About two and a half years ago, the founders of Sytek Inc., a young consulting firm in Mountain View, Calif., gave some well-known venture capitalists a look at their ambitious plan: They wanted to move from consulting to manufacturing. Specifically, they wanted to manufacture local-area networking systems -- both hardware and software -- which would allow large companies to transmit data, voice, and video to multiple facilities.They had already built prototypes, using profits from the $2.5-million consulting business. But finding the money to make and market the new products would be another matter. "At a minimum," says Sytek president and chief executive officer Michael S. Pliner, "we needed about $8 million to $10 million. There was no way we could come up with that kind of money without major outside investment."
As it happened, major outside investment was available from such discerning venture capitalists as Hambrecht & Quist of San Francisco and Continental Illinois Venture Corp. of Chicago, both of which appeared ready to ante up the necessary equity. Says the 37-year-old Pliner, "They were willing to pay a price which we found entirely acceptable."
But, in the end, the company went elsewhere for the capital -- to General Instrument Corp., a New York City -- based company with a commanding presence in the cable TV equipment business and a keen interest in Sytek's communications expertise.
The financial terms of the General Instrument deal, says Pliner, were substantially the same as those offered by the venture capitalists. General Instrument, a company with annual sales in the $900-million range, agreed to provide Sytek with an initial investment of about $9 million. In return, General Instrument would obtain about 37% of Sytek's equity and rights to buy more. Yet even if the money was the same, the Sytek founders saw other possible benefits in hooking up with a known supplier of cable TV equipment. Sytek's networking systems rely heavily on cable TV technology, an area in which General Instrument is an acknowledged leader. "We had no interest in being folded into General Instrument and we told them that up front," says Pliner. "But we viewed General Instrument as the IBM of the cable industry. Besides money, we thought it could add value to a lot of the things we wanted to accomplish."
To be sure, Sytek is not the first small company to obtain capital from a well-heeled corporation. During the 1970s, many large companies -- including Exxon, Xerox, and General Electric -- entered the venture capital arena with buckets of cash and high expectations. By and large, the giants were interested in forming relationships that could give them "windows" on new technologies Some also hoped to find diversification opportunities by investing in and, later on, acquiring the more promising businesses in their portfolios.
General Instrument, however, launched its investment program in 1981 with more limited aims. "We found that most of the big companies which had moved into venture capital were failing badly at meeting their goals," explains vice-president Frank Sterling. "Most of them were such large and complex organizations that they couldn't find ways to bring the benefits home." Moreover, corporate investors often tried to monitor their investments too closely, triggering management defections that undermined their overall goals.
In light of these experiences, General Instrument chose a different approach. Rather than going out on a shopping spree for acquisition candidates, Sterling says, "we decided to invest in companies which were doing things close to what we were doing in our own operations. That way, we'd have opportunities for commercial relationships which could bring benefits to both companies."
Sytek was the first major investment prospect General Instrument approached, and Pliner and his associates found the possibilities intriguing. "Traditional venture capitalists could have provided management support and same very good contacts," notes Pliner, "but they couldn't give us access to some of the things we knew we'd be needing." General Instrument could, for example, help Sytek provide customers all over the country with product maintenance and support services. In addition, recalls Pliner, "we felt that an affiliation with an equipment maker as well known as General Instrument could give us market credibility quickly."
On the other hand, Pliner and his cofounders worried that the relationship might force the company to abandon its entrepreneurial business style. In a data-communications market that was changing almost weekly, "we wanted the freedom to make quick decisions, and we worried about having to go through lengthy approvals," says Pliner. Aside from operating control, the Sytek executives wanted to retain their right to raise money in the future from other sources. "When the time was right," says Pliner, "we hoped to do an initial public offering."
