More proof that the model is not broken

For many years we have articulated the need for capital efficient businesses in venture investing. This requirement has become even more relevant in light of recent accusations that the venture capital model is “broken.” We believe the model is not broken as much as it is obsolete in the face of current exit-market conditions and the need to build businesses differently and on shoestring budgets. Many of our peers have taken to this message via new strategies that pursue India, China, or even Web 2.0 opportunities for capital efficiency. During this time, we have continued to grow our Early Stage Corporate IP Spinout practice with a now well-accepted conviction that the investments made by major high-tech corporations can be successfully leveraged into venture-style returns.

But how successful is this strategy in reaching the nirvana state of higher risk-adjusted returns on lower capital needs? Let’s go to the numbers!

We recently decided to put our own investment thesis to the test to see how it stacks up quantitatively. Over the past five years, Blueprint Ventures has focused primarily on Early Stage Corporate IP Spinouts, where we leverage stranded IP (typically prototype/pre-revenue technology projects) from corporations and spin them out into new venture-backed startups. These projects often have several years of technology development and tens of millions of dollars in prior R&D, but are no longer strategic to the corporation. In these cases, the corporation seeks to monetize its prior investment through early stage spinouts. This history provides a “running start” that the NewCo can effectively use to reduce its capital needs.

Hard data

Doing a statistical performance review validated to us that the Early Stage Corporate IP Spinout strategy not only generated solid returns in the past but also yielded the tangible benefits we expected. Historical data showed that these deals were more capital efficient, were likely to achieve a positive realization and had solid home run potential.

Our team’s experience with 13 Early Stage Corporate IP Spinouts tells us that they have attractive investment characteristics. But we wanted to back up our investment thesis with hard data over an extended period of time. We examined Dow Jones VentureSource data for private companies fitting the following criteria:

• Information technology companies

• Headquarters based in the United States

The model is not broken as much as it is obsolete in the face of current exit-market conditions and the need to build businesses differently and on shoestring budgets.”

Bart Schachter and Richard Yen, Blueprint Ventures

• Founded between 1990-2005 (inclusive)

• Received venture funding during its lifetime

• Were realized (IPO, M&A, or went out of business) by the end of 2005

Analysis of the resulting data set—205 Corporate IP Spinouts and 2,930 traditional startups—yielded several interesting insights.

Stretching VC

One of the first differences we noticed between Early Stage Corporate IP Spinouts and traditional startups is the amount of venture funding required to reach an exit. Corporate IP Spinouts required less VC funding than traditional startups, because they leverage significant prior investment and technology from the corporate parent. Not surprisingly, the capital efficiency benefits are most evident in the capital-intensive semiconductor and communications sectors.

M&A has become the most common exit route in recent years due to the overhead imposed by Sarbanes-Oxley to go public. Given that M&A exits are typically less lucrative than IPO exits, we believe venture investors must find a way to invest fewer dollars over a startup’s lifetime to generate a venture-style return. Corporate IP Spinouts, which require fewer investment dollars to reach market validation and achieve an exit, are one way of achieving this capital efficiency.

Live and let live

Historical data showed that early stage corporate IP spinouts were more capital efficient, were likely to achieve a positive realization and had solid home run potential.”

Bart Schachter and Richard Yen, Blueprint Ventures

The VentureSource data also indicated that Early Stage Corporate IP Spinouts have a lower mortality rate than traditional startups. In other words, Corporate IP Spinouts were more likely to reach an M&A or IPO exit and less likely to go out of business than traditional startups. This finding reflects the reduced technology risk associated with Corporate IP Spinouts. Whereas traditional startups can fail in the early stages due to technical infeasibility, Corporate IP Spinouts typically have significant intellectual property and working technology prototypes before the first venture dollars are invested.

The lower failure rate makes intuitive sense because Early Stage Corporate IP Spinouts are more mature and fully developed than traditional startups at the time of initial funding. All things being equal, most people would agree that a Series B startup is less risky than a Series A startup simply because the Series B startup is further along in its progression. Corporate IP Spinouts have the technology maturity and future capital requirements of a later stage startup with the valuation of an early stage startup. That’s an extremely attractive value proposition for venture investors.

Why isn’t everybody doing it?

What’s the financial downside to this differentiated strategy? According to our research, Early Stage Corporate IP Spinouts were less likely than traditional startups to generate 10X or higher multiples. By this definition, startups that had $10 million in lifetime venture funding would have to exit for more than $100 million. The 1990-2005 time period undoubtedly favors traditional startups thanks to the numerous Internet bubble IPOs, yet Corporate IP Spinouts fared well with 31% resulting in home runs.

The fact that Early Stage Corporate IP Spinouts lag behind traditional startups in 10X returns underscores the “buyer beware” concept. VCs that invest in Corporate IP Spinouts face an adverse selection problem where they only evaluate technology projects that the corporate parent has decided to abandon. Many of these projects are simply unattractive and have been discontinued for sound business reasons. Corporate IP Spinout investors must be disciplined and scrutinize each opportunity carefully if they are to find winners like past spinouts Ciena, VeriSign and Documentum.

Trust but verify

The VC landscape changes frequently, of course, so we plan to revisit these performance figures periodically to ensure Corporate IP Spinouts remain an attractive area for investment. If you’re a VC targeting an emerging market space, a new geography, or a unique deal sourcing strategy, we encourage you to run the numbers and see if your strategy holds water. You, your colleagues and your limited partners will be glad you did.

Note: the findings in this article are based on a Kauffman Fellows Program field project presented by Richard Yen in July 2006.Bart Schachter is a managing director with Blueprint Ventures. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software and communications semiconductors. He may be reached at bart@blueprintventures.com. Richard Yen is a Principal and Kauffman Fellow with Blueprint Ventures. Yen focuses on infrastructure software, wireless technologies and consumer Internet. He may be reached at richard@blueprintventures.com.