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Startups should factor Corporate VC into their funding strategy

22nd November 2019
CATEGORY:

Corporates now participate in almost 20% of all investments in Europe

For some time, Corporate Venture Capital (CVC) investment was viewed with scepticism by startups. Concern over true alignment of interests and the potential negative impact on exit strategy options often being cited as the major reasons. In recent years however, attitudes have changed as CVC has become a more mainstream investment class. CVC terms have become much more entrepreneur friendly and the best CVCs have figured out how to add real value to their portfolio companies. Startups should now actively factor Corporate VC into their funding strategy.

Corporate VC is on the rise

Since 2011 we have seen a steady rise in CVC participation across Europe. Pitchbook reports that in 1H 2019 this included 426 deals with transaction values totalling €6.1 billion. That's 18% of European investments by number and 38% by deal value. Deal count should reach a new high if this pace is maintained for the remainder of 2019.

In terms of stage, whilst a growing portion is in larger transaction sizes following the general market trend, a sizeable element is still at Venture and early Growth stages. This typically means Series A and B, although some transactions occur even at Seed stage.

Note, there are 2 principal types of corporate investing:

  1. Corporates that invest purely for strategic purposes - this is often transacted through the M&A department on behalf of an operating division or the CTO’s office. These tend to be infrequent and highly selective.
  2. Corporates that invest for both strategic and financial purposes, often through a quasi-fund vehicle. E.g. Intel Capital, GV (Google Ventures), M12 (formerly Microsoft Ventures). These are generally referred to as ‘Corporate VCs’ as they look and behave in similar ways to normal VCs (although looks can be deceiving!). They represent the majority of overall Corporate investment activity.

Having monitored this investment category closely for over 10 years it’s rare to see an investment made without the buy-in of an operating division. Quite often a division executive becomes your champion within the Corporate and can end up being a key driver behind the deal.

What’s in it for the Corporate?

First, its generally accepted that Corporates are much slower than startups at realising innovative solutions to industry problems. By aligning themselves with a strong cohort of fast-moving entrepreneurial businesses they can gain enormous insight into leading edge thinking.

Unlike most VC funds, the larger corporates are far less constrained by geographical limits. Major corporates will operate with a global mentality. Some will be happy to seek relationships in new geographies as a way of putting down a footprint in that territory.

There is nearly always some strategic rationale. For example, this could be to gain access to emerging technologies and innovation as an alternative to lengthy and expensive internal R&D projects. It could be to bring on board new lines of business to leverage existing assets such as manufacturing or channel capacity.

It is therefore quite common for a commercial relationship to precede - then develop alongside - the strategic investment relationship. This can all take time to come together, but it can cement a strong alignment of interests over the longer term.

What’s in it for your Company?

1. Access to patient capital. Unlike VC funds that are usually structured around 5-year investing periods followed by 5-year return periods, the money CVC’s are investing usually comes straight from the corporate balance sheet - they are not answerable to other Limited Partners (LPs). As a result, there will be less pressure on a Corporate VC to seek an exit. Their motives are clearly different, and they work to longer time horizons.

2. Corporate VCs will be less ‘active’ board members and are more likely to let you get on with things. Quite often they will not require a board seat and will be happy with Observer status. As long as everything is going reasonably well, they will be very hands off operationally.

3. The Corporate can also become an important customer or partner. In some cases, investment will come alongside a commercial relationship. This can give you privileged status as a supplier, making life more difficult for your competitors.

4. Access to specialist resources. You can potentially tap into their people, tools, equipment and facilities as well as leveraging their industry contacts and credibility. This can be a huge low-cost accelerant to your business.

Where can it go wrong?

1. The biggest risk is always the ulterior motive. Do they want to wield too heavy an influence over your Company direction and technology roadmap? Are they going to constrain your activities in sectors or applications that may restrict your growth?

2. Will they want Right of First Refusal (RFR) in their investment terms? This gives them a privileged position when a potential exit is on the table.

3. Will they be seeking commercial exclusivity? Will they expect special attention such as bespoke development and then restrict who else you can sell to? Will they want access to your source code on a liquidation event?

4. Will they be seeking Most Favoured Nation (MFN) terms, where you will have to guarantee that they will always receive preferred commercial terms over others?

5. They will inevitably slow you down. Corporates generally move at glacial pace compared to startups, so everything will take much longer than you expect or want. There is often a great deal of consensus building to be done. You need to factor this in and be patient. However, Corporate VCs that operate like a more conventional VC fund will likely be the most efficient at transactions as they will be practiced.

The first 4 items above must really be avoided. At the very least they will limit your growth potential and at worst they will be a red flag to any new investors, particularly VCs, who will likely walk away if they see such terms have already been agreed.

What will make your business attractive to Corporate VC investment?

1. Your product and core technology must be applicable to them and will be front and centre of their due diligence. If you don't have proven technology leadership, it will be difficult to cultivate interest.

2. Your IP must be protected, ideally through patents and/or through unique know-how that can guarantee a time to market advantage. Key personnel, especially technical founders, need to be committed and locked-in.

3. Your Cap Table doesn’t throw up concerns about ownership or special rights that other shareholders may have. If the Corporate is a public corporation, they will be particularly anxious that you have reputable investors (and partners).

4. You need to be running a tight ship from a legal, commercial and financial point of view. Corporate Governance standards will be very important. Anything that may give them negative PR down the track could be a deal breaker.

5. Executive alignment. They will want to know that there is a cultural fit and they can see eye to eye with the CEO, founders and other key stakeholders on overall company direction. Relationships are absolutely key, especially at the beginning – they are not viewing this as a one-off transaction.

In summary:

  • Corporate investment is on the increase and can be an excellent source of patient capital even at early stage.
  • There is nearly always a strategic rationale for investment and this is often related to a commercial relationship. Make sure you truly understand their motives.
  • Provided you deliver on your technology and product promises they will usually keep out of your way and be unfussy investors.
  • Those that seek onerous investment terms (e.g. RFR), especially those that are intertwined with the commercial relationship, should be avoided. This is the old-style ‘control mindset’ that progressive Corporates realise is the kiss of death for startups.
  • Be hot on your own corporate governance. Give Corporate investors comfort that you aren’t going to do anything that might give them a PR headache.
  • Be patient and expect everything to take longer than you would like. It’s usually worth it in the end.

About the author: John Hall is CEO and co-founder of Duet Partners. His 30-year tech career began with major US semiconductor and software companies, and was based in Silicon Valley during the '90's. Before Duet he was CEO of a VC-backed consumer electronics company, sold in 2009 following several rounds of capital raising. In the past 10 years since starting Duet he has advised dozens of founders on the startup to scaleup journey and is a retained Board advisor to a number of UK technology companies.

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