Case Study The Sale of Chromatis to Lucent
In May 2000, Lucent Technologies announced it was acquiring an almost unknown private company, Chromatis, for approximately $5 billion in Lucent stock. An analysis of the foundation and sale of Chromatis sheds light on and provides a practical example of some of the issues reviewed in this book, with an emphasis on issues relating to the company's sale.
Chromatis was founded in 1997 by Dr. Rafi Gidron and Orni Petrushka, two men who had cooperated before when they founded Scorpio Communications and sold it to U.S. Robotics for $72 million in cash in August 1996. Petrushka continued managing Scorpio under its new ownership, and Dr. Gidron worked at U.S. Robotics headquarters until it was bought out by 3Com.
Gidron and Petrushka say that after Scorpio was sold, they felt the need to experience again the sense of entrepreneurship involved in a startup. They started looking for a market in need of solutions which they were capable of offering. Gidron and Petruschka knew that after their successful experience with Scorpio, almost any initiative they would undertake would attract the keen interest of venture capital funds. Their success was not regarded as mere chance, due to their experience in corporate management and their solid theoretical background (Gidron, for instance, had been a Professor at Columbia University specializing in the area of communications).
The chosen target market was infrastructure for metropolitan communications networks ("metro"). The fundamental factors driving the market were the observations that while the volume of voice communications rises by 5 10% every year, data traffic was increasing exponentially. Consequently, without dramatically upgrading the efficiency of data communications transmissions, the existing metro infrastructure was not expected to be able to handle the data volume. A principal stimulus for the development of a market for products addressing the new congestion problem was the deregulation of the communications market in 1996, which opened the local calls market to competition. This change led to a massive wave of investments in infrastructure by existing companies, as well as by companies which wanted to enter the local markets. Obviously, the giant communications infrastructure companies such as Cisco, Lucent, Ciena, and Nortel, as well as younger companies such as Sycamore, were also interested in entering this market and capturing a significant share of it.
After concluding that communications companies were about to make massive capital investments in the metropolitan networking market, the entrepreneurs decided to examine it. First, they met with potential customers and studied their needs. This market-orientation approach, although the product was essentially technological, was different from the route Gidron and Petruschka had taken before when establishing Scorpio. This time, thorough market research was conducted before they started the development, in order to increase the likelihood of success.
Chromatis' entrepreneurs aspired to develop a full networking solution which would optimize the capacity of optical fibers by increasing the volume of traffic transmitted through them. The system integrated hardware for multiplexing several different wavelengths (DWDM Dense Wavelength Division Multiplexing), technology for transmitting data using IP (Internet Protocol), technology for connecting telephone exchanges, and other technologies. The system was to be installed at the facilities of communications carriers, and the target market was metropolitan telephone companies. Thus was Chromatis born.
Building the Company
After deciding on their strategic direction, the entrepreneurs founded the company in 1997. The company was organized as a Delaware company with a development center in Israel, and its main offices were in Bethesda, Maryland (where several communications companies are centered and switching engineers are relatively abundant). The entrepreneurs used their own money for the initial capital. It was important to them that a leading U.S. fund participate in the first-stage financing round, which would expose them to customers and competitors in the target market. Therefore, they brought together the venture capital fund JVP (Jerusalem Venture Partners) and Crosspoint fund as their initial investors. JVP had previously invested in Scorpio, Gidron and Petruschka's previous company, and since the entrepreneurs had had a good experience with the fund, and in particular its managing partners, Fred Margalit, they decided to allow the fund to act as the lead investor in the new company in the first round, which took place in March 1998, in which Chromatis raised $7 million. In October 1998, the company raised another $5 million, this round being led by Lucent Venture Partners. All of the previous investors also took part in the second round. In November 1999, when the company was finishing its beta testing and was ready to go to market, the company raised approximately $38 million from its previous investors, including Lucent's venture capital fund, and from new investors, including the Soros and Hambrecht funds. This round was based on a company valuation of more than $100 million.
At first, Gidron and Petruschka acted as joint CEOs, but later recruited the outside CEO Bob Barron, who had approximately one year earlier declined a similar offer from Cerent, a company operating in a similar field which was later bought by Cisco for around $7 billion. Chromatis' top management team also included some former Scorpio and U.S. Robotics employees.
All along the way, Chromatis recruited first-rate employees and managers. For example, it managed to recruit Mory Ejabat, one of the best known managers in the field of communications and the active CEO of the communications equipment company Ascend Communications, a company bought by Lucent one year earlier for more than $20 billion.
Before the sale, the company employed about 160 workers. In 1999, the company launched some beta trials with telecom companies, including Quest and Bell Atlantic, but had substantially no revenue.
In May 2000, Chromatis announced that it had been acquired by Lucent in a stock transaction based on a value of around $5 billion. Under the agreement, Lucent allotted 78 million of its shares to Chromatis, excluding the 7% stake of Lucent Venture Partners. Lucent allotted another 2.5 million of its shares to several key employees of Chromatis, contingent upon Chromatis meeting certain performance-based goals after the sale.
