Alternative Exit Strategies for Emerging Semiconductor Companies
Sanjay Krishnan, Consultant, Keystone Strategy
Investment requirements for semiconductor companies are
steadily escalating. Capital-intensive foundry investment often
requires large company backing and government incentives,
while fabless companies require funding of $25 million to $100
million or more and up to five years to develop and execute a cutting-edge
chip design.
Additionally, as emerging semiconductor companies grow, they
often reach a stage when the need to expand business operations
surpasses the investment owners are able or willing to provide. In
other cases, owners may need to sell their stake in exchange for cash
or other more liquid assets.
Yet despite escalating needs, changes to the funding and exit
strategies of these companies have been insubstantial, with venture
capital (i.e., "multiple-round" funding), initial public offering (IPO)
and acquisition being the most prevalent options. This suits many
emerging semiconductor companies since they are typically fabless
and structured as corporations with equity investment from venture
capitalists or "sweat equity" from the founders and management
team.
However, alternate exit strategies are gaining more interest, as
semiconductor IPOs do not attract the valuation multiples of the
boom years, and potential acquirers have become reluctant to make
large capital allocations to acquisitions in emerging technologies.
Common Strategies
IPO
Most often, IPOs are offered during stock market peaks when
business valuations are high and capital market sentiment bullish.
This allows the company to sell at a higher selling price, consequently
raising more funds.
An analysis of the correlation between the annual average of the
NASDAQ composite index and total value of venture-backed U.S.
IPO offerings (Figure 1) shows that more capital is raised during
such peaks. Consequently, high valuations may justify an IPO exit
independent of a company's funding needs. Under the Securities
Act of 1933 temporary restrictions may be placed on the exchange
of shares, but the establishment of a market for company shares
provides investors with the liquidity required for an exit.
Figure 1. U.S. IPO Market Value and NASDAQ Composite Index
1990-2009
Acquisition
Acquisitions revolve around intellectual property (IP) rights,
the engineering team and end-market knowledge. As such, a
semiconductor product company is naturally attractive to the systems
companies or original equipment manufacturers (OEMs) it serves.
For the buyer, the asset being purchased represents a product or
capability that would have been difficult to build and may serve as a
competitive advantage by blocking a rival's access to technology. For
the seller, the acquisition circumvents a lack of financing and offers
venture capitalists a return on investment.
However, only a small set of potential buyers has the need,
the capital and the willingness to make these types of purchases.
Furthermore, the semiconductor supply chain is becoming
increasingly compartmentalized, leading to systems companies
that have no interest in acquiring the capabilities of semiconductor
companies.
Consequently, the average value of venture-backed acquisition
deals varies. For semiconductors, the average value has remained
close to $50 million through the last decade. With the recent decline
in average acquisition deal size, an exit through acquisition is less
favorable for a traditional semiconductor start-up.
Either or
When considering an IPO or acquisition, it is important to note the
correlation between the number and value of IPOs and acquisitions.
In Figure 2, the negative correlation between the number of venture-backed
semiconductor acquisition exits and their mean value
demonstrates the buyer's market power. In Figure 3, the positive
correlation between the number of IPOs and their mean value
indicates the seller's ability to set a more favorable price.
Figure 2. Number of Semiconductor Acquisitions Compared to Average Acquisition Value
Source: NVCA 2010 yearbook
Figure 3. Number of Semiconductor IPOs Compared to Average IPO Value
Source: NVCA 2010 yearbook
While a successful IPO requires a large revenue base, acquisitions
are more concerned with high revenue growth rates. Ultimately, the
choice of exit strategy is guided by this implicit difference.
Alternative Strategies
Venture Debt
Most fabless companies take on debt at some point, either as venture
debt or financed receivables. This trend can be traced back to the dot-com
bubble in 2000, after which the major foundries have required
payment in advance for wafers, while systems customers typically pay
30-60 days after receipt of the chips. This arrangement can cause cash
flow problems for a growing start-up.
Venture debt is a form of loan for emerging companies without
positive cash flow. Typically, banks are reluctant to venture into
these loans, hence the name. With venture debt, the lender requires
a warrant (typically 3-10 percent of the value of the loan), which
allows them equity participation in any potential upside from the
investment. This type of financing is more common in Wall Street
transactions, such as Warren Buffett's $5 billion preferred share
investment in Goldman Sachs in 2008.
For semiconductor companies, venture debt can fill the need for
cash; however, it will not provide an exit strategy for the original
equity investors. In fact, they will experience some dilution from the
exercise of the warrants that were issued to the lenders.
Buyout
A management buyout occurs when the management team buys
company shares from current majority owners. The resulting
governance structure of owner-managers provides an alignment of
interests and incentives, creating a partnership. An owner-manager
business structure is quite rare in the semiconductor industry, due to
the large scale and long payback period of the up-front investment.
Additionally, management in a venture-backed semiconductor
company usually possesses a small percentage of ownership, and
would find it difficult to raise the necessary capital to execute a
buyout.
Large semiconductor buyouts led by private equity firms
have occurred in the last decade (e.g., Freescale and NXP). These
deals provided exits to corporate owners who no longer wanted
semiconductor businesses in their portfolios, as with Motorola and
Phillips, respectively. However, these leveraged buyouts are usually
unattainable for small chip companies.
Sellout
Management-owned fabless semiconductor companies do exist.
A chip business that has a revenue stream and is cash flow positive
from inception (the dream of many a start-up) could be 100 percent
employee-owned.
In pursuit of this goal, fabless chip companies often start as design
services companies with the intention of moving into product areas
once they grow. Thus far, the track record for this type of transition
has not been encouraging since the demands of design services tend
to consume all available engineering time.
In these situations, an owner of an employee-owned company
may find selling his or her share to the other owners to be the best
option for an exit.
Conclusion
From the entrepreneur's point of view, building a strong company with a
clear focus and selecting good management and compatible
investors takes precedence over planning for an exit. The stronger
and more successful a company is, the smoother the exit process will
be.
Nevertheless, due to the nature of new technology venture
investments, many owners do not recoup their investment;
however, knowing the risks and planning for contingencies remains
a good business practice. By considering alternative strategies,
semiconductor shareholders increase their odds of cashing in or out
successfully.
Acknowledgements
The author would like to thank Rich Redelfs, general partner at Foundation
Capital, for his generous assistance in providing a unique perspective as former
chief executive officer of Atheros and as a venture capitalist partner. His personal
commitment of time and energy is a rare, valuable and appreciated resource.
About the Author
Sanjay Krishnan is the U.S. chair of GSA's Analog/Mixed-Signal Working Group.
He is a consultant in the semiconductor practice of Keystone Strategy. He advises
semiconductor companies and government policy bodies on ecosystem strategies for
sustainable, value-creating partnerships. He can be reached at sanjay_krishnan@mba.berkeley.edu or 650-485-1776.
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