Juicing Returns Through Corporate IP Spin-outs

Additional equity upside, reduced expenses, and tax realization benefits to boot…in exchange for an asset you were going to dispose of anyway. Who says there isn’t such a thing as a free lunch?

Corporate intellectual property spinouts are a creative and attractive means of boosting buyout returns, particularly at a time when buyout firms are seeking every edge possible to maximize corporate value. A corporate IP spinout occurs when a company spins off non-core technology, intellectual property, and engineers as the basis for new venture-backed start-ups. Corporate IP spinouts typically have the following characteristics:

• less than $10 million in revenue, perhaps even pre-revenue;

• completed product or prototype in an advanced phase of development;

• several years of prior technology and IP development;

• early customer interest and market validation;

• technology team available as part of the spinout.

Corporate IP spinouts occur frequently before, during, or after a corporation is acquired by a buyout firm. Post-acquisition, the management team typically focuses on core product lines and eliminates less strategic projects that are not generating meaningful near-term revenue. This is the perfect time to consider spinning out ancillary projects via corporate IP spinouts.

R&D = Readily Dispensable

Leading tech companies such as Microsoft Corp. and Intel Corp. have been doing corporate IP spinouts since 2002, yet buyout firms are just becoming aware of this strategy as their attention to the technology sector has increased. Take-private tech deals in recent years include the acquisitions of embedded semiconductor company Freescale Semiconductor ($17.6 billion) and Danish telecommunications giant TDC ($13.9 billion), not to mention the hundreds of smaller tech companies being taken private, or large divisions being spun off by mid-market buyout firms.

Most tech companies spend between 5 percent and 15 percent of their net revenues on R&D. Buyout firms are likely to focus on a company’s core revenue-generating products and slash early-stage product lines that are a year or two away from meaningful revenue. These products may have had tens of millions of dollars of prior R&D and represent highly disruptive technology, yet they are no longer strategic to its new financially focused parent.

Cutting R&D can be an effective short-term fix, as there is minimal near-term revenue impact.

Consider VeriFone, a global leader in payment technology solutions. Publicly-traded VeriFone was acquired by Hewitt-Packard in 1997, at which time VeriFone’s R&D budget was 11.2 percent of net revenues. In 2001, HP sold VeriFone to buyout firm Gores Technology Group, which restructured the company and brought it back to financial health. Gores Technology reduced VeriFone’s R&D budget to 7.5 percent of net revenues—approximately 33 percent less than VeriFone’s R&D the last time it was a public company—prior to taking the company public again in 2005! The R&D may have been even lower in the 2001 to 2005 timeframe when the company was private.

Motorola has recently been in the news for considering a large spinout of its mobile phone business. As of this writing, the company has decided to spin the business into a separate, publicly traded entity. In the process, many major buyout firms were rumored to have evaluated a take-private transaction of the handset division. However, most buyout shops would not be interested in ancillary projects not immediately linked to the operation of the buyout entity. As a result, in many potential transactions such as this, buyout firms need to consider a corporate IP spinout partner to offload technologies with less than immediate impact on the profitability of the spinout.

Upside, Upside, And More Upside

Buyout firms may question whether a corporate IP spinout is worth the hassle because these are small deals relative to a multi-billion dollar offer. But while buyout firms can certainly continue with business as usual, savvy professionals who are seeking to give their returns a boost and further focus the new entity understand the attractive propositions offered by corporate IP spinouts.

First, the parent participates in the technology’s future upside (through an equity stake) without being required to make any further capital investment. The standalone start-up essentially leverages PE dollars going forward rather than corporate dollars. The parent corporation—at no additional expense—may recoup its initial R&D dollars and potentially reap substantial rewards if the start-up blossoms. Perhaps the best example is Xerox. Xerox Palo Alto Research Center (PARC) received equity stakes in dozens of early-stage projects spun out from its labs starting in the late 1970s. By 2001, Xerox PARC’s 10 most successful spinouts had a combined market capitalization that was more than twice as large as Xerox’s own market capitalization.

