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.
But the change goes beyond the sheer volume of deals. There has also been a shift in the nature of these so-called strategic alliances. In the past many large companies established such relationships for the purpose of gaining "a window on technology." Others tried to play the venture capital game, viewing their investments simply as a means of achieving large capital gains. In neither case was the large company counting on the long-term success of the smaller one as an operating business. The assumption was that, sooner or later, the small company would go public or be acquired, and the large company would either cash out or integrate its erstwhile partner into its own corporate structure. The new kind of alliance, in contrast, is based on the assumption that each partner has a strong interest in the other's ability to be an established, successful, independent company.
There are apparently two major forces behind the trend. For one thing, many young companies have been forced to seek sources of capital outside the venture community, which has grown cool to start-ups in recent years. That's because venture capitalists have been finding it more difficult to make money on early-stage financing. "As returns go down, people look for other investments," observes Fred Warren, a partner at Brentwood Associates, a Los Angeles venture capital firm. "It's a natural shift." Between 1986 and 1987, for example, the amount of venture dollars invested in start-ups declined from 16% to 11%. Today some of the industry's leading firms, such as Brentwood, place the bulk of their investments in latter-stage financings and leveraged buyouts. In 1983 the $161-million Brentwood IV fund allocated only 25% of its money to leveraged buyouts, using the rest as traditional venture capital. More than 70% of the firm's current $210 million has been placed in LBOs.
This shift in priorities has affected everyone looking for venture backing, even such well-known company builders as Conner. And it has been devastating to relatively obscure entrepreneurs in capital-intensive businesses built around technologies with which investors are unfamiliar. Moshe Alamaro, for one, spent the better part of two years trying to raise venture capital for Deshen International Inc., a Boston-area company formed to develop and manufacture movable electric-arc fertilizer plants. Using a long-neglected process discovered by Christian Birkeland and Samuel Eyde in 1903, the technology would allow the same equipment to manufacture fertilizer in, say, Canada during the summer and the midwestern United States during the winter -- thereby taking advantage of electricity available at off-peak rates. Alamaro is now seeking his funding from companies he sees as the natural beneficiaries of his venture's success: the utilities that would be able to sell their excess capacity, the engineering firms that might build his systems, and so forth. "I don't think venture capital firms are very venturesome anymore," he says. "They've gotten to be like banks."
But changing fashions in venture capital are not the only forces driving the trend toward natural partnerships, nor even the most important. Perhaps the greatest impetus has come from new attitudes in corporate America -- notably, the discrediting of the once-prevalent notion that big companies produce virtually all the major technological breakthroughs. These days, Fortune 500 companies regularly seek the assistance of smaller businesses in developing new technologies and products. Even the proudest of the giants, IBM, has invested in such small companies as Wisconsin-based Supercomputer Systems. Other big companies known for start-up investing include 3M, Corning Glass, Analog Devices, and Digital Equipment.
"The not-invented-here syndrome is not that common anymore," says Arthur L. Rosenthal, vice-president of research and development for Davol Inc., a subsidiary of C. R. Bard Inc., a Fortune 500 company with several small-company alliances. "Fifteen years ago you didn't see so many of these small, technically advanced firms. Now, they're of major importance."
At the same time, big companies have grown more sophisticated and focused in their investing. Through a pro-cess of trial and error, a growing number have learned that the best policy is to invest in start-ups whose technology or service fits into the larger company's core business.
Consider San Francisco-based McKesson Corp., the nation's largest distributor of such nondurable goods as pharmaceuticals and general merchandise. David Malmberg, the company's director of strategic planning and new technology, readily admits that McKesson took several disastrous turns with start-ups in fields outside its area of expertise. "We were making investments all over -- we'd look at anything," he says. "Nuclear technologies, software companies. It was ridiculous. We had no business in these areas. But it was the popular thing to do, and we were riding the crest of the wave. Then, all too often [the companies] just went south."
Chastened by the experience, McKesson now puts all investment decisions through a screen designed to filter out deals unrelated to its core distribution business. One company that passed the test is a Hayward, Calif., software house developing a computerized warehousing system -- a product with obvious benefits for the $7-billion distributor. McKesson also decided to invest in Slzrco (pronounced seltzer-co) Partners, a seltzer company in Monrovia, Calif. That deal, however, took an unexpected turn.
In the early 1980s Rich Hagan, a disabled Vietnam veteran, founded Golden Gate Bottling Co. His idea was to sell old-fashioned seltzer in glass bottles with siphons attached. Hagan bought tooling from an old siphon manufacturer in the Bronx, N.Y., collected glass seltzer bottles from around the country, and went into business. Before long, he realized that he would have to come up with new forms of packaging if the business was to expand. So Hagan teamed up with several investors to launch Slzrco Partners and went to work developing a plastic siphon for use with plastic bottles.
