Spin Ins – A Strategic Opportunity for Venture Capital and Large Software Companies?

In my last blog entry, I asserted there has been a dearth of start-ups in the enterprise software market for at least the last 5 years. According to VentureSource, from a high of 506 enterprise-oriented software start-ups securing a Seed or Series A round in 2000, only 201 new enterprise-oriented software start-ups were funded in 2008 and the vast majority of those used a SaaS, PaaS, or IaaS business model. Very few traditional model enterprise-oriented software companies were funded at all, the notable exception being in enterprise search and analytics.

As a result, large software companies whose innovation/growth strategy has relied upon a steady stream of start-up company candidates to acquire may be faced with a shortage in the not-so-distant future. Consequently, companies that have traditionally relied upon their strategic software providers to deliver innovative new solutions to enable them to further optimize back office and front office operations will suffer. 

A Spin on the Spin In

Given the current issues associated with the traditional venture capital business model (e.g. lack of liquidity) and the fear to invest in enterprise software start ups, and the innovation/growth pressures that the large software brands are faced with I believe there is a unique opportunity for the venture community and the large software brands to come together.- using a modified version of the classic spin in.

For this discussion I am defining a spin in as a company formed with the explicit endorsement and investment – including personnel, cash and IP – by a large software company and venture investors. The express purpose of the spin in is to build strategic products and/or go after new markets with the ultimate objective that the large software company will acquire the spin in at some point in the future.

The concept is relatively straightforward and has been tried, tested and proven most successfully in high tech by Cisco but it has also been used by companies in other industries as well as the federal government. However, this approach has not typically been employed by software companies.

Why? Well, primarily because there hasn’t been any need. Large software companies have had the benefit for years of relying upon the venture community to finance a plethora of competitive software start-ups that identify new markets, create innovative technology, and secure customers.  Once some/most of the technical and business risk s are removed and the 2-3 leaders emerge, the large software companies have been able to approach these  ‘winners’ and acquire one of them either willingly or unwillingly. This process has been used successfully by many of the larger brands including, but not limited to: Computer Associates, IBM, McAfee, Microsoft, Oracle, SAP, and Symantec.

Another reason spin ins have not been utilized much by the software industry is due to the widespread ‘Not Invented Here’ (NIH) syndrome that most successful software companies express. The attitude is typically “we can do this better, faster, and cheaper ourselves.”

However, the facts tend to conflict with the attitude.  As companies grow, few really innovative products are started, completed, and successfully brought to market. Each year when the products organization and executive team sit down to consider all the proposed projects for the following year, there is a finite budget to distribute. A line is drawn and all the projects that fall below the line go unfunded. The projects that are usually funded are those that are the current mainstay of the company; the ones that are most likely to generate short-term product and maintenance revenue.

The dilemma is that those projects that fall below the funding line could very well be the innovation the company needs to thwart competition and secure and grow substantial future revenue streams. In addition, many of those proposed, unfunded projects may come from some of the most talented personnel in the company. When those projects don’t make the cut, the people associated with those projects can become extremely frustrated and threaten to, and often do, leave the company to ‘pursue other interests’. This can put a significant brain drain on the company.

The framework of the spin in structure I am proposing is different from the more traditional approach and it is my attempt to address the issues of each of the constituents involved: the large software company, the venture investor and the “spin in” management/employees. While there are some financial/structural problems associated with the spin in derivation I am proposing (there are no panaceas) I believe the benefits could far outweigh them.

Product Selection

The key to selecting a specific project/product as a candidate for a spin in is to ensure the product is strategic to the success of the large software company and that the market opportunity is large enough to support an independent entity.  A product idea that is just a feature of a larger product suite is not a suitable spin in candidate. Think of it this way, if it won’t pass a venture capital firm’s due diligence as a sizeable, standalone firm it isn’t a viable candidate as a spin in.   

Financial Structure

There are several important elements required to make a spin in a viable financial structure for the large software company, the investors, and the employees. Below is my proposed framework for such a structure.

Ownership

The first objective is to ensure the spin in’s financials are kept off the large software company’s books and preventing it from diluting the large software company’s earnings while the spin in grows to profitability. To achieve this, the large software company must pass an outside auditor’s scrutiny demonstrating it doesn’t possess a majority and/or controlling interest. Practically, this means the company must own less than 20% of the spin in and cannot have a formal seat on the Board of Directors.

This is why the large software company needs the venture community as a strategic partner. The large software company can own at most up to 20% so it cannot execute this on its own. The venture community is the ideal partner because it brings money and expertise in building start ups.  

For some large companies, the lack of majority control makes a spin in a non-starter because they don’t have formal control. However, ultimate control comes from the fact the spin in is going to be highly dependent upon working with the large company to gain access to its marketing and distribution channels.  Doing anything to jeopardize that is not in the financial interest of the spin in’s management team and venture investors.

To attract a world-class management team and employees, the spin in will need to allocate a minimum of 20%-25%.

Therefore, simple math suggests venture investors will own up to 60% of the spin in at its onset and may need to provide up to 100% of the forecasted cash requirements. The large software company can contribute any one or all of the following: IP, key employees, marketing programs, a ready-made distribution channel, and even cash to account for its percentage ownership position.

Collar

The primary difference between the spin in structure I am proposing and a traditional spin in is the use of a financial “collar”. It is this collar that can ensure the large software company, the venture investors and the management team are incented to make the spin in become a successful business.

The terms of the collar I am suggesting gives the large software company a call option. This option includes a “first right of refusal” to purchase the company at a pre-determined multiple of revenue for a pre-determined period of time, thereby protecting the large software company from having to compete to buy the spin in on the open market.  This is only fair since the spin in will require the large software company to provide a significant amount of marketing and distribution support.

