand its operations and increase revenues over that period, every exit is ultimately a negotiation and this delay drives VCs to target higher exit values.

From Get Venture by Mark Davis

When a portfolio company is acquired, the buyer is expected to pay more per share than a minority investor would. There is good reason for this - the buyer is getting more than the investor. The buyer is purchasing the right to control the company. After an acquisition, a buyer can determine a company’s strategy, select which markets to focus on, pick the company’s partners, elect which assets to sell, change the company’s level of debt and so on. An investor typically can influence these decisions but not control them outright.

Acquisition prices are generally higher than prices for investment rounds, reflecting a control premium.

From Get Venture by Mark Davis 

I recently had lunch with Gary Kats, a friend from business school who has gone on to work as a tech banker. As part of our chat, we discussed the current exit environment and how it has affected the four types of exits: M&A, IPO, Secondary and Recapitalization. During the course of that conversation, it occurred to me that it would be worthwhile to outline each type of exit and provide some thoughts about how these fit into the venture capital model.

“M&A” refers to “Mergers and Acquisitions”.

In an acquisition, one company buys another, taking a controlling stake of its share and the rights to the assets. While these are structured in a number of ways and selecting a structure involves numerous considerations, the key variables boil down to: 1) whether or not the buyer takes on the liabilities of the company being acquired, and; 2) the types of assets being used to purchase the company (e.g., cash or stock).

In a merger, two companies are combined, each being treated more or less as an equal. While combinations called mergers happen all the time, they are rarely actually mergers of equals. Even if the financial structure portrays a picture of two equal companies being combined, one of the two parties typically takes control of the other in one way or another. Most often, control is determined by the board or management structure. The CEO that is selected to lead the combined entity typically keeps all of his lieutenants around, squeezing out the other company’s management team.

Most VC exits (especially in recent years) are realized when portfolio companies are acquired by larger, often public, cash-rich companies. These transactions are typically structured such that the buyer assumes the portfolio company’s liabilities. Venture investors typically expect this, as they do not want to be responsible for paying off debt after the transaction.

Additionally, VCs have a strong preference for selling portfolio companies for cash, rather than shares of the acquiring company. There is good reason for this preference: the value of the buyer’s shares can change over time, reducing the effective purchase price. Furthermore, if a buyer elects to pay with its shares, its management may believe that their company’s shares are overvalued.

By Julie MacIntosh, Financial Times

The value of mergers and acquisitions in the first half sank by nearly a third from the same period last year to $1,860bn (£935bn) as the collapse of the buy-out boom prompted a steep drop in the number of highvalue deals.

The raw number of deals announced in the first half of the year topped the first half of 2007’s total, according to preliminary figures from Dealogic. But while the five biggest deals announced in the first six months of this year accounted for 15 per cent of global M&A volume, the overall number of transactions valued above $1bn dropped sharply.

The volume of deals ann-ounced by private equity investors plunged 78 per cent to account for just 6 per cent of the global M&A market, the industry’s lowest share since 2001. The credit crunch continues to render buy-out investors unable to secure the debt they need to buy expensive assets. Corporate buyers have not been able to fill that gap but they became more aggressive in the second quarter.

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