Second, corporations can realize significant financial benefits from spinouts. These enable the corporation to move the R&D expenses off its balance sheet and avoid future expenses while still retaining upside potential. They can also unlock potential tax loss benefits associated with earlier acquisitions by generating a tax loss realization on the date of the spinout. As for public relations, a corporate IP spinout is far preferable to shutting down a division and laying off employees. And, of course, if the key employees are committed to seeing the opportunity get into the market, they are likely to leave anyway; by structuring a spinout, the corporation retains value even after the people leave to go the new venture.

Third, corporate IP spinouts enable the parent organization to build up its technology ecosystem without exposing its bottom line. From the parent’s perspective, the spinout creates a natural partner for a customer, supplier, channel or OEM relationship. For example, imagine that a bank chooses to stop developing a home-brewed software application for regulatory compliance because maintaining software applications is not its core competency. Rather than abandon the project, the bank can spin out the team and the IP into a new start-up. The parent company receives bug fixes, feature upgrades and higher quality customer support without diverting further IT resources to the project. On the flip side, the software start-up has a flagship customer and an instant revenue source. It’s a win-win situation.

Deal Execution

Buyout professionals are accustomed to divesting large, non-strategic business units post-acquisition. Give them a $100+ million revenue-generating division and they know the drill: hire an investment banker, reach out to potential strategic acquirers, and may the highest bidder win! But give them a pre-revenue or early-revenue product line and the process is less clear. Investment bankers are unlikely to take on such a small divestiture given the minimal fees involved, and strategic acquirers prefer to buy well formed businesses rather than nascent technologies.

That’s where corporate IP spinouts and firms like Blueprint Ventures enter the picture. Buyout firms can expose these high-potential products or projects to early-stage venture firms, who can spin them out as the basis for new standalone start-ups. The parent corporation and the VC firm bring different but equally necessary skills and assets to the table. The corporate parent contributes patents, trade secrets, and key engineers to the new start-up, typically receiving an equity stake in return. The corporate parent may also negotiate an ongoing channel or OEM relationship with the start-up as part of the spinout. The VC firm invests new money in the early-stage venture and recruits seasoned management to lead the start-up. In exchange, the VC firm receives preferred equity and a board seat.

Finding the right VC partner is critical as the corporate IP spinout process has many moving parts—intellectual property assignment, technical team transition, and hiring of a management team among others—that can be difficult to navigate. Blueprint Ventures has significant experience in these deals through its 14 corporate IP spinouts from leading technology companies including Intel, NEC, Fujitsu, and Brocade. Venture firms like Blueprint Ventures benefit from corporate IP spinouts by investing in high potential technologies, and private equity firms benefit by receiving upside for non-core assets. Again, it’s a win-win situation for all parties involved.

Case In Point

LANDesk Software is a perfect case study of a corporate IP spinout gone right. Utah-based LANDesk had been an operating software group within Intel for almost a decade. In 2002, Intel made a strategic decision to focus on its core semiconductor business and exit the software business altogether. Intel was unable to identify a strategic buyer in large part because LANDesk’s revenue run rate was in the $10 million range rather than the $100 million range. Rather than shut the division down, Intel spun out LANDesk into a venture-backed start-up where Blueprint Ventures and other venture firms invested in the new company. As part of the transaction, Intel retained an ownership stake in LANDesk and wrote off several million dollars in LANDesk expenses via this arms-length transaction. In less than four years, LANDesk blossomed to over $85 million in revenue and was acquired by Avocent (Nasdaq:AVCT) for $416 million in 2006. Intel netted over $60 million in this exit, a noteworthy figure for a division they were ready to abandon altogether. Those $60 million in pure profits would be a welcome bump to any private equity firm’s returns.

Buyout firms succeed by focusing their newly privatized companies on their mission at hand and making their assets work for them. A corporation would find it unacceptable if its employees played truant or its cash reserves weren’t bearing interest. Why should non-core intellectual property and technology get a day off? Dust off those patents, monitor non-strategic technology projects that are about to get cut, and see how you can make your technology assets work for you. It’s a smart way to provide an extra lift to your returns.

Bart Schachter and George Hoyem are managing directors with Blueprint Ventures, an investment firm that focuses on capital-efficient technology start-ups and corporate IP spinouts. Reach them at bart@blueprintventures.com and george@blueprintventures.com.