How many times does an entrepreneur with a great idea believe they are the only one suited to run their new venture? Usually, they believe they need to be the CEO. However, even if they are the well suited to lead a venture in the beginning, they are not the one to drive to higher levels beyond development. When this expansion phase occurs, the board usually has the difficult task of letting the entrepreneur/CEO know that it is time for him to take a new role in the company.

Often this communication does not go well, and the end result is that the entrepreneur cannot understand the message and leaves the company.

Here are two case studies I’ve personally witnessed:

1. Typical CEO transition scenario

A three year old company is doing very well. Making lots of profits and growing. The CEO and the board hire a seasoned executive with more big company experience than the entrepreneur/CEO has to help the CEO. The CEO and the new executive bond well, and it looks as if this transition will go well. In fact, the entrepreneur/CEO tells the new executive that he is glad the new executive has come on board, and that he will know when it is time to turn the reins over and step aside. About a year later, the board wants this transition to take place, but instead of knowing that it is time for prudent change, the entrepreneur/CEO starts fighting his board and terminates those executives on staff who agree that it is time for the change. This plays out over several months and by the time the board realizes what has really occurred, the company has lost market share, revenue, profits and cash. The change finally occurs, but it is too late, and the company ends up going out of business, when this did not have to happen if the transition had occurred smoothly.

2. Ultimate irony scenario

Another example is even more interesting. It would be funny if it was not so sad. An experienced venture capitalist decides to change “sides of the table”. An entrepreneur comes to him with a great idea but understands that he does not have the skills or inclination to run a business, only be a developer. The VC decides to run the company for a while until it gets going, at which time he will hire a new CEO, and go back to being a VC. As the company progresses, the business is able to raise in excess of $100 million towards building the company. It becomes clear after the major institutional round, at least to some of the employees and board members, that it is time for an experienced CEO. The VC acting as CEO however now decides that he is the only one that should lead the company and refuses to listen to his fellow VC’s and board members. He fights the board for quite a while, and in the meantime, the company’s spending runs out of control. By the time the board finally removes him from his position, the company is nearly out of cash, and has not completed its milestones. The irony of this is that the VC/CEO had experience on the other side of the table many times and witnessed other entrepreneur/CEOs not wanting to be replaced and fighting with the board. But in this case, he got enamored with the idea of running the company, he took it personally and lost sight of his original mission.

So, we give advice to young entrepreneurs to remind them that having a successful business should be more important than stroking their egos by being the CEO. Most entrepreneurs are best at developing ideas not at managing businesses. We advise that they have to be ready and willing to step aside – many times early on or earlier than they might like – and appreciate that it is nothing personal. It’s just part of the process of building a successful company.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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Ernst & Young Transaction Advisory Services (“EY-TAS”) has just released (June 23, 2010) an update on that earlier survey indicating that M&A activity for the second half of the 2010 year is even stronger than previously expected. While that is good news indeed, a couple of comments contained in the survey release have clear relevance to local companies either considering putting their money to work in select growth markets, or local companies seeing an opportunity to be acquired by those companies considering putting their money to work in select growth markets.

• According to EY-TAS, “The deal market will be defined by smaller, higher-quality deals fueled by low interest rates and corporate cash stockpiles.” The key phrase here is “higher-quality.”

• Further, according to EY-TAS, buy-side companies will be seeking “acquisitions that complement their strengths.”

Last year, we at The Brenner Group undertook a buy side advisory relationship with one of the oldest and most highly respected professional service firms in Northern California. Our counsel to this client, that was seeking to wisely and adeptly find target merger partners or acquisitions to solidify its growth prospects well into the 21st century, was to concentrate on “higher quality transactions that complement existing strengths.” That is the path we pursued on behalf of our client, and it is a strategy obviously shared by acquirers world-wide. It is a continuing focus that we continue to prescribe for both prospective buyers, and for prospective sellers needing to define who and what they are.

Of specific interest from EY-TAS’ survey update, with regard to the Technology sector, they state: “Huge cash reserves are giving leading technology companies the financial flexibility to focus on building revenues through organic growth and M&A. These companies are well-positioned to execute on attractive deals that provide entry into new markets and access to new technologies.”

With regard to the Health Care industry, the following is stated: “Consolidation is and will continue to be a means to achieving cost synergies. Relative to other industries, financing for health care deals is more available.”

As was discussed in my April pieces, there are significant opportunities for intelligent growth through mergers and acquisitions for forward looking buyers. There are also significant reward opportunities for sellers who have built well-performing and well-managed ventures that are strategically strong and well-positioned. Most recent indicators are that the remainder of this year should be a busy time for transactions.

Michael Roy is Director of Mergers & Acquisitions at The Brenner Group where he has focused primarily on middle market advisory and transaction engagements. Prior to his affiliation with The Brenner Group, Mike held posts at firms such as Pacific Marketing Partners, Corporate Finance Associates, and Lehman Brothers. Mike has authored multiple “white papers” relating to the food and beverage industries in the U. S., to commercial real estate acquisition opportunities, and to environmental technology developments. He graduated from the University of Notre Dame and received a Woodrow Wilson fellowship for post-graduate study.

