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

  tom gilbert: a foreign idea

I was reflecting back five years ago, which seems like an eon when you're working in a startup company, Five years ago almost to this week my partners and I were calling upon a Senior VP at StorageTek to put an idea before them for a spinout. Unlike Lockheed Martin, that company had no history whatsoever of having done a spinout, nor did they have a Hal Kennedy to shepherd those ideas to reality, so it was a foreign idea.

          I’m trying to think about what we did right and wrong. One of us had been an entrepreneur before, so that helped. It gave us some courage. We were all mid-level management people in a mid-sized company involved in long-term development of intellectual property that we truly believed in. One of the things we did right was to recognize the opportunity for a spinout when it happened.

          The opportunity came about because we had been acquired by a much larger corporation which did not value the intellectual property we were bringing to market. They bought us for another line of business altogether. It took about a year for them to finish digesting us and figure out that they didn't want anything to do with our baby. That gave us about a year to hatch an escape plan. We truly believed in our products. We believed in our customers who had bought the products. Reflecting on Randy's comments about what SpaceVest found attractive, we had existing mature product and we had paying customers. We had a potential distribution channel in the parent corporation.

          We also knew that they wanted to get rid of us. We were a problem. We were a drain on their budget. We were a distraction to their sales organization. Unfortunately, they had existing customers, so they didn't feel like they could just cancel the line of business.

          We recognized that opportunity and took it to management. The proposition we put before them was, “We will go out and get our own funding. You can lay us off; get us off your books. We will support this product. We will continue to bring the promised new products to market for your core business customers and make everybody happy.” That was such a great solution to a big problem that they did not ask us for any equity or royalties. It was a wonderful situation.

          We valued the parent corporation as a potential distribution partner, so we proposed a cross-reseller agreement. We also knew that mid-level management in our original company would be opposed to the spinout, so we went right to the top and got their agreement before anybody got wind of it. It turned out that there was tremendous pushback which we did not anticipate. The folks who did not come with us valued the intellectual property as well and thought it was a great giveaway. In some sense it was. They gave us this gold brick and said, “Go!” Since there was no heritage of doing spinouts at that company, the right thing to do was to go to the very top management team and propose the idea and get fundamental agreement before any details were discussed.

          Another thing that we did right was to recognize that we had to protect the intellectual property. We spent a lot of time and effort on it. Hale & Dorr and Dave gave us a lot of assistance at the time, and I think we got that correct.

          One of the things that we did absolutely wrong, as all entrepreneurs do, was to underestimate the difficulty in obtaining funding. We felt that because we had an existing product that was well-regarded and an existing revenue stream, we would just write a business plan and money would flow in. It did not happen that way, of course. That was a near-death experience and would have had severe repercussions for the parent corporation, who did not protect the customers they were trying to solve the problem for. In retrospect, that was a mistake on their part. To have somebody like Hal doing that work proactively rather than letting it happen by accident would have been the right thing to do, but it did work out well.

Mr. Sylvester: In hindsight, is there something you could have done in the early stages to make that funding process smoother?

Mr. Gilbert: I think it was lack of experience on our part. We didn't have a clue as to what the problem was, much less the answer. As I said, we believed that we had all the elements for success within our grasp and that funding was not going to be an issue. In retrospect, we should probably have approached potential investors at the same time we were proposing it to the parent company. We should have gotten the VCs to look at it and said to them, “If we did this deal, would you be interested? What are the conditions we need to make happen before we go out the door in order to make this an attractive investment?”

          As it turns out, there was no taint for lack of intellectual property protection, no encumbrances that prevented that. It was just that the difficulty of getting the funding was something we underestimated

Mr. Parker: SpaceVest was tremendously advantaged by virtue of that experience. Because Blue Ridge did not do what Tom just indicated in the original spinout, by the time we stumbled across them, these guys had two to three years of, quite frankly, living within their means. That was something we had not typically seen in the companies we were looking at. You're talking about a company and a culture and a management team that focused on living within what cash it could generate to build the business. That's the kind of situation we like to see.

          Tom, you didn't realize that was going on when you were doing it, but that's . . .

Mr. Gilbert: I think we realized.

Mr. Parker: Yes, but not by plan. [Laughing]

jesko vonwindheim: a very interesting deal

Your experience is interesting, Tom. Mine has been one of standing in the middle between the corporation and the investor and doing spinouts by trying to bring those two parties together. I've probably attempted somewhere between seven and ten spinouts in my lifetime. Four turned into companies, and three of those are still operating. One of them, CRONOS, was a pretty big hit.

