Corporate Venture Capital – an Acquired Taste for the Discerning
Before I start here is a disclosure. I have now been involved in eight start-up companies as a manager or founder, six as CEO, with exits valuations ranging from zero to a listing on the NYSE. In addition I have made many more investments as a venture capitalist.
Whilst raising funds for start-ups I have, on many occasions, taken investment from corporate venture capital groups, including Intel, BASF, Applied Materials and LG Display. In addition, as an institutional venture capitalist I have co-invested with a bunch more corporate venture capitalists.
Types of corporate venture groups
In my experience there are three extreme forms of corporate venture capital groups:
1. Those driven purely by financial return
2. Those driven purely by ‘strategic’ returns to their operating organizations. ‘Strategic’ means that an operating group of the corporation in question has serious interest in working with a start-up, or licensing and/or buying its technology, or even acquiring the start-up at some stage
3. Those driven solely by marketing and publicity outcomes
In reality, most corporate venture groups fall somewhere in between the lines; each and every corporate venture group could in principle be positioned as a dot on a three-axes ‘radar’ plot.
My impression is that, in the current era, corporate venture seems to be more biased towards strategic interest or marketing interest and not so much on financial return; although this is difficult to monitor since most corporate investors do not disclose their investment thesis, sometimes because they haven’t even articulated it to themselves.
In principal, corporate venture groups should tailor their investment choices, the investment management models, and the choice of management staff to their specific investment thesis (i.e. the relative degree of strategic versus financial versus publicity motivation), and this is where some corporate venture groups get it horribly wrong.
In addition many corporate venture groups are continually changing strategic direction. Sometimes they even go out of existence only to reform later on. As an outsider it can be very confusing to watch and this constant change doesn’t engender any sense of confidence in these groups as ‘stable’ investors.
As an entrepreneur one of the wonderful things about institutional venture capitalists is that, whilst they don’t always behave in ‘good’ ways (at least from an entrepreneur’s perspective), they pretty much always behave in predictable ways. The same cannot be said for corporate venture capitalists.
Those last few paragraphs sound a little negative, so I would like to go on record and say that there are some fabulously professional corporate venture groups that are a dream to work with.
For example, Intel Capital and the Applied Materials Venture Group, both in Silicon Valley, have been plying their trade for decades and can offer a very amenable experience to the entrepreneur, if somewhat different to institutional venture capital.
The key is to be aware of those differences.
Now I would like to go out on a limb and suggest that the high-quality corporate venture groups are in the minority and the majority of corporate venture groups are a much riskier proposition as a source of capital.
Why so? Well many corporate venture groups are quite young and haven’t yet been through a few cycles of investment whereby they hopefully engineer out many of the inefficiencies in their investment model. Even some of the older groups seem to be able to ‘forget’ their hard-earned lessons when they go through ‘restarts’ associated with corporate restructuring.
Being an entrepreneur in a tech start-up is all about having a great idea, lots of capital, great enthusiasm and luck, a ton of start-up experience, deep industry knowledge and also the ability to reduce all unnecessary risks.
In this context corporate venture capital is often considered an unnecessary risk, not just by entrepreneurs but also by institutional venture capitalists when looking at co-investing in deals with corporate venture capital groups. Given this I often wonder why startup companies ever take corporate venture funds.
There are three simple answers:
1. They don’t know any better, or
2. They have no choice or,
3. There are overwhelmingly good strategic and/or operational reasons to work with a specific corporate venture group that sufficiently offset the implicit negatives
They don’t know any better
I am sure that many readers have seen inexperienced entrepreneurs that are very excited to have done a seed round of funding with a large corporation only to find out that the this funding ends up choking any opportunities for the start-up.
I won’t labor the point other than to say that the inexperienced types tend to find each other in the venture capital world. And it rarely works out well.
They have no choice
There are two types of companies that may have no choice but to accept corporate venture capital.
Start-ups in many of the older industry segments have for some time struggled to find institutional venture capital support. Primarily this is because average returns on investment in these industry sectors do not warrant institutional venture capital investment.
This is a reflection of a number of factors including:
1. These are low-growth and mature industries
2. The products in these sectors have relatively low margins
3. There are relatively fewer opportunities for new platform technologies and the customer base can often choose to simply ignore any revolutionary changes
4. There are low multiples for M&A transactions and IPO’s, and
5. The start-ups in these sectors typically have high capital requirements and long times to exit.
In contrast, Internet and Smartphone App startups, by way of example, have few of these problems and are now very much the focus of mainstream venture investment. In these and other sectors there are higher returns that justify institutional venture investment and this fact exacerbates the problem of getting investment into older industry sectors.
However I would note that whilst being unfashionable and of lower return, good technology companies in older industry sectors sometimes have a less facile operating environment with much less competition.
With an informed and experienced corporate venture team I would argue that older industry sectors can sometimes offer an interesting alternative (as measured by risk and return) for an entrepreneur when compared to the current over-crowded and clustered institutional venture sectors.
Another reason why companies might have no choice but to accept corporate venture capital is that they are operating in odd geographies (like Australia and most of Europe, for example).
