Natural Partners

New businesses create a major trend by forming partnerships with established companies.

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A new source of start-up financing

Without much fanfare, a revolution has been occurring in the way that entrepreneurs find start-up funding. People who used to rely on venture capital are setting up new kinds of partnerships with established companies and getting a lot more than money in return. It's already a major trend among technology firms -- I see it everywhere I go. And I suspect that this is only the beginning. -- J.K.

This was not supposed to happen to someone like Finis Conner. A legendary figure in Silicon Valley, he had cofounded both Shugart Associates and Seagate Technology Inc., two of the more spectacular success stories in the history of the computer industry. Yet when he set out to raise money for a new disk-drive start-up in 1986, he got the kind of reception usually reserved for novices. Some venture capitalists acted as though they were doing him a favor just by listening. A few openly questioned his ability to manage. As for the handful who came through with offers of money, they did so at valuations so low that Conner feared losing control of his venture.

To be sure, Conner understood why investors might be skittish: a sudden downturn in the microcomputer business had left many of them with burned fingers and cold feet. "The conditions in the industry made everybody suspect," he says. Nevertheless, the 45-year-old entrepreneur found the experience galling. "I was angry and disappointed. I felt like I was constantly being asked when I'd stopped beating my wife. Every venture capitalist seemed to want to squeeze me a little bit more."

Frustrated, Conner turned for advice to Rod Canion, president and CEO of Houston-based Compaq Computer Corp. The two were old friends: Conner had served as Canion's sounding board during the launch of Compaq. Now, Canion returned the favor -- and then some. "He asked me, 'Why should you take this grief?' " Conner recalls. "He suggested that Compaq take a position in the new company. So I told the VCs, 'Forget it. I don't want your money.' This is how Rod Canion saved this company."

The offer represented more than the generosity of a friend. Canion saw in Conner Peripherals Inc. the solution to a major problem confronting his own company -- the need for a dependable source of technically advanced disk drives to go in Compaq's new line of portable computers. "We could see ways to improve [disk drives], but we saw no one doing them," Canion says. Conner was ready, willing, and able. Beyond that, he had a revolutionary design for a lightweight disk drive providing both high performance and exceptional reliability. That was just the kind of disk drive Compaq needed to reinforce its own reputation as the leader in technology and quality among manufacturers of microcomputers for business.

"The arrangement allowed us to gain an advantage over our competitors," says Canion. "For [Conner], it was a way to get going. For us, it was a form of vertical integration -- but a couple orders of magnitude less expensive."

Compaq invested $12 million in Conner Peripherals, initially getting 49% of the stock in return (see "The Structure of a Deal," page 6). But the start-up received more than capital. It also got a major customer, not to mention the marketing knowledge and technical expertise of one of the premier management teams in the microcomputer industry. Conner Peripherals made the most of it. In 1987, its first year of production, the fledgling venture garnered a remarkable $113 million in sales, with more than $11 million in aftertax profits. In 1988 sales and profits climbed to more than $256 million and $20 million, respectively. Scarcely two years after being effectively shut out by the venture capital community, Conner Peripherals was employing almost 2,900 people and had emerged as one of the most successful high-tech start-ups of the 1980s.

And Compaq, for its part, hasn't done badly, either. It is so pleased with the Conner disk drives that it offers them in all its computers. Meanwhile, its revenues have continued to soar, passing the $2-billion mark in 1988 (just six years after the company's founding). Equally important, Compaq's reputation for quality and performance remains secure -- thanks partly to its deal with Conner.

It's becoming an increasingly common story in the world of growing companies. Start-ups that would once have been prime candidates for venture capital are instead looking for other sources of funding, and their search often leads them to established companies in related industries. In many cases, they wind up talking to potential customers, as Conner did; occasionally, they go to potential suppliers or distributors. Whatever the relationship, the goal is to find a larger company that stands to benefit from the start-up's success. If the pieces fit, the two companies do a deal, providing the smaller company with capital and expertise, and the established company with a promising relationship and an ownership stake. Win-win. Call it a natural partnership.

The concept is not altogether new. Large companies have been taking minority positions in smaller ones for decades. Lately, however, the trend has been accelerating -- particularly, though not exclusively, in the high-technology arena. The extent of the change was evident in a 1986 survey of 121 high-tech CEOs by the Southern California Technology Executives' Network. Those CEOs ranked corporate partnerships first among the various choices for new funding -- almost twice as popular as venture capital. On a national level, meanwhile, the number of Fortune 500 corporate investments in venture-backed small companies skyrocketed from 32 in 1980 to 477 in 1987, according to Venture Economics Inc., in Needham, Mass.

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