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Most discussions these days about the fate of early stage technology companies concern the difficulty they are having obtaining financing. The IPO (Initial Public Offering) window has closed for them, and angel investors and venture capitalists are making very few investments other than follow-ons in selected existing portfolio companies. Layoffs are being made, and expenses are being cut to the bone, by companies in an effort to reduce their cash “burn” rates and extend the time frame that available operating funds will keep the business afloat. This environment, where investment capital from more traditional sources is likely to be unavailable or may be offered only on unacceptable terms, has created a variety of opportunities for strategic investors to pursue creative deals with undercapitalized companies that have developed or are making progress toward developing valuable technologies. Established companies in relevant industries and individuals with specifically relevant technical or operating experience are seeking to pick up the pieces by identifying promising technologies and providing funding, commercial relationship support and management guidance — or by simply acquiring businesses or technical developments on the cheap. The transactions that are occurring in pursuit of these strategic opportunities are varied, and often must be creatively structured to satisfy the multiple constituencies of previous investors and management of the targeted developmental business. This article will highlight a few of the interesting trends and deals we are seeing in the strategic investment arena. NON-CORE ASSET SALES There is a wealth of under-performing technology assets in the marketplace which, in their present setting, will not reach their full potential for development. The reasons vary. In some cases, the technology is a non-core asset that management neglects in favor of its principal enterprise. In others, the company may lack the technical skills, cash or marketing know-how to complete development of a saleable product or to successfully market it. In these cases, there are opportunities for savvy strategic investors, particularly if they have strong operating experience or a relevant technical background, to pick off strategic technologies and complete development, re-launch the marketing program, or reposition the product. One strategy for underfunded companies is to dispose of non-core technology assets that are not critical to the central business mission on which the company is focusing. For many public companies, the analysts, investors or consultants have told management that a particular set of products or services have value and that they need to unload other divisions, subsidiaries or developmental technologies to focus their resources on the core business. The stock of these companies is frequently trading at levels that reflect a market capitalization (total value of the company) that is less than the cash on hand (the market does this when it believes the company will use up that cash more rapidly than it will earn profits). In the case of privately held companies, venture capitalists, nervous about plunging portfolio values, are demanding changes to speed the arrival of revenues and profits and have told management to slash the monthly “burn” rate of expenditures and focus on the sectors with the greatest chance of near-term success. This phenomenon has created potential for savvy strategic investors who can discern value in underutilized, underfunded or unsuccessfully marketed technologies. Strategic players with knowledge of current trends in specific segments of the software market are particularly advantaged here, as they will know how to improve and manage under-performing software developments. One company we represent is buying up software divisions from public and private companies disposing of non-core businesses. The prices are very favorable, given the primary motivations of the sellers to cut operating expenses and shed liabilities rather than to realize gains on investments. The principals of this strategic buyer have many years of line operating experience, which is crucial to distinguish value from hype. The buyer is trying to acquire compatible technologies to be managed under centralized administrative functions to produce improved margins, and is linking up with programmers in Eastern Europe to provide low-cost technical development. A castoff technology may well be commercially viable in the right hands. GOING PRIVATE TRANSACTIONS With the dot-com implosion in full force, numerous one-time high-flyers have seen their stock price fall below the $1 per share threshold necessary to stay listed on either the Nasdaq National Market or the SmallCap Market. Once delisted, the company’s stock is relegated to the Electronic Bulletin Board or, even worse, the “pink sheets” of over-the-counter trading. Delisting undermines the principal benefits of being public: since a delisted stock is virtually illiquid, the company loses most of its ability to use its shares to raise capital, acquire other companies, or motivate employees with stock options. Some companies will find it advantageous, either before a virtually certain delisting occurs or after, to remove the company from the public arena and “go private” by buying the shares held by the public. Even absent a delisting threat, many smaller companies that went public in the dot.com craze may conclude that their public listing is now more detrimental than beneficial. Once private, the company is