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

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Insider Trading + Expert Witnesses

Over the last month there has been a rash of insider trading news involving the use of expert witnesses by hedge and mutual fund managers to gain insider knowledge about publicly traded tech and life science companies.  The SEC has issued a series of subpoenas to top tier investors, including SAC Capital, Citadel, Janus, and Wellington, to learn more about their use of expert witnesses.

To gain insight into highly technical companies such as tech and life science companies, institutional investors use expert witnesses, typically supplied by specialist firms such as Gerson Lehman Group and Primary Global Research, to support their own diligence work.  In theory, the guidance that an expert witnesses provides should be limited to publicly available information; however, recent reports by the Wall Street Journal suggest that many expert witnesses have been leaking sensitive information to investors who then used the information to jump ahead of the stock market.  The most egregious accusation was uncovered by the WSJ that the scientific advisory board of a biotech company divulged results from a key clinical trial to an investor before publicly presenting the data. 

While insider trading amongst high-flying hedge and mutual funds doesn’t directly affect the university startup ecosystem, it does have repercussions.  

Tech and life science companies are incredibly capital intensive.  The public equity markets provide an exit opportunity for VCs as well as capital to support the long-term growth of venture-backed companies.  The economic downturn effectively shutdown capital markets for venture-backed companies from 2008 to early 2010.  This put incredible stress on VC funds, which were forced to bridge many of their investments to exits for 2-3 years longer than anticipated.  Many funds are now running low on capital and do not have enough exits in current funds to justify raising new funds. 

The health of the venture ecosystem relies on having a well functioning capital markets system - without it, VCs become overly reliant on M&A and are open to price pressure from acquirers.  Only recently have the capital markets begun to thaw.  The news of insider trading amongst leading tech and life science companies, including Advanced Micro Devices, Human Genome Sciences, MedImmune, and Merck, will undoubtedly once again shut down capital markets, leaving VCs in the lurch.

Let’s hope that the SEC’s expert witness inquiry gets quickly sorted out and IPOs once again start flowing for venture-backed companies.  If not, VCs will continue to be capital constrained and there will be little money flowing into university startups.

FierceBiotech's 2010 Fierce 15

Every year FierceBiotech publishes its list of the top 15 up and coming biotech companies.  Anyone can vote for his or her favorite company making the list rather subjective, but for the purposes of this blog entry that does not really matter.  The main point I want to stress is the fact that 11 of the 15 companies (listed below) are university spinouts (according to my count).  The remaining 4 companies were either created de novo or were corporate spinouts. 

• Accerlon: Columbia, Harvard, MSKCC
• Adimab: Dartmouth, MIT
• Anchor Therapeutics: Tufts
• Catabasis: Harvard
• Dicerna: City of Hope
• Eleven Therapeutics: Harvard, UAB, Stanford, MIT
• iPieran: Harvard, Children’s Boston
• Kymab: Sanger Institute
• Plexxikon: NYU
• Tetraphase: Princeton
• Gelesis: MIT 

I looked at a number of these companies as investment opportunities over the past year and believe that the above list has a number of fantastic companies.  But, there are tons of other companies out there that could have made equally strong cases to be included in the Fierce 15.  So what separates these 11 university spinouts from companies not included in the Fierce 15? 

Scientific Talent:  Many of these companies were founded by leading academics that are both thought leaders in their respective fields and have also had prior entrepreneurial success.  For instance, Joseph Schlessinger, the founding scientist of Plexxikon, is one of the world’s top kinase researchers and previously founded another kinase-focused startup, Sugen (sold to Pfizer).  VCs tend to be attracted to such scientists because they understand the challenges associated with creating a startup, are experts in their respective fields, and are able to attract top researcher scientists to their startups. 

Business Strategy: Of the 11 companies, almost all of them are real companies, not virtual.  VCs are on the hunt for startups that have multiple shots on goal and/or are developing a platform technology.  Supporting the development of multiple products is way more expensive than for a single asset, but diversification provides a safety net for investors.  Also, products can be partnered or licensed which results in non-dilutive capital generation for the company.  

Management Talent:  VCs like to invest in repeat entrepreneurs with significant domain expertise.  To use Adimab as an example, the CEO, Tillman Gerngross, is a former Dartmouth Professor and a co-founder of GlycoFi (sold to Merck).    

Hot Technology Area:  There aren’t a lot of me-too or reformulation companies on the Fierce 15 this year.  VCs are looking for creative ideas in the areas of antibody discovery, iPSC, kinases, and protein-protein interactions.