Analyzing the Aerospace and Defense sector thru a VC lens

We recently had an opportunity to explore venture funding and exits via M&A in the Aerospace and Defense (A&D) industry. Given that this is not a sector that traditional venture investors routinely invest in, we thought sharing a few of our findings might be worthwhile to others.

First of all, the number of VC-funded companies in the A&D space was more than we had anticipated. However, the VC-funded companies were mostly in the IT space, particularly in internet security, intelligence solutions, etc., which was not really much of a surprise. VCs tend to gravitate towards areas they are familiar - IT for most VCs. Not to mention that IT companies are often much more capital-efficient and enjoy much higher margins than hardware component manufacturers - criteria that make those investments more palatable to present at the partners’ meeting on Mondays.

In general, companies in the defense industry have a significantly different approach to product development, marketing and sales when compared to businesses selling to the commercial sector. Product and business development are targeted to meet the requirements of a specific defense program (or call for proposal) as opposed to building a generic product (or a suite of products) to address a large market need. As a result, the products and the solutions developed to addresses those requirements tend to be highly customized and in most cases, not generic enough to be sold to a mass market. So, a typical defense sector company, even a small one, often ends up with a large and varied portfolio of products, each developed for a specific defense program, and each targeting a small / niche market opportunity. This is in sharp contrast to companies in commercial sectors.

Revenues for companies in the defense sector tend to be lumpy. In addition, year to year revenues could go significantly up or down, without any fault of the company, because defense programs can be downgraded or eliminated altogether based on politics, funding, etc. Also, visibility into revenue pipeline tends to be limited as the startups, who typically sell to large defense contractors, depend on those large companies to win bids for defense programs. So, predicting revenues for a startup becomes trickier than for companies in other sectors.

On the M&A side, the A&D sector is quite healthy because of the presence of several large defense contractors, who compete against one another to win defense programs, and as a result are always on the lookout for the latest technologies. Here are a few highlights on the M&A in the A&D sector:

• Of the large A&D companies, Lockheed Martin has been the most acquisitive over the last five years (2005-2010) while L-3 has been the least.
• A large number of exits in the A&D sector are either “mega deals” (>$1B) or small deals with <$10M purchase prices. There is a notable lack of exits in the mid market ($100-750M).
• The number of venture funded companies with successful exits is fairly modest in the A&D sector with Insitu (funded by Battery, acquired by Boeing for $400M) being the most notable exit in the last 5 years.
• Venture-funded companies with successful exits have been mostly in IT-related sectors such as network security, intelligence services, and IT services. This is likely because companies in those sectors appeal to venture investors and thereby, attract more venture funding.
• Recent data indicate that large A&D companies are sitting on plenty of cash which will likely lead to more M&A exits in the space.
• As per PWC’s Mission Control report on M&A in A&D, the median value / sale ratio for A&D deals over $50M was 2.2 in 2009 but has fallen to 1.7-1.8 for deals over $50M.

While venture funding has been modest in the A&D modest, here are a few of the venture funded companies that had a successful exit in the last five years:

Company	Sector	Investors	Exit Outcome
Sierra Monolithics	RFICs and modules for wireless, wireline, and military applications	$27.2M from USVP, Storm, and IBM	2009: Acquired by Semtech Corp. (NASDAQ: SMTC) for $180M
Insitu	UAVs and tools for reconnaissance	$48M from Battery and a few others	2008: Acquired by Boeing reportedly for $400M; revenues were ~$150M at that time
nCipher	Internet security	$24M from 3i, Newbury Ventures	2008: IPO at $500M valuation; then acquired by Thales for >$100M
Oakley Networks	Monitor insider communications and Internet usage across the enterprise	$29M from Kleiner Perkins, Fidelity Growth Partners	2007: Raytheon acquired Oakley and another company for $211M in aggregate
Analex	IT solutions and services	Undisclosed amount from FirstMark Capital	2007: Acquired by QinetiQ for $173M
Savi	Active RFID supply chain solutions	$155M from Accel, MDV, Oracle, Walden, Mitsui	2006: Acquired by Lockheed Martin reportedly for $400M; revenues were $80M

M&As in the Aerospace and Defense (A&D) sector

As part of a due diligence effort, we recently had the opportunity to analyze exits via M&As in the Aerospace & Defense (A&D) sector. Given we see a fair number of university companies operating in the A&D space, we feel that sharing our thoughts and findings would be beneficial to several such companies.