freed from the pressure of public scrutiny, the distraction of required public disclosures, and the need to meet targets for short-term quarterly results. Missing the analysts’ numbers by a few cents won’t be a catastrophe any more. The company can take the time it needs to build the company properly, develop needed technology and expand its markets. Elimination of the costs of SEC compliance, lower legal and accounting bills and the ability to redeploy resources from investor relations to product development and marketing are all attendant benefits. The company planning to go private will need to choose the appropriate structure: tender offer, merger, reverse stock split, asset sale and dissolution, or leveraged buy-out. Counsel will guide the company through the intricacies of Rule 13e-3 under the Securities Exchange Act of 1934 and the impact of state anti-takeover laws, but the biggest challenge is where to find the funds needed to buy out the minority shareholders. Not all public technology companies will be in a position to pursue this strategy. In today’s market, leveraged buyout investors that most frequently bankroll going private transactions will look for companies that generate consistent and increasing revenues and positive cash flows to service the debt used to buy out the public shareholders. Entities that don’t meet these criteria will only be attractive candidates for going private if a well-financed strategic buyer can be found that has a plan to make the target’s business profitable as a result of complimentary businesses, improved operational management and marketing, and reduced overhead cost burdens. Sometimes the strategic buyer turns out to be the target’s majority shareholder (in fact, in a few cases recently handled in our office, a majority shareholder of a publicly traded company that had previously taken the company public in a spin-off transaction chose to reverse the process in the form of a going private tender offer). SPIN-OFFS With the IPO market shut down, some public companies may find it advantageous to spin off a subsidiary by distributing the subsidiary shares in a tax-free divestiture to its shareholders. This tactic may be appropriate when the company has a line of products or a business segment whose robust growth is not matched by the performance of the rest of the company. Theoretically, separating a hot division from a slow growth or development stage parent can unlock shareholder value by allowing the market to independently value the more attractive business. This tactic is similar in form to the now-discredited craze of 1999, where old economy companies sought to spin-off the on-line component of their business. Valuations of the Internet component were wildly inflated based on the then-prevailing valuation multiples of revenues and market “captures.” The performance of most of these spin-offs has been dismal, and many such spin-off plans were ultimately shelved after the market for technology stock turned sharply downward. The current generation of spin-offs is based on a fundamentally different premise, namely, that the distribution involves a healthy company generating significant revenues with a clear path to profitability. For example, Adaptec, Inc. filed for a public offering in September 2000. Finding the public capital markets closed, Adaptec withdrew its registration statement in January 2001. In May, Adaptec completed the spin-off of its fast-growing Roxio division, which manufactures CD-burning software, through a stock dividend to shareholders. As of Aug. 23, Roxio was trading at approximately its initial May price, which in today’s down markets is something of a minor triumph. The obvious downside of the spin-off is that while the parent company may enhance shareholder value by creating a new, more viable spun-off public company, this does not raise any capital to expand development of the remaining business of the parent company. It is here that a strategic partner or partners for one or both of the parent and the spun-off subsidiary may facilitate the business and financial logic of a contemplated spin-off. STRATEGIC ALLIANCES A multitude of business partnering arrangements can offer troubled technology companies the chance to take advantage of the technologies, complimenting businesses and resources of a larger partner rather than undertaking on its own all of the efforts required to pursue its business plan. While alliances have been in vogue for a number of years, they take on a new urgency and involve greater levels of real substance in today’s challenging markets. One applications developer, which we represented recently, entered into a deal to obtain research and development and product testing services from a much larger software company. Instead of making a cash investment in the developer at an unacceptably low valuation, the software company will receive equity in the early stage company on the basis of the completion of project milestones. The developer gives up a smaller equity stake than would be necessitated if it sought a cash investment in today’s private equity market and saves the resources it would otherwise have had to expend on research and development and testing. Another interesting example is on-line exchange companies that have agreed to issue equity to corporate users based on their level of transactions put through the on-line exchange. In another instance, we have represented a major distributor that is expanding its supply chain to on-line distribution. Its principal methodology has been to make strategic investments in early-stage