the entrepreneur and the enterprise
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Q: We talked about the constituencies of
stakeholders—management, entrepreneur, VC, and, to some degree,
the employees. What about the customers? How do we get them
involved in the process and what issues do you need to address in
spinouts to make sure that they're comfortable?
Mr. Parker: From the VC standpoint, you figure out
what core customers you want to have working with you for the
longer term, and that’s not necessarily from a revenue
standpoint. This is a VC telling a company what to do, but, bottom
line, it's a much longer term proposition than surviving on the
second day of the spinout with a residual revenue stream from a
customer base that isn't really focused on the company's long-term
business plan. If there's a focus on the customer base, focus on
those who have beaten the alpha, beta, and production form of the
product and, secondly, who understand the product and services
vision over time. In terms of priority, third is how much revenue
they're generating for the company on day one of the spinout.
Mr. Gilbert: One of the things we did prior to the
spinout was to approach our single largest prospective customer
for the new spinout product and asked, “Would you still buy it
from us as an independent little company? We're about to do this.
Would you still be our customer?” This was a large government
agency, and we were concerned that they wouldn't do business with
us. We got completely the reverse reaction. They said, “Great,
now someone will actually listen to our requirements.” It was
perhaps a bit naive on their part because they were anticipating
that we had funding lined up. They are still a very, very good
customer of ours, I'm glad to say, and it worked out well. We
chose them strategically because they were also the single largest
government customer of the parent corporation’s core business.
It was sort of an indirect three-body arrangement in the sense
that, I won't call it blackmail, but the whole value proposition
to the parent corporation was that we were going to support this
customer with a product that we crafted for them. We said, “If
you cancel us and don't let us go forward, you're going to
disappoint your biggest customer.” That was a way to reinforce
the value of the product.
Mr. Kennedy: We had a very interesting experience
with this about three or four years ago when we acquired Loral.
Loral had a contract with a government customer to provide
oversight on the work Lockheed Martin was doing. When we acquired
Loral, we were in an immediate conflict of interest and we had to
work with our customer. We essentially spun out that contract, but
it was a large one with a lot of people on it. The first question
was: Is there continuity in the contract and will the customer do
business with us? The customer was vocal and said, “Yes, but I
want the work force maintained. I'm really buying the intellectual
capability of those people on this contract, and I want them taken
care of.” Lockheed Martin felt the same way. They were our
employees that we were about to divest, and we wanted them taken
care of. We were in an auction process and we put at the top of
the list of things the bidders were to supply to us: How do you
plan to treat the employees? Price was not the first criteria. The
offer we actually accepted was not the highest price offer. We
accepted a lower price from a company that offered a better
package to the employees. From an ethics standpoint, it's the way
we would like to be known, but it's also the way the customer
wanted it handled. Price is not always foremost. Maintaining the
integrity of the operation as it supplies the customers is the
number one criteria.
Q: Hal, you said that 12 out of your 13
companies have been successful, which is a very good statistic.
Congratulations. On the flip side, are there another 13 out there
that you potentially missed by having such a high hurdle rate?
I've been in London for the last four years with two incubators,
and I’ve seen corporations invest $10 million in a company,
where I think that if they had invested a million each in ten
companies, they would have had three great companies rather than
one mediocre one.
Mr. Kennedy: Yes, it depends on how you want to
design the process. First, we don't invest other than putting in
our intellectual property, so that sets up a very different
dynamic. It's back to pulling plants up to see how the roots are
growing. I think that when parents start putting $10 million at a
clip in the companies that are spun out, they tend to over-manage
them. Billion-dollar companies just have this nasty habit of
choking on $10 million investments, and it creates too much
oversight between the parent and the licensee or the spinout.
Do you do a lot of deals and take your lumps in a fairly
high failure rate, or do you do a small number and hit home runs?
We've elected to cherry pick like crazy and only hit home run
balls. That's why 12 of the 13 companies are still in business.
The record for defense commercialization is so bad that we made a
conscious decision at the beginning of this process in 1997 that
we would definitely cherry pick. We’d be more than willing to
let a few good ones go by in an effort to shore up the notion that
this can work, and that the process is, in fact, possible.
Some people are in a different position and have the
ability to suffer through some failures and be able to say,
“Look, it's venture capital. Two out of five succeed and our
track record is average. That's all we ever ask for.” There are
other corporations that can probably sustain a hit ratio like that
better than we could. For them, my advice would be, yes, do
classic venture capital because, to your point, you're missing a
lot of good ones if you only do the best ones.
