Catch a ride on the tech buyout wave

The buyout world splashed into the public consciousness with the 1987 blockbuster movie “Wall Street.” Michael Douglas won an Academy Award for his role as Gordon Gekko, the corporate takeover mogul who belted out memorable lines such as, “Greed is good!” and “I’m gonna tear his eyeballs out, I’m gonna suck his skull!”

Like Gekko then, today’s real-world buyouts are bigger and badder than ever with the advent of mega-sized buyout funds. It took the buyout industry almost two decades to break the record RJR Nabisco buyout of $31.3 billion in 1988 with the buyouts of HCA ($32.7 billion) in 2006 and Equity Office ($38.9 billion) in 2007. In today’s market, the buyout moguls—armed with funds approaching $20 billion and superheated with low interest debt leverage—are likelier to break that record in two months than in two decades.

Buyout artists who once focused on more traditional businesses are also turning their attention to the technology sector. Public-to-private tech deals in recent years include embedded semiconductor company Freescale ($17.6 billion) and Danish telecom giant TDC ($13.9 billion), not to mention the hundreds of smaller tech companies being taken private, or large divisions being spun off by mid-market buyout firms.

What does this rash of buyout activity mean for technology venture investors, their returns and their portfolio company exit prospects? Interestingly, current buyout trends and buyout’s short-term financial focus bode well for venture-backed technology startups in the long run. Let’s examine some public-to-private buyout scenarios and how current buyout trends ultimately benefit venture-backed companies.

Strip and flip

The buyout strategy is pretty straightforward: Take a struggling (or not-so-struggling) company private, improve operations, drastically reduce expenses, clean up the balance sheet, then flip it back to the public markets at a profit. One of the first expenses slashed post-buyout in technology-focused companies is the R&D budget. Most tech companies spend between 5% and 15% of their net revenue on R&D.

Cutting R&D can be an effective short-term fix, as there is minimal near-term revenue impact. Consider the early days of Computer Associates’ massive acquisition wave in the late 1990s when it acquired software companies, stripped their R&D budgets, and saw its profits go through the roof in the short-run. This same effect is happening in tech buyouts today.

With mega-buyout shops raising bigger funds, doing more deals and stripping target companies down to size, they create even more opportunities for VCs to do what we do best: drive innovation by funding new companies that create economic value through future growth.”

George Hoyem and Richard Yen, Blueprint Ventures

Take the example of VeriFone, a global leader in payment technology solutions. Publicly traded VeriFone was acquired by Hewlett Packard in 1997, at which time VeriFone’s R&D budget was 11.2% of net revenue. In 2001, HP sold VeriFone to buyout firm Gores Technology Group, which restructured the company and brought it back to financial health.

Gores reduced VeriFone’s R&D budget to 7.5% of net revenue—approximately 33% less than VeriFone’s R&D the last time it was a public company—prior to taking the company public again in 2005! The R&D may have been even lower in the 2001-2005 timeframe when the company was private.

Nothing behind the curtain

Technology companies that go through the privatization and re-IPO process emerge with improved financials, but they lack the innovation and new products needed to maintain long-term competitiveness and revenue growth. With R&D budgets decimated, new product innovation screeches to a halt.

The irony is that with product cycles in the one- to two-year timeframes, this effect may not impact top-line revenue for several years—about the time it takes a buyout firm to reengineer the company’s financials and flip it back to an unsuspecting IPO market.

This situation will ultimately create opportunities for venture-backed startups. To stimulate future growth and innovation, these newly public companies will need to acquire innovative startups developing next-generation technology.

In terms of M&A timing, these technology companies will need to acquire startups post-IPO and use their public stock as M&A currency. In most technology buyouts, any excess cash has been used to consummate the transaction and the balance sheet becomes loaded with debt.

Technology companies that go through the privatization and re-IPO process emerge with improved financials, but they lack the innovation and new products needed to maintain long-term competitiveness and revenue growth. This situation will ultimately create opportunities for venture-backed startups.”

George Hoyem and Richard Yen, Blueprint Ventures

There is rarely any extra cash in these companies available to acquire new companies, so while private, growth through M&A is unlikely. Acquisition targets are also less likely to consummate a private-to-private stock transaction because there isn’t an easy way to liquidate their holdings. As such, tech buyouts will often wait to get public again before aggressively pursuing acquisitions.

Software heavyweight Corel is evidence of this trend of companies that were taken private becoming acquisitive after their new IPO. Founded in 1985, Corel was a major software developer famous for launching key software titles including CorelDRAW and WordPerfect in the 1990s.

After hitting upon hard times, Corel was bought out and taken private by Vector Capital in 2003. Vector turned around the business and took Corel public again in early 2006. The R&D reduction that occurred between 2003 and 2006 left Corel’s product pipeline empty. As a result, Corel has used acquisitions rather than internal innovation as a means for revenue growth. In less than a year after the IPO, Corel acquired three companies to bulk up its product line and spur inorganic growth: WinZip Computing, a maker of compression utility software that had previously been bought out by Vector; InterVideo, a maker of video and multimedia software; and U-Lead Systems, a maker of video imaging and DVD authoring software.

VCs as barbarians

Current buyout trends have created an opportunity for VCs to overtake buyout moguls as the barbarians at the gate. As more technology companies get taken private and the IPO market continues to improve, a large backlog of technology M&A demand will develop in the next few years. This imbalance of supply and demand has already contributed to higher average U.S. venture-backed M&A transaction values, which doubled from $38.3 million in 2003 to $76.3 million in 2006 and rose further to $98.9 million in the first quarter of 2007. Increased demand from technology buyouts to acquire innovative startups will result in even higher M&A valuations going forward.

The R&D rationalization also creates an interesting opportunity for venture investors to pursue Corporate IP Spinouts. Buyout firms are likely to focus on a company’s core revenue-generating products and slash early stage product lines that are a year or two away from meaningful revenue. These products may have had tens of millions of dollars of prior R&D and represent highly disruptive technology, yet they are no longer strategic to its new penny-pinching parent. Venture firms that collaborate with these buyout firms can cull through the R&D remains and extract valuable technology and intellectual property. These key assets can serve as the foundation for successful venture-backed startups.

As venture investors, we hope the roaring buyout market continues to flourish, as their success bodes well for our success. With mega-buyout shops raising bigger funds, doing more deals and stripping target companies down to size, they create even more opportunities for VCs to do what we do best: drive innovation by funding new companies that create economic value through future growth. Are VCs better positioned than buyout funds to generate superior returns in the coming years? Only time will tell.

George Hoyem is a managing director of Blueprint Ventures, which makes seed-stage and early stage investments. Hoyem focuses on software, wireless, security and IT and communications infrastructure. He may be reached at george@blueprintventures.com. Richard Yen is a principal with Blueprint Ventures. Yen focuses on infrastructure software, wireless technologies and consumer Internet. He can be reached at richard@blueprintventures.com.