Startup Endgame Still a Puzzle

Are you a startup looking to cash out in 2002? Better not count on it.

That's the message from VC and financial experts surveying the M&A landscape. Despite the fact that private company valuations continue to drop, the market is likely to get worse before it gets better.

One reason: Potential buyers -- big vendors such as Cisco Systems Inc. (Nasdaq: CSCO), Nortel Networks Corp. (NYSE/Toronto: NT), and Alcatel SA (NYSE: ALA; Paris: CGEP:PA) -- are still resizing their own businesses for 2002, which is shaping up to be the second consecutive year of falling carrier spending levels.

The chances for liquidity at venture-backed companies will only get better if one of two things happen, says Steve Domenik, a general partner at Sevin Rosen Funds. "Either the stock market will recover or, if this goes on long enough, the demand for technology will [improve acquisition chances] since the potential acquirers have all cut back on research and development."

"There's been no need to acquire private companies," says Brian Kinard, a general partner with Blueprint Ventures. "No one else is acquiring them right now."

Kinard also points out that there are probably too many private companies of each kind -- such as MEMS makers -- to be absorbed right now, which may lead to more bankruptcies in certain equipment and component subsectors.

The IPO market for venture-backed companies was grim in 2001 as only one networking and communications company, Tellium Inc. (Nasdaq: TELM), raised as much as $100 million during its public offering (see Market Gives Tellium a High Five). In 2000, 34 networking and communications companies raised a total of more than $5 billion, according to new data from VentureOne.

Semiconductor and software companies had a little more success in the IPO markets, as NetScreen Technologies Inc. (Nasdaq: NSCN) and LogicVision together raised some $200 million during the fourth quarter of 2001 (see NetScreen's Screaming IPO).

Table 2: Venture-backed IPOs, 4Q01
Company Name Industry Segment Amount Raised ($M) Offering Price Ticker Exchange
NetScreen Technologies Software $160.00 $16.00 NSCN Nasdaq
LogicVision Semiconductors $40.50 $9.00 LGVN Nasdaq
Total ($M) $200.50
Source: VentureOne

The M&A market was also on the skids in 2001, as venture-backed companies were involved in 69 transactions that were valued at $2.7 billion during the fourth quarter of 2001. Not since the fourth quarter of 1995 -- when 39 companies were acquired for $2.5 billion -- has so little been paid for the selling companies, says VentureOne.

Table 1: Top Venture-backed Communications M&A Deals, 4Q01
Company Name Amount ($M) Close Date Acquiring Company
ShareWave $28.30 10/03/01 Cirrus Logic
Transilica $145.09 11/28/01 Microtune
Pacific Broadband Communications $200.00 12/14/01 Juniper Networks
RiverDelta Networks $309.40 10/15/01 Motorola
Total ($M) $682.79
Source: VentureOne

As a sign of the times, the large acquisitions announced during the quarter focused more on a quick return on investment rather than a multibillion-dollar price tag. Tellabs Inc. (Nasdaq: TLAB; Frankfurt: BTLA), for instance, said it would acquire Ocular Networks Inc. for about $300 million in cash and about $55 million in stock options. But the company expects to see the Ocular acquisition generate $50 million to $100 million in revenues by the end of this year (see Tellabs Nabs Ocular).

Another sign of the times: Two of the largest communication systems mergers that happened during the last part of 2001 involved companies that made gear, not for greenfield competitive local exchange carriers (CLECs), but for cable operators, which seem to be the only credible threat to the digital subscriber line (DSL) services offered by the big phone companies (see Motorola Deals for RiverDelta and Juniper Buys Pacific Broadband ). At the end of the third quarter of 2001, the regional Bell operating companies (RBOCs) had 3 million DSL subscribers, versus 5.9 million cable modem subscribers at the top seven cable companies, according to recent research note by Robertson Stephens analyst Jim Friedland.

Table 3: Top Communications and Networking M&A Deals in 2001
Company Name Amount ($M) Acquiring Co. Date
Cyras Systems $1,148.39 Ciena 3/29/01
Amber Networks $421.00 Nokia Corporation 8/29/01
LightLogic $400.00 Intel Corporation 5/23/01
RiverDelta Networks $309.40 Motorola 10/15/01
GigaNet $208.77 Emulex 3/1/01
Pacific Broadband Communications $200.00 Juniper Networks 12/14/01
Versatile Optical Networks $167.10 Vitesse Semiconductor 7/31/01
Optranet $72.25 Extreme Networks 2/6/01
Total $2,926.91
Source: VentureOne

For venture capitalists, though, it pays to look, not at what companies are buying today, but at what longer-term problems they're not solving, says Sevin Rosen's Domenik. "I think the thing that will make a difference [for carriers] is really new technology that is so compelling that things have to change. None of this size-of-a-dime, price-of-a-nickel stuff, either."

— Phil Harvey, Senior Editor, Light Reading
The_Holy_Grail 12/4/2012 | 11:05:45 PM
re: Startup Endgame Still a Puzzle Its amazing how much money was pissed away on acquisitions that did not play out. Some could argue it was stock deals and didn't burnup cash, but what about the dilution? As we all know, most large corporations make decisions for wallstreet and not for the employees.

I just wonder who is held accountable for these non-successful white elephants? We all hear about the layoffs, but most if not all, hit the workerbees. This is very unfortunate because it has left a sour taste with many very good engineers that I have spoke with.
steve 12/4/2012 | 11:05:41 PM
re: Startup Endgame Still a Puzzle What dilution? A short math lesson please: If company A, worth $1b, acquires private company
B, for $100m in stock, and company A's stock price does not go down, there is no dilution. Sure there is more company A stock outstanding, and its market cap is bigger, and each share represents less percentage ownership in the company, but per share option value has not changed, and that is what you should care about.