The deal left almost everyone involved in the industry dumbstruck. The company was founded less than two years before the sale and had no meaningful revenues or guaranteed contracts. Apparently, a successful combination of technology, management, and strategic alliances, particularly the one with Lucent, had a material impact on the mere fact of the company's sale.
Analysis and Prologue
Confirmation that the optical networking industry had become a hot field in the capital market had already been given when Cisco bought Cerent, Chromatis' competitor, in a $7 billion stock transaction in 1998. Without any comparable self-developed technology, it was only a matter of time before Lucent, one of Cisco's most prominent competitors, would acquire a similar company. The area in which Chromatis operated appeared to be even hotter when Cisco announced that orders for Cerent's product, which integrates data flow on fiber optic networks, had risen to approximately $2 billion per year.
As it appeared when the acquisition was announced, Chromatis' price tag resulted not only from a comparison with the sale of Cerent to Cisco, but also from Lucent's relative disadvantage in the metropolitan communications market in which Chromatis operated. Chromatis offered Lucent almost a complete solution for an existing and emerging need in the metropolitan communications market, a solution with which Lucent was familiar from a relatively early stage due to its investment in Chromatis through its venture capital fund. In other words, although Chromatis had an independent market (as its beta trials with telecom companies had proven) which enabled it to keep going as an independent company, Lucent always stood in the background as a potential buyer. Thus, the need to become acquainted with one another, a stage which is necessary in any merger negotiations, was obviated. From the perspective of real options, the introduction of Lucent's venture capital fund to the company increased the likelihood that Lucent would acquire the company (as indeed was the case). In other words, introducing Lucent as an investor was tantamount to buying a partial put option. However, Chromatis paid no small premium for this option stemming from the fact that Lucent's competitors attributed a lower probability to their possibility of buying Chromatis. As discussed in the chapter on valuation, any decision on the creation of a binding and long-term relationship with a leading company in the field can entail a cost in the form of a reduced likelihood of relationships with competing companies.
Nevertheless, it is important to note that despite its relationship with Lucent, the company also attracted the interest of other companies that considered buying it, such as the communications equipment company Sycamore.
As was apparent all along, a major key to Chromatis' success was recruiting leaders in every field. The two entrepreneurs understood that the product they were planning was needed in the market, understood how important it was to raise capital quickly, and how essential the money was, mainly to recruit the best people in the market in each field. The recruitment of such people, along with their superb product, enabled the company to demand and receive investments with the relatively high valuation of $100 million.
Lucent, on its part, had performed 33 acquisitions in the four years preceding its acquisition of Chromatis as part of its strategy of expanding into markets with faster growth rates than its traditional core business, and to complement lines of products it had had no time to develop independently in its laboratories. Starting from the point in which it entered the company as an investor, Lucent's investment in Chromatis was clearly of interest to it for strategic reasons, namely, reinvigorating its leading position in the optical networking market. Chromatis was addressing the metropolitan networking market, which was particularly attractive to Lucent since this market lacked a dominant player such as Nortel was in the long haul networking market.
How can such a high acquisition price be explained when the annual value of the equipment market targeted by Chromatis was $2 billion (even when one takes into account projected sales of around $8 billion in 2004)? The explanation lies in the valuation of companies by strategic investors: From Lucent's point of view, sales in Chromatis' target market were expected to encourage sales of other equipment sold by the company. In addition, until that time, Lucent still depended on obtaining large contracts with, among other companies, AT&T, from which it was spun off. Therefore, expanding its spectrum of products in order to appeal also to smaller clients could help Lucent in broadening its product offering and the scopes of its contracts. In the acquisition of Chromatis, as well as in acquisitions in similar markets in which there are few major suppliers, the explanation for the price lies more in the acquirer's strategic considerations than in the valuation of the target as an independent company. In addition, in stock transactions both the target and the acquirer take into account other considerations that could affect the value of the deal. For instance, the value of the acquirer's stock, as well as the ability to sell the stock received in the transaction, could affect the value of the deal. A cash transaction is not equivalent to a stock transaction with the same announced value, as the plummeting of Lucent's stock price in the coming year indicates.
In August 2001, Lucent had announced that it is shutting down the Chromatis division (originating from the acquisition of Chromatis). The potential clients for the products developed by Chromatis, the Competitive Local Exchange Carriers (CLECs), were themselves facing a dramatic reduction in sales with some of them collapsing into bankruptcy, and hence almost stopped acquiring new equipment. Lucent itself was facing a meltdown in most of its businesses, and was trying to reduce its own "burn-rate." As part of its restructuring, which included the layoffs of over 50,000 employees and refocusing on existing products, Lucent gave up on Chromatis.
The closing of Chromatis only one year following its acquisition for $5 billion signifies the dramatic shakedown in the technology area in general, and the communication field in particular. This shakedown, which started in the later part of 2000, and which people felt was associated primarily with the "Internet bubble," rapidly spread to most areas in technology. Again it was shown that the timing of investments, as well as of venture development and of exiting it, is by no means less important in determining the prospects of a venture, its entrepreneurs and its investors, than the actual strategy of the company, which includes an optimized composition of employees, technology, cost structure, "sweet spots" in target markets, innovative pricing models, and astute strategic alliances.