Weekly Briefing Note for Founders 26/9/24

25th September 2024
CATEGORY:

CVC investment into startups - Pros and Cons

Over recent weeks we have been digging into the topic of investor expectations. Aligning founder and investor expectations forms the bedrock of trust that is essential for this long-term relationship to work.

Last week we examined how expectations vary with funding stage. This week we look at how expectations vary with investor type. Specifically, we look at Corporate Venture Capital (CVC) and how expectations can sometimes be very different from those of financial investors like VCs.

Ensuring a strong alignment of expectations across all major investors is a key role for the CEO. This is a vital element in the investor selection process and negotiating the right investment terms. Mistakes here can cause serious downstream problems for the startup.


The Rise of CVC

Over the past 10 years, CVC has become an increasingly important source of startup capital. Analysis by Bain shows that CVC now accounts for nearly a quarter of all venture capital investing; 10 years ago, it represented just 11%.

As McKinsey has also shown, venture investing by corporations has become commonplace. In the past two decades, a significant proportion of Fortune 100 companies have built corporate venture capital units. New CVC funds are regularly being launched across many sectors.

The impact on startups has been significant. In addition to the cash funding, McKinsey's analysis shows that startups with CVC backing are more likely to grow and less likely to fail. In terms of stage focus, Series A is the most popular entry point followed by Seed.

But the world of CVC is still relatively unknown and is often poorly understood by founders. To fully appreciate the opportunities and risks of CVC we first need to look at how CVC fits into the broader model of Corporate Venturing. Then we can zoom in on the pros and cons for startups.


Corporate Venturing Model

For decades, corporates have experimented with different innovation models to foster greater competitive advantage. In recent times, attempts to build internal innovation teams have been hampered by the growth of startup culture. Entrepreneurial types have increasingly pursued their own dreams outside of the corporate environment.

In response, corporates have sought to develop market advantage by pursuing the 'Corporate Venturing' model. This allows a range of innovation scenarios to be developed with an increasing focus on leveraging external talent.

The classic model, captured perfectly by Frederic Pampus in his highly useful graphic, depicts 4 complementary scenarios: Build, Buy, Partner and Invest:

  • Build = Corporate Venture Building - the internal model designed to ideate, validate and build their own ventures, such as in house accelerators
  • Buy = M&A - acquire startups and/or merge own with external ventures as part of the core growth strategy
  • Partner = 'Venture Clienting' - become a customer or supply chain partner of a startup to solve internal problems
  • Invest = Corporate Venture Capital - invest equity and become a minority shareholder

The most innovative corporates make use of all four scenarios. There is an increasing tendency for corporates to start as a venture clients, transition to investing, and then consider M&A.

The exact route will vary depend on individual circumstances, often heavily influenced by company culture, especially towards NIH (not invented here) and risk taking.

As Bain points out, a particular benefit of early-stage investing is that it can further de-risk future M&A. With small cheque sizes in the early stages, investors can buy themselves a seat at the table and watch a company or technology grow over time. If the company becomes an acquisition target, the parent company has two to four years of diligence from exposure through the early-stage investment. This brings in valuable information to diligence that can significantly de-risk the investment and integration.

In recent times, the CVC scenario has become the fastest growing strategy, even as regulators have pushed back hard on Big Tech M&A activities. Becoming a shareholder with information rights or even a board seat can provide significant insight and competitive advantage.


CVC structure and motives

From the perspective of the corporate, CVC investing has 2 key drivers or 'expectations':
1. Gather market intelligence (to accelerate internal innovation efforts), and
2. Provide financial returns (no corporation wants to see its capital diluted or destroyed).

There is a wide variation in the balance sought between these 2 objectives. This balance is often a function of how capital is allocated to the CVC activities (which is also then reflected in the specific organisational structure). There are 3 primary structures:

Capital allocated via the balance sheet: Potential investments are pursued opportunistically (there is no dedicated allocation of capital into a fund). The remit usually falls within the Corporate Development team, who will likely be very M&A centric in their thinking. They will be far less versed in making minority investments. As a result, these can be tricky relationships to foster and deal making can be fraught.

Capital allocated into a fund vehicle: Here there is a dedicated allocation of capital and with it often comes a dedicated team. They are typically better versed in making minority investments and often have a much clearer understanding of how startups work. Strategic considerations will likely be prioritised but financial returns will also be important.

External fund vehicle: The fund operates at arms-length from the corporate, making investment decisions with much greater autonomy. The focus will primarily be on financial returns rather than meeting strategic objectives. It will have more the look and feel of a classic VC investor.

One of the great debates around structure is how the investment team is compensated. External teams fight hard to include some form of 'carry' much like a classic VC. This can boost personal earnings significantly and help with retention. Internal teams rarely benefit in the same way and top investors are often at risk of being recruited away by other VCs.

