a different spin on startups

Spinouts are a different approach to startups in which an entrepreneur leads an effort to commercialize—as a brand new company—a product or technology that was developed inside a large organization. Spinouts have much in common with other startups, and some unique attributes as well. For one thing, they are deals with three partners—entrepreneur, parent, and investor. At this Netpreneur Coffee & DoughNets event held June 26, 2002, a panel of spinout veterans examined the process of finding the entrepreneurial spirit inside the enterprise.

panelists:
Hal Kennedy, VP for Technology Commercialization, Lockheed Martin
Tom Gilbert, co-founder, Blue Ridge Networks
Jesko VonWindheim, CEO, CRONOS/JDS Uniphase
Randy Parker, Managing Partner, SpaceVest  

moderator:
David Sylvester, Senior Partner, Hale and Dorr LLP

Copyright 2002 Morino Institute. All rights reserved. Edited for length and clarity.

Disclaimer: Statements made at Netpreneur events and recorded here reflect solely the views of the speakers and have not been reviewed or researched for accuracy or truthfulness. These statements in no way reflect the opinions or beliefs of the Morino Institute, Netpreneur.org or any of their affiliates, agents, officers or directors. The transcript is provided “as is” and your use is at your own risk.

mary macpherson: welcome

Good morning. I'm Mary MacPherson, and I would like to welcome you to Netpreneur's Coffee & DoughNets.

          We realized when we scheduled this event that this is the first time we've been back at this location since July of 2000. I looked to see what the topic was then. It was, “If I Knew Then What I Know Now.” I think that remains a timely topic for many people.

          Before we begin this morning's program, let me tell you about something new from Netpreneur that we think is pretty cool. It's called The Loop, and it's a new email-based discussion group. It's a place to continue the conversations that begin at events like this one. We have a lot of ideas for The Loop, and, to begin with, our panelists have agreed to answer additional questions in the group. We'll be taking questions for the next 24 hours, plus any that we don’t get to this morning, and our speakers will reply over the next few days.

          Let me also acknowledge our volunteers this morning who help us with these events: Gregg Davis of IIP Solutions, John Kupik of BCA, Michelle Zelsman of Monsoon Communications, and Kristie Helfrich of the Center for Regional Economic Issues, who recently relocated here from Cleveland. Thanks to all of our volunteers, thanks to the Netpreneur team, and, as always, thanks to the Morino Institute for its support.

          Let's get started with today's program which, also very timely, is about spinouts. Let me turn it over to Dave Sylvester.

david sylvester: introductions

Good morning. Thank you all for coming. My name is David Sylvester. I'm a partner in the law firm of Hale and Dorr, and I'm honored to be here.

          Before I introduce our panel, let me tell you what we're going to be talking about today. I'll start by telling you what we're not going to be talking about. We're not going to be talking about the spin-offs that you read about. That is when a corporation, normally a public corporation, does a distribution to its shareholders, generally on a pro rata basis, for purposes of getting those shareholders some direct value in subsidiaries of the corporation. What we are going to be talking about today is much more timely for this area, and that is how corporations and managers of venture capital take technology or ideas or concepts or even, in some cases, people from existing large organizations and put them out into the public marketplace to commercialize them.

          That will raise lots of issues, including intellectual property (IP) issues, issues with respect to employees, issues with respect to customers, and a myriad of issues that will result from a corporation taking a subset of its ideas and, in essence, jettisoning them to a new, independent enterprise. That independent enterprise will often need financing, management, and all the other things that a startup will need. Given what's going on in our marketplace, you'll see it happening more and more, particularly with the large government contractors who are taking technology and commercializing it in ways that they've never done before. They're using people like these four panelists to get this technology to people like you and me so we can make our lives better.

          Let me start, to my far left, with Hal Kennedy, who is VP for Technology Commercialization at Lockheed Martin. Hal's role will be to talk from the corporate perspective, and he's been very much involved in doing this for 30 years.

