Client Success Stories

Acquisition Helps Telecommunications Company Meet its Goals in a Changing Marketplace

High-speed fiber optic communications networks that transmit billions of bits of data around the globe on a nonstop basis have emerged as the critical infrastructure of the Information Age economy. As a leading provider of next-generation optical transponders and subsystems—key components in the backbones of these networks—Kodeos Communications, Inc. has carved out an important position for itself in the marketplace. Now Kodeos is relying on a combination of venture capital financing and strategic acquisition to support its efforts in achieving their longer-term goals. These goals include advancing its market leadership globally and continuing to develop market-leading products.

As the networks grow in size and complexity, so do the challenges of making sure each packet of data reaches its intended destination in the most efficient and accurate way possible. The optical transponders and subsystems developed by Kodeos serve as digital expeditors in that endeavor, and there is immense and growing demand for the products among world-class systems equipment developers such as Lucent, Cisco, Scientific Atlanta and others. Simply put, Kodeos specializes in breaking through existing technological barriers to develop products that enable networks to operate cheaper, better and faster.

“The main benefit we offer is that our transponders are not affected by some of the channel impairments—in this case, called dispersion—that can occur during transmission,” explains John Wyatt, the company’s chief executive officer. When the opportunity to leverage its technological advantage for growth through a serendipitous acquisition presented itself, Kodeos seized the opportunity, relying on Geller & Company, its outsourced financial services team to help bring the deal to completion.

Innovative Products Increase Network Reach
As more and more businesses turn to the Internet to increase efficiencies and improve access to information, market requirements are evolving. Internet traffic has been rising exponentially, taxing the capabilities of metropolitan and regional networks, and regulators are pushing service providers to offer high-bandwidth access to more businesses and homes, increasing the stress on network capacity. At the same time, service-provider economics demand lower capital and operational expenditures.

Kodeos products provide a perfectly matched solution to those market forces. Compatible with existing optical networking infrastructure, its transponders combine high-speed electronic data signals into a single optical signal that can be transmitted and received over longer distances with no signal degradation. Through the use of unique line coding that enables an increased number of wavelengths per fiber, Kodeos technology can double a signal’s normal span distance.

Having met its early challenges, Kodeos is now focused on its long-term goal of becoming a worldwide market leader. In that regard, Kodeos recently completed a key move with the acquisition of Intersymbol Communications, Inc., a transaction that adds a new facet to Kodeos' capabilities, and broadens its future market potential.

The company was founded by a pair of optical communication scientists, Jason Stark and Gadi Lenz, both of whom spent part of their careers at the renowned Bell Laboratories research facility and hold Ph.D.s from MIT, among their many other degrees. Launched in January 2001, just as the telecom bubble burst, the company has worked hard to survive the ensuing lean market times, says Wyatt, former president of JDS Uniphase’s Transmission Subsystem Group.

“We have hired the best staff in the industry for engineering and marketing, and during the past year we have successfully placed our optical transponders in eight of the top nine telecom system companies in the world,” he says. “Also, our products have been rated as having the best-in-class transponder performance at the fiber optical communications industry’s leading exhibition.”

Gearing Up to Meet the Next Round of Challenges
Having met its early challenges, Kodeos is now focused on its long-term goal of becoming a worldwide market leader—no small task in an industry where rapid and constant change is the norm. In that regard, Kodeos recently completed a key move with the acquisition of Intersymbol Communications, Inc., a transaction that adds a new facet to Kodeos’ capabilities, and broadens its future market potential. While Kodeos is the standard-setter on the transmit side in its product area, Intersymbol brings the same kind of leading-edge expertise to the venture on the receiver side.

Kodeos investors first met with representatives of Intersymbol, a leading developer of advanced electronic dispersion compensation (EDC) solutions four years ago to explore a partnership, but decided the timing was not right. Then 18 months ago, Kodeos began discussions with Intersymbol about using the company as a supplier for EDC chips in the receiver portion of Kodeos transponders, a straightforward vendor-supplier relationship.

However, because Intersymbol’s expertise represents such a complementary technology to Kodeos’ transmitter-side coding technology, when Wyatt met with Intersymbol Chairman Larry Marshall last summer, the discussion quickly focused on a possible merger-acquisition deal. “In particular, Intersymbol was looking to move up the subsystem value chain, and Kodeos was the perfect partner,” Wyatt explains.

A deal was structured for Kodeos to acquire Intersymbol as a wholly-owned subsidiary. Since both companies are privately held, the details of the transaction have not been made public. This was Kodeos’ first acquisition, and although Wyatt describes it as “a relatively simple deal,” there was a learning curve involved.

