If you are a corporate business development executive or institutional limited partner, read on: There is a way for you to make money in the early stage venture world.
Today’s newswires are filled with stories of startups that raised $75 million or $100 million in funding only to be acquired for $50 million. The mean value of Broadcom’s many acquisitions over the last few years is under $50 million. For Siebel, it’s just north of $50 million. Considering the amounts invested in these acquired startups, these exits are a far cry from the 5X to 10X return venture investors expect. Capital efficiency is the most obvious key to earning true venture-style returns. But where to find projects with 5-10X potential-projects that require $25 million (or less) in total venture funding to reach an exit? One way to do that is by seeking early stage corporate intellectual property (IP) spinouts. That is, extracting IP assets from a corporate parent that has already spent $10 million to $30 million or more on a project.
Hundreds of billions of dollars are invested in corporate R&D annually, generating a huge amount of IP and patents in the process. IBM alone was granted 3,277 patents in 2004. IP can be a powerful asset, laying the foundation for revenue-generating product lines and for fending off and initiating IP lawsuits with competitors. Yet many R&D projects lose their relevance over time never result in commercial products or licensing value. The resulting technology may be useful and quite valuable, but it simply may not be suitable for its current home. This situation arises for a variety of reasons:
Strategic misalignment. Corporations sometimes choose to shelve promising early stage products because they are no longer “core” to their strategy. The high-tech landscape changes quickly, causing a company to pursue a new product or market focus and halt once-critical R&D projects.
Too much R, but not enough D. Many corporations invest in basic research and hope to later find an appropriate “fit” within the company. Despite an occasional Post-It success (3M), many projects don’t reach the commercialization phase because they fail to find a practical application within the company’s markets of expertise.
Insufficient market size: Most VCs would rush to fund technology addressing a $500 million market, but it may not be large enough to move the needle at a corporation with $50 billion in revenue.
After spending millions of dollars and several man-years on R&D, how can corporations monetize their IP? Some seek to license IP to other companies through royalty agreements. This approach is an increasingly popular, but typically delivers less value than expected. The licensor receives surprisingly little compensation for the IP given its early stage nature. With incremental development, the licensor could bring the technology to a point where it could fetch a far higher price tag. Similarly, the licensee may be leery of acquiring undeveloped IP that is “thrown over the wall.” Without access to the requisite talent (i.e., the original engineers), the licensee may find it difficult to take the raw patents and turn them into commercial products.
Corporate venture arms once bridged this gap by funding internal development and spinning out these projects into standalone startups. But corporate venture arms have drastically reduced their activity level in recent years. Some corporations like Nokia have spun out their corporate venture arms into independent venture firms, while others-like Dell, Applied Materials and even Microsoft-have abandoned corporate venture investing altogether. The diminishing presence of corporate venturing has created a discontinuity in the IP market, eliminating an important channel for spinning out early stage IP from corporations.
Venture investors focused on early stage corporate IP spinouts are starting to fill the void left by corporate venture arms. In such a Spinout, the venture firm works with the parent corporation to extract key intellectual property assets, which it uses to create a new venture-backed company. The parent corporation and the VC firm bring different but equally necessary skills and assets to the table. The VC firm invests new money in the early stage venture and recruits seasoned management to lead the startup. In exchange, the VC firm receives preferred equity and a board seat. The corporate parent contributes patents, trade secrets and key engineers, receiving a common equity stake in return. The corporate parent may also negotiate an ongoing channel or OEM relationship with the startup as part of the spinout.
Corporate IP Spinouts are attractive propositions for the parent corporation for several reasons.
* First, the parent participates in the technology’s future upside (through an equity stake) without requiring further capital investment. The standalone startup leverages VC dollars going forward. The parent corporation-at no additional expense-may recoup its initial R&D dollars and potentially reap substantial rewards if the startup blossoms.
* Second, corporate IP spinouts enable the parent organization to build up its technology ecosystem without exposing its bottom line. From the parent’s perspective, the spinout creates a natural partner for a customer, supplier, channel or OEM relationship. For example, imagine that a semiconductor company chooses to stop developing a home-brewed CAD tool since software is not its core competency. Rather than abandon the CAD software, the semiconductor company can spin out the software IP into a new startup. The parent company receives bug fixes, feature upgrades and higher quality customer support without diverting further engineering resources to the project. On the flip side, the CAD software startup has a flagship customer and an instant revenue source. It’s a win-win situation.
* Third, corporations can realize financial benefits from spinning out R&D or product lines that would otherwise be shut down. Corporate IP spinouts enable the originating corporation to move the R&D expenses off its balance sheet. It can also unlock potential tax loss benefits associated with earlier R&D investment dollars by generating a tax realization event. In terms of public relations, a corporate IP spinout is far preferable to shutting down a division and laying off employees. And of course, if key engineers are prepared to leave the parent to pursue the technology independently, a spinout allows the corporation to retain value even after the people have departed.
Many technology companies-including IBM, NEC and the Palo Alto Research Center (PARC)-are looking to spin out their IP. Many are just getting started. What should the parent corporations look for in a VC partner? Every VC claims to bring a strong professional network, exceptional technology skills and a sharp market vision. To a large extent, most do.
The most critical characteristic required to lead a corporate IP spinout is patience. In our experience, these transactions require six to nine months from initial pitch to final closing. This timeline is longer than typical early stage VC investments because spinouts involve not just two parties (VC and startup) but also three (VC, startup, and parent company). Unlike the fast-paced world of entrepreneurial startups, the world of large companies moves slowly and deliberately. Corporations should find a VC who is willing to spend the time and energy to work with them, one who has the fortitude and patience to guide a deal to a close.
Another requirement is a steely-eyed venture investor perspective. Most corporations eager to engage in this process will have many projects available for spinout. In evaluating these projects, the venture firm must be unshakeable in its quest for world-class technology. The best technology spinning out of one company may be inferior to that of another company. The venture firm must diligently work with many corporations as well as “traditional” entrepreneurs to find the best opportunities for venture investment. Unless the venture firm is continuously trolling all waters, it will fail to back the best investment opportunities.
At Blueprint, we have made corporate IP spinouts a specialty. Of our last 11 deals, seven have been based on corporate IP spinouts from Fujitsu, NEC, Intel, and PARC, among others. These deals are sourced from a set of approximately three-dozen corporate relationships that are rigorously maintained by the firm. Our corporate partners succeed by making their assets work for them. Our limited partners succeed by gaining capital efficiency for our early stage projects. Corporations and limited partners listen up: Dust off those patents, review those R&D prototypes and figure out how to make money in the early stage investment world.
Bart Schachter and George Hoyem are managing partners at Blueprint Ventures, an early stage firm based in San Francisco. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software, and communications semiconductors. Hoyem focuses on software, wireless, security, and IT and communications infrastructure. They may be reached at