          Before I go on, I want to step back a bit and give you a good example of what VCs do to you. I've got Randy sitting beside me here --

Mr. Parker: Do for you.

Mr. VonWindheim: To you. I've got Randy sitting beside me with ten pages of crib notes. When we were preparing for this panel we were on the phone and he kept saying, “Now, we have to make this really informal.”

          I had this great presentation I was going to show you all. I was ready to do the projections and everything. We get here, I look next to me, and Randy's got ten pages of crib notes with highlights. All I've got this tiny piece of paper. Good job, Randy, you've done it again. [Laughing]

          To come back to spinouts, what I think it boils down to is a very interesting deal. You have to look at it as a deal, and the deal is interesting because it's a three-body problem. Tom has just described it aptly. He said that perhaps the thing he would have done differently would have been to bring the money to the table at the same time, instead of just working directly with the corporation and going out and getting money later. I absolutely agree with that. I don't think I would have had the courage to do what Tom did . . .

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Mr. Gilbert: [Laughing] Or the stupidity ...

Mr. VonWindheim: It does depend a lot on how good you feel about your business, but, typically, the businesses I've seen have a burn rate, and, as a result, you have to raise money. To walk out the corporate door before you've raised that money is a very tough situation.

          Now, the drawback of a three-body problem is that it's a very difficult deal to do. It's a unique kind of situation because you've got the corporation with their motivations, the new company which is still within the corporation that has its motivations, and now you're bringing investors to the table who have their own motivations. For the entrepreneur in the middle, strategically placed between the corporation and the VC, it is a tremendous job of facilitation. Your chances of failure just in putting the deal together are quite high.

          You have to ask yourself: Why is the corporation spinning this business out? Well, they're not spinning it out because they think they're going to make a gazillion dollars off of it in the next two years, right? They're spinning it out because it's a problem and they're trying to get rid of that problem. I’ve put together a list of ten or so reasons why.

          To start with, perhaps it's a really lousy business in their eyes. You've got to watch out because you've got to pitch this to investors as something that's other than lousy. On the flip side, maybe it's a really good business and, as Tom mentioned, middle managers are getting concerned about the deal. If someone thinks it's a good business, there's no way they want to spin it out, so, in a spinout, you've got a deal that is usually somewhere between Hell and Nirvana. If you end up in either of those camps, you're probably not going to be successful.

          I worked for a technology incubator where we spun out a number of companies. My job was to build the commercial side of the business, and, whenever we started with an opportunity, the incubator was absolutely convinced that they had to spin it out tomorrow. They were very motivated because it was costing them money. After a few months, when the commercial business started looking better and better, the CFO would come back and say, “Maybe we should keep this internal because we're going to be making money next year.” It’s very challenging, and it requires a mature perspective within the corporation to make it work.

          Here’s another reason: maybe the opportunity is not big enough. The folks inside might say, “Hey, I've got the customer. Everything works. It's wonderful.” But when the VCs come to the table they say, “This looks like a $5 million business. Why would I want to do that?”

          Maybe it's only a technology. If you're thinking about spinning out just a technology without customers and so on, that's a very, very difficult play.

          Quite often, there are business opportunities that work within larger corporations because the corporation needs a piece of it in their portfolio—or they did in the past. That doesn't mean that the business unit is uniquely competitive in its marketplace. Maybe it's just another player. That's one of the first things VCs are going to look at. They're going to ask, “What's going to make you unique?” It's not good enough to say, “We've been unique because we're part of a $28 billion corporation and we pick up business as we go along.” There's got to be a unique competitive advantage. It comes back to: Why is the corporation motivated to spin it out?

          Then there's the experience issue. A lack of startup experience either on the spinout team's side or the corporate team's side can be a real problem. I've seen this personally a number of times in deals I've put together. I've spun out a company where we had to put together a management team that was attractive to the investors; and I’ve worked with corporations that were trying to spin out companies with management teams that new nothing about the outside world. It’s very difficult to make that work.

          There's also a corporate fear of competitive overlap. If the corporation has a concern about the spinout competing against it in the future, you've got a problem.