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1. Management. The first one is similar to the old adage regarding real estate. A wise person once said that when buying real estate there are three things to look for – namely, LOCATION, LOCATION, LOCATION. All else falls in line if the location is good. Well when I look at a company to either invest in or help, the first thing I look at is really three things – MANAGEMENT, MANAGEMENT and …. MANAGEMENT.

Without sound management, companies cannot and will not succeed. When looking at management, I like to look for a team of managers who respect each other, who are, or want to be, collaborative in style, and probably most importantly, who are decisive. Not making a decision is worse than making the wrong decision, or worse yet, not making any decision.

Some danger signs to consider when reviewing management is the way the CEO interfaces with the board of directors. A CEO who will not allow open and complete access by board members to the Executive Staff, not just the CEO, is probably insecure, or perhaps hiding things from the board. He may not want to risk having his staff contradict what his message to the board of directors has been. A CEO and team that keep missing deadlines or objectives is another sign that things might be going awry. These missed deadlines and objectives are a clear indication that the staff is probably not communicating, even with each other, on a truthful basis. Their credibility with the board will also suffer. So, bring in a coach or a replacement may be necessary to get the management to work in an effective and cohesive manner.

2. Technology. The second thing to look for is TECHNOLOGY problems. These problems can fall into two different areas. The first, and probably most important would be called technological feasibility. A good example to demonstrate this would be looking back at the computer about 15 to 20 years ago. When COMPAQ first introduced a portable computer, it was heavy, with two floppy disk drives, and a six inch green CRT display. If someone had proposed producing a two pound notebook with a flat panel high resolution color display, a 128 GB solid state drive and a quad core processor, people might have really liked what was being described. However, technology had not advanced far enough, or small enough, to accomplish these lofty specifications. Therefore, an investor who had invested in this dream would have faced technological feasibility issues, and the company probably would have failed.

The second issue surrounding technology is poor execution. If the technology is feasible, but the team has not been able to complete development, then refer to the first point above, because the problem probably resides with management.

3. Marketing. In essence, the question here is can the company generate sales for the new product or service? In most cases, a young company is established and capitalized to fill an unaddressed primary need in an emerging or existing market. Assuming the market is real and the technology works, a failure to generate sales traction is a marketing execution problem. Either the marketing guys spec’d the wrong product to begin with or they failed to successfully market the product once it was available.

So, as you prepare to invest in a new company, or are involved in an existing company, be aware of these three areas and stay vigilant to avoiding the common mistakes made by many others.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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Many of our clients are venture capital backed technology companies that have been growing successfully and have commenced making acquisitions. On the one hand, they feel the ecstasy of getting their deals done. On the other hand, they must confront the agony of fair value accounting.

The Basics of Purchase Price Allocation

A company that makes an acquisition must adjust its financial statements to reflect the inclusion of the acquired assets and liabilities at their fair values. Fair value is closely related to the traditional concept of fair market value. For many items (such as cash assets, accounts receivable, and accounts payable) the determination of fair value is usually straight forward because the values recorded on the seller’s financial statements often reflect the items’ values. In the case of hard assets such as property, plant, and equipment, the market value of the assets may be different than the values carried on the seller’s books. As a result, the acquirer may have appraisals performed to determine fair value conclusions.

However, accounting principles require that the fair value of intangible assets and goodwill must also be determined. Intangible assets can include technology that was developed by the seller (or was in the process of being developed), existing customer relationships, marketing intangibles (such as trade names and trademarks), non-compete agreements, and other contractual arrangements that may be expected to generate economic benefits for the buyer, as well as other items. The extent to which the price paid for a company exceeds the fair value of the identifiable acquired assets (net of the fair value of assumed liabilities) is called goodwill.

Purchase Price Allocation studies determine the fair values of the tangible and intangible assets, as well as liabilities and goodwill.

The Challenge of Fair Value Accounting Principles

The challenge for a client is that the fair value framework entails concepts and definitions which may seem very distant from the specific business strategies and objectives that led to the acquisition in the first place. The challenge exists because the information needed to make the purchase decision is very different from the information required for fair value accounting measurement. The fair value of acquired assets (and liabilities) does not measure the value an asset to the acquirer based on what the acquirer intends to do with the asset. Instead, fair value is the value to a hypothetical “market participant” that will use the asset to its highest and best use.

Take a hypothetical example where one of our clients has just acquired a smaller relatively unsuccessful company that had developed an attractive technology. The conversation concerns the value of the acquired company’s brand name:

“We didn’t buy this company to get its brand name; we bought the company to get the technology. We thought this company was unable to build an adequate marketing and sales capability. That’s why their investors decided to exit. So obviously the brand name is worth nothing.”

The difference between value of the brand name as perceived by management and value under accounting rules may be extreme. In this case, a “market participant” might choose to utilize the acquired brand name. If so, its value would need to be quantified.

