Electronic Design

Entrepreneurs Can Take Advantage Of VC In A Down Economy

Technology analysts and the high-tech media have engaged in hand wringing and soul searching over the ability of the high-tech sector to create new jobs through economic growth. The self-analysis hit a fever pitch following a cover story in The New York Times on September 6, 2010 questioning the ability of high-tech sectors in North America to continue as a source of innovation and job creation. Part of the problem stems from specific tasks that have become outdated or moved overseas, such as hardware system design or software publishing. As entrepreneurs, how can utilize these apparent structural changes to our advantage?

The concerns are half-right, but are scarcely limited to high technology alone. Virtually every market sector in North America faces a dearth of jobs as we slowly leave the recession of 2008-09. While the causes are many and varied, one factor common to many sectors such as health care and pharmaceuticals, heavy industry, and high tech is that established companies, both privately held and those traded on public exchanges, are sitting on large piles of cash that they are not using to diversify, either in breadth or depth.

Such conservatism plays a direct role in how innovative ideas are disseminated within vertical markets, particularly given the reduced portfolios of traditional venture capital (VC) firms since the 2007 downturn. Startups that make it to a mezzanine or Series B round in the current environment almost invariably must rely on pools of traditional VC, working in conjunction with VC arms of established companies and with private-equity sources. If established companies fail to invest in small, agile startups or fail to create new product divisions during downturns, the ability to innovate suffers.

Innovative Opportunities
Sometimes, a small software development firm can reach a level of visibility serving emerging markets such as iPad, iPhone, or Android smart-phone applications. But expanding to significant size requires a partnership, investment, or outright acquisition from a larger partner.

Sometimes these partnerships can take unexpected forms. When Cliff Kushler, founder of T9, developed a new touchscreen-based method of text recognition, he knew the resulting startup, Swype, would need to seek funds from handset vendors such as Samsung and Nokia. What wasn’t clear during Swype’s early funding is that the company would have to go a step further, to the venture arms established by wireless operators, to bring the innovation to market. In February, Swype announced it had gained $1 million in funding from NTT Docomo Capital—an unusual source of funds for an application developer working with smart phones.

In certain circumstances, established companies are entering the merger and acquisition game, but often with an attitude of paying share prices significantly in excess of the acquired company’s valuation. Two such cases immediately come to mind. First, Intel Corp. paid a whopping $7.68 billion for McAfee, a move that seemed only intended to give Intel a stake in network security. Second, Hewlett-Packard entered a bidding war with Dell Computer over 3Par, an interesting storage company that might play well with HP’s server strategy, but seems scarcely worth the $2.1 billion HP paid to win the bidding war.

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Companies with venture capital arms, such as Intel and Infineon Technologies, could continue with their existing strategies of making several small investments in initial, mezzanine, and Series B rounds for startup companies. In recent months, Intel has invested in such companies as Vriti Infocom, OpenPeak, One97, and You Broadband. Infineon’s money has been critical to such companies as Acunia and Jungo Software. These types of investments seem a far better way of spreading one’s bets in a down economy than spending close to $10 billion for a security company, even one with existing market share. In addition, innovation and support of new, growing companies helps the economy at large to generate jobs.

Larger companies similarly get more bang for the buck acquiring smaller companies with finely honed talents, particularly those with active design teams who are anxious to find partners. A good example of such a deal is Applied Micro’s $32 million acquisition in August of Copenhagen company TPACK, which had expertise in developing FPGA-based interfaces for very high-speed communications.

Money Under The Mattress
A CFO using a strategy of borrowing cheaply to keep plenty of extra cash on hand might say in a company’s defense that the climate in Washington is too uncertain to use cash to add jobs. However, taking a calculated risk on an up and coming, innovative firm in the high-tech industry could pay big dividends compared to holding cash at record low returns nearing 0%. As a tangential benefit, jobs created from more entrepreneurial investment help the economy at large emerge from a devastating recession. A CFO’s tight money strategy in this economy helps neither the corporation nor the general economy.

When one considers the current political and economic climate, there seems to be every reason in the world for corporate VC groups to make investments in startups. Both political parties understand that job creation is vital to their self-interest, and what better way to affect this than in support of bipartisan efforts to support corporate tax breaks?

At a time when larger companies already have cash on hand, that cash should be used for smart investment to expand business potential. This could take the form of hiring a dedicated staff for a new market area, making an investment in a startup to the tune of several million dollars, or acquiring a highly focused company in the range of $10 million to $200 million. It does not mean throwing money amounting to several multiples of valuation at a large publicly traded or privately held company with brand cachet, as Intel did in purchasing McAfee.

The “outer boundaries” of the utility of a larger company working with a smaller one might well be represented by Cisco Systems’ 2009 acquisition of Pure Digital Inc. At the time, the $590 million offered by Cisco would seem to place the acquisition close to the category of overpayment. Yet Pure was still a young company that had achieved unprecedented success in a down economy with its Flip handheld video camera.

Cisco acquired Pure just as it was introducing its Ultra HD models of 1080p pixel resolution. Cisco executives had specific ideas about enhancing the Flip video with Wi-Fi connectivity, and Cisco pledged to keep the management and design team at Pure intact. In the 18 months since that acquisition, Cisco has largely lived up to that promise. But a half-billion-dollar acquisition of a young company represents an unusual boundary condition for the general rules we have suggested here.

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What’s Next
The more that large corporations keep a tight hold on war chests of equity, the more that the flat economy becomes a self-fulfilling prophecy.  Maintaining a conservative investment strategy as the economy is recovering risks plunging the U.S. and partner nations into a “lost decade” similar to that of Japan in the 1990s. Further, it risks burning out and disillusioning a generation of high-tech workers in North America. Now that many hardware manufacturing and software back-end processes have moved to Asia, corporate finance departments risk ruining those corporate divisions in product definition, application development, marketing, and so forth that are the sole U.S. differentiators in a globalized economy.

Some companies want to hold off on any expansion or investment plans until early 2011, operating under the assumption that even a major Republican expansion in the election of 2010 could lead to instant changes in corporate taxation policies. Others seem to be resigned to holding off on major investment until the 2012 race for a new executive administration. This is far more than short-sighted. It denies the North American economy the chance to bloom again, after three years of profound decline. We believe the fastest way to recovery is maintaining a healthy environment that supports investment in growing, innovative companies.

Finally, a note to all entrepreneurs and innovators: A recent study conducted by VentureOnLine found many corporate venture capital groups investing even in a down economy. We found 27% are from the IT, electronics, and telecommunications sector, almost 23% from pharmaceuticals, health care, and chemicals, nearly 14% from engineering, manufacturing, energy, and utilities, and about 19% from other (services).

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