Although Hagan solved the technical problems, he quickly ran into financial ones and began approaching venture capitalists. "They liked the idea and were intrigued by the product," Hagan recalls. "But [at the time] they invested in high tech. I guess this didn't qualify."
In 1983 a venture capitalist introduced Hagan to Malmberg. At the time, McKesson was already involved in the bottled-water business through its Alhambra subsidiary in northern California and its Sparkletts subsidiary in southern California. Clearly, Hagan's seltzer concept fit in. "The venture people couldn't understand anything that didn't have a microprocessor," Malmberg says, "but when I took the idea to our water people, they said, 'Gee, this is great.' They thought the product had a lot of potential."
Hagan and McKesson's representatives sat down to negotiate a partnership. As they talked, Hagan began to realize that he might want more from McKesson than he had thought. Not only did the company possess a huge distribution network; it could also afford to build the manufacturing facilities needed to commercialize Hagan's breakthrough. (Some of the plastic molds for the process cost $250,000 each.) "I came to the realization that all this was beyond my capabilities," Hagan says. "I knew my limitations. That's a problem for a lot of entrepreneurs, but there comes a point where you have to give to get."
So Hagan decided to sell the patent for his technology to McKesson, which provided him with a lucrative consulting contract and a royalty. Even so, he views the deal as a kind of partnership. "Although I get paid through a large corporation, I still feel like an entrepreneur," says Hagan, who heads up the technical part of the effort. He points with pride to the new state-of-the-art Bay Area factory just built by McKesson for the national rollout of his seltzer product. "They are fulfilling my dream, after all -- which is to see that product on the shelf."
Hagan is not alone in finding that big-company partners often provide more assistance to a start-up than traditional venture investors. Nor does the younger company have to be acquired to get it. By the very nature of the deal, Finis Conner says, such alliances force a start-up to concentrate its efforts in a more realistic and more businesslike way.
That's because new companies usually develop a product first and then scurry around looking for customers. All too often it turns out that the product -- no matter how elegant in design -- never had a market in the real world. An alliance turns the process around. "When you build the product with a customer, it's a totally different experience," Conner says. "You don't build for your own fancy, but for a real need. It greatly reduces all your risks."
Compaq's real needs certainly helped determine the initial product design for Conner Peripherals. The two companies worked closely on developing the new disk drive for almost 10 months. Along the way, Conner Peripherals changed the drive's interface. Instead of a product oriented to high-end workstations, the company ended up making one geared to the IBM-AT standard preferred by Compaq and other IBM-compatible makers. In addition, Compaq's engineers helped guide the manufacturing process, alerting their counterparts at Conner Peripherals to the problems that had plagued other drives Compaq had purchased, and making sure that the problems were solved. "Usually, you just keep walking down a road until you fall into a ditch," says John Squires, executive vice-president of research and development at Conner Peripherals. "The Compaq people told us where the ditches were and helped us avoid them. It wasn't just a matter of building a good drive, but of building one that would work in the real world for a real customer."
By the same token, the partnership also provided Conner Peripherals with instant credibility in the marketplace. "It made us very visible," Conner says. "It showed that we were at the cutting edge. Normally, it's hard to convince companies, particularly large ones, to go along with a new company. The Compaq connection eased the way for us." It did indeed. Today Compaq accounts for 47% of all Conner Peripherals's sales, with the balance coming from such major corporations as Toshiba, Zenith, NEC, and Olivetti. Some of these have also established special relationships with Conner Peripherals, whereby the larger company's engineers work with Conner's people to design customized products.
All this has, of course, produced enormous financial benefits for Conner Peripherals. According to senior vice-president and chief financial officer Carl Neun, its marketing costs are 2% of sales, less than half the industry average. By going with an IBM-AT interface, the company avoided making a substantial investment in the wrong kind of tooling and inventory, and it was able to cut other manufacturing costs as well. As a result, every $1 invested in its factories in San Jose, Singapore, and Italy can generate about $25 in revenue, according to Neun. By comparison, other companies typically make $5 to $10 in revenues per $1 of plant and equipment.
"Partnerships allow you to become very focused in your work," says Neun. "When you're working with your customer, rather than merely selling him, you know where you want to go. It gives you a predictability of demand -- something that usually doesn't happen to a new company."
The obvious benefits are not enough to ensure the success of a partnership. Besides having complementary interests, the two organizations must be able to work closely, avoiding conflicts over corporate culture or strategy. That proved relatively easy for Conner Peripherals and Compaq, both of which are entrepreneurial companies controlled by product-oriented engineers. Perhaps more important, the CEOs were longtime acquaintances with deep mutual respect. "We are as different as night and day," Conner says of Canion. "He's calm and secure, and I kind of do my thing by sheer energy. But Rod and I understand each other."
