Desperately Seeking Partners
Lucy P. Marcus was quoted in Investment Dealers’ Digest cover story
Tom Stein & Matthew Debellis
In May Occam Networks Inc., a telecommunications start-up that had raised a total of about $47 million, was running out of money, and its venture capital backers, including Norwest Venture Partners and New Enterprise Associates, weren’t inclined to give it more. Instead, they suggested a union with a company that needed Occam as much as it needed them-Accelerated Networks Inc.
Though publicly traded, Accelerated was struggling even more than Occam. The company’s business model was in tatters, revenues were stalling, and the company was facing Nasdaq delistment. But it did have something Occam desperately needed: a cash horde of millions of dollars. By executing a reverse merger, Occam was able to get its hands on the money and stay in business. The new company, renamed Occam, has been able to retain its Nasdaq listing.
“It’s tough to raise new money for your start-ups, even if they have a good product,” says Promod Haque, general partner at Norwest. “So if you can merge with another company that has some money in the bank and some presence in the market, you are able to make everyone happy.”
The VCs did not make any money on the deal, as Haque is quick to point out, but that’s not the point anymore. The situation has grown so dire for their portfolio companies that the ever-creative financiers have come up with their own market-bottom gambit: the shotgun wedding of desperate portfolio start-ups with cash-rich going-nowhere rivals. And even those are in short supply.
During the boom, it was only acceptable for a private company to be acquired by a larger public company, which would result in a substantial return for the VC backers. But today, most public companies are waiting until these small companies are virtually bankrupt to buy them at rock bottom prices. That grim reality has made private-to-private transactions more desirable to the VCs, who are the primary matchmakers in the deals.
Whether public or private, mergers and acquisitions have become a means to secure additional funding for VCs’ portfolio companies, and keep them afloat. That’s not to say that there’s a ton of business out there. Although the slide in the number of venture-backed mergers isn’t bad, it’s the value the deals represent that’s alarming. In the first quarter of this year, 60 deals were consummated, with a dollar value of just $1.6 billion. That’s down from 70 deals worth $8 billion in the first quarter of 2001, according to Venture Economics and the National Venture Capital Association. Compare those numbers to the first quarter of 2000, when 90 VC mergers were completed for an incredible $23.5 billion.
A different environment
None of the factors that drove deals during the height of the market exist anymore. For example, acquisitive companies no longer fear bidding wars, and they no longer feel the need to race to market with a new technology before the competition. In some cases, that’s a blessing.
Consider the merger between Crystallize Inc. and Tickmark Solutions Inc. John Abraham, partner at Battery Ventures, says his firm identified several acquisition targets that would complement Ann Arbor, Mich.-based Crystallize, which develops software that enhances enterprise applications. Earlier this year, Battery, a majority owner of Crystallize, suggested that Crystallize consider acquiring Tickmark, a New York City-based start-up that also develops software that enhances enterprise applications. The two companies compete for similar customers, and their products complement each other, Battery reasoned.
Crystallize executives agreed and, after several months of negotiations, a stock and cash deal was announced in July. Because they didn’t have to rush the deal, the parties were able to carefully consider whether it would be a good one. “We spent the last few months negotiating the transaction and doing due diligence,” Abraham says. “There was no need for urgency.” Battery’s Abraham insists that Crystallize is stronger because of the deal. The Tickmark acquisition increases Crystallize’s customer base, its cash position, revenue and market share. Most important, it speeds the road to profitability, according to Abraham.
Historically, companies engaged in mergers either to broaden their product or service offerings, to raise revenue or to prevent a rival from gaining a competitive or strategic edge, says Ben Coughlin, a principal at Spectrum Equity Investors. But in today’s market, the first type of these acquisitions is out, while deals that boost revenue and income are in.
“People aren’t thinking strategically; they’re thinking bottom line,” adds Robert von Goeben, managing director of Starter Fluid Management LLC, an early-stage venture firm. “They’re buying sales forces and sales pipelines.” That means customers and market share must be part of the deal, rendering many early-stage technology companies unattractive. For that reason von Goeben instructs his portfolio companies to concentrate on winning customers and building revenue. “There’s no reason to think that M&A activity is going to pick up this year or even next year,” he says. “We’re just heads down at this point.”
