In May 2000, Lucent Technologies announced that it would acquire an almost unknown private company, Chromatis, for approximately $5 billion of Lucent stock. An analysis of the founding and sale of Chromatis sheds light and provides a practical example of some of the issues reviewed in this book, with an emphasis on issues related to the sale of the company.

Beginning

Chromatis was founded in 1997 by Dr. Rafi Gidron and Orni Petrushka, two men who had previously cooperated when they founded Scorpio Communications and sold it to US Robotics for $72 million in cash in August 1996. Petrushka continued to run Scorpio under his new ownership and Dr. Gidron worked at the US Robotics headquarters until it was purchased by 3Com.

Gidron and Petrushka say that after the Scorpio sale, they felt the need to re-experience the entrepreneurial sense that comes with being a startup. They started looking for a market that needed solutions that they were able to deliver. Gidron and Petruschka knew that after their successful experience with Scorpio, almost any venture they would undertake would attract strong interest from venture capital funds. His success was not considered a mere chance, due to his experience in business management and his solid theoretical training (Gidron, for example, had been a professor at Columbia University specializing in the area of communication).

The chosen target market was the infrastructure for metropolitan communications networks (“metro”). The fundamental factors driving the market were observations that while the volume of voice communications is increasing by 5-10% each year, data traffic is increasing exponentially. Consequently, without drastically improving the efficiency of data communications transmissions, the existing metro infrastructure was not expected to be capable of handling the volume of data. A main stimulus for the development of a market for products that address the new congestion problem was the deregulation of the communications market in 1996, which opened up the local calls market to competition. This change led to a massive wave of infrastructure investment by existing companies, as well as companies that wanted to enter local markets. Obviously, giant communications infrastructure companies like Cisco, Lucent, Ciena, and Nortel, as well as younger companies like Sycamore, were also interested in entering this market and capturing a significant part of it.

After concluding that telecommunications companies were about to make massive capital investments in the metropolitan networking market, businessmen decided to look into it. First, they met with potential customers and studied their needs. This market-oriented approach, while the product was essentially technological, was different from the route Gidron and Petruschka had taken earlier in establishing Scorpio. This time, extensive market research was carried out before development began, to increase the probability of success.

The Chromatis entrepreneurs aspired to develop a complete network solution that 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 via IP (Internet Protocol), technology for connecting telephone exchanges, and other technologies. The system had to be installed in the facilities of the communications operators and the target market was the metropolitan telephone companies. Thus Chromatis was born.

Building the Company

After deciding on its strategic direction, the entrepreneurs founded the company in 1997. The company was organized as a Delaware company with a development center in Israel, and was headquartered in Bethesda, Maryland (where several communications and switching engineers are found). relatively abundant). The entrepreneurs used their own money for start-up capital. It was important to them that a leading US fund participate in the first stage financing round, which would expose them to clients and competitors in the target market. For this reason, they brought together the JVP (Jerusalem Venture Partners) venture capital fund and the Crosspoint fund as their initial investors. JVP had previously invested in Scorpio, Gidron and Petruschka's previous venture, and since the entrepreneurs had had a good experience with the fund, and in particular with its managing partner, 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 grossed $7 million. In October 1998, the company raised another $5 million, this round spearheaded by Lucent Venture Partners. All previous investors also participated in the second round. In November 1999, as the company was completing its beta testing and ready to go to market, it raised approximately $38 million from its previous investors, including Lucent's venture capital fund, and from new investors, including funds of Soros and Hambrecht.

At first, Gidron and Petruschka acted as joint CEOs, but then they recruited outside CEO Bob Barron, who about a year earlier had turned down a similar offer from Cerent, a company operating in a similar field that was later bought by Cisco for about $7 billion. . Chromatis's senior management team also included some former employees of Scorpio and US Robotics.

Along the way, Chromatis recruited top-notch employees and managers. For example, he 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 a year earlier for more than $20 billion. .

Before the sale, the company employed about 160 workers. In 1999, the company launched some beta tests with telecommunications companies, including Quest and Bell Atlantic, but did not make any substantial revenue.

The transaction

In May 2000, Chromatis announced that it had been acquired by Lucent in a value-based stock transaction of about $5 billion. Under the agreement, Lucent assigned 78 million of its shares to Chromatis, excluding Lucent Venture Partners' 7% interest. Lucent allocated another 2.5 million of its shares to various key Chromatis employees, contingent on Chromatis meeting certain performance-based targets after the sale.