A partnership can succeed without such a bond between the CEOs, but it is essential that the key people on both sides have a common commitment. Just ask Arthur Lacerte, founder and CEO of Basic Computer Systems Inc., a $2-million software company in Anaheim, Calif.
A Canadian and a former Big Eight accountant, Lacerte had built Basic into a successful niche player, targeting such markets as advertising agencies and office-product dealers. In 1982 he approached United Stationers Inc., a large Chicago-based wholesaler of office supplies and equipment that was interested in selling and supporting his office-product software.
The proposed deal had the elements of a good alliance. Basic would supply the technology; United Stationers would provide both name recognition and, with more than 100 salespeople and extensive contacts nationwide, a huge marketing boost. In addition, Lacerte enjoyed a good relationship with the top management at United Stationers. Unfortunately, that wasn't enough. "Top management thought [the software program] was important, and the salespeople were champing at the bit, but the key managers were overly cautious and bureaucratic," Lacerte says. "There were lots of meetings, and they'd be here for days, but nothing happened." In the end, the alliance failed to generate more than a fraction of the projected sales. Lacerte says he gave up, selling the software package to United Stationers for about $600,000.
This experience, along with several other abortive alliances, has left Lacerte skeptical of such deals between small and large companies. "The big problem is the lack of control," he says. "You are completely dependent on the quality of the people the large company dedicates to the project. There's not much small companies can do to influence that. They just don't have the resources, and they aren't prepared for the bureaucracy. That just kills you."
Indeed, small companies cannot do much to influence their big-company partners, and that often leads to lost sleep, as Jack Taylor discovered in March. Taylor is cofounder and vice-president of marketing for Brier Technology, a start-up making high-capacity floppy disk drives that has a partnership with Irwin Magnetic Systems Inc., a major manufacturer of computer-backup tape drives. All went well with the partnership until Taylor woke up one morning to discover Irwin had been sold to one of its competitors. Now, he doesn't know what to expect. "The crazy thing is that we have no idea whether this is a positive, negative, or indifferent development," he says. "I guess it's all part of the risk you take in working with someone else. It's the background you have to live with."
Despite such disadvantages and risks, we are likely to see more natural partnerships as time goes on, and not only because of domestic factors. In the long term, the value of such alliances may lie in their ability to help U.S. companies compete more effectively in international markets.
That could prove to be a strong incentive. As adept as U.S. entrepreneurs have been at bringing new technologies to market, they have regularly stumbled in developing their manufacturing and distribution capabilities. Large U.S. companies, on the other hand, have generally shown themselves to be far less proficient at commercializing technology -- even their own -- than their counterparts in Japan, Germany, and other industrialized countries. In marrying the strengths of large and small companies, natural partnerships just might give foreign competitors a run for their money.
From that perspective, such alliances offer U.S. companies some of the benefits of the traditional Japanese system, which links a host of small, often dynamic companies with the resources of a giant one. "But this is a refinement of what the Japanese do," notes Mark L. Radtke, vice-president of Venture Economics Inc. "Corporate people here know they can't dominate, or the small-company people will leave with their technological expertise and their knowledge of the market. Corporate people also know they need the technology to stay ahead. For them, the alliance with the smaller company is the way out."
Just how international competitive pressures might foster natural partnerships can be seen in the linkup between Cray Research Inc., the world's leading supercomputer maker, and GigaBit Logic Inc., a semiconductor manufacturer located in Newbury Park, Calif. Founded in 1981, GigaBit was the nation's first producer of gallium-arsenide computer chips, which it supplied to Cray, among others. But in 1986 GigaBit ran into serious cash problems, and that spelled trouble for Cray. If it lost GigaBit as a source, it would be forced to rely on other suppliers -- many of them connected to its competitors -- for essential components in its new Cray 3 line of supercomputers. Rather than run such a risk, Cray bought a 15% interest in GigaBit, a deal that helped attract other investors as well.
"The attitude of major users has changed: in 1984 they didn't care where the chips came from. Now, they've seen what happened in memory chips and the dangers of relying on the Japanese," says John Heightley, CEO of GigaBit, which made roughly 70% of its sales last year to Cray. "For a company like Cray, it's crazy to depend on Japanese companies that are also potential competitors."
The same logic led Brier Technology, the disk-drive start-up, to form a partnership with Intelligent Systems, a Norcross, Ga.-based electronics conglomerate. "When Brier needs something from the Japanese, they can get it from us instead," says Leland Strange, president of Intelligent Systems, which also owns Quadram, a computer-board manufacturer, and Datavue Corp., a laptop-computer company. "Sure, the Japanese could have helped them a lot, but this way the technology and hopefully more of the manufacturing can remain here in the States."