          To Hal's right is Tom Gilbert. Tom is a co-founder of Blue Ridge Networks and he will be performing the role of entrepreneur. Blue Ridge Networks resulted from a spinout from StorageTek about four or five years ago, so Tom will be able to tell us what issues he addressed and how he has been dealing with the results.

          To Tom's right is Dr. Jesko VonWindheim, who's a VP and GM of a business unit at CRONOS/JDS Uniphase. He will speak from the perspective of someone who's gone through the process from beginning to end more than once. He will show us a perspective looking through the rearview mirror, including what went wrong, what went right, and how he made it all a success.

          To Jesko's right is Randy Parker, a Managing Partner at SpaceVest and a very prominent venture capitalist (VC) in the local community who has significant experience doing spinouts. I was told that about 30% of SpaceVest’s portfolio companies resulted from spinouts of large government contracting organizations. Randy will be able to add the perspective of how we value these spinouts, and what the VC and marketing communities will be looking for in terms of success.

          Let me ask Randy to start, then we'll go to each of our other panelists to give their insights on the topic, then we'll take questions.

ransom parker: the common thread

I want to start by thanking you for your participation in the session, but also acknowledging, to paraphrase Groucho Marx, that any entrepreneur who would sit here and listen to me at 8:00 in the morning is someone I probably don't want to invest in. [Laughing]

          Hal has a follow-up to that later, as we rehearsed this.

          For those who don't know SpaceVest, we're a venture capital firm based in Reston, Virginia. In round numbers, we have $300 million under management. It's actually slightly less than $300 million, but I use that number because we're still marketing our third fund and I found that it's probably prudent to inflate things a little bit—not that the companies we review for investment do that. [Laughing]

          Our global limited partners include corporate insurance and pension funds, such as the Boeing Company, Sofical, Barclay’s Capital, and others. Our focus has traditionally been on space-related technology companies, including telecom infrastructure, data communications networking, integrated networks, and software productivity tools. Our sweet spot is best defined as expansion rounds under which we would commit anywhere from $4 million to $8-$9 million over the life of the investment. Since the beginning of 1999 we've co-invested with probably 50 different VC firms, locally, regionally, and nationally. Our latest fund, which is vintage 1999, is well within the top quartile for performance. We’re pretty optimistic about what we can raise from this point forward. In round numbers, we have $100 million in fresh capital to invest between the two funds. Several of our portfolio companies are spinouts, although I won't represent to you that we grabbed these companies from day zero in terms of their maturity.

          What I would like to do is set the table for my co-panelists and give you a quick summary of the companies that SpaceVest is involved with.

          I’ll start with CRONOS, and there's a very strategic reason why I'm sitting next to Jesko. CRONOS initially focused on the design and fabrication of micro-electromechanical systems in commercial, government, and university customers, and focused its mission even more when it was acquired by JDS Uniphase. We invested in the company in December of 1999, and it was acquired by JDS in April or May of 2000.

Mr. VonWindheim: April

Mr. Parker: It finally closed in April of 2000 with a significant return for us and the company. We led a Series A round in December of 1999 at $8 million, and we're very pleased with the result. We think that our ongoing relationship with CRONOS and the principals is going to serve to both of our benefits.

          Blue Ridge Networks, represented by Tom Gilbert, is a company in Chantilly, Virginia, that develops high security virtual private network (VPN) products and outsourced managed services. Their distribution partners include companies like Broadwing, Internap, Dimension Data, and others. We invested in the company in October of last year. We led an $8 million round with a $4 million investment and we're very excited about Blue Ridge’s prospects. They were a spinout from StorageTek in 1997, at which time the core intellectual property, the then existing products, and the core technical team was spun out as an independent organization.