Another difference can occur when the client intends to utilize a specific asset, and expects synergies from the acquisition to produce significant economic returns. In this case, the “market participant” assumption can result in a lower accounting value than the value that is perceived by management. The fair value rules spell out “… buyer specific attributes and intent should be disregarded if different than another market participant.” (ASC 820, http://asc.fasb.org). Synergistic effects would not be included in determining the value of the asset. For instance, if the sales projections included synergies that are unique to the client and not available to other market participants, then the sales projections would need to be reduced to remove the synergies.

In summary, acquisitions require accounting and financial analysis to analyze the transaction from two different perspectives. The first perspective identifies the specific costs and benefits to the buyer – including synergistic benefits that may not be available to other potential acquirers. The second perspective is to examine the acquisition from the perspective of other potential acquirers (“market participants”), and assume each identifiable asset is put to its best and highest use.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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The acquisition will provide discussion fodder for months if not years to come, and we will see if HP can turn Palm into a serious competitor for the iPhones, Androids and Blackberries of the world.

In this post, I will stay clear of any strategic speculation, but rather focus on the process of the transaction.

The proxy statement recently sent out to the shareholders provides some interesting turn-by-turn insights into the transaction. A number of lessons can be learned that are equally applicable to smaller transactions.

How events unfolded

The story starts with a meeting of the Palm Board of Directors on February 17, 2010, where they reviewed operational results. Anticipated revenues for the quarter ending 2/26/2010 were 25% below plan. Anticipated revenues for the quarter ending 5/28/2010 were 63% below plan.

That has to hurt.

The Board channeled its pain into an “assessment of strategic alternatives”, also known as “raise money, license the IP, or sell the Company”. Bring in the investment bankers – in this case Goldman Sachs and Frank Quattrone’s Qatalyst Partners.

At this point, the share price hovers around $9.62 – down but not out from its recent high of $17.46 in September 2009.

On February 25 the Company officially revised its revenue guidance downwards for the current quarter and the current fiscal year. The stock closes at $6.53 the following day and erodes further in the coming weeks to $3.85 on April 6, the day before takeover rumors start.

The bankers and management draw up a list of 24 strategic partners. Between the end of February and beginning of April a total of 16 companies are contacted of which 6 sign a nondisclosure agreement to take a look under the hood. Three of them (“Company A”, “Company B”, and the ultimate acquirer, HP) are invited at the end of March to submit preliminary proposals for a transaction. Two more hover about the fringes (“Company C” and “Company D”).

HP submits its first offer at $4.75 per share on April 13, below the public market share price of $5.16.

Company A came in with a cash offer of $600 million which after preferences would have returned little or nothing to the common shareholders; Company B delivered an unspecified, drawn-out stock deal ; while Company C proposed a cash offer in the range of $6.00 – $7.00 per share with the promise of a fast close. But after taking a closer look, Company C later revised its offer down to $5.50 per share.

Bird in hand, Palm’s CEO and advisors communicate on April 24 to HP and its advisors that, “to remain in the process, HP must improve its offer significantly and immediately”, which they promptly did, increasing their offer to $5.70 per share on the same day.

In the end, Company C did not match that offer, but proposed an alternative transaction under which it would acquire certain patents and take a nonexclusive license to Palm webOS in exchange for a one-time cash payment of $800 million. The Board eventually dismissed the licensing agreement as too dilutive to the value of the overall Company.

The deal with HP at $5.70 per share was announced on April 28.  Prior to the announcement, the shares were trading at $4.63.  The $1.2B offer represents a 23% premium over the price on the previous trading day, and a premium of almost 50% over the price before any rumors of a transaction started to circle.

Unfortunately it also represents a discount of 41% from the time the M&A process was initiated and before the devastating results were announced; and a discount of 67% from the last high in September 2009.

Several lessons can be learned from the process:

1. Start your M&A process early

There are a number of reasons to start the process early, especially in a situation where the company is strategically stalled, as in Palm’s case. Usually the runway is limited, and any delay also restricts strategic options. For Palm, the option to license out webOS turned out to be an inadequate non-starter. Once the bad news is out, share prices fall quickly and any transaction is perceived as a “fire-sale”. Missing the revenue target by over 60% one quarter out qualifies as VERY bad news. So bring in the bankers before you run out of options.

2. The more the merrier

Not all bidders may be the ideal candidate, and any auction in such an environment will inevitably attract bottom-feeders. But a healthy number of participants will keep the auction competitive, make the ideal candidate pay up, and generally force a transaction in a timely manner on the best available terms.

3. Keep key employees motivated

Once a company is on the auction block, employees will consider their options too. It is important to retain  key employees to effectuate a transaction as well as maintain the value of the company. This is especially true for technology companies, where most of the value is intellectual property that is embedded in the workforce. Palm’s Board recognized this early on and approved a Retention Bonus Plan for certain employees on April 1.

4. Cash is king

Somewhat obvious, but in a situation such as Palm’s it is hard for any Board to accept and consider the complexity and value of a stock deal. Not surprisingly, Company B’s proposal was not pursued further, in part because of the ambiguity and uncertainty of a stock deal.