Internet companies that expand its marketing capabilities. With corporate venture capital increasingly out of favor (if professional venture capitalists can’t be successful in this environment, how can operating companies think they will perform better?), the distributor is considering non-cash investments in exchange for equity. For example, it may commit to supply products at a discount that would otherwise be unavailable, or agree to make the on-line company a preferred provider of services, with equity to be granted to the distributor based on revenues generated by the relationship. In an environment where cash financing of all kinds is hard to come by, creative strategic alliances can be a valuable substitute to continue forward with an underfunded business plan. BRIDGE LOANS When underfunded technology companies run critically short of cash and have no better financing options, they frequently are forced to seek a bridge loan to keep their businesses operating until more permanent financing can be obtained (it is, of course, always optimistically assumed that the “bridge” will not be the last financing round!). Vulture investors may be available to make such bridge investments, but the terms are very hard to swallow. A better route for the company may be to seek bridge funding from a party with a strategic interest in the company’s survival and performance — for example, a customer that wishes to ensure the continuing availability of the software, product or services of the underfunded company. If a strategic partner is interested in the continuing use or development of a technology that is used by its business or is imbedded within its product offering, it may be willing to extend financing to the owner of the technology on better terms than would be available from other investors or lenders. The strategic partner may, appropriately in such circumstances, seek to secure its position by demanding a security interest (and source code escrow) in the relevant technology, thus allowing it to take control of the technology and continue its uninterrupted availability in the event of the business failure of the owner of the technology. In some cases these loans are made by strategic investors in anticipation of the ultimate failure of the business and in hopes of eventually obtaining the desired technology. BACK DOOR ACQUISITIONS All of the previous discussion involves transactions that a strategic investor may pursue by agreement with management of an underfunded technology company. Another strategy we have seen involves obtaining a strong investment position in a strategically interesting technology company without the approval of the target’s management, or even over their objection. This can, in some companies, be done by acquiring directly from the most recent venture capital investors all or a majority of the most recently issued series of preferred stock of the target company. While these securities usually do not confer majority ownership or board control, if they were issued before the market correction eroded business valuations, these preferred shares frequently will have dividend, liquidation preference, antidilution, board participation, right of first refusal, next round investment approval and other rights that (particularly in today’s market of diminished valuations) give the holder a commanding position to ultimately obtain control of the target as its operations require further funding. Almost any additional funding is likely to require the approval of the preferred shareholders and will provide an opportunity to increase their percentage ownership through antidilution or participation rights. Many venture capitalists are performing triage on their investment portfolios, shedding investments that they don’t view as likely winners to focus on making additional investments in selected portfolio companies. In this scenario, a preferred stock investment with substantial rights to take ultimate control may be available at a fraction of the amount originally invested by the divesting venture capitalists. It should be noted that there is a real risk that management of the target will be hostile to this approach, since they will not receive anything for their founders’ shares or options and may view the strategic investor’s interest in ultimately taking control as a threat to their position. This can result in management efforts to find loopholes in the preferred shareholders’ protective rights to pursue transactions that will dilute the strategic investor’s ownership or otherwise make unattractive a later move by the strategic investor to take control. A significant investment in a company with hostile management is no easy ride, but it may allow a successful acquisition of control over time at a lower investment cost than could be negotiated for a straight acquisition of the target. To summarize, the current market conditions that face underfunded early stage technology companies have created many opportunities for strategic players to step into relationships with companies that they believe have developed interesting technologies. The strategic partner can add its experience and financial resources to allow technologies to be completed, improved or marketed, or simply to better manage the business operations associated with commercial exploitation. Creative transactions to pursue these opportunities are keeping deal makers and lawyers busy while the capital markets sleep. James E. Abbott and Alan J. Bernstein are partners at Carter, Ledyard & Milburn in New York.

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