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Something Ventured:
July 23rd


Insight For BC Technology Entrepreneurs

By
Brent Holliday

The Haus Wins!

"Our house is a very, very fine house,
It's got two cats in the yard,
Life used to be so hard..."
- Crosby, Stills, Nash and Young - Our House

I'm sure you did the same thing. A few years ago, when you first heard the name, you thought to yourself, "I've heard of them. I buy their tomatoes and red peppers at Safeway." C'mon, admit it. You did to. And then when you heard that they were a technology company and they spelled House like this (Haus), you thought to yourself, "What a dumb name!" Yes you did. Me too.

I'm sure you did the same thing. A few weeks ago, when you saw HotHaus CEO Ross Mitchell at the BC TIA Awards Dinner, you said, "He's a bit cocky! He's crowing about how simple his technology is, that it fits on one floppy disk, and that everyone in telecommunications wants it." But you thought he was a bit self-deprecating too. And you wished him luck under your breath.

I'm sure you did the same thing. A few days ago, when you picked up the Globe or the Post or the Sun and you pulled a Roger Rabbit (you know, chin hits ground, eyes pop out three feet, attached only by the optic nerve to your body). Yeah, me too. Four hundred million dollars! Repeated. Repeated again, slowly. Reached for the phone. Called someone, anyone and said, "Didja see that? HotHaus bought for four hundred million freakin' dollars!"

For those of you just waking up this week or for those foreign viewers, Broadcom (NASDAQ: BRCM) bought HotHaus Technologies for US$280M or roughly $414 M CDN in an all stock deal.

I'd just like to start by welcoming British Columbia to the map, thanks to Ross, his 60 employees and their investors, most notably Working Opportunity Fund. {The map is one that has not really included Canada much over the past few years, let alone BC. Recent additions outside of Northern California, Boston, New York, Austin and Seattle include Israel and Scandinavia. The cartographers of this map include investment bankers and analysts in New York, venture capitalists in the Valley and executives at Fortune 1000 companies. They decide who gets on the map. Ballard? Yes it woke up the cartographers, but it isn't information technology. PMC-Sierra? A merger, so it didn't rate as highly on the meter. With Creo and Pivotal ready to put BC on the map, HotHaus has helped solidify our position significantly} Hallelujah!

You've heard the platitudes and read all of the articles in the mainstream press. They are well-deserved. HotHaus just won the Stanley Cup of technology. I'm going to take a couple of different tacks. Well, what did you expect? Here's what I am going to cover:

  1. Why so much for a company with $4-5 million in revenues?
  2. What does the deal mean for BC technology (I've already mentioned the "map" thing)?
  3. Just how much did the employees make in this deal?

Why did Broadcom pay so much? 100 times revenue is a pretty steep valuation. Some Interent IPOs don't get valued that high. Well, only a few… but it's still staggering to think about. I have four reasons for you.

1) Pooling of Interest Transactions – High flying stock gives a company a brand new currency under US accounting rules. Calling the deal a "pooling of interest" is another term for merger. This is the preferred route for IT companies to acquire, because if your stock goes up, you negate any dilution effect from issuing new stock to the company being acquired and you haven't used any cash. Technically, a merger is supposed to be between "equals". BRCM had US$203 M in sales in 1998. HotHaus had US$3M. Not exactly equal. If you overlook that niggly detail, the pooling of interest is attractive because it allows the pooler (BRCM) to overpay without adverse effects on its income (For more on the debate about pooling transactions, see http://www.upside.com/texis/mvm/story?id=37447a070). It is a well known fact in the U.S. that pooling allows for higher valuations than cash deals. In this case, I would venture a guess that Broadcom might have paid four to five times less for HotHaus, had it been a cash deal.

2) The Buy Each Piece of the Bigger Pie Argument – HotHaus' software converts data, fax and voice from traditional phone networks to packet networks (like the Internet). Broadcom makes chips that run broadband access gear, cable modems and set-top boxes (actually, they design them and someone else makes them… they are called a fabless semiconductor company, because they lack fabrication plants). Broadcom thinks, in the words of Henry Nicholas, CEO, that "The home market is the volume play for the future". They bought Epigram a few months back for a similar amount to HotHaus. Epigram has chip designs to run data over the phone lines inside your house, between information devices, without interrupting conversations or DSL services. Very cool. It means you can hook up your son's PC to yours using existing jacks in the wall and play deathmatch Quake games while your daughter talks on the phone. So, HotHaus has the ability to interface between circuit switched data and voice on the plain old telephone system coming in to or leaving your house and the packet switched network coming in or leaving through your cable modem or set-top box. Confused? Broadcom isn't. They see a day when all of your information, entertainment and communication needs run seamlessly through the pipes you already have in your home. HotHaus had a piece of their puzzle.

If the home networking and information access market is going to be huge, then paying $1B in small company acquisitions now (Epigram, HotHaus, Maverick and Armedia) might seem like small potatoes when you own the market later. Case in point: Everyone gasped when Microsoft paid $425 M for Web TV in 1997. With all of its recent investments in cable companies, like Rogers, the strategy is starting to become clearer. And the price will soon look like a bargain for all the viewers tuning in through Microsoft technology.

3) The Competitive Protection Play – A favourite of market leaders, like Intel. This strategy is likened to "hush money" whereby a large player buys out a promising young technology to put it on a shelf so no one else gets their hands on it. Broadcom might have seen HotHaus as a threat, because they would have licensed their technology to Broadcom and all of its competitors. By owning it and giving it to no one else, Broadcom might get a certain advantage. This makes a lot of sense if the technology is protectible (i.e. patented) and would add a lot of value to the deal.