And if you have any prayer of getting a return on your stock options your management team better have an eye on where wall street thinks value is, because that is the only way you are going to realize any value.

And btw, everyone benefitted and everybody is paying the price for the ponzi scheme we all participated in over the last few years, not just the workerbees.
laserbrain 12/4/2012 | 11:05:40 PM
re: Startup Endgame Still a Puzzle Remember that the only sour taste is at those who didn't get acquired (or got acquired and didn't sell)

Managing for wall street is the price of capital. You can manage for your employees all you want and stay private where their equity is illiquid and worthless. Me? I'll opt for liquidity every time. show me the money.
DarkWriting 12/4/2012 | 11:05:38 PM
re: Startup Endgame Still a Puzzle Pssst, hey buddy, here's a clue. Capitalism is the world's largest pyramid scheme. That's why there's a business cycle. But don't spread that around or someone may have to kill you. It will be a great day for humanity when some economist comes up with a better economic system. Until then, I guess we'll just have to live with the system that takes advantage of the man's most endearing attribute, greed.

Given the constraints of this system, however, I don't disagree one bit with your analysis.

>And btw, everyone benefitted and everybody is >paying the price for the ponzi scheme we all >participated in over the last few years, not >just the workerbees.
AisA 12/4/2012 | 11:05:33 PM
re: Startup Endgame Still a Puzzle >Pssst, hey buddy, here's a clue. Capitalism is >the world's largest pyramid scheme. That's why >there's a business cycle. But don't spread that >around or someone may have to kill you. It will >be a great day for humanity when some economist >comes up with a better economic system. Until >then, I guess we'll just have to live with the >system that takes advantage of the man's most >endearing attribute, greed.

Capitalism isn't a pyramid scheme. Capitalism is a system where value can be traded for value. The problem lies in the people who try to get value without providing value. The business cycle is a response to this excess that brings things back to the reality that you can't perpetually receive value without giving value in return.

Also, a system does not have the capacity to take advantage of greed. People have greed and take advantage of others within the system. I wouldn't hold your breath waiting for a "better" system to come along. Any system other than open capitalism means that there has to be some management entity controlling trading. The problems in such a replacement system would only be transferred to the greedy people in the managerial role within the system taking advantage of those within the system providing value.

lightmaster 12/4/2012 | 11:05:31 PM
re: Startup Endgame Still a Puzzle Balto,

The dillution is for the shareholders of the aquired company. The easiest way to understand it is in earnings per-share.

Let's say Company A has 100 million shares outstanding and earns a billion a year in profits. That's 10 dollars per share. They buy company B for 10 million shares and issue new shares, which leaves 110 million shares outstanding. Now, assuming that company B, at some point, earns 100M a year, its a wash since the new company is still earning 10 dollars a share. Any more, and the aquiring company got a good deal. Any less, and the shareholders end up with lower EPS, which drives the stock price down.

Of course, its a bit more complicated than that. One has to account for the fact that earnings, both of the base company and the aquired company, are not static year to year, strategic value, etc. But, the bottom line is that none of the multi-billion aquisitions, INCLUDING CISCO"S AQUISITION OF CERENT, have added to the earnings-per-share of the then-existing stockholders from a profit contribution perspective. Whether they were "worth it" is another question.

Bottom line is, it may be funny-money to the corporation, but it is very real to the stockholders.
steve 12/4/2012 | 11:05:29 PM
re: Startup Endgame Still a Puzzle lightmaster

Your analysis is accurate, but not particularly relevant. What matters is the perception of the acqusition by those who influence Company A's stock price. If Company A acquires a company that allows it to enter a new fast growing market, even though reported earnings per share might go down for a period, Company A's revenue or earnings multiple might expand, leaving all shareholders even or ahead.

Your discussion about who gets the future earnings of Company B is at the heart of most merger discussions and revolves around the topic of how much future "synergy" (I hate that word but it is the industry standard) is paid to company B shareholders in consideration for the acquistion and how much stays with Company A shareholders. You correctly observe that Cisco paid too much of the future synergy to Cerent shareholders.

The other observation is that if your stock price is wildly inflated, you dont mind as much paying a ridiculous price for company B as long as you are not giving up much in stock for the acquistion, because your currency is so overvalued also. What you focus on is relative value. Obviously this does not apply to cash deals.

And for the other posters: capitalism is at its core the most effective mechanism for allocating one scarce resource: money. We are witnessing the mother of all reallocations both to and from the tech sector.
lightmaster 12/4/2012 | 11:05:28 PM
re: Startup Endgame Still a Puzzle Balto,

I think we are in violent agreement. When the industry was running on hype, eps was of no consequence because Wall Street looked at growth as a larger factor than current earnings. However, I would point out that my analysis BECAME relevant when the air came out of the networking industry and wall street started looking at things like earnings again. The rules have changed, at least for the time being.

FYI, Ciscos aquisition of Cerent, in spite of its negative contribution to EPS, could have still been a very good one because it got them a very large foot in the door to the service providers transport network. The problem is, they've never done anything with it, or with other carrier equipment aquisitions. Now, it's basically 5 year old technology, with no real supporting cast (Pirelli, Qeyton, Monterey?) They're just milking it like a cash cow - one with extremely thin margins.
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