          Sometimes a corporation wants too much. I've seen this a lot. Sometimes you own something and you value it a lot higher than people on the outside. As you try to put a deal together, you run into all sorts of problems. I was thinking about this yesterday. I don't think I've done a single deal that didn't fall apart at least once. The ones that were successful fell apart two or three times before we got them out the door. The reasons for that are often related to the negotiation process, when the corporation thinks they've got way, way more value than they're actually bringing to the table.

          It really boils down to whether the corporation, investor, and team motivations match up. You, as the entrepreneur, had better make sure that they match up. At the end of day, if they match up, you still have to make sure it's a good deal. If all those things don't happen, it's not going to work.

          What are the things that make a deal work? Very briefly, again, you've got that three-body problem.

          On the corporate side you've got to have a business-focused team that's doing it for a long-term upside opportunity. As Hal mentioned, they have an in-house technology or opportunity that they can't drive forward within their business structure. They should have a good process. Frankly, I've never come across a really good corporate process for spinning out, so that's news to me if it works. I've talked to Hal a little bit and I think that the maturity of his perspective is absolutely awesome for the entrepreneurs within the company. Another thing is patience. These things tend to fall apart, and you have to be patient to bring them back together.

          On the investor's side, they have to be ready to work. If they're just coming in to try to pick up a great deal, that won't be good enough. Usually, these opportunities need to be formed before they actually become viable in the outside world. Dollars have to be available immediately. You would not believe the number of investors I've seen, although I shouldn't call them investors because they come to the table without money. What they're trying to do is to find a deal and then raise some money. Well, thanks, but I can do that myself. There are a lot of these types of folks who don't really have a lot of money and are just looking for deals. That's not going to work. The investors also need patience. I put together a deal a few years ago where the investor was very patient, came back to the table three times and ultimately we worked the deal out, but I couldn't believe that they didn't walk away.

          Then there’s the spinout team. They have to have a balance of excellent entrepreneurial experience—the operations experience, the product experience, etc. All those things have to be present on the team. They have to be business-focused. Let's forget for a second that you really love what you're doing and you believe in it. Is there a long-term business opportunity here?

          What the entrepreneurs provide that nobody else can, and this is absolutely the key to the opportunity, is the vision to make it happen. The corporation and the investors cannot provide that vision. The entrepreneur or the team is both a facilitator and the ones who bring that vision forward. If they can do that and facilitate between the other two entities, the investors and the corporation, they're going to do very well.

          Thank you.

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the audience: q&a

Mr. Sylvester: Let me start with the first question. Randy, given what Jesko said about the dynamic that operates in the spinout decision with respect to whether the idea or technology is valued by the corporation, how do you, as a VC, address it in terms of your valuation, your process, and your go/no-go decision?

Mr. Parker: There are two aspects, one of which is valuation. Let's take care of that one pretty simply. There are all kinds of ways to value your percentage ownership in a company. You can run comps, you can run DCFs, run whatever you want. The bottom line is that the valuation is established by somebody putting a number on the table and a seller accepting the number. Period. So let's put that one aside.

          The other aspect is: What is the corporate interest in an ownership position in the spun-out company? There's a large red set of flares that go off when corporation X—not Lockheed Martin—says, “We've got this great technology. I've got Joe the engineer and his buddies who think it's terrific. These are the markets to which it can apply and, by the way, here you go.” That's problematic because the bottom line is that if it's that great, I don't think I need to land a division of company X and invest in it without any residual commitment and/or enthusiasm for it. If it’s a situation where the corporation is saying that they’re doing this because it was my birthday yesterday, that doesn't work. In valuation, you get through the comps, the capital structure, who needs what, and you get down to the bottom line: What is the technology? What is the business plan? What's the management team look like? What condition is the technology in? What kind of customers does the technology service now? What can it service?

          Primarily, it’s: What is the management team? What are the attributes of the management team coming out with the technology and/or that can be attracted to the technology?

Q: Tom, since you are in the ultra-secure virtual private network business, which is a very hot sector, why you couldn't go to a customer or potential customer and get funding for your corporation? Hal, why wouldn't you invest in that company as a necessary part of your business, for the Lockheed engineers, for example?

Mr. Gilbert: What we had developed back in 1997 was not widely recognized as being a valuable technology at the time. That was in the beginning of the commercialization of the Internet, when research firms were telling corporations that under no circumstances should they ever put sensitive corporate information over the Internet using any technology whatsoever. We had the technology to do it, but no one would believe us.

          Our core customers were the US intelligence community who had tutored us in what high security needed to be. We thought that all customers were deep-pocket customers who would just keep buying the product once they had assessed it. Of course, that's not the way it works.