4) The Labour Crunch – Tough to find top quality engineers these days, what with all of the start-ups etc. One of the analysts covering Broadcom noted that 80% of the 135 employees acquired were engineers (that does not include HotHaus). The analyst suggested that this was a huge benefit to a firm trying to keep product development momentum. Now imagine that you are Henry Nicholas and your VP, Business Development walks in and says, "I found a company that has a critical piece of our technology map and they have 50 high quality engineers. Get this. The engineers will be 40% cheaper going forward because they live in Canada. And we'll get tax credits if we keep them in Canada. What a deal!" In today's labour market in the US, this is a dream come true. I would think that the value of each engineer to Broadcom would be $5M - $10M in today's market.

Taken all together, the value paid by Broadcom starts to make sense.

What does this deal mean for BC technology? I already alluded to the fact that the US financiers and companies will pay attention to BC tech companies, now more than ever before. There has not been a technology deal of this magnitude done in all of Western Canada. It's huge! Guess who else will notice? The government. Yup. The feds and the provincial ilk will pay a little more attention. I can here it now, "Ross, you sell-out. You gutless sham. Why would you ever sell to the American heathen when it is so good here in Canada? We are selling Canada to the Americans. What will happen to our precious culture?" You get the picture. What the governments don't realize (or don't vocalize) is that when a US firm buys in Canada they stay and they grow (think EA Canada, Seagate Software, Motorola Canada). Then you get more taxes being paid by more Canadians.

The real meaning of this deal for BC technology and the future companies is the multiplier benefits of rich, smart technology people. Ross and his team will eventually leave Broadcom. They will have tons of money and, hopefully, tons of new ideas. Others will approach them to get "angel" funding. I can't underline this enough. A strong angel community and a pile of people that have "won" in the start-up space is the foundation of a larger technology community. Combined with CREO and Pivotal, there will be some fully vested people looking to do their own successful companies in a few years. {To all of you folks at Pivotal, Creo and HotHaus… you have my number…}

Just how much did these guys and gals at HotHaus make? This is the fun part. Ross? That's easy. I bet he owned 35% of the company. According to that assumption, he is worth $145M today. But not all of us get to be founder and CEO. What about the regular employee? Assume that our example employee is a lower level engineer (lets call him Rich) with a $55,000 salary and 5,000 options at HotHaus. The options are priced at $3 (assuming the last round of financing gave the company a value of $30M CDN and 10M shares). That means if the company value goes above $30M, without dilution, Rich is "in the money". Well, Broadcom just set the value of the company at $414M. So Rich is well… rich. The company value increased $384M or almost 12 times the last round. When the company sold, Rich immediately vested all options (common practice) and was given Broadcom shares, equivalent to the amount of money that his option were worth. So, he now has $3 x 12 = $36 worth of profit per option x 5,000 = $181,000 worth of BRCM stock. Not bad, eh? I can hear all of your wheels turning now. What if I had 10,000 options? $362,000 Nice!

Oh, and Rich is free to sell his BRCM stock or hold it. No lock-up. Do you think there will be some new cars in the HotHaus parking lot in the next few weeks?

I want to congratulate Ross and his team on their achievement. Outstanding job! I have picked up my jaw and will now look for a few more just like HotHaus.

Responses From Last Week -

Brent,

I'm with you in principle, but I think you've missed a couple of things.

1. Your three placard holders (mainframe, client/server, web) share something: each is a devotee of the then CURRENT technology. Believe it or not , there have been web advocates since the late 1960's – when packet switching was an arcane research experiment. Its developers were unknown and unsung, as are today's REAL, youthful groundbreakers – ie those working on optical and molecular devices.

2. Which brings me to my second point, which is that the critical development which permits today's software explosion is not youthful enthusiasm ( which has always been ubiquitous) but affordable hardware. Everyone seems to have forgotten this. By way of illustration, just imagine what would happen if $500. Student home physics kits included fully operational, high energy particle accelerators. Ten year olds would be pushing the knowledge boundaries of fundamental physics, and giving the Nobel prize winners a run for their money. No doubt society would then celebrate such kids' success - and completely forget the accelerator designer who unlocked their potential!

So let's keep an eye out for the local kid all set to deliver something genuinely trendsetting, eg to finally consign mechanical memory devices to a well deserved oblivion. He/she will truly reward the company bold enough to look beyond today's technology.

Keep up the harangue.

Peter Gellatly

Mark Anderson has talked about designing software for kids that lets them program at an early age (There was one such program called Logo, but it has disappeared). Kids will grow up creating things that blow our minds if they get the right tools. Thanks for writing back.

Brent,

I love the article, scary to think someone who is interested and makes an effort to keep up can still fall behind due to the vast load of info that is streaming at us. I often like to speak with young teens and ask what they do on the web and find it pretty amazing at how many new technologies they are familiar with.

I read a recent article about Silicon Valley which had similar undercurrents, although they were speaking about the startup process. Business models, corporate loyalty, technologies, etc. were being thrown to the wind. You create more opportunities by sharing ideas and concepts than by holding them close. It is truly an open market for VC funding, ideas, people, and business models (the article neglected to mention that many people probably got burned due to divulging info).

What I find interesting is that it has been an extremely successful model for the valley. So, what does that mean when millions of these kids (not just the few today) realize that not only can they copy their favorite films and music but shake up the global economic system (not just the Internet system)? I do not think it is a question of whether, but rather when. Within 5 years, the majority of early teens that have grown up with the Web will be at a point where they will flex their collective intuitive knowledge of this new media. That's when the real fun will begin...

Laurie Baggio

That's right! These kids are sharing ideas as their currency. The Silicon Valley works because of that. I talked about it before. I have learned a lot from books and magazines, but you learn more at a trade show or conference because you are interacting and sharing ideas. Thanks for being a regular responder Laurie!

What Do You Think? Talk Back To Brent Holliday



Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).


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