By Andrew R. Garman, Managing Partner, New Venture Partners LLC
"Our ideas of innovation have gone stale. We need to innovate in the area of innovation itself"- John Seely Brown, Xerox PARC
Corporate technology innovation is changing. Smart companies no longer feel the need to own and control all of their intellectual property (IP). Sometimes the most profitable business model is to use others' technology. Intel, Microsoft and Cisco have demonstrated this repeatedly. Even more interestingly, sometimes the most profitable business model is to let others use your technology.
Why do spinouts? It is a natural consequence of doing great research and development that creative scientists and engineers will develop technology that corporate business units can not and should not commercialize. For example, in 1999, developers at Lucent's Bell Labs developed a breakthrough, fully compliant, Java based operating system, cleverly designed to run on scaled down microprocessors found in handheld devices. However, it would not have made sense for Lucent's wireless business group, focused on systems infrastructure, to bias its offerings toward a single client device standard. Hence an independent company, Savaje Technologies, was born. By virtue of its independence Savaje has been able to assemble a consortium of backers comprising the top wireless operators in the world.
Sometimes the corporation is best served as a customer, but not an ongoing developer, of home grown software. When it is not a part of the corporation's core business to produce a particular class of software, the code inevitably gets stale and progressively more difficult to maintain and upgrade. An independent software vendor whose sole mission is to develop, upgrade, maintain, and sell the software into a competitive market, ultimately serves the corporate purpose much better. British Telecom developed an ingenious software application to schedule the timely arrival of its 20,000 field technicians to its customer locations. The software is strategically critical to BT as it governs the primary physical contact between the company and its customers. In 2003 BT elected to spin the technology out into a separate company, now called Vidus, Ltd., to put the software into a stable, well funded platform with the right development and management team. In its first year of independent existence, the Vidus has licensed its software to each of the largest telco, utility and cable companies in Great Britain.
There are other reasons for corporations to do spinouts. The value of equity held in ventures can be substantial. Through careful divestiture of non-strategic technology assets, and thoughtful disposition of the subsequent equity positions, Philips Electronics has generated several billion dollars to its bottom line in recent years. Even at the end of the technology bubble in 2001, the market capitalization of the ten biggest spinouts from Xerox Palo Alto Research Center exceeded the market cap of Xerox by more than a factor of two.
Moreover corporate R&D directors will argue that creating an alternative, entrepreneurial channel to market can drive a fundamentally different mindset and behavior on the part of the research staff. Certain technologists may find the invention process or gaining the respect of their peers in the technical community sufficient reward for a life's work. Others may find that entrepreneurship, and its attendant wealth creation, presents a more compelling set of rewards.
With the labs taking on a more commercially oriented, time to market culture, the business units enjoy a secondary effect. The passion to create a venture that gets the technology to market first forces the business units to pay attention much sooner to what's going on in the labs. The business unit must make a decision to fund a new product or let it go. The clock speed of the entire corporation tends to increase.
While the rewards can be very great, the actual practice of incubating, transitioning, building and getting liquidity from corporate spinouts turns out to be challenging ("challenging" is a euphemism for "really hard to do"). Most corporations that attempt to do this on a systematic basis fail. Understanding the needs of the traditional venture capital backed company is not second nature to the major corporation. Many of those that do succeed fail to sustain that success over the long run as management and strategies change. We believe that corporations that wish to succeed at this game over the long run should outsource the management of spinouts to a third party with the right experience base and a long term oriented financial platform.
How to do spinouts. At New Venture Partners we have built a team of operations and investment professionals that understand how to do spinouts, having collectively created nearly fifty new companies over the past seven years. Here are some of the lessons we've learned about how to do it well.
- Align interests with the corporation. The traditional venture capital model is to convince key technologists to leave the corporation and design around the existing developed IP. This may work once. A better way is to create a business structure that allows you and the corporation to win together in an equity sharing arrangement that can be repeated many times for many spinouts. Furthermore the parent corporation is motivated to buy hardened, commercial technology back from the venture, which can be a fantastic reference for other customers.
- Pre-negotiate a single deal form for every spinout. Negotiating the complete terms of a spinout -- IP transfer, employee transfer, physical asset transfer, venture structure, economics, transition services, incubation management, supply agreements, etc. -- with the corporation is time consuming. Do it once. Then use the template to crank out multiple deals over time.
- Develop a disciplined venture development process. Unlike traditional venture capital, you don't start with a fully formed company and management team. You must oversee their creation in a well-managed program. The result should be a qualified set of customers, a commercially ready technology, a good management team and a sensible business plan.
- Syndicate quickly. It is very easy to get trapped in an endless development cycle. Figure out the minimum time and expense required to meet a set of targets that make the new venture attractive to mainstream, sophisticated venture investors. Then get it out and get it co-funded by other smart, deep-pocketed investors.
- Get technologists from inside and management from outside. Nobody really knows the technology (and surprisingly often the market) like the inventors. You don't want to throw the code over a transom to someone else. If the core R&D team isn't interested in a venture, don't do it. On the other hand, if they want to manage the venture themselves, don't let them.
- Be practical about intellectual property. Here's your typical starting position: the guys in the corporate IP department want to license a narrow slice of the IP on a non-exclusive basis, limited to a minimal field of use, with the right to terminate the license if they feel like it. Outside counsel for the venture capitalists wants all related past and future IP to be assigned to the company with a global non-compete. The right answer, which both sides can live with, is always in the middle. A tough battle ensues that you mediate to a win-win conclusion. A week later no one cares anymore.
- Leverage the parent corporation. This is a tremendous asset not available to traditional start-ups. The parent can very often be a customer, a channel, a marketing partner, a co-development partner, a service and support organization. It represents the kind of strategic partnership that gives instant credibility to the new venture that other start-ups typically take years to create.
- Do the VC's job as well. Almost all corporations who try manage spinouts themselves make the mistake of not taking care of their shareholder interest post spinout, nor having a ready pool of capital available for follow-on investment. Having done the hard work of identifying, incubating, spinning out, establishing and funding a new company you can't rest on your laurels. The work continues, sitting on a board, driving the company to its ultimate exit. And you must have a deep reserve of capital to sustain the company and preserve a significant equity position through multiple rounds of financing.
Not all corporations should do spinouts. Some do an unusually fine job of focusing their R&D efforts only on projects they know they want to commercialize. Some have the wrong corporate culture to foster entrepreneurship. Certain companies, for example Microsoft, are doing just fine without it. For the rest of the world, tapping into this different route for innovation will prove exciting ("exciting" is a euphemism for "challenging") and lucrative.
Andy Garman is a managing partner of New Venture Partners LLC, a $300 million venture capital firm focused on corporate spinouts, with offices in Murray Hill, NJ and Ipswich, England. He has been involved in creating or investing in more software and technology ventures than he can count from British Telecom, Philips, Lucent, Xerox, Bankers Trust, SRI International and Stanford University. Andy can be reached for article feedback at: agarman@nvpllc.com.
