News and New Products

Special Report: Private equity and the new exit strategies

By Ed Sperling -- Electronic News, 1/26/2007

First of two parts: Electronic News/Electronic Business sat down with Ray Bingham, managing director of General Atlantic, a private equity firm; Jim Hogan, a private venture capitalist; Rajeev Madhavan, chairman and CEO of Magma Design Automation; and Faysal Sohail, managing director of CMEA ventures. What follows are excerpts of that conversation.

Q: Private equity still carries the reputation of ‘Barbarians at the Gate,’ where leveraged buyout firms bought up companies in the 1980s, stripped them down and sold them for maximum profit. Has anything changed?
Bingham: Private equity describes a very broad layer of capital markets. In the old LBO model, the only tool was financial restructuring. Private equity describes a lot more than that. The LBO guys of the ’80s and ’90s—the barbarians at the gate—used a crude financial tool. They hacked costs out, got rid of slow-moving management, but largely they didn’t lead with renovating the business. They were simply removing corporate sludge and then re-spinning the businesses back into corporate markets or refinancing the EBITDA (earnings before interest, taxes, depreciation and amortization) they were liberating by cutting these costs out. We view ourselves as growth equity players. We use a very significant range of financial tools to obtain an interest in a company to take advantage of what we see as an inflection point or an opportunity in a technical market. Those tools might include a buyout, public or private, or a buyout of a division of a public company or the buyout of a private company that’s in need of some kind of capital, energy or new alignment in the marketplace. It always starts with a strategic proposition rather than just dropping more money to the bottom line.
Hogan: At these inflection points, there’s also an opportunity to do some aggregation of these private assets that you can’t do in a public company.

Q: It doesn’t look like there are many new public companies coming, right?
Bingham: It used to be that if you could get together $10 million or $20 million in revenue and a promise of profitability you could do an IPO. Today, even if you could, you probably don’t want to do it because all the money you drop to the bottom line would be used up in SarbOx (Sarbanes-Oxley reporting). With the sale of Freescale for $18 billion to Blackstone, a consortium of buyout guys, there’s not any indication that they led with the notion of gutting the company of costs. Even though they’re playing with very big chess pieces, their grand idea is that if you take a look at the IDMs (integrated device manufacturers] left in North America and Europe, there could be a very interesting realignment of product groupings within those companies to create stronger IDMs. Once they are free of public markets, they could create a strong consumer markets company, a strong wireless company and a strong automotive electronics company.
Madhavan: Aggregation is made much easier by going private. That helps with what some of these companies have acquired during the Internet boom. They have lots of businesses that may not make sense. As the semi industry matures, it’s easy to get that kind of alignment of businesses being strong in certain segments.
Hogan: In the EDA industry, which is one we’re all familiar with, if you go private you can mess with the business model a little bit. You don’t have to accept the business model that’s in place. You may be able to hold pricing stronger, you don’t have the quarterly pressure, and you can push deals a little harder.
Madhavan: Going public in EDA is a stupid idea when you’ve spent this much on SOX and the new regulations. The number of companies that will go public as a result of that will come down a lot, and even the other ones that are public should look at this as an opportunity. If I was doing a new startup today, I wouldn’t make going public the exit. It’s just the wrong strategy.
Bingham: It’s just one possible exit today. Years ago, it was nirvana. It was what you were working for. You didn’t think about getting bought or merging. Today there are a number of outcomes that are available—good financial outcomes as well as good realization of technology.

Q: So are IPOs dead?
Hogan: Yes, the IPO market is dead.
Sohail: I don’t think they’re dead, but I think the bar is much higher. Twenty million dollars [in revenue] will no longer do it. You can raise capital. If it involves liquidity, it’s going to go more and more toward large platform plays. Magma was certainly the last large platform play. In the past, you were seeing that even on point tools, and that’s dead. If you can run it like an LLC (limited liability company), that’s a great way to do it.
Madhavan: Back in the day when I was looking at an LLC—basically a mom and pop shop—it looked like a very ugly model. With respect to Magma, we were lucky. If it had been 18 months later, things would have been very different. There’s a luck element and a timing element.
Sohail: There’s an ROI element, too.
Hogan: Every Rolling Stones tour is $1 billion. Every one of those is an LLC.
Bingham: That’s a great example. When you’re building your company, you need to decide whether you’re building technology or you’re building a platform. The attributes, the investment, the capital and the people you assemble with each of those is different. With a Rolling Stones concert, nobody has expectations beyond the liquidity of the concert. If I’m building a point tool, I have to be clear that it’s a point tool and why should I invest in the infrastructure? A credit is due to Magma. What they were building was organized as a company. They recognized the market was looking for a platform. It was a platform that you could expand, you could plug point tools into, you could do the kinds of things that we were trying to do at Cadence or others were trying to do at Synopsys. It was something the market was willing to engage with. The point tools the customers were not willing to engage sufficiently with.