By the way, nobody knows for sure when they start which are
the good ones. You can be too risk averse.
Mr. VonWindheim: You definitely want to pick the winners. Who's got the time to work on
failures, right? My perspective would be that you take the ones
that are going to fail and try to make them fail early. [Laughing]
Pick the winners and go forward. The only ones who have the
fortitude to have this portfolio are the people with the money,
because, to some extent, money is what they're putting into it.
VCs actually spend a fair bit of time, too, on boards and so on,
but, from their perspective, if they've got a portfolio that's got
some losers and some big winners, they’re doing fine because
they're making their IRR. You, as the entrepreneur, have five
years invested in this thing. You've only got one shot in those
five years, so take Hal's perspective. I would rather let five go
and find the one that's a gem than the other way around. I can't
split myself into six people.
Q: When undertaking these corporate
spinouts, do you incorporate put or call options to reacquire the
technology down the road? If so, what features would you
incorporate, and what are the advantages and disadvantages of
those components to a transaction?
Mr. Kennedy: We do what you suggest, but we go at it
in a different way. It's probably easier for a defense and
aerospace company than for most corporations to separate the
fields of use and wind up pretty assured that you’re in a
noncompetitive scenario with the spinout. What we tend to do is
withhold, or “clawback,” or keep back defense and aerospace as
a market and license the rest of the commercial opportunity to the
other side. As a result, we're typically not in competition with
each other. We typically start the deals with significant rights
to improvements in both directions.
Usually, the aerospace company continues to work on the
technology and makes advancements that are useful to the new
company. We like to see them in the new company because, as a part
owner, their success is our success. Meanwhile, the new company
raises lots of venture capital and goes off and improves the
technology for the commercial space. We can use some of those
things as spinback to the aerospace and defense sides, rather than
write call options around the future prospect, we just
cross-license from day one.
Mr. Sylvester: Randy, from your standpoint as a VC,
having these kind of clawbacks might create heartburn for you.
Mr. Parker: We don't implement or execute the
spinout, we provide the capital. Let's put spinout over here and
let's look at this thing that's foaming around over here. When I
look at the term sheet of the deal that I'm representing, I'm
going to start from the premise that I want that term sheet to be
as clean as possible. I want the ideal world. The premise that I
would start from is that I've got total control of the
intellectual property and total control of the bodies that are
going into the corporation. Forget the word spinout. This is now a
corporation. I have all the requisite proprietary information
agreements, the invention assignment agreements, etc. I'm going to
look at this and say, “Okay, my ideal world is that this is as
pure and clean as if these folks had developed this stuff in their
basement and I just stumbled across them.” From that template
you end up compromising and negotiating with both the entrepreneur
and the corporations. Every deal is going to end up being
different, but it's going to be a stretch for us, much less any
other team who would invest in a company that has been spun out,
to accept anything substantially more than what Hal described in
terms of the corporation's residual marketing rights and IP rights
in government sectors, or whatever predefined markets there would
Mr. VonWindheim: I learned this the hard way in some of the early deals that I put
together, particularly for this one incubator I worked for. The
first deals, and I didn't even know it, were totally whacko from a
VC’s perspective. It's hard enough to raise money, now you’re
going out and raising money around a deal that doesn't look like
other deals. It may not seem like a big issue, and you think you
can get over these things, but you can't. If you want to structure
a deal, it had better look like a typical VC deal. I think Hal
would agree, because I've heard this from him. You've got to take
the VC's perspective in spinning it out, and VCs do not like to
see a put and a call in a deal.
Mr. Parker: VCs don't like to see anything that
they're not used to seeing before.
Mr. VonWindheim: Right. So there's classical structure.
Mr. Parker: There are classical people who have the
attention span of a gnat on Ritalin. It doesn't work. In the case
of CRONOS, the fact of the matter was that back in 1999 there were
some structural aspects to the proposed spinout that were
problematic for a number of VCs. We were stumbling around trying
to put our shoes on at that point. We were not . . .
Mr. VonWindheim: They came to the table third.
Mr. Parker: Third?
Mr. VonWindheim: Yes, you were third.
Mr. Parker: Really? I thought we were second.
Mr. VonWindheim: We had to improve the deal in its structure quite considerably.
Mr. Parker: There was a lot of work that had to be
done. That's how it worked.
