Apple’s $350 Million Will Help PrimeSense Get Over Its Loss of Independence

Israeli startup couldn't beat 'em, so it joined 'em.

PrimeSense, which Apple agreed last weekend to buy for an estimated $350 million, doesn’t represent the typical story of a high-tech startup achieving a successful exit.

Although its product is found in millions of homes around the world, its potential customer base is a mere handful of global high-tech giants like Microsoft, Google, Apple, Sony and Samsung that can use PrimeSense’s microchips in their consumer products.

With its tiny customer base, PrimeSense faced enormous business risks. One major customer choosing a competitor’s product or acquiring the competitor outright could substantially shrink the company’s target market overnight.

To date, the Tel Aviv-based developer of the motion-detecting system, which is featured in Microsoft’s Kinect component of its Xbox 360 video game console, had raised about $84 million in capital. PrimeSense raised $9 million in its first round of funding from Genesis Partners and Gemini Israel Ventures. It later received another $20.4 million in a round led by Canaan Partners, and finally $50 million in 2011 from private equity firm Silver Lake at a company value between $200 million and $300 million. Currently with 150 employees, PrimeSense turned its first profit in 2010.

The value of the deal reflects strong profits for the company’s long-time shareholders but not a very high premium on later investments. Shareholder Silver Lake in particular isn’t expected to walk away with large profits.

In recent years PrimeSense was considered one of Israeli high-tech’s most promising companies and featured in the media’s lists of top startups. The company developed a revolutionary technology that seemed to have derived from science fiction films like “Minority Report.” Through a system centered around a chip developed by PrimeSense, it became possible to control electronic devices with simple body movements.

“We are living in the age of user experience, and people want devices to be more comfortable and easier to operate,” says PrimeSense CEO Inon Beracha. “Until PrimeSense came out with Kinect, nobody knew what a natural user interface (NUI) was. A new category was established. Since then other companies have arisen in Israel and the field is flourishing. More companies entered the arena, including Intel with its Perceptual Computing.”

The company’s technology gained its initial exposure when it was integrated in Kinect, the motion detection device used by the Xbox 360 game console. The product was a raving success, with Microsoft reporting having sold 8 million units within 60 days. PrimeSense’s star was on the rise.

But it quickly turned out that by pinning its future on its strategic relationship with Microsoft, PrimeSense risked running into tough unforeseen challenges down the road. Indeed, it found itself at a difficult crossroads when its collaboration with Microsoft, its main customer, was lost. Microsoft acquired Canesta and replaced PrimeSense’s technology in its second-generation Kinect component for the new Xbox One. In March 2012 PrimeSense said 50 of its 190 employees would be laid off.

Beracha and PrimeSense investors stated in interviews over the years their intentions of building a large, independent company. “We believe in the vision of a large Israeli company,” Beracha told TheMarker last year following the layoffs. “Life would obviously be simpler if we would sell it, but we want to maintain a large company in Israel. Even stable companies need to undertake complex business moves.”

One of the company’s achievements pointed out by Beracha was the community of developers it created. Cooperation between the developers led to the creation of a three-dimensional scanner for feeding 3-D printers in collaboration with 3DS. Another development was a virtual dressing room showing how clothes would look when tried on for size.

The company’s market, however, dictated the business development format that led to its eventual acquisition by one of the world’s leading technology enterprises.

Early this year PrimeSense introduced its family of Capri 3-D sensor chips developed for mobile devices. “We were the first to understand sensors in the mobile field,” says Beracha. “We presented samples with chip maker Qualcomm for augmented reality, and at the Google I/O developers’ conference last May we exhibited a prototype object scanner for interior decorating. We still haven’t arrived at a commercial product, but there are plans to embed the chip in mobile phones. We’re working on the third generation of the chip that we haven’t yet exposed to the media. It will be revolutionary in performance and target current and future markets.”

Beracha explains that the human-machine interface, the field in which PrimeSense operates, is less standardized than other aspects of the electronics market, and this presents a great challenge. “The moment there’s a standard and it is applied, like for instance at DSPG (a communications chip maker that Beracha previously managed), that’s the end of the story,” he says. “When it comes to user experience, new things need to be invented. In the case of Kinect we needed to demonstrate experiences and define the system even before anyone had seen a 3-D sensor. It’s a bigger challenge than selling a WiFi or Bluetooth chip.

“In this case the large companies know this, and you offer a better and cheaper solution,” says Beracha. “When you offer them something they’re not familiar with, you need to explain and convince them so they’ll understand why it’s good and how money can be made with it. Some companies had the bad experience from the past of other companies developing similar products.”

To create new markets, PrimeSense needed to help its clients formulate business models so they could see the payback from adopting the new technology, according to Beracha. “We are a tech company but we move along the technology-psychology spectrum,” he explains. “It’s not enough to have developed the best system in terms of performance. The challenge is showing the clients what it can do for them, and not just on a technological level.

“Looking, for instance, at the world of television, a manufacturer knows it will cost him more money putting the sensor in the product when making the decision,” continues Beracha. “The question is how he’ll make money from it. This isn’t a technological, but a commercial challenge. You tell him the sensor in the product can provide him with services that will start a revolution. The transaction with the customer won’t end when he buys the TV, but it will be possible to sell him clothes and put additional content and commercials in every movie he watches. Not every TV set manufacturer grasps the implications, and he needs to be explained why it can save him from a catatonic situation in which every Chinese manufacturer can sell the same screen for a lower price.”

Consumer electronic companies are acquired at a relatively low premium, especially when compared to Internet companies, due to the complexity of their market structure, according to Oren Raviv, senior analyst at IDC Consulting for emerging technologies.

“This is due to a combination of demand and the strategic development of these types of companies,” explains Raviv. “On the demand side, how many companies are considered potential buyers of such technologies? These are mainly electronic equipment giants, makers of cellular devices and smart TVs for example, and microchip manufacturers. Some have already made acquisitions in this field and others are doing the development of the technology in-house. Also, as opposed to the world of applications and digital media, these are companies that develop nothing but technology. The purchasing companies buy intellectual property and physical products, not user bases. In this case, it’s easier for the purchaser to examine and compare product quality and price it against the cost of developing it on its own.

“In terms of strategic development,” says Raviv, “such companies don’t really have an independent future, but are meant to be part of a larger company that can provide the economic resources needed to continue developing and upgrading products.”

At this point it still isn’t clear how Apple will make use of PrimeSense’s technology. It is believed Apple will use the gesture technology for its smart TVs. There’s also the possibility that PrimeSense’s latest series of Capri chip sets will be used for iPhones and iPads, but chances of this happening are remote, according to a high-ranking Israeli venture capitalist, because the company’s product is comparatively expensive. “So you need a more expensive product like a TV,” he points out.

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