In selecting a CVC, it is important to understand the structure and motives. This helps decode the particular mindset at play and how this might drive future behaviour.


Pros and Cons of CVC investment for startup

To set the correct expectations, CEOs need to look carefully at both sides of the CVC coin.

First, the Pros:

Market credibility - Corporate investment will almost certainly provide a strong endorsement of the technology as well as the market opportunity. In this way CVC investors can be seen as useful 'cornerstone' investors: They may not put in the most money, but they will give confidence to others.

Market intelligence - Just as the corporate will learn from the startup, the same is often true the other way around. The corporate can provide insights into market trends and an understanding of the big problems that the sector is facing.

Resource access - On the basis of this privileged relationship the corporate can sometimes provide access to specialist (and expensive) resources as well as helping validate solutions. This is often the case when a commercial relationship is developed alongside the investment.

Market access - Corporates can open doors to other customers, partners, and prospective acquirers. They can also provide a distribution channel for the startup's product. In this case the corporate can become a key part of the startup's supply chain.

Now the Cons:

'Early exit' - If the terms of investment are slanted too much in the CVC's favour, then this could be perceived as an 'early exit'. Other corporates will then be unlikely to make either an investment or an acquisition approach in the future. VCs will also be more likely to shy away. (see Dangerous Terms below)

Misaligned influence - A divergence in strategic direction may emerge. The startup may pivot or change strategy, and the corporate may try to force a realignment with their own strategy.

IP/knowledge leakage - The corporate may use insights gained to navigate around the startup's IP and build an alternative solution of their own.

Deal complexity - Where a commercial relationship is being developed alongside a prospective investment in the startup, deal interdependencies may emerge. This can cause delay and frustration. The CEO now has to navigate two separate groups within the corporate to make everything converge: the CVC team and the relevant operating division.


Dangerous Terms

Corporates tend to invest with much greater sensitivity to risk and a more aggressive stance on control. These are some of the investment terms that can cause downstream trouble. CEOs must preempt these as much as possible to ensure they don't damage future prospects:

  1. Right of First Refusal (ROFR) or Right of First Offer (ROFO)
    CVCs may request the right to buy additional shares or acquire the company before other investors or potential buyers. This can complicate future fundraising rounds or acquisition offers.
    RISK: Other investors might find it harder to exit the company, as the CVC can block or delay potential exits. This can limit liquidity for other shareholders.

  2. Strategic Veto Rights
    CVCs might demand veto rights over key strategic decisions, including business model changes, partnerships, or exit events like mergers or acquisitions.
    RISK: These rights can give the CVC too much control over the startup's direction, limiting flexibility for the startup's management and other investors.

  3. Exclusivity or Non-Compete Clauses
    A CVC may request exclusivity in certain areas or prevent the startup from working with or selling to the CVC's competitors.
    RISK: This can restrict the startup’s ability to grow and diversify its partnerships or client base, limiting its market potential and attractiveness to other investors.

  4. Strategic Alignment or Influence Over Product Roadmap
    CVCs sometimes ask the startup to prioritize building products or features that align with their parent company's strategic needs.
    RISK: While this can provide valuable insights and resources, it may also sidetrack the startup from pursuing other market opportunities that could be more attractive to traditional VCs.

  5. Board Seats and Information Rights
    CVCs often request board seats and extensive information rights to keep close tabs on the company’s progress and ensure alignment with their strategic goals.
    RISK: A CVC may act in the interest of their corporate parent rather than in the best interest of the startup or its other investors. This can cause governance challenges and conflicts of interest.

  6. Exit Preferences
    CVCs may want special terms regarding how and when they can exit the investment, potentially through a buyout by the corporate parent or preferential treatment in an acquisition scenario.
    RISK: This can create conflicts with other investors who may prefer an IPO or a different exit strategy, and it might also affect the timing and valuation of an exit.

  7. Restrictive Future Financing Terms
    CVCs may try to limit the startup’s ability to raise future rounds from other strategic investors or even from traditional VCs, which can lock the startup into a narrower set of funding options.
    RISK: This can reduce competition in future funding rounds, potentially leading to lower valuations and more restrictive terms.

  8. Conversion to Acquisition
    In some cases, CVCs may include terms that give them the option to convert their investment into an acquisition at a predetermined price or under certain conditions.
    RISK: This can limit the startup’s exit options and may not always lead to the best possible valuation for the company.


In summary

While CVCs can bring significant strategic benefits, such as market credibility, access to resources, customers, and industry expertise, some of the terms they request can create challenges in future fundraising or exits.

Startups must carefully balance the immediate benefits of CVC investment with the potential long-term implications for their growth, independence, and attractiveness to other investors.



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