5. Keep the options open

A straight sale is not always the best option, and Palm’s Board considered a range of different strategic options. Although the ultimate transaction was a sale of the whole Company, this open option approach helped to attract more and diverse potential interested parties. In this case, a straight sale was the easiest to evaluate for the seller, and – as indicated above – as the game moved to later innings, the less viable options were retired.

6. Elephants can dance

This one is probably less obvious. The deal was pulled off on a very abbreviated time line. This is exceptional from the seller’s perspective, but even more from the buyer’s. Palm certainly was motivated by a dwindling cash balance, deteriorating fundamentals, and the inability to double-down on its webOS roll-out in light of the weak initial market success. HP had its strategic reasons to buy into the deal, but the speed of execution was forced by the competitive nature of the auction that did not leave much room for delay.

Now, if only HP and Palm do their post-merger integration at the same speed as they did the transaction, we should see some new and exciting products in the marketplace fairly soon.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and is an Accredited Valuation Analyst (NACVA). Gunther is Treasurer and a Member of the Board of Directors of the the German American Business Association (GABA)

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M&A on the rise

For those business owners who have built and operate a business that is financially, operationally, strategically, and intellectually strong and well positioned for future growth, significant sale opportunities are returning. A continuing need for operating efficiency is driving a new surge in industry consolidation—the big guy wants to get bigger. Buying market share, assets, and resources is still considered an efficient and effective means to an end. Additionally, as a wet and cold winter finally turns into the promise of spring and the warmth of summer, buyers’ bank accounts that were frozen for the past 18 months are opening and significantly higher equity values are giving some an alternative currency to exchange. Related, a plethora of private equity funds of all kinds and sizes are returning to the marketplace and are particularly interested in bringing fresh opportunities into their portfolios. Both corporate and private equity buyers are also benefiting from an increasing availability of debt financing in the marketplace.

In a survey report issued in mid-April, the international corporate communications firm Brunswick Group revealed that more than two thirds of top bankers and lawyers who orchestrate mergers and acquisitions believe that deal-making activity will rise again. That’s a big change from survey results of one year earlier when only 29 percent of respondents forecast signs of recovery within 18 months. According to Steven Lipin, a Brunswick Group senior partner, “This year’s results reveal a substantial change in sentiment in the M&A world and advisers appear to be quite optimistic that the deal activity we’ve seen in the first quarter of 2010 will continue and potentially accelerate during the remainder of 2010.” Further according to a recent article in the Dealbook section of The New York Times, merger volumes for the first quarter of 2010 alone were up more than 18 percent from last year.

Through just the early part of 2010, a wide range of buyers have been closing corporate acquisitions. Closest to home, major technology players GOOGLE, INTEL, ORACLE, CISCO, IBM, SYMANTEC, and SYBASE have been leaders in acquiring much smaller strategic targets at significant premiums. In particular, industry buyers are aggressively pursuing targets that represent new and better ways to meet their respective markets. Typical buyer intent is not just to increase revenues or reduce expenses, but to expand and enhance product offerings to an existing customer base. This represents a great current reward and future growth opportunity for smaller to mid-sized companies that are unique and opportunistic.

Prepare your business for an M&A event

If it is time for you to seek a buyer or a merger partner for your business and the business is strong, growing, and financially stable, it is likely a window of opportunity is currently opening. Of equal relevance, if your business or your industry is struggling, there are important things that you can and should do. We’ve listed below a few areas where business owners and managers of under-performing companies should focus:

• Building management depth and strength;

• Improving financial and IT systems and capabilities;

• Developing sales and marketing muscle;

• Diversifying the customer base;

• Implementing organic growth initiatives;

• Rationalizing operations; and

• Addressing contingent liabilities.

While many business owners have developed a clear and appropriate internal succession plan to assure that a business “remains in the family,” many business owners and investors do expect to participate in an exit strategy that sees their business either acquired from outside or merged into another existing operation. If you and your business are ready for the prospect of a formal merger or acquisition, all indications are that deal making is returning to an active mode. If you and your business are not yet ready for such a prospect, now is the time to bring all elements of the business up to full snuff and be ready when opportunity does knock.

Michael Roy is Director of Mergers & Acquisitions at The Brenner Group where he has focused primarily on middle market advisory and transaction engagements. Prior to his affiliation with The Brenner Group, Mike held posts at firms such as Pacific Marketing Partners, Corporate Finance Associates, and Lehman Brothers. Mike has authored multiple “white papers” relating to the food and beverage industries in the U. S., to commercial real estate acquisition opportunities, and to environmental technology developments. He graduated from the University of Notre Dame and received a Woodrow Wilson fellowship for post-graduate study.

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Supporting the Capital Confidence Barometer results, another recent survey conducted by corporate communications firm Brunswick Group revealed that top bankers and lawyers (typically the grease that facilitates mergers and acquisitions) were even more optimistic, with 67% saying they thought the deal-making business was clearly on the increase.

Not surprisingly, increased availability of debt financing in the marketplace is a significant factor in prospective acquirers returning to the deal-making table.