          We fundamentally didn't understand our own value proposition. It took us, I would say, at least four of the five years we've been in business to truly understand what business we were in. Back in 1997 we couldn't have gone to an investor or even a large customer and put a mature proposition in front of them. The technology was there; we just didn't understand it ourselves.

Mr. Kennedy: Let me make a couple of points. First, a third of large corporate America is involved, at least intellectually, if not actively, in spinning things out. Of that third, only maybe half have a corporate venture capital arm, which means an interest and a willingness to make investments. Lockheed Martin does not have one. We don't invest in these projects other than licensing our intellectual property. The risk profile of venture capitalized companies is so inconsistent with the risk profile of a person who would buy a share of Lockheed Martin stock that we don't think it's appropriate for us to be investing money in venture capital. If our shareholders want their money deployed that way, they're better off doing it themselves rather than having an aerospace company do it for them. That's one of the reasons we wouldn't invest in a company like Tom’s.

          In terms of Tom’s product, now you have to start really pulling apart industries. As a generalization, and this may sound odd, the aerospace industry does not compete, per se, on the strength of its computing and IT prowess. Unlike financial institutions and other markets where IT is central to the business and a competitive advantage, it's not so in aerospace. We need good enough computers to calculate the fluid dynamics of the vortices behind the wing of an F-16, but, once we've got that, it's probably good enough. To have bleeding edge IT systems is not in our best interest. As a result, we like to be a second adopter or a follower in terms of IT systems, as opposed to an innovator. We would be interested in a product that, say, allowed virtual teaching and learning or virtual collaboration after it had already been proven in the marketplace. That's why we wouldn't be an investor.

Q: What effect do employees' fears of divulging their intentions to their companies have on the atmosphere of doing spinouts from corporations? Is it something they have to worry about?

Mr. Kennedy: No, I don't think so. By the way, if you look at our population internally, it's stable. I'm coming up on my 30-year anniversary, and the place is full of people like me. Most of us enjoy what we're doing.

          Internally, we are running what amounts to a risk-free environment right now, but I'd hesitate to generalize for the rest of corporate America. In terms of popping up with ideas, I am a safe haven, so to speak, in the corporation. People call me without attribution. They bounce ideas off me. I tell them whether or not I think it can fly. If it can fly, I always vector them immediately back to their bosses. You can't do a total end run around the whole management chain of a corporation by just speaking to the person at the top or the one responsible for these things—which in this case is me—and leave everybody in the middle out.

          There were some good points made earlier, however, about taking the idea to the top. I have the support of the executive office of Lockheed Martin Corporation. When you talk to me it's like talking to the top. If I say it's a good idea, then it's time to socialize it back down through the chain of command. It has to happen that way.

          If it's a bad idea, I tell people it's a bad idea. I am known as a blunt guy. I will tell them when I don't think it's a good idea, or whatever the reason is—that I don't think we can raise capital, I don't think we can make it work, it's too core to us to spin out, we don't want to compete with it in the marketplace, etc. At that point, they go back to their day jobs. I think it's a risk-free process we have set up.

Mr. Parker: The only comment I make on that is if the generator of the idea of the spinout has fear of introducing the notion internally to the corporation, then it's highly likely that individual needs some EST training or something else to deal with what's going to come down the road. That's nothing compared to what these folks will have to deal with later.

Q: It's refreshing to see folks in tech commercialization looking for real products, real revenue, and real technology again, rather than some dotcom, pie-in-the-sky investment. Hal, I have a question for you regarding GlobalStar. Lockheed Martin was involved in a consortium to build voice, data, and GPS in its GlobalStar consortium. Can you talk about where it went wrong since it's in bankruptcy?

  Mr. Kennedy: Not very well. I’m the guy who starts entrepreneurial ventures. GlobalStar was not quite in that genre, so I'm pretty far removed from it. That's sort of a mega project. I do micro projects, by comparison. That one came out of the notion of growing one of our businesses into adjacent markets. My notion of it, from a position very far removed, has been one of market timing. Like a lot of other people, we didn't understand that the tech wreck was on its way, especially in telecommunications. Read the story about MCI on the front page of The Washington Post this morning if you want to see another $3 billion fiasco in telecommunications. We didn't understand what was about to happen any better than anybody else did. I think that's the root cause of what got us in trouble.

[continued]

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