Following preliminary talks on the West Coast, Pliner and Sytek chairman Jack Goldsmith flew to New York, where they discussed their worries with General Instrument's top management. They said that they wanted to control a majority of the seats on their company's board of directors. General Instrument could name two of the five directors and would be permitted to hike its equity interest from an initial level of 37% to 51% later on. But even if their stake reached that level, Pliner says, "we asked them to promise on paper that once our sales reached $25 million, we'd be free to go public." In addition, Sytek insisted that a 90% vote of shareholders be required on major issues -- "to insulate us from capricious decisions," says Goldsmith, and to prevent General Instrument from changing the company's basic direction or divesting its assets.
Such stipulations might have scared away other investors, but General Instrument's executives -- from the chairman on down -- agreed to them. They believed an attempt to drive a harder bargain might backfire. "We didn't want to muscle them into any agreement they weren't comfortable with," says Frank Sterling "We felt that the key to making the relationship work would be to let them run their own business. If we didn't do that, they wouldn't be happy. And we might end up with an empty shell."
A thick legal document was prepared, spelling out the finer points of the deal, but Pliner realized that no contract could be written to protect Sytek, or its management, completely. As a result, he and Goldsmith did extensive reference checks on General Instrument and its executives with business contacts and suppliers. "We had to believe in the credibility of the people," Pliner says, "And we wanted to make sure that their goals could be compatible with ours."
General Instrument's references checked out, and the deal went through Since then, Sytek has hammered out a series of other business deals with its new equity partner. Early in 1982, for example, the company arranged for General Instrument's data-systems division to provide Sytek customers with on-call repair service in about 60 cities. By setting up third-party maintenance through General Instrument, Sytek avoided the expense of building an operation of its own from scratch The ability to offer service is critical from a marketing perspective, notes Pliner, "but from a profitability standpoint, it's usually a loss leader."
A second deal involves a "multimillion dollar" contract with General Instrument's Jerrold Cable Division, under which Sytek will develop a more powerful local-area network system, called MetroNet. Unlike Sytek's current hardware- and software-based systems -- which are sold to corporations or universities interested in linking entire office complexes or campuses -- MetroNet is designed to operate on a citywide basis, from both homes and businesses, through cable TV facilities. According to the plans, both Sytek and General Instrument will be manufacturing components for the new systems, which will be sold jointly to cable operators.
In addition, discussions are under way on a manufacturing agreement that would make General Instrument a key supplier of electronic components to Sytek. By purchasing such items as circuit boards from General Instrument's offshore plants, Pliner says, "we hope to take some costs out of the products we sell in a competitive marketplace."
Clearly, these deals cover a lot of ground, but Pliner insists that each of them has been negotiated on an arm's length basis -- and only after Sytek has explored its other options. In any event, the complex relationship has been a smashing success -- judging from Sytek's overall growth that is. Since General Instrument's investment in late 1981, Sytek's sales have increased from about $2.5 million to more than $16.7 million for the year ended May 31, 1983. The number of employees, meanwhile, has surged from 75 to more than 250. "We've had all the benefits of being part of a larger company," says Pliner, "but we've been able to control our destiny and build an independent company."
Sytek's independence was especially evident last year, when the founders raised another $10 million through a private equity placement arranged by Hambrecht & Quist. Although some of the new money came from General Instrument (which upped its interest to 50.5%), most of it was raised from institutions, including the IBM pension fund and the University of Rochester's endowment fund. Nevertheless, Pliner indicates that an initial public offering may be necessary sometime in 1984, in order to raise capital for Sytek's product-development efforts in the years ahead. For this, Sytek has already obtained General Instrument's blessing.
Indeed, General Instrument's Sterling believes that his company will benefit handsomely from such a development. He also believes that General Instrument and Sytek will retain their commercial ties even after the financial stake is liquidated. "We'll be doing deals with Sytek just as long as they're of benefit to both companies," says Sterling.
Pliner, for his part, takes a similar view. "Only part of this relationship has been based on money. If money was all we wanted, we would have gone with the venture capitalists."