          Hal Kennedy was involved in the initial spinout from Lockheed Martin in March of 2001 of Xytrans, based in Orlando, Florida. Xytrans is a company that focuses on the development and manufacture of millimeter wave transceivers, integrated transceiver products, and receivers for broadband and two-way satellite telecommunications. SpaceVest was not involved in the original spinout, but we did lead the Series B round which closed in May of this year. We led the $8 million round with a $2.5 million investment. Several other new investors came in, as well as the current investors who participated heavily in the round. Xytrans addresses three key markets , all of which are intermediate or long-term markets, as is every market these days: terrestrial sellers of infrastructure satellite terminals, VSAT, and terrestrial broadband. What was spun out of Lockheed Martin in March of 2001 was the intellectual property and the core technology team. Within the core technology was a substantial investment over probably a 10-year period that resulted in the products that Xytrans has today.

          I was flying up with Hal last night, struggling for the common thread among these three companies. Why did we do these deals? There are five points that are common to all of them. I won’t bore you with the details of what I think the advantages are, nor will I eat up too much of these guys' airtime, but here are five key opportunities that we saw across the board with these companies.

          The first is from a VC’s standpoint, and, in this respect, you can use the term “vulture” capitalist. We saw the opportunity to take advantage of and leverage the investment that others had made in product development. I'll be very clear, that was mercenary, totally mercenary. Nothing altruistic in it. We saw multiple millions of dollars invested in the various products that the companies had developed in their prior form. We said, “We have to figure out a way to take advantage of that.”

          Another attribute of these three companies was that the core technology teams that had been involved in the development and servicing of these technologies and products were basically intact and were going to be spun out attached to their technology and products. That was key to us.

          The third aspect was that in each case there were legacy customers who were providing a number of things, the most important of which was third-party knowledge of the technology and products. The technology and products had been beaten around and harassed and thrown up against the wall by actual users, as opposed to being housed in an R&D environment. That also was key to us.

          Related to that was the fact that in all three cases there were contracts in place that were providing—believe it or not—revenue and a certain form of gross margin for the companies prior to our investment. It provided a platform from which to diversify the company into commercial markets.

          The fifth aspect was the fact that we were able—by virtue of what these folks had done, not by virtue of what we had done—to take advantage of the IP that was housed in these companies, IP that was protected. It was protected first from a legal standpoint, but, more importantly, from a domain expertise standpoint as well. It's one thing to protect the IP from a legalistic viewpoint. You can have all the legal protection you want, but, if you don't have the people who know the technology and the market into which it's being sold, the legal aspects don't mean an awful lot.

          That’s my summary. I actually have four or five more pages, which was subsumed in 42 slides, but they told me I couldn't do that.

hal kennedy: bridging the worlds of risk

Good morning. I want to thank Netpreneur and Morino Institute, our hosts, for the opportunity to be here.

          I'm the corporate guy. You can tell because I have the suit and tie on.

          I have an interesting job. I work for a $28 billion corporation that's aligned—beautifully aligned in terms of decision velocity, marketing skills, risk profile, and so forth—to the customers in the market that it serves, a market which is not venture capital. I am the only full-time person in the corporation who gets to bridge from that corporate culture into the venture capital community, which, when you show up dressed like this, they say behind your back, “It's one of those corporate guys. He's in costume.”

          That actually happened to me. I was visiting one of our spinouts in San Jose not too long ago dressed like this. I typically do not go there dressed like this, but I had other business that day inside the corporation. The CEO pulled me aside and said, “Hal, we love having you here but you can't show up in costume. It just gets everybody on edge and spooks them.” I think they thought I was out there to sell them, which I was not.

          In a more serious vein, I get to be the interface between the traditional, large corporation and a venture capital community that's often comprised of solo entrepreneurs and small firms—people who, frankly, in many cases, have little or nothing to lose. Frequently we find ourselves at transaction tables as the only party with deep pockets, sometimes by orders and orders and orders of magnitude. We behave in a very introspective way that tends to be slow compared to your decision velocities, although this has been a problem we think we've largely fixed at Lockheed Martin. However, we still tend to behave like that compared to the venture capital world, and we need to do it. We're trying to protect a $25-$30 billion corporation in the process.