The deal stunned nearly everyone involved in the industry. The company was founded less than two years prior to the sale and had no significant revenue or guaranteed contracts. A successful combination of technology, management and strategic alliances, particularly that of Lucent, appeared to have had a material impact on the very fact of the sale of the company.

Analysis and Prologue

Confirmation that the optical networking industry had become a hot field in the capital market had already come when Cisco bought Chromatis competitor Cerent in a $7 billion stock transaction in 1998. no comparable self-developed technology, it was only a matter of time before Lucent, one of Cisco's most prominent competitors, acquired a similar company. The area in which Chromatis operated seemed to get even hotter when Cisco announced that orders for Cerent's product, which integrates data flow into fiber-optic networks, had risen to about $2 billion per year.

As it appeared when the acquisition was announced, Chromatis's price 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 a nearly complete solution for an existing and emerging need in the metropolitan communications market, a solution Lucent was familiar with from a relatively early stage due to its investment in Chromatis through its venture capital fund. . In other words, while Chromatis had an independent marketplace (as its beta testing with telcos had shown) that allowed it to continue to operate as an independent company, Lucent always remained in the background as a potential buyer. In this way, the need to get to know each other, a necessary stage in any merger negotiation, was obviated. From a real options perspective, the introduction of Lucent's venture capital fund into the company increased the likelihood that Lucent would acquire the company (as was in fact the case). In other words, presenting Lucent as an investor was tantamount to buying a partial put option. However, Chromatis paid a significant premium for this option, due to the fact that Lucent's competitors attributed a lower probability to their ability to purchase Chromatis. As discussed in the chapter on valuation,

However, 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 evident throughout, a major key to Chromatis's success was recruiting leaders in all fields. The two entrepreneurs understood that the product they were planning was necessary in the market, they understood how important it was to raise capital quickly and how essential money was, mainly to recruit the best people in the market in each field. Hiring these people, along with its excellent product, allowed the company to solicit and receive investments with a relatively high valuation of $100 million.

Lucent, for its part, had made 33 acquisitions in the four years prior to the Chromatis acquisition as part of its strategy to expand into markets with faster growth rates than its traditional core business, and to complement product lines that had not previously been acquired. had time to develop independently in their laboratories. From the moment he joined the company as an investor, Lucent's investment in Chromatis was clearly in his interest for strategic reasons, namely to revitalize its leadership position in the optical networking market. Chromatis was targeting the metro network market, which was particularly attractive to Lucent since this market lacked a dominant player in the long-distance network market like Nortel.

How can one explain such a high acquisition price when the annual value of the equipment market Chromatis was targeting was $2 billion (even when accounting for projected sales of around $8 billion in 2004)? ? The explanation lies in the valuation of the companies by strategic investors: from Lucent's point of view, sales in Chromatis's target market were expected to encourage sales of other equipment sold by the company. In addition, until that time, Lucent remained dependent on winning large contracts with, among other companies, AT&T, from which it was spun off. Therefore, Expanding its product spectrum to also attract smaller customers could help Lucent broaden its product offerings and contract scopes. In the Chromatis acquisition, as well as acquisitions in similar markets where there are few major suppliers, the price explanation lies more in the acquirer's strategic considerations than in the valuation of the objective as an independent company. In addition, in stock transactions, both the recipient and the acquirer take into account other considerations that could affect the value of the transaction. For example, the value of the acquirer's shares, as well as the ability to sell the shares received in the transaction, could affect the value of the deal.

In August 2001, Lucent had announced that it was closing the Chromatis division (which originated from the Chromatis acquisition). Potential customers for Chromatis-developed products, Competitive Local Exchange Carriers (CLECs), were facing drastically reduced sales and some of them collapsed into bankruptcy and thus almost stopped purchasing new equipment. Lucent itself was facing a collapse in most of its businesses and was trying to reduce its own "consumption rate". As part of its restructuring, which included laying off more than 50,000 employees and refocusing existing products, Lucent resigned from Chromatis.

The closure of Chromatis just one year after its acquisition for $5 billion means the dramatic shakeup in the area of technology in general and the field of communication in particular. This extortion, which began in the late 2000s and which people felt was primarily associated with the "Internet bubble," quickly spread to most areas of technology. Once again it was shown that the timing of investments, as well as the development of the company and leaving it, is no less important in determining the prospects of a company, 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 the target markets,