Enthusiasm is returning to the venture sector, but the optimism is guarded. Freewheeling spending on startups is passe, and the mantra of capital efficiency resonates with most rational investors. Our earlier articles have explored this renewed discipline. Here, we will focus on a specific category of high-leverage startup: the corporate spinout.
At Blueprint Ventures, we’ve made corporate spinouts an integral part of our deal-sourcing strategy. We have investigated many opportunities in this genre and while we have rejected most, we have found several that proved quite attractive. In cases where we’ve invested, company progress post-deal is quite positive so far. In exploring an opportunity, our diligence process has adapted to look at spinout specifics: what? why? and how? Here we present some insights, from deals done and deals discarded.
Any investor wants a thorough understanding of precisely what he’s buying when he writes his check, and corporate spinouts can take a variety of forms. The deal may range from a license to a nascent technology, fresh from the corporate research center, to a fully developed multi-national business with revenue and perhaps even profits! Understanding exactly what is being offered in the deal is critical; the corporate seller is typically (but not always) a shrewd negotiator with a specific agenda. Whatever the package includes, the investor needs to be sure the package is sufficiently complete. Licensing technology without getting access to some key patents, or taking on a product business with no channels of distribution, could be disastrous. Staffing is critical-key developers may be slated to stay with the parent, or the general managers of business units may be planning to retire as part of the spinout.
These may seem like obvious issues, and they are once they become apparent. However, unlike a conventional startup, in which the entrepreneur wants to get rich just as much (or more so) than the investor he’s pitching, the spinout is offered by the corporate owner, which likely has motivations of its own. The parent may or may not have a stake in the future success of the offspring. There may be next-generation technologies or services that the parent is keeping for itself and the spinout will end up in a competitive situation and at a disadvantage to boot.
It isn’t all bad news, however. There can be tremendous value and leverage in a spinout that allows for better capital efficiency by accelerating the time-to-market. Corporations often have huge research and development budgets, and in headier times may have poured large sums into inventing something that they now can’t use in their core businesses. In the best case, that investment has already been written-off and getting any type of consideration is deemed a good thing.
In 2002, Blueprint invested in LANDesk Software, a provider of desktop management solutions that spun out of Intel Corp. Intel had acquired the company in 1991. While the business unit enjoyed a solid reputation as a leader in its segment, Intel was spinning it back out as part of a drive to return to its silicon roots. The investment group formed an acquisition entity and installed Joe Wang, a seasoned desktop software executive, as CEO. The transaction included the purchase of the LANDesk product portfolio, as well as other assets and intellectual property. About 150 staffers moved from Intel to the new LANDesk Software, and the company hit the ground running as a profitable business with marquee customers. Intel retained a minority stake in the new entity, which has performed admirably, doubling sales since the spinout.
Not all “self-contained” spinout candidates are attractive, though. We’ve seen situations where the business had significant revenues, but the product line had grown stale due to lack of investment. In one specific case, our assessment was that product refresh would be expensive, revenues would decline significantly, and profitability-and, therefore, an exit opportunity-would be elusive. Even though the parent had sunk significant sums into the project over its life, and the historical revenue stream was impressive, we elected to pass.
Understanding the motivation for the spinout provides additional clues for investigating the attractiveness of the technology and the viability of the business. A parent may choose to sell because the unit no longer fits the strategic directives of its parent, or because the unit itself is evolving away from the corporate focus. Sometimes the unit is at a crossroads-a next-generation product needs to be developed or the technology needs to be updated to a new standard, as examples-and the parent is reluctant or unable to make the necessary investment.
Taking the business to a new level will likely require some heavy lifting and may be more challenging outside the protective cocoon of the parent. Thus, the new investor not only has to make sure he isn’t being sold a bill of goods, but also has to be confident that the next steps to the promised land are feasible, practical and fundable.
Earlier this year, we got intrigued with an image-analysis technology that NEC, the Japanese electronics giant, was spinning out. Developed in NEC’s Silicon Valley research labs, this signal processing software could examine a real-time video feed, identify objects, track them over time and recognize “behaviors.” It was originally conceived as being applicable to commercial broadcasting (such as automatically characterizing plays in sporting events). NEC had engaged entrepreneur Brooks McChesney to explore other uses for the technology. He identified security applications (such as identifying suspicious persons and vehicles in sensitive areas, like airports) as an attractive segment, and spearheaded the prototyping of the technology for that application.
This summer, Blueprint led the formation of that NEC business, which is now known as Vidient Systems. Brooks is the CEO, and several key technologists have joined from NEC. Vidient has licensed key patents and other intellectual property. It has installed “alpha” systems at several airports, as well as some other commercial locations, and the U.S. Transportation Security Administration has tapped the company for additional deployments. NEC retained a small ownership position in Vidient and recently completed a distribution agreement with the company, becoming its first channel partner.
Often, there’s a belief (in fact, it’s often part of the pitch) that when out from under the corporate umbrella, there will be the opportunity to remove bloat and improve the focus of the unit. We view such promises with skepticism. While there is often a modicum of truth to these claims, we think there is more leverage in business expansion, so we look for situations where a modest investment can unleash significant growth.
In some deals, the venture capitalist brings necessary entrepreneurial spirit to a project that has been languishing in the corporate environment. Our network of experienced startup executives can be a key ingredient in getting a spinout off the ground. In structuring the deal, it can be important to ensure that the parent “lets go” of the offspring so that it can realize its full potential.
The parent’s financial interest in the new business can take several forms. In almost all the deals we consider, the parent retains some level of equity interest (usually common stock). Doing so not only enables any new funding to be directed solely to the new business (rather than paying off the parent), but it also gives the former owner a vested interest in the new unit’s success. The parent may also have a royalty relationship with the spinout that allows the parent to accept a lower initial valuation in exchange for participation in any upside.
Last year, Blueprint led the spinout of Platform Solutions Inc. (PSI) from Fujitsu Ltd. Fujitsu was winding down what had once been a very profitable business selling IBM-compatible mainframes. The proprietary PSI technology allows mainframe software to run on commodity server machines and holds great promise as the price/performance of those servers continues to improve. Key staffers came to PSI from Fujitsu, which also provided access to its extensive qualification labs. Blueprint sourced the company’s new CEO, Michael Maulick, a seasoned executive with years of leadership experience in IBM’s mainframe sales organization.
There are some very attractive, capital-efficient opportunities for venture investors in corporate spinouts. Pursing these deals requires a special kind of diligence that goes beyond traditional investments. VCs often must bring management talent, restructure the business as an entrepreneurial enterprise, and drive deal terms to meet investment objectives. With careful selection, spinouts offer significant leverage and the opportunity for a sizable reward. In the end, the ultimate benefit for these types of deals is the ability to invest in a company that has leveraged previous investments within a corporation at a low price point, resulting in excellent capital efficiency.
George Hoyem is a Managing Partner with Blueprint Ventures. His investment focus includes software, security, and IT infrastructure companies. David Frankel is a Technology Partner with Blueprint Ventures. He has more than 20 years of entrepreneurial, technology, investment, and executive experience. His technology interests include wire-line and mobile communications, high-performance computing, and IT infrastructure.