“One thing we learned was how important it is to ‘project manage’ the overall document generation and sign-off processes. Otherwise, you can delay the process and incur additional legal fees,” he says. “Once again Geller & Company was very active as our financial advisor since they support us in all of our accounting and finance needs. Joe Gitto, head of Geller & Company’s New Jersey office, and Bruce Enayati, senior manager, both members of Geller’s Emerging Business Group, were very involved in helping with the due diligence and financial analysis. They also advised us on how the deal should be structured and played an important role in the mechanics of the closing process by making sure all the documentation required by the lawyers was provided.”

For more information, please contact Joe Gitto at jgitto@gellerco.com

Capital Trends

Properly Structured Pipes are Regaining Popularity

A financing strategy that is gaining in popularity is private investment in public equity. PIPEs, as they are commonly referred to, received a lot of attention—mostly negative—at the start of the decade, as the tech bubble was in its death throes. A number of high-growth, small-cap companies, mostly tech and telecom ventures, turned to PIPEs as a last-ditch effort when they were in desperate need of financing. The deals were fashioned in a way that became known as “death spiral” or “toxic” structuring, and many lost nearly all of their value.

However, there are several ways to structure a PIPE that avoid the sale of variable-priced securities or the sale of securities accompanied by variable-priced “sweeteners” that characterized the death spiral variety. The most common involves the sale of securities at a fixed-price or fixed-conversion rate. Slightly less popular, but potentially effective in certain situations, is a PIPE structured on the sale of fixed-price or fixed-value securities accompanied by value sweeteners such as warrants.

In 2000, the year many tech PIPEs crashed and burned, the total issuance value of PIPEs reached $24.7 billion. PIPE financing declined over the next several years, but ticked up again in 2005, with 1,660 transactions completed by public issuers for a total dollar volume of $26 billion, according to PrivateRaise LLC, a provider of market information on private placement transactions. Since January 1, 2001, more than 7,400 PIPEs worth almost $106 billion have closed.

PIPEs Used to Fund Growth
“In general, PIPEs are most attractive to companies with a high-growth scenario that have momentum in their securities and prefer to use their equity as a vehicle to fund some of their growth,” says Shaun Collyer, director, Investment Banking with Rodman & Renshaw, a New York-based investment banking firm. “Companies that have liquidity and a good story are candidates for PIPEs. They don’t necessarily have to be profitable, but they have to have good prospects.”

"In general, PIPEs are most attractive to companies with a high-growth scenario that have momentum in their securities and prefer to use their equity as a vehicle to fund some of their growth. Companies that have liquidity and a good story are candidates for PIPEs. They don't necessarily have to be profitable, but they have to have good prospects."

A reverse merger—the acquisition by a private company of a “shell” company with no operating business and insignificant profits—followed by a PIPE investment can be an effective strategy to help promising early-stage companies overcome investor reluctance relating to a long time horizon to profitability and lack of a predictable exit strategy. The now-public company does a private placement of equity or equity-linked securities with accredited investors, followed by registration of the resale of those securities with the Securities and Exchange Commission.

Other advantages PIPEs can provide include the increased interest that investors show in a publicly-traded company, access to a defined amount of capital, lower transaction costs, reduced market risk following the completion of the initial sale cycle and speed to market.

“If all filings are up-to-date, a PIPE typically can be done very quickly using an off-the-shelf filing,” Collyer says. “The first PIPE with a firm like ours can take a few weeks, but where we add a lot of value is with multiple transactions. If we’ve worked with the company before and are comfortable with the issuer, we can get them done overnight, literally, in some cases. That’s a big advantage to companies because it allows them to move quickly to capture value at the moment it’s available.”

Drawbacks Include Disclosure and Well-Defined Objectives
Possible negative issues to consider include the rigors associated with being a public company. These include requirements to keep the resale registration statement effective for two years and to comply with Regulation FD, which forces greater public disclosure of material, non-public information.

“Some companies that go this route are shocked by the amount of compliance and the complexities associated with accounting and financial reporting as a public company,” explains Mike Bernstein, managing director of Geller & Company’s Emerging Business Group. “The private company may have had a smooth running department with competent staff, but finds itself struggling to keep up when almost overnight, they face life as an SEC registrant,” he adds. Also, the issue of stock dilution is often raised in connection with PIPEs, but Collyer points out that the additional dollars a PIPE brings in add incremental value to the company. “It’s better to have a slightly smaller piece of a much bigger pie than the other way around,” he says.