For prospective buyers, there are significant strategic growth and development opportunities out there. We are now well into the 21st century and doing business is faster, more aggressive, and often profoundly international. Business success, even locally, requires keeping up. As many industries continue to consolidate, serious consideration should be given continually to what are the best strategies for staying ahead of the competition. Sometimes, refining a unique niche makes a lot of sense. Sometimes, recognizing the importance of being bigger and stronger is the obvious choice.

Identify the right target

Experts in the conduct of corporate merger and acquisition transactions generally agree that for a prospective buyer, there are key pre-requisites that need to be identified in a prospective target:

• Strong management—there really is a formula whereby 1+1 can equal 3, but it requires the courage and forethought to bring aboard leadership that is tested and proven.

• Market leadership—I recently heard a terrific metaphor (pardon the politically incorrect connotation)—“strapping two one-legged persons together doesn’t create an Olympic runner.” The key to strategic success is identifying and bringing in market strength, not weakness.

• Sustainable competitive advantages—a little like a good NFL draft where position needs are successfully filled.

• Financial stability—a successful combination hits the ground running—it makes little sense trying to dig out of someone else’s financial difficulties.

• Excellent growth potential—the intent is to grow and prosper.

• Potential business synergies—an obvious pre-requisite, but often overlooked. And not only must there be clear business synergies, there must also be clear cultural and “personality” synergies between the target and the pursuer.

As anyone who has participated in an acquisition or merger transaction will attest, the process of M&A is just as much an “art” as it is a “science.” Not only is it necessary to understand the operations, the accounting, the legal details, and the financial formulations, but it is critical to understand the nuance between pursuer and pursued relative to style, culture, personality, and all the other unique elements that differentiate one organization from another.

Michael Roy is Director of Mergers & Acquisitions at The Brenner Group where he has focused primarily on middle market advisory and transaction engagements. Prior to his affiliation with The Brenner Group, Mike held posts at firms such as Pacific Marketing Partners, Corporate Finance Associates, and Lehman Brothers. Mike has authored multiple “white papers” relating to the food and beverage industries in the U. S., to commercial real estate acquisition opportunities, and to environmental technology developments. He graduated from the University of Notre Dame and received a Woodrow Wilson fellowship for post-graduate study.

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We have dealt with distressed companies through multiple cycles over the past 20+ years and are sure of one thing: even if you never have to liquidate and wind down a company, it is best to understand the issues associated with such a potentiality before they progress too far.  So, with the help of Cooley Godward Kronish, we created a primer for executives and investors regarding legal, strategic, and operational issues facing distressed technology companies. We periodically offer that primer in a seminar/webinar, and our next one is scheduled for May 12. We hope you can join us.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms.  Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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My favorite quote: “But in a bust, having a lot of cash can be a huge competitive advantage because you can use that cash to put enormous pressure on your underfunded competitors.” Amen to that.

Fred Wilson from Union Square Ventures picked up the gauntlet and countered with The Case For The Lean Startup: “I have never, not once, been successful with an investment in a company that raised a boatload of money before it found traction and product–market-fit with its primary product.”

Which prompted The Revenge of the Fat Guy with some more clarification on why big is beautiful, and some cleaning up of common myths about that elusive product-market-fit.

The dogfight has elicited a slew of reactions throughout the blogosphere, my preferred one is making the not-so-obvious connection to Dr. Seuss’Lorax.

With so much body weight being tossed around, the questions remain: (1) who’s right and (2) what does that mean for your startup?

Who’s right?

Both, of course.

Ben Horowitz walked the walk and spent his way to success with Opsware. Arguably, this was before Opsware had found its sweet spot and dominance in the data center automation segment. Now one successful fat start-up does not a prescription for success make, and for every successful fat start-up there are plenty of failures (remember WebVan?). But the same can be said for the lean start-up. The lack of money does not predict success. Arguably, there are more dead lean start-ups than fat ones; although not necessarily by choice.

Fred Wilson has invested in about 100 web companies, and has yet to see success in doling out too much money too early.

What does it prove? If somebody gives you a boatload of money, and you spend it wisely, you can be successful; conversely, if they don’t give you so much money, but you spend it wisely, you may still be successful. Chances are, however, that you’ll build it and they won’t come.

What does that mean for your startup?

I surmise to say “it doesn’t matter”. Investors just aren’t giving out those boatloads of money anymore, so you might as well get used to the low-carb diet.

The other aspect that’s not so clear in either post is what’s good for the company and positioning the product may not be good for the founders or investors.

Boatloads of money usually come with boatloads of dilution; unless a company can prove quickly significant traction in its market. Dilution for the founders and dilution for the investors. Now it is true that 1% of McDonalds’ pie is worth more than 100% of the burger joint next door, but things are not so rosy after the second re-structuring, wash-out, and reverse split.

Boatloads of money also significantly increase the benchmark for success. Once a company burns through $30+ million, it’s hard to make everybody happy with an exit of less than $100 million. These days, most exits aren’t above $100 million, so most investors aren’t happy. What happens often enough is that with new funding, a viable strategy to get the company to an exit of $50 million is ditched in favor of a high risk, “swing-for-the-fences” strategy to get the company to the magic $1 billion exit. But this evolves from a structural issue within the venture capital industry at large, covered in two earlier posts (Bigger isn’t better Part 1 and Part 2).