To ensure the large software company remains interested in the success of the new entity over the long term, irrespective of potential market and regime changes, the venture investors hold a put option to sell the spin in back to the large software company at a certain point in time at a certain multiple of paid in capital.

The collar can be structured such that the management team and employees are incented to drive a range of increased valuation outcomes tied directly to revenue and expense objectives. For example, the call and put options can be set such that they don’t begin to run until year 5. This gives the management team the ability to drive the company’s revenues as high as they can to drive a higher multiple if the call option is executed. If the put option is executed, the management team and employees only receive 50% of their equity ownership which incents them to make the business as successful as they can. Both options can expire at the beginning of year 8 so that if the large software company or the venture investors don’t execute their option, the management team is free to operate thereafter.

Although it is beyond the scope of this article, I have put together a set of terms and models with a variety of outcomes that show how this modified spin in approach is financially attractive to the large software company, the venture investors and the management team.

Summary

Software innovation is still needed by the large software companies and enterprises. For all the reasons discussed, large software companies are not able to do much real innovation internally. For at least the past 5 years, the venture community with few exceptions hasn’t been willing to fund new start ups focused on traditional enterprise software. And, due to current macro-economic conditions, the venture community is struggling with its business model.  As a result, I believe the enterprise software innovation engine could slowly grind to a halt if the status quo remains. I believe there is a unique opportunity for both of these communities to partner using a modified spin in approach. While clearly requiring compromise by all parties involved the spin in could solve a number of key issues that could enable the enterprise software innovation cycle to thrive.

The potential benefits of a spin in approach for large software companies are:

  • Strategic projects that might not be funded because they are below the line are able to get funded.
  • The cost of development is carried off the parent company’s balance sheet until such point the product is in the market and generating revenue so it is potentially non-dilutive to corporate earnings.
  • The parent company is able to effectively retain key personnel by enabling them to exercise their entrepreneurial spirit.
  • The spin in retains some of the parent company ‘DNA’ so cultural issues that affect most acquisitions are minimized.
  •  The products that are developed can be managed such that they are architecturally consistent with the parent company’s products so there is little overhead integrating the “spin in” products.

 

 The benefits to the venture investors are:

  • They can be certain the technology and business being created are interesting to the large software company from the onset, so they can invest with some confidence that the start up will ultimately have value v the typical 9 out of 10 failure rate they normally experience.
  • While the upside will be capped, it his highly likely there will be a reasonably positive return within 5-8 years and therefore the investment will be accretive to the fund’s multiple and IRR.

 

The benefits to the entrepreneurs are:

  • You will be funded!
  • Lack of sales and marketing, not technology, is what typically kills most enterprise software companies. With a strategic investor/partner that is motivated to give you access to its customer base with a relevant offering this issue is mitigated.

I have shared this modified spin in concept with some executives at a few large software companies and I think I’ve heard all the reasons why it won’t work. However, as a former senior executive of a large software company, I haven’t yet heard anything to date that, with some work and compromise, makes the concept a non-starter.

So, I’m putting out a challenge to all those large enterprise software company CEOs and senior executives. Find that innovative project you’ve wanted get to market but for some reason just can’t get off the ground. I will share with you the full overview of this modified spin in model and why I believe it will work.

  • http://smoothspan.wordpress.com/ Bob Warfield

    Bruce, makes a lot of sense. I wrote this article the day before you published this proposal:

    http://smoothspan.wordpress.com/2009/05/15/why-do-so-many-big-companies-suck-at-innovation/

    I think the collar is also an interesting option for partnership agreements where no actual capital is raised but the parties want to go to market together.

    Cheers,

    BW

    • http://www.interwest.com Bruce Cleveland

      Bob: Great post! We are clearly on the same page!

  • Avanish Sahai

    Bruce – excellent post and I think a model whose time has come. Talk soon,
    Avanish

  • http://www.dealarchitect.typepad.com vinnie mirchandani

    Bruce, good to see your post on sandhill.com…I posted a commentary on my blog at

    http://dealarchitect.typepad.com/deal_architect/2009/05/software-spin-ins.html

  • Tim Negris

    Hi Bruce,

    Since I first became aware of it, I have really enjoyed your blog and have passed along a number of entries to some of my smarter inventor, analyst, and investor friends for their enjoyment, education or edification. But, this entry is the best so far – elegant, original and actionable; I will be circulating it widely.

    Best,

    Tim

  • http://www.prudentcloud.com Subraya Mallya

    Bruce
    This is such a fantastic concept. Especially the concept of collar. The main hurdles enterprise companies face is mitigated with the joint marketing efforts. On the flip side companies get to keep smart people by giving them opportunities to work on their strategic (and interesting) projects.

    Subraya Mallya

  • http://hiteshee.wordpress.com Hitesh Parashar

    Bruce:

    This is an interesting structure/approach. Did any brave soul come forward to try this out? I could see how this would be very useful in some situations if all the incentives are aligned properly.

    I agree with Bob that it would make a lot of sense to try it in a partnership situation too. For companies with a platform strategy it could make sense to seed the potential platform applications start-up partners funded using this approach.

    This blog post also reminds me of an author/entrepreneur I recently met – Jon Fisher. He advocates building companies (most relevant for enterprise software) with the end goal (a large software company as the exit) in mind. Your approach provides a good structure to what he calls strategic entrepreneurism.

    I am enjoying reading all your blog posts and spreading them to my network of SaaS entrepreneur friends.

    – Hitesh.

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