Mr. VonWindheim: But it was only when we, as the corporation and spinout team,
structured it so that VCs could accept it that it actually became
a doable deal. By the time SpaceVest got to it, they had the
benefit of us learning our way through that. There were things the
corporate parent didn't want to let go of, but, eventually, they
realized they had to.
Q: Are there any special performance or
other key metrics that you put on a deal to measure the
entrepreneur's performance in a spinout compared to a straight
startup? Are there any different criteria that you put the
entrepreneur through once you've got the deal in front of you?
Mr. Parker: No.
Mr. Kennedy: Probably the biggest set of battles I've
been in with VCs in structuring deals are clawback provisions.
When we license intellectual property there are a few things we're
looking for, like success and some earnest work at arriving at
success. Typically we write clawback provisions in the
intellectual property licenses that say things like, “If you
can't raise X-amount of dollars within Y period of time, your
license expires. If you're going into bankruptcy, your license
expires. If you are starting a fiber optics company with our fiber
optics technology and you decide to change it into a sneaker
company and compete with Nike, your license expires.” These are
provisions to keep people somewhat close to their business plan.
We give a lot of latitude, too, because companies tend to wander
from their business plans based on very good reasons—with the
concurrence of the board of directors. There are usually a few
clawback provisions in the licenses, but, by the time you hit a
second or third round, the VCs are writing all that stuff back out
of the documents because the company should have satisfied those
conditions by then. They should have raised enough money to get
going, developed some presence in the market, and generated
traction with customers that would assure you that they are going
to make use of the intellectual property and so forth. The
conditions fall away as time goes by.
Q: Can you provide some advice on the
following situation? Our company has been acquired by a larger
corporation which decided that our particular technology wasn't a
part of the ongoing plan. In essence, they laid off the
engineering team and put the technology in a box in the closet.
Tom, your situation is so similar to this. Any suggestions?
Mr. Gilbert: If the corporation does not have a Hal
Kennedy, and my perspective is that most don't . . .
Mr. Kennedy: Most don't .
Mr. Gilbert: Frankly, I think the best shot is the
approach we took. Figure out which member of the executive team
either has the most to gain or the most to lose in the situation.
Go to them with a personal value proposition. “I'm going to
solve this problem or I'm going to help enhance your position
because you've got $20 million sunk in something that's a losing
proposition. I can help turn it into a positive.”
That's what we did. In our particular case they didn't see
the intellectual property as an opportunity, they saw it as a
liability. Our value proposition was to remove the liability, and
it was well received.
To add a comment on the previous question, from our point
of view, our single biggest focus in structuring the ultimate
agreement was to get the words "perpetual rights"
written into the intellectual property clause. We got that
because, once again, they didn't value it. The fundamentals of the
deal, as with all deals, is a different perspective on the value
of the object in question.
Mr. Parker: I would just note that
technology-in-a-box ages very, very rapidly, and not necessarily
because it gets outdated by someone who comes up with a successor
technology. It’s because without human beings surrounding it who
are current on it and primarily interested in it, technology has a
half-life of microseconds. Without the people who invented it and
know it, the valuation of that technology drops off precipitously
over time. It's not all about IP; it's much more about people.
Mr. VonWindheim: Someone has to turn around and show the company they can make more
money with the technology out of the box than in the box. You can
put a fairly simple conceptual plan together, run some fairly
simple financials, and, if it's to the company's financial benefit
to take the technology out of the box, they will. That’s
assuming that there's not a good strategic reason for them to
shelve it. Sometimes there are reasons that go beyond finances,
but the easiest thing is to show them that they're going to make a
heck of a lot of money if they let you do something different with
Q: To you’re point, Jesko, about making
sure that there are three people at the table—the management,
the entrepreneur, and the VC—who do you approach first? If you
approach the VC first, how do you deal with confidential
Mr. VonWindheim: You absolutely approach the corporation first. Everything has to be
done above board with the corporation. There was an earlier
question about fear for your job. First of all, if you have fear
for your job, that's a whole mess right there. You’d be better
off doing something else if that's your situation.
Number one, you approach the corporation, and that's where
you start selling. Sell to them. Convince them that it's
financially in their interest to do this. The next step, once
you've got the basic agreement that this is a worthwhile idea to
look at, is to approach the investors and see whether they feel
the same way. Then usually what happens, by the way, is that you
iterate towards a common theme or it falls apart.
Mr. Sylvester: Great. I want to thank the panelists for
joining us today and providing us with these great insights, the
audience for their questions, and Netpreneur for putting on this