Start-ups with a steady revenue upswing based on products that customers vouch for are some of the strongest acquisition targets. “Start-ups have to do more work than just show revenue. They must package’ themselves by shoring up their financials, trimming fat and reworking any outstanding and maybe even overpriced real estate and equipment leases,” says Louis Doctor, a partner at Arbor Advisors, a boutique M&A firm in Palo Alto, Calif.
“We’ve seen situations where the lease obligations are worth more than the companies,” Doctor says. “Buyers don’t want to take on problems. Prospective buyers aren’t always taking apart start-up products to test technologies but instead are talking with customers to make sure they’re happy and paying their bills.”
Sleeping with the enemy
In some cases, the only way for companies to raise new cash from VCs-and in doing so, stay alive-is to merge with competitors. That’s what happened with corporate search-engine firms Answerfriend and Electric Knowledge, which joined to form InQuira Inc. in June. Both firms were independently searching for new capital and had separately knocked on the doors of VC firms Partech International and Walden International.
Amos Barzilay, a managing director at Walden, and Vincent Worms, a managing partner at Partech, were friends who had worked together before. They were both interested in the search-engine sector, but neither felt comfortable gambling on either of these two companies. So they hatched a plan to fund both Answerfriend and Electric Knowledge to the tune of $10 million in total, but only under the condition that the two firms merged. It was a bitter pill to swallow for the entrepreneurs at the two companies, especially since they had been archrivals for several years.
But they really had no choice. “Quite simply, it was a good idea to put these companies together,” says Barzilay. “It’s possible both companies could have raised money independently, but rather than betting on the number two or the number three company in the space, we felt our returns would be much higher if we combined the two and backed the company that will become number one in its space.”
In a somewhat similar scenario, supply-chain software start-up Tradec agreed to merge with competing start-up PowerMarket. The deal was particularly sweet for Tradec, which picked up PowerMarket’s cash reserves as well as an additional $11 million in fresh VC financing. The deal leaves Tradec’s original venture backers, Novus Ventures and Portage Venture Partners, with 58% of the company, while PowerMarket’s original backers, Kleiner Perkins Caufield & Byers, Norwest Venture Partners and RRE Ventures, retain a 42% interest. Tradec and its venture backers were attracted to PowerMarket’s strong cash position, as well as the opportunity to raise new capital from PowerMarket’s top-tier venture backers. PowerMarket and its backers, for their part, liked the fact that Tradec’s product was well established and that the firm had a strong customer base as well as greater traction in the marketplace.
“It’s logical that a cash-rich company lacking in product depth or staying power would fit nicely with another private firm that has greater strength in the market but may be lacking growth capital,” says Norwest’s Haque. The merger should allow the new company, which retains the Tradec name, to expand its footprint in a supply-chain industry that is quickly consolidating. “Too many companies got funded in the last several years that were not uniquely differentiated,” says Haque. “Ultimately, it’s more attractive to be a survivor.”
Pulling off such deals is difficult. In particular, mergers between two private companies, known as private-to-privates, can be extremely tough. Many venture-capital firms vie for an edge, each wanting to come out the winner. Egos come into play. Negotiations, especially to determine agreeable valuations, are gut-wrenching. “There is fear and uncertainty in the venture world,” says Greg Blonder, a general partner with Morgenthaler Ventures. “VCs are very different from one another; they all have different goals in mind.”
Adds Bart Schach-ter, a general partner at Blueprint Ventures: “Everybody wants to do private-to-private deals, but very few actually succeed. It takes a tremendous amount of intestinal fortitude, because valuation, team composition and who comes out on top are all very subjective. I’ve been holed up in these tough discussions all day in a hotel room trying to decide who comes out on top.”
