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the entrepreneur and the enterprise
  a different spin on startups
page three of three | previous page

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.

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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 be.

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.

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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 it.

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 information?

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 event.

[End]

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