When the founders of venture-backed home networking company Epigram Inc. first met with their eventual acquirer, high-speed broadband communications provider Broadcom Corp. late last year, Epigram was by no means soliciting a sale. Rather, the two companies approached each other rather guardedly.
Viewing each other as potential competitors in an emerging industry, Epigram and Broadcom wanted to put out their feelers and explore the possibility of working together.
“A buyer would have to meet our numbers,” says Ed Frank, who founded Epigram with Jack Holloway in late 1996. The company’s founders believed that their business would skyrocket as the Internet continued to create an even larger market for their products, which integrate home appliances such as personal computers, televisions and DVD players onto one network. Epigram believes it could have achieved a market capitalization of $1 billion by the end of 2000, Franks says.
Epigram’s founders, however, soon realized that Broadcom had rapidly created a fairly large market presence as a provider of high-speed Internet access and had the potential to accelerate their company’s introduction to the marketplace. In April, less than half a year after that first meeting, Epigram agreed to be acquired by Broadcom. Any initial bitterness Epigram’s employees might have tasted in being engulfed by a larger corporate entity was sweetened by the sale’s $316 million price tag.
“If you ask to a person, they’re happy we did this,” Frank says of Epigram’s former employees.
Despite a red-hot market for venture-backed initial public offerings (VCJ, August, page 38), mergers and acquisitions abounded in the first half of 1999, refuting the notion that the rise in M&A deals in the past several years was in response to a poor IPO market. Rather, sales of smaller companies to more established corporate entities increasingly have become a necessary part of today’s business world. And, as the bull market continues to drive valuations of entrepreneurial companies to record heights, M&As have emerged as a more attractive exit option for venture capitalists.
Keeping the Pace
According to Venture Economics Information Services, a data company affiliated with Venture Capital Journal, in the first half of 1999, 91 venture-backed companies raised $7.19 billion by merging with or being acquired by other companies. (Thirty of the 91 companies did not disclose their sale prices to Venture Economics and therefore are not included in the first half capital total.) By comparison, a record 186 M&A deals – including 72 that did not report their sale prices to Venture Economics – raised $8.44 billion in all of 1998.
The sharp increase in valuations for VC-backed M&A deals is perhaps even more apparent in the average individual price tag for acquired companies in the first half of this year – $117.94 million, a jump of more than 70% from last year’s $68.63 million. Ninety-six first half venture-backed IPOs, the highest mid-year total in two years, seems to suggest that the robust public market helped drive valuations higher than ever before.
“I’m not sure there’s a direct correlation between [the IPO and M&A markets] …but a hot stock market certainly gives companies a lot more options,” says Mark Jensen, a director of high technology at consulting giant Arthur Anderson and managing director of its Silicon Valley office.
Today’s business climate demands that companies get big fast. And in a hot stock market, companies in need of growth capital to make it to the next level quickly can access “public venture capital” by opting for an IPO, rather than raise a mezzanine round of private equity, Jensen explains. However, sometimes a sale is the most viable option. Companies such as Epigram, centered around one technology in need of global distribution, might find it easier to attract a corporate buyer willing to pay a significant price for an acquisition, rather than scramble to catch up with expensive and time consuming research and development.
In the ever-evolving Internet industry, the need to move fast and bring good ideas to fruition is more important than ever. And in many cases, the sale of a portfolio company to a corporate buyer provides VCs with an opportunity to realize value in their investment before moving on to grooming the next emerging technology.
“The Internet business model has accelerated the process,” says John Martinson, president of the National Venture Capital Association and a managing director of Edison Venture Fund, noting that businesses in cyberspace require far less physical infrastructure and are thus easier to get up and running. “You can build companies faster.”
Getting a company started and building a future Fortune 500 business, however, are two different things entirely.
“I think it’s harder than ever to build a company today, from start-up to stand alone,” Jensen explains. “The world is a lot more complicated. A small company, even with the best VC backing, is resource constrained.”
A good example of this trend is Epigram, which played a huge role in defining the home-networking market before most people had even thought of the concept, Frank explains. The company received more than $13 million in two rounds of venture capital financing from Advanced Technology Ventures, Mohr, Davidow Ventures, Benchmark Capital and Institutional Venture Partners by the end of 1997 to help build an attractive core technology that needed a global distribution platform.
In the end, however, the sale to Broadcom was the best way to realize the company’s potential. Broadcom, which went public in April 1998, was big enough to accelerate Epigram’s vision to the market faster than the start-up could have hoped if it tried to remain on its own.
