Are M&As the New IPOs?

By Margot Carmichael Lester

Despite a few signs of life in the public markets - consider Netgear's rescheduled IPO and FormFactor's expanded offering - the real action in the technology sector is in mergers and acquisitions.

"Normally, about 10 percent of exits are IPOs," said Greg Bohlen, CFO of Aurora Funds, a venture capital firm in Research Triangle Park, N.C. "It had gotten to 25 to 30 percent during the boom."

By contrast, he says, "Ninety-nine percent of exits last year were mergers or acquisitions." That's a figure he expects to hold this through year, perhaps longer.

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Two factors are driving the merger and acquisition activity: analyst scandals and slightly higher prices for tech stocks.

"Elliot Spitzer devastated the Wall Street economy," says Bohlen, former director of investment banking at UBS Warburg, where he covered private equity clients (venture capital and sponsor).

"Bankers have relied for years on the expertise of analysts about what business models are working," he continues. "The number of analysts on Wall Street is dropping significantly and the number of companies covered is dropping significantly. That makes it difficult to get companies public and support them once they are public. Until it reverses, we'll not have public markets for new offerings."

Another driver is the slight rise in tech stock prices.

"In general, tech stocks are starting to recover and that's creating additional momentum," says Dana Warren, a Partner in the Los Angeles office of Bingham McCutchen.

"Consequently, these relatively low prices are an opportunity as opposed to a symptom of a long-term illness," he continues. Companies looking to merge or buy have an incentive now to get in before partners or targets go public and have higher valuations. "There's a view now that there is a future."

Successful Exits
How can a start-up technology concern attract venture investment and grow to acquisition? Good question.

"Venture capital firms are still very, very focused on their portfolio companies," Warren notes. "They talk a lot about seeing a lot of business plans, but it's pretty frustrating to get a clear picture of what they want to see."

Therefore, Warren and other start-up advisors counsel their clients to get back to basics: show a well-defined addressable market of sufficient size and a clear path to achieving significant penetration. They also push a hard financial line.

"We counsel our clients to manage toward self-sufficiency," Warren notes. "Don't plan to get funding. Plan to bootstrap. You want to get the company as far along as you can. Planning as though you'll never have the funding may make it easier to find it."

"Start-ups are in for a very tough road," says Ravi Chiruvolu, a general partner with Charter Venture Capital in Palo Alto. "There are too many - more than there is a demand for. I think a lot of companies still have to go out of business. I'd say 50 percent will be out of business in the next two years."

For that reason, Bohlen says, "Investors want to see companies that have a chance to quickly build markets and profitability without the potential for a death spiral."

In the end, Warrens says, "Anything that shows the promise of an exit helps the [venture] investment happen."

The Industry Standard
If a start-up gets venture backing and survives, there's still no guarantee of an acquisition, much less a fruitful IPO.

The best acquisition targets "skate to where the puck is, " Chiruvolu says. They have become the industry standard or have created a market the acquirer cannot serve. "Acquirers may not pay for current revenues, but they will pay on the value they'll get."

"The classic example is this: Microsoft wants to grow into a market in which you have enterprise-level software that [is] the de facto standard in that market," Bohlen reasons. "The only way for them to grow is to acquire you."

That's the model being deployed at Roxio, the developer of software products for CD/DVD burning, photo editing and video editing. The Santa Clara, California-based company has been making strategic acquisitions for the last year, including Napster, the music file-sharing concern, which it bought in November.

In May, the company acquired Pressplay from co-owners Universal Music Group and Sony Music Entertainment, which has a proven online music infrastructure that can serve as the platform for the Napster re-launch. Roxio acquired substantially all of the interests of Pressplay for $12.5 million in cash and approximately 3.9 million shares of Roxio common stock, for a total value of about $39.5 million less about $1 million in transaction costs.

"From a business perspective, Pressplay has superior infrastructure, scalable architecture, services and partnerships, a strong management team -- and they pioneered the space," says Elliot Carpenter, Roxio's CFO. Pressplay also offers the features music fans want: streaming, downloading, full-portability CD burning and devices and access to more than 300,000 tracks through catalog rights with all five major record labels and exclusive rights to Billboard charts.

The acquisition creates a new market opportunity for Roxio and will allow the company "to expand its role in digital media from not only digital media creativity software but also to digital media software and services," Carpenter says.

Roxio will be in investment mode as it prepares to launch the new service between now and March 2004. Carpenter says, "Profitability will not be immediate but entering this business is part of the strategy to drive long-term revenue and profits."

A Mission-Critical Need
The other way tech companies can position themselves for acquisition: "Create a product or service that people really need," Bohlen continues. "Figure out the right mode for charging and build a company around it."

Consider Talaris Corporation. The San Mateo-based company developed an e-procurement application for business services such as travel and entertainment, telecommunications, printing and delivery. The solution enables users to procure services from any electronic device while enforcing corporate policies. It also tracks and enforces pre-negotiated terms and use of preferred vendors. The company claims it's the first integrated cost-containment solution.

"Talaris addresses a big market," says Chiruvolu, who sits on the company's board. And one with a lot of pain. U.S. corporations spend an estimated $471 billion on employee-centric services annually. Approximately 41 percent, or $193 billion, of these expenditures do not comply with corporate policies or provider agreements. As a result, companies are charged 15 to 27 percent more for services, creating $29 billion to $52 billion in lost savings per year, according to AMR Research.

"It's a home run," Chiruvolu says. "They could be a very big acquisition."

The Future
The renewed merger and acquisition activity and a few public offerings are expected to help private equity investment and the economy, Warren says. "Though I'm not sure [they] should. When you're dealing with 4 to 7-year time frames for exits, who cares what the market is now? But it does have a psychological impact."

While there's a trend toward more of these transactions, observers remain only guardedly optimistic, refusing to proclaim a boom.

"Remember," Chiruvolu says, "being in the desert with a cup of water feels like a waterfall."

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