Q: Is the EDA market different?
Madhavan: What’s unique about EDA is a bunch of guys with a great algorithm building a point tool. But they need to do a different model. If they take a lot of VC money, expectations are unrealistic. They need to build it in such a fashion that they can integrate with some of these platforms and sell at a very good valuation. That’s a very entrepreneurial makeup.
Sohail: The biggest problem in EDA is that a lot of those point tool ideas have gotten big venture money. That makes it hard for a profitable exit.
Madhavan: I was talking to someone the other day whose company has about $15 million revenue, has raised $20 million more, and he was proud that the valuation of the company was $100 million. To me that valuation has killed their exit completely. It’s a fatal flaw.
Hogan: For a point tool company, the economics are such that you better not raise more than $6 million to $8 million and you’d better be in the low teens in terms of valuation. Then you can get a decent exit.
Sohail: If you raise $5 million, you get out at $50 million. If you raise $10 million, you get out at $100 million. That’s a wonderful exit, but you have to solve a critical problem three years ahead. It takes you two years to get to beta, three years to get to an FCS. You have to see the problem three years ahead and nail it—and not spend $20 million.

Q: Will companies start going public on different exchanges?
Sohail: That’s already happening. You can go public today. You can raise less money, but if you’re a small company—sub-$20 million—it is not an issue. But it’s going to take you a little longer to get to liquidity. It’s not like Nasdaq where you go public and six months later you have full liquidity.
Madhavan: Short-term there are those markets, but longer term these markets and their rules are following Sarbanes Oxley and other things. Whether they are right is a different argument, but they are being forced to follow the rules.
Hogan: It’s in the United States’ best interest not to give up that market. It will adjust.
Bingham: As investors, entrepreneurs and business people, you have to go back and ask why you’re going public. Going public is raising capital. Why are you raising capital? To give someone a payday as an entrepreneur? If so, then be careful what you wish for. And there might be better ways to achieve that liquidity that don’t come with the tail that public ownership does.
Sohail: We’re starting to buy out some of the entrepreneurs or buy out part of their stake. Liquidity is in question and it’s been six years. They need a couple million dollars in their pocket. We’re happy to buy out their shares and increase our ownership.
Madhavan: A lot of companies in EDA are happy with a $20 million to $30 million exit. In order for them to make money they have to be either at the less than teens (millions) investment. A $100 million exit will be difficult in EDA.
Hogan: Today there’s only an ‘A’ round. There isn’t a ‘B’ round.

Q: So there are four options, according to what you’ve all said. You can go public when you hit that threshold, you can go public in a different market at a lower threshold, you can be acquired or you can take advantage of private equity.
Sohail: The big LBO, private equity guys are coming down, and the big venture guys are going up. The venture guys are raising $1 billion to $2 billion. They’re looking at the aggregation strategy.

Q: But something fundamental has changed. The startups were started by engineers. Financial experts don’t look at things the same way. How has that changed the dynamics of the exit strategy?
Hogan: Engineers get an idea and go off and build technology. It’s rare that they say they’re going to build a platform. That hasn’t changed.
Madhavan: If I’m doing startups today I would be doing something more like Ambit than Magma. Ambit was a bootstrap. It wasn’t a complete mom-and-pop shop, but that’s how we ran it. The economy now is similar to what it was then. The whole game was, ‘I have a better mousetrap than Synopsys.’ Today the valuation won’t be as high, so you have to keep your costs down, and there’s no way to build that channel.
Sohail: In EDA today, we see analog/mixed signal as a clear opportunity. Customers are clamoring for better tools. We clearly see in the whole yield space, 30 startups all tackling the same issue. There’s clearly a need for a new platform in that area. Nobody has it.
Madhavan: I disagree. DFM is design for marketing. There is not a market on its own. There is no such thing. It will be part of the Cadence tools, the Magma tools, the Synopsys tools and the Mentor tools. In that, we may have assets that came from company A, company B and company C.
Sohail: I totally disagree. This fundamentally changes the problems that are coming up. It may end up in one of those companies, but it will be a different way of designing than is being done today once you get down to 45 nanometers.
Madhavan: Conservatively, though, more than $150 million in venture funding has been raised in DFM. The VCs are going to lose a lot of money.
Bingham: You can approach the problems of DFM or power or mixed signal as a point solution, in which case you organize your investment around that. If you do it right, you can make a lot of money. Or you can approach it as a leverage point to change the market and become the new platform. That’s a different strategy. Both can be successful. I think the odds on each are different. You can hit a lot of singles or you can swing for the fences. But they’re very different investment and engineering strategies, and they each require a different kind of team, including an investment team.

For the second part of this special report, click here.