No Exits? VCs Start Funding Spinouts –

The largest first-round funding of 2002 wasn’t a startup. Not in the traditional sense. On Jan. 31 of last year, defense contractor Raytheon Co. announced that it had spun out TelASIC Communications Inc., a fabless semiconductor company. TelASIC had secured $22.5 million in first-round funding from the likes of Com Ventures, Mission Ventures and Redpoint Ventures. It was a sign of things to come.

As the economy slowed and companies hunkered down, the shedding of non-core assets into the hands of “friendly” financial buyers-namely VCs-became a common occurrence. On Aug. 19, 2002, Network Associates sold off privacy software developer PGP to PGP Corp., an independent company formed by Doll Capital Management and Venrock Associates to fund the spinout with $14 million. Sources say the VCs snapped it up for about $5 million, a steal considering that Network Associates had bought PGP for about $40 million five years earlier.

Less than a month after the PGP deal, San Francisco’s Vector Capital and Salt Lake City’s vSpring Capital bought software maker LanDesk from Intel Corp. Intel had already invested more than $250 million in its LanDesk product group over the last decade, “so even at $50 million, it would have been a great deal … and it was better than that,” crows Alex Slusky, a Vector general partner.

Yet, with more than 100 employees and about $50 million in revenue-plus the fact that it’s profitable-LanDesk is hardly a startup. Neither is PGP. So, what’s going on? Have VCs forgotten that, among all investors, they’re the ones who are supposed to be taking the startup risk? What happened to funding three guys, a dog and a business plan?

With so few exit opportunities for their portfolio companies, VCs are looking for deals that will reach liquidity in a short amount of time, allow them to invest large amounts of stockpiled cash and don’t require heavy lifting. And that has led them to pursue buyouts of mature companies carved out of large corporations that spent millions developing them. While it makes VCs look more like bankers, Matt Bigge, a general partner with Silicon Valley Innovation Capital, contends that VCs pursuing these deals are sticking to their core business. “When you get back to the basics of being a VC, you find an undervalued asset, take that lump of coal, polish it and turn it into a diamond,” he says.

Orphans Wanted

Opportunities to find lumps of coal abound. Large corporations, which went on acquisition binges in the technology boom, are suffering from indigestion. As Intel, Network Associates and the like spin out non-core assets, trim expenses and focus on what they do best, VCs are meeting them at their doorstep.

“It used to be that a strategic corporate buyer was able to pay more for some of these orphans but that’s not the case anymore,” says Rick Dalton, a managing director in the Foster City, Calif., office of merger specialist Broadview International. “With VCs and other financial buyers, they can spin off these things and keep some of the IP. It’s not about the highest bidder but rather the friendliest buyer.”

With what usually amounts to not much more than a typical Series A-sized financing, VCs can take advantage of what are still attractive sale prices in acquiring revenue-producing products, established technologies and even fully intact engineering and product development teams.

Although once the domain of pure buyout shops, these deals are now attracting early-stage VCs seeking to diversify their portfolios-and make a quick buck at a time when so few true venture-backed companies are able to make it public or find a buyer.

Growth Strategies

Purists may take exception-arguing that VCs are supposed to build businesses, not buy them-but Brian Barlow, a vice president at venture firm Broadview Capital Partners, says such spinout deals (what he calls “growth buyouts”) still require a lot of company building.

“I recently talked with a historically early-stage fund who claimed to have carved out 25% to 33% of their fund, as well as two general partners, to focus exclusively on buyouts, spinouts and recapitalizations,” Barlow says. “The logic was to put a lower-risk investment strategy in place to return the fund’s capital and let the remaining 66% to 75% of capital in early-stage ventures provide the returns.”

The venture capital community has $250 billion in capital under management today, $90 billion of which has yet to be deployed, according to Venture Economics. Even though several firms have scaled back the size of their funds, most haven’t, and they’re feeling pressure to invest because they are collecting management fees on large amounts.

By acquiring spinouts-or even by doing PIPEs (private investments in public equity) or financing the mergers of startups-VCs-turned-bankers can often shave time and money off the product development cycle and wind up owning the sole leader in a space.

Phil “Dunk” Dunkelberger, CEO of PGP, says that if Doll and Venrock had started a company from scratch rather than buying PGP, it would have taken a new startup nine to18 months to get a product to market. “Just having the trust factor with your customer base is huge,” says Dunk. Then there’s the speed to profitability, not to mention the shortened time to liquidity, to make these deals even more attractive. “If I invest in a guy today, I might not see liquidity for six to seven years,” says Ben Dubin, a partner in venture firm Asset Management Inc. of Palo Alto, Calif. “That’s longer than most VCs want, especially if they’re already three to four years into a fund. There’s no faster way to exit except to invest in more mature companies.”

Risky Business

Such an acquisition strategy does not come without risks, however. First, there’s the danger of purchasing damaged goods, in terms of product and team. “Are these startup guys or big company guys you’re getting?” asks Broadview’s Dalton. Moreover, do the existing customers even want the product? “We spent months just contacting customers to see if they’d even be willing to purchase the next PGP software upgrade,” says Dunk. “Fortunately, their answer was yes.”

The bottom line is that VCs buying spinouts may need to spend more time on due diligence than they do with a Series A deal. Doll spent four months checking out PGP, while Vector spent 10 months doing due diligence on LanDesk, “not to mention the seven-figure legal bill,” says Vector’s Slusky.

Then there’s the fundamental question of whether VCs have or can master the same skills as buyout veterans, such as managing (or replacing) an established team weaned on the resources of a large corporation. Last, there’s an issue as to whether a technology can stand on its own two feet without the benefit of the larger corporate brand behind it.

In the current market environment, however, these questions may be irrelevant. You do what you have to do to stay alive-and show a return for your limiteds. Says Bigge of Silicon Valley Innovation Capital: “In today’s VC market, you either get creative or you get out of business.”

Peter D. Henig is a Bay Area freelance writer who specializes in writing about entrepreneurs and venture capital.