Similarly, Insite Peripherals Inc., another disk-drive start-up, has sought the backing of stronger U.S. companies as it prepares to go after the Japanese-dominated market. It has formed an alliance with Iomega Corp., which makes the Bernoulli Box, another kind of computer storage device. Iomega has a state-of-the-art manufacturing center in Roy, Utah, where it will manufacture Insite's drives under the terms of the agreement. "We lost this industry to the Japanese the first time because we weren't paying attention to quality manufacturing," Insite president Jim Adkisson says. "Now, with the new technology we developed, we have a second chance. But we can't do it alone as a start-up. We need partners to make it happen."
It is probably this sense of partnership -- of teaming up to go after a common goal -- that is driving the trend. Most young companies, after all, would prefer to work with an investor concerned with long-term product development and corporate strategy rather than one interested mainly in cashing out at a decent multiple. "Working with a real partner on real products changes everything," Finis Conner says. "With this kind of alliance, you don't run wild. You don't run for the short-term killing. You run it for the long run, for yourself and your partner. And that's how it should be."* * *
Research assistance was provided by Elizabeth Conlin.
CONNER PERIPHERALS INC.
Headquarters San Jose, Calif.
Type of business Disk-drive maker
Founded June 1985
Date of partnership June 1986
Revenues at time of partnership $0
Relation to partner Supplier
Purpose of deal Start-up funding
COMPAQ COMPUTER CORP.
Type of business Personal computer manufacturer
Revenues at time of partnership $625 million (FY 1986)
Relation to partner Customer
Purpose of deal Source of advanced disk drives
Headquarters Monrovia, Calif.
Type of business Seltzer-water bottler
Date of partnership June 1984
Revenues at time of partnership $0
Purpose of deal R&D funding
Headquarters San Francisco
Type of business Wholesale/distributor
Revenues at time of partnership $4.3 billion (FY 1984)
Relation to partner R&D partner
Purpose of deal To capture sparkling-water market share
GIGABIT LOGIC INC.
Headquarters Newbury Park, Calif.
Type of business Semiconductor manufacturer
Date of partnership April 1987
Revenues at time of partnership Not available
Relation to partner Supplier
Purpose of deal Equity investment
CRAY RESEARCH INC.
Type of business Supercomputer manufacturer
Revenues at time of partnership $687 million (FY 1987)
Relation to partner Customer
Purpose of deal To ensure supply of gallium-arsenide chips
THE STRUCTURE OF A DEAL
The Compaq-Conner Peripherals 'natural partnership'
The natural partnership between Compaq Computer Corp. and Conner Peripherals Inc. was always about more than money, but money certainly played a role. Under the terms of the 1986 deal, Compaq received 49% of Conner's stock for two $6-million investments. Equally important to both companies was the joint-development agreement, which outlined how they would work together on the new disk drives. Using software microcode instead of mechanical parts, the new drives proved easier to customize, cheaper to build, simpler to test, and more reliable than previous models. So happy was Compaq with the results that it accounted for 89% of Conner's sales in 1987, its first year of production.
That was a mixed blessing for Conner. The danger was that other potential customers would be scared off, undermining Conner's ability to establish itself as an independent company. "There was concern about the Compaq share of the company," Conner admits. "It was hard to convince [our other customers]. We were lucky that no one else had a drive with our format."
But both Compaq and Conner were determined to avoid a subservient, Japanese-style subcontractor relationship and took steps to allay the fears of other potential customers. Although Compaq initially had directors on Conner's board, a strong legal agreement ensured that Compaq would not have access to sensitive information picked up in negotiations with other potential customers, many of whom are Compaq's direct competitors. (The board members from Compaq have since resigned from their Conner seats.)
With Rod Canion's approval, Conner worked hard to diminish Compaq's stake in the company. In that, ironically, he got help from venture capitalists, who responded to the company's first-year success by offering money on terms that Conner and his team found acceptable. In August 1987 a group of venture firms put $27.5 million into the company. In April 1988 the company went public, raising an additional $42.5 million through stock sales. In the process, the Compaq share of the company dropped to 41%. Yet Compaq still plays a crucial role in preventing the kind of venture capital domination feared by Conner. With about 20% of the company in the hands of employees and officers, institutional venture funds now own less than one-fifth of the stock.
Meanwhile, Compaq's share of Conner's production dropped to 47% in 1988, as concerns of other customers abated. Among Conner's major customers are such fierce Compaq competitors as NEC, Zenith, Toshiba, and Olivetti. Several of them also have product-development deals with Conner, and Olivetti has a European-based joint venture. "We believe in fathering products with customers," Conner says. "So these alliances will continue to make sense for us, even as we grow into a larger and more independent company."
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