Summary

• Large companies in the A&D sector are fairly acquisitive with only a couple of exceptions such as L-3 Communications.
• In spite of a healthy M&A activities in the space, the amount of venture funding is found to be significantly lacking. Consequently, the number of resoundingly successful venture-funded startups in the space is abysmal, save for a couple of exceptions, most notably Insitu.
• Most deals can be classfiied as either “mega deals” or asset purcahses with relative few in between, particularly in the $10-100M category.
• The venture-funded companies that got acquired were mostly in network security, intelligence services, and interestingly enough, IT services. This is likely because companies in those sectors typically attract more venture funding.
• Recent data indicate that large A&D companies are sitting on plenty of cash which will likely lead to more M&A exits in the space.
• As per the PWC Mission Control report on M&A in A&D, the median value / sale ratio is ~1.8 for deals over $50M in the A&D space.

Notable acquisitions of venture-funded companies in 2005-2010

In 2010, SignaCert, an IT services company based in Portland, OR, was acquired by Harris Corporation for less than $10M. SignaCert had raised about $10M from Intel Capital, In-Q-Tel, and Garage Ventures.

In 2009, Northop Grumman acquired Sonoma Photonics, a provider of thin-film based optical components reportedly for ~$20M. Sonoma had raised $14M from Atventure GmbH.

In 2009, UTC paid somewhere between $10M and $100M to acquire StrionAir, an air filtration equipment vendor, that had raised $19.5M from Carlyle, Sequel, Solstice, and Vista Ventures.

In 2009, Telsima, a wireless broadband access software company that had raised $110M from CMEA, NEA, Intel Cap, SVB, etc. was sold to the Harris Corporation for $12M in cash.

In 2009, Sierra Monolithics, a provider of RFICs and modules for wireless, wireline, and military applications that had raised $27.2M from USVP, Storm, and IBM Venture Capital, was acquired by Semtech Corp. (NASDAQ: SMTC) for $180M in cash.

In 2008, Boeing reportedly paid $400M for Insitu, a developer of UAVs and tools for reconnaissance. Insitu had raised $48M from Battery and a few other smaller investors and had ~$150M in revenues at the time of acquisition. To the best of our knowledge, Insitu continues to be the most successful venture-funded startup in the A&D space over the last 5 years.

In 2008, Thales SA acquired nCipher, an internet security company for over $100M. nCipher had raised ~$24M from 3i, Newbury Ventures, etc and had gone public at a ~$500M valuation before getting acquired.

In 2007, Raytheon acquired Oakley Networks that had developed technology to monitor all insider communications and Internet usage across the enterprise. Oakley had raised ~$29M from Kleiner Perkins, Fidelity Growth Partners, etc. Raytheon reports that it had acquired Oakley and the robotics division of Sarcos for an aggregate of $211M.

In 2007, Alignent Software, a provider of road mapping software, was acquired for an undisclosed amount by Sopheon (LSE: SPE). Alignent had raised $7M from Mission Ventures, Horizon Ventures, etc.

In 2007, Analex Corporation, a provider of IT solutions and services to the Dept of Homeland Security, DoD, etc was acquired by QinetiQ for $173M in cash. Analex had raised an undisclosed amount of capital from Firstmark Capital.

In 2006, Lockheed Martin acquired Savi Technology, Inc., a developer of active RFID supply chain solutions reportedly for $400M. Savi had raised $155M from Accel, MDV, Oracle, Walden, Mitsui, etc and had $80M in revenues at the time of acquisition. Based on recent press, etc., Savi seems to be thriving well within Lockheed Martin.