Another reason private-to-private deals are so difficult is that they don’t represent an exit for venture investors. In other words, they don’t result in a cash or public stock return. It’s not what venture capitalists hope for, but they consider it a minor victory when they can grow and strengthen a portfolio company through a merger. “You’re hopefully preparing for a more successful exit later,” says Blueprint’s Schachter. “We see it as betting on not one horse but two. The stake is smaller, but you have a greater chance of winning the race.”
Another problem emerges when VCs and their entrepreneurs don’t see eye to eye. Venture capitalists, while partners to entrepreneurs, are obliged to show investors solid, consistent returns. However, entrepreneurs nurture their start-ups like children, making it difficult for them to let go, whether profitable or not. As tensions build in tough economic times, entrepreneurs and venture capitalists can find themselves at opposite ends of the bargaining table.
One example is 3i, Britain’s largest venture firm, which upset an entrepreneur when it moved to sell off one of its portfolio companies. 3i decided to sell Go, a start-up discount airline, to rival easyJet, a subsidiary of British Airways Plc, in a deal worth roughly $630 million. That made Go Chief Executive Barbara Cassani-who stated publicly that she wanted to take the company public rather than sell it-unhappy.
As Cassani’s complaint illustrates, mergers can be tough on entrepreneurs, especially when they are forced to change their original business models or sell out when they are not ready, argues Morgenthaler’s Blonder. “Some are jazzed by the opportunity and others are depressed,” he says. “VCs have to act as a third eye.” In this market, he insists, VCs must point out to entrepreneurs what they can’t see clearly for themselves.
“Many first-time CEOs still don’t believe that they can graduate from entrepreneur school without taking their company public,” says J. Sanford Miller, managing director at 3i responsible for late-stage investing in the U.S. “They are interested in achieving financial independence for themselves.” That desire can sometimes blind them from seeing the bigger picture. Miller said it would have been irrational for 3i to have turned down the Go acquisition deal and wait for an IPO, especially given the fragility of the public markets and the volatility of the airline industry.
Getting assets cheap
VCs, like everyone else, don’t know what the economy will serve up in the next six to 12 months, but they are confident the M&A market will start to gain steam. They especially anticipate that public companies will jump back in the game, especially because the valuations of venture-backed companies have fallen so low. So far, however, many public companies are willing to wait until struggling private companies go bankrupt, when they can swoop in and acquire the assets for a song.
Over the last several months, dozens of previously well-funded companies have run out of venture capital and been forced to sell their assets dirt-cheap. In many cases, these are companies that would have fetched top dollar during the boom market of a few short years ago. “Today, buyers will just wait for you to run out of money,” says David Creamer, managing director of Broadview International, an investment-banking boutique that specializes in high-tech mergers and acquisitions. “They smell blood and are hovering like vultures before swooping in and scooping up the assets.”
Recently, Bertlesmann AG acquired the assets of song-swapping pioneer Napster Inc. for a paltry $8 million. Parade Networks paid just $3 million for the assets of Jetstream Communications Ltd., a company that made equipment used to send voice communications over high-speed Internet connections, and that had raised a whopping $115 million in venture capital. Loudeye Corp., a publicly traded provider of Webcasting services, picked up the assets of Digital Media Broadcast for an undisclosed amount. Meanwhile, Electronics for Imaging acquired Unimobile, a provider of wireless services that had raised $16.7 million in venture capital, for the shockingly low price of $2.5 million. People familiar with the deal said that Unimobile was actually close to being bought for the considerably higher price of $20 million only a few months before but that the deal fell apart at the last minute. Ironically, at the time Unimobile felt it was worth more than $20 million, according to a source close to the deal.
Lucy Marcus of Marcus Venture Consulting, a consulting firm that specializes in venture capital, says potential acquirers would rather watch struggling venture-backed companies go bankrupt. “It’s a sad state of affairs,” she says. “The M&A market is looking something like a flea market, with acquisitive companies rummaging through the junk heap looking for just the right bits and pieces.” It almost seems like payback for the days when start-ups without any customers-or even any products to speak of-were rapidly snapped up by the likes of Cisco Systems Inc. or Microsoft Corp. for billions of dollars.
