Palm Defends Its Deal

Its sale of a 25% stake staves off predators and gives Palm room to re-energize.
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Palm

(PALM)

may have just bought its freedom.

The smartphone company,

in selling a 25% stake to private-equity firm

Elevation Partners

on Monday, got the one thing that its core management has fought hard for over the years: the ability to be an independent player and control its destiny.

The $325 million deal will also buy Palm the two executives it hopes can help revitalize its business -- Jon Rubinstein, former senior VP of hardware engineering and head of the iPod division at

Apple

(AAPL) - Get Report

, and Fred Anderson, Apple's former CFO.

Anderson recently

agreed to pay back more than $3 million and to submit to a $150,000 civil penalty to settle a stock options backdating case at Apple, while not admitting any wrongdoing.

Now, with happy shareholders, potential predatory moves thwarted and some of the sharpest minds in Silicon Valley on board, Palm believes things can only get better.

"The key reason we did this is because we believe in the future of this company," says Ed Colligan, CEO of Palm. "It is a high-risk-high-reward deal, but we felt we had the resources to make it happen."

But what Palm hasn't made clear, yet, is how the transaction will help the company hold its own in an increasingly competitive market, or create the kind of breakthrough products, such as the BlackBerry Pearl, that have put rival

Research In Motion

(RIMM)

on top.

Palm's gambit, for now, has seemingly melted shareholders' hearts. Palm's stock soared 9.2% and closed up $1.48 to $17.57.

Under the planned recapitalization, Elevation Partners will invest $325 million in Palm, and the company's shareholders will receive $8.50 a share. Palm plans to take the new investment, existing cash and $400 million of new debt to finance the $940 million cash payout to shareholders.

"Obviously, we think this is going to be a great investment," says Roger McNamee, co-founder of Elevation Partners. "We committed one-sixth of our fund's assets to this deal."

Palm had $500 million in cash at the end of the third quarter and will be left with about $300 million when the deal closes.

But some analysts remain skeptical of the change. "The debt adds interest burden and reduces Palm's cash at a time where investment may be required for business recovery," wrote Mike Abramsky, an analyst for RBC Capital, which makes a market in Palm.

"Palm's issues run deep, and the company's Treo smartphones lag peers in pricing, product development and design issues." Additionally, the stock pop could be temporary, he estimates.

Palm had no choice but to make the changes to optimize its balance sheet, says McNamee, a successful tech investor and co-founder of Silver Lake Partners. "They had a huge amount of cash and just having it there made it harder to recruit people because the cash was a drag on equity," he says.

Elevation Partners will not get any of the cash distribution that Palm is making, says McNamee. "Nearly 55% of today's market cap is being given out as cash distribution, while shareholders will continue to retain 75% of the company," he says. "So the notion that Palm gave up 25% is not really accurate."

Palm's deal with Elevation was a result of the company's desire to bring former Apple executive Jon Rubinstein on board, says Colligan. Palm is betting on Rubinstein, who left Apple last year, to re-energize its product line.

"One of Jon's requirements was that he really wanted Elevation to be part of the team," says Colligan. "Jon and Fred (Anderson) have worked closely in the past and they work very well together."

The idea appealed to Palm because it offered the kind of opening it was looking for. The deal with Elevation would put an end to the frenzied speculation around a possible private-equity buyout or an acquisition offer from a larger handset maker such as

Motorola

(MOT)

or

Nokia

(NOK) - Get Report

, while allowing Palm to bring on trusted investors.

"We have had a number of conversations with various different players," says Colligan, "and relative to everything we looked at, this was the best opportunity."

A complete sellout would have been contrary to what Sunnyvale, Calif.-based Palm has long fought for, says a former Palm executive.

Palm, which was founded in 1992, was acquired three years later by U.S. Robotics. In 1997, two years after its acquisition, Palm became a part of

3Com

(COMS)

when it bought U.S. Robotics.

Unhappy with the direction Palm took under 3Com, Palm's founders left the company and started Handspring. Though 3Com took its Palm subsidiary public in 2000, it took three years to complete the circle. Palm and Handspring merged in 2003.

Since then, says a former executive, Palm's core management -- including Colligan and co-founders Jeff Hawkins and Donna Dubinsky, who still holds a seat on the board of directors -- has been emphatic about the company being an independent player. Hawkins is still involved with the company and recently launched

the Foleo mobile computing device.

"The problem with selling the business is you would have to give up all the upside," agrees McNamee. "What Palm liked about the proposal is that we said we want to be a minority investor and we have a very long time horizon."

With the latest deal, Palm also has managed to replace Eric Benhamou, its former chairman of the board, and the one person who could have been pushing for the company to be sold.

Rubinstein is now expected to be the executive chairman of the board. Palm also replaced another board member, Scott Mercer.

The recapitalization is expected to close in the third quarter of the calendar year and is subject to shareholder approval.