          So I'm the bridge to the venture capital community.

          There are some classic things you need in order to have a successful venture and a successful spinout. I thought I would tick off a few pros and cons, but I will skip the top level stuff because everybody in the room is supposed to know that. You need a really good idea; you need a really good business plan; you need a very good management team; and you need a really good set of VCs. I don't want to dwell on those. You all know that already, I hope.

          By the way, really good VCs are not just folks with a lot of money. That is a necessary requirement, but not nearly sufficient. Good VCs have market exposure, domain expertise, and a fat Rolodex. They can help the entrepreneurs be successful and develop distribution channels and strategic partnerships. That's what the VCs need to do besides put in money. But you already know that, right? That's one of the things SpaceVest does so well and why, as one of the original investors in the spinout of Xytrans in March of last year, we were delighted to see SpaceVest come into the B round. They brought a lot more than money. Frankly, the inside investors in the A round were very content with the progress of the company and happy to capitalize it through an internal raise. We went outside for more capital, but not for the capital. We went outside for the expertise, the domain knowledge, and help in establishing channels of distribution. We were delighted to have somebody like SpaceVest come on board because they can bring those things to the venture. They add much more value than the difference between the pre- and post-money valuations based on the money they put in. Those are the kind of folks we like to have on board.

          So, having covered the basics, what's the level underneath that makes for successful spinouts from large corporations, and, maybe some dos and don'ts? Mark Twain wrote at the bottom of a letter once, “If I had more time I would have written you a shorter letter.” That's why I'm using notes this morning. I have six minutes to tick this off. So I'm going to work off notes. I usually don't do that.

          The number one issue beyond those basics is one of managerial autonomy. If the parent for the technology is a large corporation, and if the parent is directly involved in the management, they will pull the plant up every six months to see how the roots are doing. You don't want that. In fact, if that happens, you'll kill the plant. You need managerial autonomy in spinouts, and this translates into a minority interest held by the parent. No more than 49% tops, and, hopefully, a lot less than that.

          In the spinouts we're doing, Lockheed Martin is taking anywhere from 5% to 49% of the ventures, depending on what we think the value is that we're contributing with the intellectual property. We do not want to control; we are not commercial folks, and, usually, we're not skilled in the market domain that the spinout is going to address. We want people skilled in those things to run the company, not us. I think that's a key. If you look at the spinouts of the past, particularly in the defense industry, well, we had a former CEO, Norm Augustine, who always used to say, “The defense industry is unblemished by success in commercialization.” That was the case. The number one fault was that we tried to manage those ventures in the old days, and we're not good at managing commercial ventures. If you're going to do one, get yourself some autonomy.

          Next is physical proximity. There ought to be a law written about this. Technology transfer success is inversely proportional to the distance over which you try to do it. We like to spin companies out no more than two or three miles down the street from wherever the technology got invented. Typically, if your key people spinout, they don't want to move, and you want access back to the parent for further technology transfer. If you try to do that coast-to-coast, you are going to fail, most likely. If you do that down the street from where the parent technology is, you have a much higher probability of success. Geography matters, and it's not necessarily where the market is; it's where the technology is coming from that could be key. You want an ongoing relationship. In the case of Xytrans, where we spun out technology that the US Army and Lockheed Martin had spent $200 million on by the time it was spun out—this is very mature, very sophisticated technology—we also had $40-$50 million of capitalized lab facilities inside Lockheed Martin to support the technology for the core business. Those labs are available to that small spinout, and the spinout, because it's one mile down the street from the parent company, can drop in, get expertise from the key engineers, and make use of that great capital facility without having to replicate it themselves. This is a big bonus to the spinout, so physical proximity has another payoff, and that is it tends to nurture an ongoing relationship, which I think is very important to success.