“It’s not a choice between M&A or IPO,” Frank says, explaining why his company chose to sell rather than wait out a potential IPO down the road. “It’s really about, How do you make great ideas happen?'”
A Better Image
While high sale prices have made selling portfolio companies easier to swallow for investors, M&A exits may be losing the somewhat negative connotation they had in the past. Rather than being perceived as the failure of a company to go it alone, acquisitions are now perceived as necessary vehicles of growth in today’s rapidly moving business world.
“A lot of the acquisitions are what I call positive mergers,'” says Flip Gianos, a general partner at Menlo Park, Calif.-based InterWest Partners, explaining that most of the companies being acquired are healthy, successful businesses. “Fifteen years ago, most acquisitions were because the company couldn’t go public.”
Heavy M&A activity, which at one time might have signaled a slow IPO market for a particular sector, now is, in many cases, a sign of a healthy, growing industry that is active on the acquisition front.
Excellent valuations in industries such as telecommunications and e-commerce are reflected in both the public market and in M&A deals, Gianos points out. Computer-related companies accounted for 52 of the 96 first half IPOs and 44 of the 91 M&A deals, with an average valuation of $65.6 million. The communications industry produced 16 IPOs and 13 M&A deals, commanding a whopping $96.1 million average.
Telecom companies, leery of what their competitors are up to in R&D and on the acquisition front, have been quick to move on complementary new technologies and companies that will help them cover their market space.
“[The] telecommunications [industry] has to have the fastest deployment of new technology,” Arthur Anderson’s Jensen says, noting that acquisitions of hardware, software and networking companies are necessary to keep up with the development of infrastructure that supports the growth of the Internet.
Apart from Broadcom’s acquisition of Epigram, another example of this trend was the second largest venture-backed M&A deal in the first half of this year – CIENA Corp.’s $552.3 million purchase of Lightera Networks Inc., just a little more than a year after the company was started from scratch.
Four CIENA employees, Jagdeep Singh, Charles Chi, Dan Klausmeyer and Drew Perkins, founded Lightera in February 1998 with $10.5 million from InterWest, Venrock Associates, Brentwood Venture Capital and Kleiner Perkins Caufield & Byers. The Cupertino, Calif.-based company set out to develop an optical core switch that helped reduce the amount of space needed to carry traffic on telecommunications networks.
CIENA believed it already was on its way to developing something similar to Lightera’s technology, but less than a year later CIENA decided it would be better off gaining quick access to what Lightera had accomplished by incorporating the start-up into its own enterprise.
“Clearly, in the telecommunications equipment business … acquisition is important because scale is important and because a broad product line is important,” Gianos says. “Customers [carriers] want to see new technologies, end-to-end solutions and broader product lines.”
Other industries, such as biotechnology and health care, have tested the M&A route for more traditional reasons – because prolonged slumps have limited their options. Biotech saw five M&A deals reap an average of only $40.1 million each, and only two IPOs. Nine medical health-related companies were either merged or acquired, garnering $50.5 million each, and only one went public.
“We have seen a lot of consolidation in the biotech industry because there is a lack of available capital,” Jensen says.
A Brave New World
Although the M&A deal might be a more acceptable exit alternative to an IPO than it was in the past, the ultimate goals of entrepreneurs and venture capitalists have not changed much.
“The best approach to any start-up is to build an independent business,” Lightera’s Chi says. “I think it’s pretty difficult to build a company with the intention of selling.”
Gianos, whose firm’s portfolio includes both CIENA and Lightera, agrees. “You don’t want to start a company that you know can’t go public,” he says.
Yet the impact of the Internet on the economy and the speed with which a modern company must grow has helped groom a savvier, more open-minded climate in which entrepreneurs and VCs alike are willing to sell to the highest bidder, so long as the fit is right for their business.
“We’re in the middle of a huge makeover of the GNP,” Gianos says, noting that companies ranging in maturity from start-ups to long-standing businesses are being forced to adapt to the new e-business era. “Everybody’s going to change the way they do business. Over the long term, it’s pretty exciting.”
Computers, Communications Lead
Industry No. of M & A Deals Average Purchase Price
Communications 13 96.11
Computers 44 65.58
Electronics 5 94.9
Biotechnology 5 40.36
Medical Health 9 51.52
Consumer Prod 6 67.5
Indust Prd/Svc 3 1.2
Other 12 83.88
Source: Venture Economics Information Services