The most important consideration for companies contemplating a PIPE is to make sure the use of the capital raised will be for events or objectives that are well-defined, Collyer stresses. Many of Rodman & Renshaw’s clients, for example, are biotech firms that need the capital to conduct ongoing research and clinical studies. “Raising money just for the sake of raising money is not a good idea,” he says. “If you raise capital, but don’t put it to work, it causes overhang in the stock and ultimately detracts from the company’s value.”

For more information, please contact Joe Gitto at jgitto@gellerco.com.

Financial Reporting

FAS 123(R) Raises Issues for Private Companies Considering Public Offerings

The Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (revised) takes effect for most companies this year, and its impact on executive compensation may be of particular interest to private companies planning an initial public offering of stock. Most notably, the new standard is expected to trigger changes in the valuation approach they use, which could result in a substantial increase in compensation expense.

FAS 123(R) generally requires private companies to expense stock options and other equity-based compensation arrangements beginning this year. It also results in more awards being classified as liabilities rather than included in equity. The new rules apply not only to newly granted awards, but to existing awards not fully vested and existing awards that are changed, repurchased or cancelled on or after the start of fiscal 2006.

“Previously, most companies did not expense options on the income statement, showing them only as a pro forma disclosure instead,” says Scott Levy, practice leader for the New York area, NY assurance practice at Grant Thornton LLP. “Now they will have to be expensed on the face of the income statement. Depending on the number of options issued and the fair value assigned to them, it can have a material effect on a company’s net income. How will investors view this? How will it influence the market price of the stock? These are important questions,” Levy adds.

Valuation Challenges
There are several valuation-related challenges FAS 123(R) raises for private companies, says Susan Roos, a partner with PricewaterhouseCoopers LLP. “Companies can choose from several valuation methods, although most use the Black-Scholes model. But often it is not the method that presents the problem, but the input,” she explains.

The main inputs for a Black-Scholes calculation are exercise or strike price, current fair value of the underlying common stock, risk-free interest rate, dividends (usually zero for private companies), volatility and time to expiration (or estimated time to exercise).

"Previously, most companies did not expense options on the income statement, showing them only as a pro forma disclosure instead. Now they will have to be expensed on the face of the income statement, and it can have a material effect on a company's net income. How will investors view this? How will it influence the market price of the stock?"

Because most private companies have only had sales of preferred stock, arriving at an arm’s-length valuation of their common stock can be difficult, Roos notes. Some turn to an outside valuation expert, while others make it an in-house endeavor. “This is an issue whether they are considering going public or not, but any company going through an IPO can expect to get more scrutiny,” she says.

“In addition to the share prices, the value of an option is significantly influenced by the volatility of the underlying common stock and the time-value of the option itself,” Roos says, offering the hypothetical example of a $20 at-the-money option (exercise price same as current price) with a 10-year term, 80% volatility and risk-free interest rate of 4%. “The intrinsic value charge in this example is zero, because there’s no difference between the prices. Under the old rules, the company would not have to take a charge. With Black-Scholes it is $16.65 per share, and if you change the volatility to 100%—for companies in the technology sector, volatility averages between 80% and 120%—it goes up over $18. However, if you were able to cut the time in half, to five years, it would only be $13,” Roos explains.

Compensation Charges
One aspect of FAS 123(R) that should be advantageous to private companies is that it results in compensation charges being recorded more accurately, both Levy and Roos point out. “It requires all entities to recognize the fair value of share-based payment awards classified in equity, unless they are unable to reasonably estimate the fair value of the awards for one of two reasons,” Levy explains.

One reason is if a company cannot reasonably estimate the volatility of its share price. In that case, it is required to use historic volatility of an appropriate industry sector, and the result is known as calculated value rather than fair value. The second reason is if the complexity of an award’s terms prevents a company from reasonably estimating its fair value. The award is then valued at intrinsic value and variable accounting must be used.

Tax-Accounting Implications
Roos cautions that the tax-accounting implications of FAS 123(R) should not be overlooked. “People have focused on the valuation issue andthe charge to be taken, but most don’t realize it can be very complex from a tax-accounting perspective. There is detailed recordkeeping that needs to be done going forward, and re-creation of past recordkeeping may be required in some cases,” she warns. “The other thing to keep in mind is that forfeitures play a very big role in the calculations and financial reporting, so make sure you consider them carefully and have the required recordkeeping for them.”

Levy and Roos both stress the importance of taking steps to begin dealing with FAS 123(R) issues right away. “Don’t wait until the fourth quarter of 2006,” Roos says. Adds Levy, “I strongly encourage companies to discuss stock option issues with professionals who have significant experience in this area. If it is not a standard option, consultation should be made to understand the accounting implications.”

For more information, please contact Antonette Favuzza at afavuzza@gellerco.com.