          Next is bi-directional no-hire agreements. Now we're down into the noise level stuff on these transactions, but this has turned out to be critical. We used to write transactions with unidirectional no-recruiting provisions. We were concerned that the startup, once it got going, would try to raid Lockheed Martin and there would be a further brain drain. That turned out to be not so much of a problem, but it's still at least a hypothetical issue. What you see in companies that are less mature in developing their process are one-way non-recruit provisions. It really ought to be a non-hire provision and it really ought to be two-way. We had one very unfortunate incident, and I never would have expected it, A Lockheed Martin manager on his own initiative attempted to recruit back one of the key people in the spinout because his project was falling behind and he really wanted the guy back. That would terribly hurt the spinout. I think it's bad for the relationship, borderline unethical, and just something we don't want to see happen. You can slam the door on that possibility, as remote as it is, by having the provisions work in both directions. The parent shouldn't be able to hire back its ex-employees over some period of time—like two to three years—and the new startup should not be able to go recruiting inside the parent. There is one exception, and this is how they're written, except by mutual consent. Everyone wants to be reasonable. If there are key people who want to leave or there are key people who would help the enterprise, and if that can be worked out between the parent and the startup, fine, let's work it out. In most cases, most people are reasonable, but that needs careful attention.

          Next is a strong bias towards success. I would say even beyond the traditional bias within the venture capital community that has existed since March of last year when, frankly, the only deals getting done were A deals. A, B, C, and D deals, even F deals used to get done before March of 2001. Now everybody wants A deals and A+ deals. We do, too. Large corporations do not want the public relations mess that goes with failed spinouts. It doesn't take very many failed spinouts to sour both the internal management and the venture capital community on doing more deals. These really need to be successful and need to be A+ deals, and we approach them all that way. We have started 13 companies since 1997; and 12 are still in business. I think that's an extraordinary record because the majority of them came through the tech wreck of 2001 and are still around. It's because of this very strong bias towards success. We don't do dotcoms. We seldom do services companies. We shy away from software companies. This may sound very pedestrian, but we do old fashion product companies that have real products for real customers and create real revenue and real EBIT and real cash flow. That's all we're interested in talking about. If you have something else on your mind, not only don't approach Lockheed Martin, don't approach a big corporate entity. They're probably not interested.

Mr. Sylvester: Before you finish, Hal, let me ask you a few questions. Why does a company like Lockheed Martin do these deals? How do you decide which technologies get spun out? And, are they usually initiated from the top down?

Mr. Kennedy: We're a systems integrator and we're very process driven. I would love to tell you that there was a formal driving process for this, but there was not. It starts any one of a variety of ways. When we are proactive—and we're doing more and more of this—we invite in incubators and VCs and expose what we think are high value, potentially commercial technologies. They give us bright ideas and come back to us with proposals on how they would like to go about commercializing our technology.

          On the other end of the spectrum we have 145,000 employees. They all have my phone number and my phone rings at least once or twice a week from someone I don't know inside the corporation who says, “Hal, let me introduce myself. I have a great idea and I think it is worthy of commercialization.” We take all of them seriously and review every one. On occasion, the great ideas come from the inside folks. Significantly, though, they also come from outsiders. The typical employee who is dedicated to aerospace and defense believes that they have great ideas about commercialization. Most of them, however, are not in a commercial market. Other than as an avocation, they don't necessarily have the markets completely understood as outsiders do. It's the difference between push and pull. We have technology and we have been spectacularly unsuccessful at pushing it into the marketplace. When somebody from the marketplace comes to us and says, “I need a left-hand threaded fiber optic connector that I can build for less than 20¢ apiece. Have you got a technology that can do that?” That's pull. That's the market talking to us. If we have a technology that can fill that gap, we're onto something. We're more interested in pull than push, but we work it both ways.

[continued]

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