Most VCs are quietly fuming over the fact that their portfolio companies are selling at rock bottom prices. “The idea of acquirers waiting on the sidelines until the very last moment is not a positive trend,” says Heidi Roizen, a managing director at Mobius Venture Capital (formerly Softbank Venture Capital). “In the end you could wind up losing the founders and critical team members you may have wanted to retain. I think the acquisition process has been degraded. There is no worse way to start a new relationship than by screwing the people you are supposed to be teaming up with.”
Given the sheer number of privately held companies in the marketplace, as well as their rapidly declining valuations, it would be reasonable to assume that this market would be a bonanza for bargain hunters. But, overall, M&A activity is still on the tame side. “There are a lot of deals you think are going to happen and they don’t,” says Patrick Ennis, a general partner at ARCH Venture Partners. “The market spooks people.”
The dwindling appetites of public companies further exacerbate the weak M&A market. With stock prices so low, even established corporations aren’t doing much shopping for new products and services. They may be timid after the flurry of M&A activity in the late ’90s when buyouts often reached the billion-dollar level. However, corporations with strong cash and stock positions can command low valuations today. And for a change, they have time to mull over their options. “The footsteps companies heard from the competition a few years ago are no longer there,” says Curtis Feeny, managing director at Voyager Capital. “So they can wait and get the price they want.”
Even though companies wait and wait, deals in which public companies buy start-ups are few. Corporate acquisition departments should be looking for start-up gems, says John Boyle, a general partner at Worldview Technology Partners. Boyle led many acquisitions as vp of business development for 3Com Corp. in the early- and mid-90s. “I don’t see it happening yet but it should,” Boyle says. “There’s some amazing technology out there available for 10 cents on the dollar. If I’m a big company, I see a great opportunity to improve my product portfolio without breaking the bank.”
But as corporate buyers wait longer, their options steadily decline as more and more start-ups fall off the face of the earth. Still, no one is rushing to complete deals-and the length of time it takes to complete a transaction is taking much longer. “Conversations are incredibly long,” says Starter Fluid’s von Goeben. “Nothing happens quickly.” David Creamer of Broadview concurs. He says that in 2000 start-ups would get engaged with multiple buyers and close the deal in two to three months. “Now it takes easily double that time, and the success rates for completed private deals is way down,” he says. “If in 2000 the success rate was 50% or 60%, now it’s half that.”
The brave front
VCs as a rule have always been starry-eyed optimists. They insist they are seeing life in the M&A market, and many interviewed for this story predicted a strong rebound in the calendar year’s final quarter. They are encouraged by several signs and expect corporations to increasingly buy start-ups at attractive prices. VCs cite recent deals by stalwarts like Cisco and Broadcom Corp., which have begun making acquisitions after laying low for more than a year. Indeed, Cisco recently completed two acquisitions: Hammerhead Networks Inc., a connectivity-tools developer, for $174 million in stock, and Navarro Networks Inc., an ASIC developer, for $85 million in stock. Chipmaker Broadcom recently acquired purchased Mobilink Telecom Inc. for $215 million. In yet another notable deal, Business Objects, a business software maker, agreed to acquire start-up Acta Technology Inc., a provider of real-time data integration software, for $65 million in cash.
Another reason for VC optimism is that corporations have cut so deeply into their employee rosters and product-development departments. When the economy bounces back, they’ll have no choice but to look to new technologies from private companies to fill the holes. Acquiring venture-backed companies will be faster and more cost effective then growing organically.
Anticipation of a resurgent M&A market is changing the way VCs invest. Before the recession, it was common for VCs to plan for both IPOs and acquisitions as exit strategies. Today, with IPOs no longer an option, many VCs will only invest in companies they believe are probable acquisition targets. “There are some things we look for in all our deals,” says 3i’s Miller. “Before, IPOs were the main thrust. But that attitude has shifted. Up front, we are making sure there are logical buyers for the companies we invest in. Today we would not make an investment if there wasn’t a potential acquirer on the horizon.”