Critical strategies for successful technology spinouts

As VC gets more and more competitive, it’s important to differentiate deal flow. Spinouts are a great opportunity to do that if you are willing to spend the time and effort, as illustrated by our recent spinout of Veracode from Symantec and the success of previous spinouts, such as Kalido from the Shell, Nitec from Merck, and Novexel from Aventis Pharma.

Unlike typical early stage ideas, a technology spinout offers mature, proven technology. The entrepreneurial team that will form the new spinout company (NewCo) has already been working together at the existing company (OldCo). If negotiations result in a well-designed separation agreement and create a true partnership between all parties, NewCo will have the opportunity to flourish. Often NewCo launches with an invaluable and unique business partnership with the well-known and successful OldCo.

We couldn’t be happier with the successful spinout of Veracode. In less than a year, the Burlington, Mass.-based company has raised nearly $20 million and has attracted significant interest from blue-chip beta customers. Veracode formally launches this month (February) at the RSA 2007 conference.

The benefits of spinouts can be compelling if early stage venture capitalists approach the process with a template incorporating proven strategies for meeting challenges inherent in the process. Here are the key lessons we learned from the Veracode spinout.

1. Start with a strong entrepreneurial team

You want a resilient, risk-tolerant entrepreneurial team, one whose members are prepared to accept the hiccups and delays of the spinout process and put their employment with OldCo on the line. The process can be tumultuous and requires their commitment, but the right team will likely be chomping at the bit to get started.

In our spinout of Veracode from Symantec, the entrepreneurial team had come to Symantec as part of its acquisition of @stake, a startup success in the security software service industry. The technology and team were so strong that Matthew Moynahan, an executive at Symantec, joined Veracode as CEO after the spinout. The team withstood difficult negotiations and Moynahan credits their hardiness and know-how for much of the new company’s success.

“You want both entrepreneurial spirit and excitement without irrational exuberance about great technology being the only ingredient to success,” Moynahan says. “Our founding team had a blend of startup experience and operational scars from scaling commercially successful businesses, which led to a combination of executives stepping up for a ‘stretch assignment’ and those that have ‘been there before.’ This means a lot of hunger and passion, appropriately tempered by the realities of the marketplace.”

2: Find an internal champion

Identify someone who believes in the technology and understands the opportunity for its growth outside the company, someone influential at OldCo who really gets it and can make things happen. You’ll want a high-level executive with an intrinsic appreciation for innovation. Your champion can smooth the way and foster a partnership between the entrepreneurial team and OldCo, as well as highlight the business benefits for OldCo, making the difference between a spinout that leaps forward and one that dies in transit.

The benefits of spinouts can be compelling if early stage venture capitalists approach the process with a template incorporating proven strategies for meeting challenges inherent in the process.”

Jeff Fagnan, Partner, Atlas Venture

For almost a year, we worked with the entrepreneurial team for Veracode to advance the deal. Symantec Senior Vice President of Corporate Development James Socas became aware of the entrepreneurial team’s effort, recognized the potential value to Symantec, and got involved.

“Although we knew we had a winning proposition for all constituents, it was difficult to advance until we located and engaged Socas,” notes Maria Cirino, chair of Veracode. “His influence was incredibly effective and helped all parties come to an agreement that made everyone happy.” Cirino was formerly a senior vice president at Verisign, which acquired Guardent, a market leading managed security service provider, where she was CEO and co-founder.

3. Create a win-win relationship for OldCo and NewCo

OldCo and NewCo need to develop a true partnership to overcome the resistance that can sometimes accompany the technology spinout.

OldCo will be reasonably worried about letting go of intellectual property, losing talented people and losing future revenue. Obvious questions (such as “If the technology is so good, why not keep it?”) can foster reluctance. Reservations may lead OldCo to want to establish right of first refusal and other limits in an attempt to protect itself from loss of potential profits.

It’s essential to make OldCo an equity holder, a true partner and to help it understand that all parties will benefit when NewCo is a hit. OldCo’s vision for NewCo must be success and independence. The intent is a true technology spinout, not a spin of NewCo out of OldCo, and then a spin back in.

Symantec saw the value in the on-demand security technology and recognized that it would have more breathing room to develop outside of its internal operations.

“Symantec is a very smart company and smart companies know their strengths,” says Moynahan.

“It was able to give birth to the technology without diverting important internal resources to force grow it in a less-than-optimal environment.”

Creating an appealing deal for Symantec required a meaningful equity stake, as well as a preferred business relationship with Veracode. It was integral to Symantec’s comfort level to establish a gentleman’s agreement to a partnership that could easily be pointed to as valuable should Veracode be wildly successful.

It’s essential to make OldCo an equity holder, a true partner and to help it understand that all parties will benefit when NewCo is a hit.”

Jeff Fagnan, Partner, Atlas Venture

For Veracode, a satisfactory deal involved addressing a host of other desires. We had an entrepreneurial team enthusiastic about returning to a small startup environment, which they had really missed. Coupling that with a full equity position and the opportunity to be the founders of Veracode made the spinout very attractive. Plus, a dollar value simply couldn’t be assigned to the fulfillment they anticipated from seeing the technology they had been working on for years reach the commercial market.

Of course, handling IP issues can be thorny. NewCo, and really any truly successful company, must control its own destiny and own the IP. It’s not sufficient for NewCo to license the IP from OldCo.

In the beginning, Symantec wanted to just give the entrepreneurial team a license to the IP, which would have hobbled the team in a number of ways. Lengthy, complex negotiations resulted.

Understandably, Symantec wanted protection from potential Veracode claims that Symantec was violating the ownership of the IP. Conversely, the entrepreneurial team was wary of leaving itself vulnerable to future, direct competition from the more influential Symantec. Agreements had to be developed to protect all parties so they could forge a close and beneficial partnership without fear.

The resolution of these IP issues was essential to the triumphant completion of the spinout. A complex web of concessions and protections ensured a unique relationship between Symantec and Veracode that would lead to more money for both companies in the event of unforeseeable future products and opportunities. Forging a structure that allowed each company the freedom to innovate and grow without detriment to the other was critical to maintaining a positive, mutually beneficial partnership, while preserving the fundamental independence of Veracode.

“Though we came directly from the mother ship, Symantec, through the structure of the spinout, provided room for us to breathe and grow,” Moynahan says.

You also need to be creative about different ways to acquire IP for the spinout. For example Veracode sought additional IP from another software company, Macrovision, which left it with a comprehensive portfolio of IP assets.

4. Make sure OldCo is the undisputed beneficiary of the spinout

The beauty of the process, and the reason these strategies are so vital, is that without a successful technology spinout, the IP languishes in OldCo, its potential locked up in an environment where it simply can’t be maximized. For OldCo, this IP represents untapped revenue, a vertical unlikely to be exploited in house. The spinout removes OldCo from the risk and expense of exploring the IP’s possibilities, yet provides the opportunity for distinct profits.

With the venture business becoming more competitive, spinouts can be a great source of new deals for VCs willing to put in the necessary time and effort. We relish the prospect of identifying the requirements of OldCo and the entrepreneurial team and helping deliver a rich NewCo positioned success. VCs that approach technology spinouts in this spirit of true partnership with OldCo and the entrepreneurial team, armed with strategies for overcoming the obstacles, can realize significant returns for everyone.

Jeff Fagnan is a partner in the technology sector with Atlas Venture and focuses on emerging companies in enterprise and Internet infrastructure, as well as alternative energy technologies and advanced material science. He may be reached at Atlas Venture is a leading international early stage venture capital firm that manages over $2.5 billion in committed capital and invests in technology and life sciences businesses in the United States, Europe and Asia.