Like Black Jack, doubling-down doesn’t always double your payout, but often enough leaves you with the loosing hand. Unless of course, you count the cards very, very carefully – as Ben did at Opsware.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Strategic buyers’ interest

Strategic buyers are usually mostly interested in the product and the market. In the sense that patents support a competitive advantage, and this is reflected in premium margins, they add considerable value. In some industries, such as life-sciences, patents are indispensable. In other industries, patents only play a supporting role. Some strategic buyers will be interested in patents for defensive purposes: either they have a product or they intend to develop a product that may infringe on the intellectual property of the seller.

Strategies of non-operating entities

Most of the non-operating entities will eventually try to find targets that license the technologies (or collect damage awards through litigation). Some will act for operating companies as a direct or indirect front to take intellectual property off the market and prevent others from enforcing the rights aggressively.

How does all of this affect start-ups?

1. Broad Strategy

From the outset, the patent strategy should be as broad as practically possible. This means being cognizant of other applications for the technologies, even if there are no current plans to pursue them. These areas can lead to additional license revenue and make the intellectual property more attractive to a wider range of potential buyers and licensees (strategic and non-operating alike).

2. More isn’t always better

Many companies are trying to amass as many patents as possible in support of a very specific product concept. It might be more cost effective to have fewer, but stronger/blocking patents, that also extend into adjacent application areas.

3. Who’s infringing. Today and tomorrow

It pays off to be aware of anybody currently infringing or on the trajectory to infringing on the company’s intellectual property. Any such instance – even if small and in different markets, will help to make the patents more marketable and may lead to higher income now or later.

4. Enforce the patent rights yourself, or have a “friend” enforce

Which leads to the question what to do if there actually is somebody infringing upon the patents. If the perpetrator is a direct competitor, it certainly makes sense to enforce the patent rights oneself. If the infringement happens at the margins of ones application, or is not worth the effort, or if the necessary funds aren’t there for a drawn-out legal battle, then there are plenty of non-operating entities that may take on such a case without the company itself acting as the bull in the China shop. Usual arrangements involve a sell-and-license-back agreement with the acquiring entity.

5. Geographies matter

Sometimes it pays to patent one’s intellectual property not only in the more obvious jurisdictions where the company intends to do business, but also in others, where potential acquirers reside. Some international non-operating entities will not be interested in US-only patents, but rather look for international scope.

This gives just an overview of some of the considerations for technology start-ups and their patent strategy. Beauty is in the eye of the beholder, and often start-ups are too narrow in the pursuit of patent protection and miss some of the beauty that others may see.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst (CFA) designation and an Accredited Valuation Analyst (AVA/NACVA). Gunther is a Member of the Board of the German American Business Association (GABA).

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The project reminded me of how much the landscape of acquirers of IP has changed in recent years as the market for buying, selling, and licensing IP becomes more mature. There are a host of different players with very distinct interests and operating models.

In this first of two blogs, I will describe some of the main types of participants in more detail. In a second post, I will touch on the implications for the patent strategies of high-tech start ups.

Who’s out there?

In a broad sense, potential buyers of IP assets can be divided into operating and non-operating entities. Operating companies intend to use the patents to support (or defend) their operating business; non-operating entities are companies with no substantial operations other than enforcing intellectual property claims. They acquire patents for offensive (trying to license the IP or receive damage awards from infringers) or defensive purposes (trying to prevent others from seeking damage awards).

In the last decade, there has been a lot of development in the area of non-operating entities. The category may have started out as the derogatory “patent trolls”, but at this point has matured into an industry with a number of players with distinctly different strategies:

- Enforcing Entities: these companies seek to offensively enforce their patent rights vis-à-vis current or potential users that may have an interest in licensing the IP or are suspected of infringing upon the rights. These entities can be structured in a range of ways: some are structured as a fund; some were formerly operating entities that sold off the operating business to focus on patent right enforcement; and others started out as individual inventors with a successful track record of enforcing their prior inventions.

- Defensive Trusts: these entities are a relatively recent development. Large, operating companies band together to form trusts that acquire patent rights for defensive purposes. The rights will be licensed to some or all of the member companies as a “protective shield”. Depending on the trust, the patents may be sold after the initial round of internal member licensing to provide cash flow back to the trust as well as to keep the threat of litigation alive with non-members.

- Aggregators: whereas Enforcing Entities usually aim for an immediate and targeted activity, aggregators take a broader and more patient approach: Their aim is to amass a large patent portfolio in certain areas that will represent a critical mass for later enforcement.

- IP Development Companies: as public and private research organizations have become more skilled in their efforts to monetize their inventions, they have also become more active in seeking to round out their own IP portfolio through acquisitions. Some will have their own enforcement activities, while others may license a more complete set of IP to third parties.

- Buy-side, sell-side brokers: as the players in the intellectual property get more specialized and mature, so do the related intermediaries. A lot of operating companies and several non-operating companies do not want to openly engage in IP transactions, but rather do so indirectly through third parties. This preserves confidentiality for competitive and pricing considerations. By keeping the “need” for certain IP confidential, the buyer also does not provide any clues about their strategy, or legal Achilles’ heel.

Each of these entities may have its own focus on certain industries and may have its own process with its own timeline. For example, defensive trusts will necessarily focus on the industries of their member firms, and will likely only bid on a patent portfolio once they receive interest from their member firms. This may take a while and they may not be as responsive as other entities capable of making faster decisions.

Knowledge of the different strategies is essential in executing a successful IP sale. However, an awareness of the different strategies of these companies may also lead to a re-thinking of the IP strategy of start-up companies that intend to maximize the value of their intellectual property either in an ultimate sale, or in additional revenue from licensing agreements along the way.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst (CFA) designation and an Accredited Valuation Analyst (AVA/NACVA). Gunther is a Member of the Board of the German American Business Association (GABA).

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A recent Grant Thornton study digs a little deeper and identifies 1997 as the peak year for the total number of public companies in the US. Since then and through 2008 the number of listings has declined by almost 40%. This is especially remarkable as listings on other global stock exchanges have increased: the number of listed companies in Hong Kong has almost doubled.

Grant Thornton traces this development back to the advent of online brokerages in 1996 and introduction of new order handling rules in 1997. The decline in listings was already in full swing when the dot-com bubble peaked. The rate of decline has slowed somewhat since Sarbanes-Oxley (between 2004 and 2007: coinciding with the economic recovery), but accelerated again towards 2008.

Grant Thornton argues that the root cause of this depression in listings is not Sarbanes-Oxley, but an array of regulatory changes that were meant to advance low-cost trading (such as decimalizing spreads), but have had the unintended consequence of stripping economic support for the value components (quality sell-side research, capital commitment, and sales) that are needed to support markets, especially for smaller capitalization companies.

There likely is more to it:

The pace of smaller IPOs after the dot.com crash may have been much higher without Sarbanes-Oxley, or with a reasonable exception for small-cap companies. This has combined with decreased investor appetite for “public venture capital” in the US vis-à-vis emerging markets.

Is any of this likely to change?

Grant Thornton makes several recommendations to bridge to more traditional IPOs, such as the establishment of an alternative public market segment that supports a higher fee structure for market makers, as well as private markets with limited access, such as solely to qualified investors. IPOs might pick up in a recovery, but they are unlikely to reach the 360 new issues per year that are calculated as the equilibrium number to avert further erosion of total listings.

Given investor interest in overseas markets compounded by an increase in domestic M&A activity and bankruptcies, a further decline in listings in the US is much more likely until a new equilibrium is found.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Whereas the timing of a transaction (up-market, down-market, hot technology space, etc.) is certainly of importance to the general consideration of whether or when to sell, the execution time from when the decision to sell has been made until the transaction closes is relevant in any market.

Obviously, there is a time value of money, and one dollar in a couple of weeks is worth more than one dollar in six or nine months. The simple compounding effect gets amplified for companies with a high cost of capital – such as venture capital.

Getting stale

But more than that, once deals are marketed they tend to have a limited shelf-life before they become stale. Interest in the company may be waning, and the economic situation of the company as well as the larger economy can change negatively as time drags on. Any potential acquirer will do a “make or buy” analysis. The assessment can change over time as the deal lingers on.

It is a crucial condition to a successful transaction that a sense of urgency among the buyers be constantly stoked. This holds true for a sale in an auction as well as for negotiated sales.

Confidentiality is another consideration: the longer the deal process lingers, the higher the likelihood that word gets out. This may be an advantage if the company is selling its assets and wants to target the largest possible universe of buyers, but it can be detrimental if it keeps customers from buying its products pending a transaction, or employees start to become nervous over the outcome of the transaction, or competitors start taking dead aim in the marketplace.

Auction 90TM

The Brenner Group has developed a formulated process for the sale of a company: Auction 90™ . As the name implies, in its purest form it takes 90 days from the start of the engagement until a buyer is contracted.

The process has been designed in an auction setting and can be executed as an open auction (where the goal is to maximize exposure) or a limited auction (where a limited number of bidders are corralled along a pre-defined process to expedite the transaction.

Timing

There are several factors that influence the execution time:

1. Asset sale versus stock sale

As the name implies, a company sells only its assets (or a sub-set of its assets) in a piecemeal manner. Any proceeds to the company will then be distributed to debt- and equity holders. In a stock sale, the owners of the company sell their stock to the acquirer, thereby disposing of the company in a single transaction. The assets (and liabilities) will continue to be owned by the company. Usually, asset sales can be executed faster than stock sales, in part because stock sales require more analysis and due diligence by the buyer.

2. Complex due diligence

Obviously, the more there is to a company, the more due diligence there is to do, and the longer it takes for a transaction to close. Complex technology, employees, overseas offices, and contractual relationships all take time to analyze. The further a company is along in terms of customer buy-in, product development, and actual sales, the easier it is for an acquirer to do due diligence.

3. Economic and industry environment

Obviously, deals will take longer in times when everybody is hunkering down and trying to cut costs. There are exceptions to the rule – if companies provide technology or products deemed “mission critical”, deals will still be done expeditiously. For example, Electronic Arts acquired online game company Playfish for $375 million at the same time EA announced layoffs of about 1,500 employees from its core staff.

4. Cash deal, share deal, merger

If the acquirer pays in cash, there is little to analyze. A transaction where the acquirer pays with shares needs additional scrutiny: are the shares registered, or restricted, or readily marketable, what is the trading volume, etc. The more weight on deferred payment, the higher the risk for the seller; especially as the seller has little control over the acquiring company’s operations going forward.

5. Auction, negotiated deal, limited exposure auction

Usually, an auction will lead to a speedier close, as it keeps all participants focused on a deadline. While a negotiated sale for a highly sought-after company can proceed swiftly, undue urgency may not leave the seller the necessary time to investigate other strategic options that could result in a higher price. Read more about auctions in my previous post Going…going…GONE!

Ideally, technology companies are bought, not sold. Employing the right sale strategy ensures an optimum transaction value.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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In the post dot-bomb era, VC’s became increasingly risk adverse, and wanted to fund only those ventures with proven entrepreneurs and only ventures that had already been fleshed out to remove much of the technology risk, leaving only a market risk to conquer.

Now, since the Great Recession, VC’s have gotten even further risk adverse, although they claim otherwise. Today, most VC’s are concerned about their Limited Partners interest in the start-up space, because their own liquidity has been diminished, but probably more importantly, they have had negative returns on the VC sector of investing for over ten years! So the VC’s are looking to invest in deals that might have a reasonably short exit in order to increase their returns. Also, by looking at shorter time frames for exits, they are almost sure to invest in later stage ventures which by their nature have taken some, if not all, of the techno logy risk out of the equation.

The rise of the angel

So what does that leave for early stage entrepreneurs? In the late 1980’s and early 1990’s wealthy individuals became a source of capital for early stage deals. These individuals became known as angel investors. In the late 1990’s, and especially in this decade, these individual angel investors organized themselves into groups. By acting in a group, many angels believe they get the collective intelligence of the members of the group, which broadens their own market for possible investments. They also get to spread their investment risk out, by investing smaller amounts individually into more deals collectively. This formula is beginning to replace the traditional venture capital model.

Angel investors have more tolerance for the time it takes to build a successful business, because they don’t have to answer to limited partners, they only have to look in the mirror and satisfy the reflection looking back at them. Angel investors are prepared to invest in early stage companies, and when structured properly, they are able to see a positive return when an exit does – hopefully – occur. Be aware however, that angels are more intelligent now than they used to be. Today, they also look to how much capital the enterprise will require beyond the angel round. If this amount is large, they might want to have some later stage venture capitalists actually look at the deal to judge their future interest in the team and the space.

So, if we look at the funding order available for entrepreneurs today, the first place they should look after their own family and friends, should be to the organized angel investment groups. They still have to deal with more individual investors who make their own decisions, but they are typically dealing with intelligent, qualified investors. So, we can say that these angel groups have now taken the place of the traditional venture capital early stage funding.

When the entrepreneur has fleshed out the technology, and maybe even the market, traditional sources of venture capital may be available to increment the angels’ investment.

Time will tell whether this change in the funding ecosystem is permanent or temporary. But for now, entrepreneurs need to work with angel groups.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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If VC firms ought to be smaller, what does that say about the VC industry as a whole?

VCs have been investing more than $20 billion each year since 1998. In 1999/2000 investments shot up to over $20 billion per quarter, but went down sharply afterwards, then starting a slow upward trend to an annualized rate of about $30 billion at the end of 2008 when the current economic crisis kicked in.

A Kauffman Foundation report by business-blogger-at-large Paul Kedrosky (his blog: infectious greed) pegs the reasonable size of annual venture investments in the US at $12 billion (instead of the $30 billion rate we saw in 2008). He largely gets there from return-considerations, as well as using a fraction of overall GDP.

Further suggesting the vc industry is contracting Bill Gurley from Benchmark gives a very good summary of how venture capital will likely get caught in the asset allocation squeeze (or the “denominator effect”): a typical institutional investor may allocate 5% of all assets under management to venture capital. As the total assets shrink because the value of all other asset classes such as stocks and bonds shrink, so will the money available for venture capital. Exacerbating this trend – and making it a long-term effect – would be a lower relative allocation. Whereas institutional investors have increased their relative allocation to venture capital over time, now may be the time to reduce it, following dismal returns from the industry for much of the last decade. The 5% could very well be cut in half – along with the venture capital industry. Gurley’s outlook still trends towards a “stabilized market size of well over $15B a year”.

Eventually, funds disbursed by venture capital firms will follow what they’ve raised. And little did they raise indeed so far in 2009: A dismal $1.7 billion was raised by VC firms from limited partners in the second quarter of 2009. Hopefully, we’ll see some recovery from such low numbers: This would lead to a very small industry indeed.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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