Because of the poor venture capital deal flow in these places (the good deals go directly to Silicon Valley) and the consequential absence of sufficient institutional venture capital, there is often an opportunity for corporate venture groups (which tend to be less scared of foreign investment than institutional venture capitalists) to pick and choose investments in these geographies.
There are overwhelmingly good strategic and/or operational reasons to work with a specific corporate venture group
Sometimes a corporation is, for example, so well placed in a market that they offer the very best market partner or even thesole exit opportunity. In these cases it can make good sense for a start-up to work with the venture capital group of the corporation, so long as there are experienced managers on hand to minimize the downside risks of such an involvement. Even so, the question should always be asked as to whether an operational agreement can be done with the corporation in the absence of a corporate investment deal.
Working with corporate venture capital
If, as a CEO of a start-up, you find yourself compelled to take money off a corporate venture capital group for one or more of the reasons (as listed above) then here are some simple guidelines (in no particular order) that should be considered that may help to reduce any unnecessary risks to your business.
1. I believe that the primary interest of a corporate venture capital group should be a strategic interest because this is where they have an unfair advantage (e.g. market presence and technology awareness). And if they don’t have this then why take their money?
2. Sometimes, just sometimes, the market presence of the corporate group is so overwhelming that investment by their corporate venture group is seen as compelling due diligence into the opportunity. This can help in getting co-investors on board. Often however, institutional venture capitalists can be very nervous about the idea of co-investing with corporate venture capitalist, especially ‘global’ companies without many years of experience investing through a Silicon Valley office.
3. It is always good to understand how a corporate venture group measures the ‘performance’ of its corporate venture fund. Is it purely based or IRR, or is this offset by ‘strategic value-add’ to the corporation? Are the corporate venture managers on a salary with a bonus or is there profit share system in place? These things really matter and you should know the answers.
4. It is always worthwhile understanding the experience base of the corporate venture people you are talking to. I have met people that have three years of work experience in a corporation as a junior finance manager followed by an MBA, where after they have walked straight into a corporate ‘VC’ role; clearly they will make mistakes. On the other hand I have worked with corporate venture managers that have done the hard yards as associates and principals at institutional venture capital firms; these people have bothered to learn the venture capital trade and their corporations have respected that venture capital is a trade.
I like to make an analogy to blue water yacht racing – you can read all you like about venture capital and blue water yacht racing in text books but in neither case will it help you stay alive in the water without also doing the years of apprenticeship.
5. Your company should be developing new ‘platform’ technologies, rather than new products off an existing platform. I believe that operating corporations are best placed to develop new products off existing platforms but, due to internal processes, are often less able to fund risky new development of platform technologies, and indeed often do not have R&D people with the required pioneering mindset. Whilst not their only role, this is the gap in the market that start-ups fill on behalf of corporations.
6. Any corporate venture investment should have strong support from within the operational groups of the investing corporation. Preferably this includes C-level support, and is based on alignment of the start-up company’s technology and the current strategic intent for growth or profitability of the corporation. Within the corporation it is a good idea for there to be an ‘acquisition’ thesis. Although this rarely works exactly to plan, it can be a living document that helps create and maintain internal support for a strategic investment.
7. Companies that receive corporate venture investment must have more exit opportunities other than acquisition by the single investing corporation. That is, they must be ‘real’ companies with great management, and not just spin-out R&D groups tied to the mother-ship. In fact the more tension there is between an acquisition by the investing corporation and the start-up’s efforts to create higher-value alternatives for itself, the faster is the development of the technology, products and sales. It is a good problem to have.
8. As ever, a start-up should not take investment off a corporate venture capital group unless the corporate venture capital group has the financial capacity to be there for the whole journey. And planning for the journey to exit must include delays and detours and extra rounds of funding, as is always the case for start-ups. Associated with this, in the older industry sectors it is often the responsibility of the lead corporate investor to round up interested co-investors, including other strategic investors, VC’s and venture debt providers.
9. For a start-up, taking money off a corporate investor can create all sorts of issues that can possibly diminish enterprise value at exit. For example, the relevant market might see the start-up as ‘aligned’ to the corporation and be less likely to work with the company as a true independent supplier. Indeed this issue of alignment can lead to much fewer exit opportunities in an M&A scenario.
10. Also, competing corporations often do not co-invest in a start-up of joint interest, and this can lead to fewer funding opportunities for the start-up.
11. By working with start-ups, corporate operating groups often risk IP ‘contamination’ which also reduces alternative exit opportunities and exit value for the start-ups. Contracts and investment pricing must be well managed to offset this risk.
12. Often investing corporations want first and/or last rights of refusal on the sale of the start-up or its key assets. This reduces alternative exit opportunities and should be avoided at all costs.
13. Another issue is the continuity of the investment manager role in corporate venture groups. All too often, three years into a deal a venture manager at a corporate venture group simply changes jobs or leaves the corporation altogether. This is a serious pain in the butt for the entrepreneurs and institutional venture capitalists because it takes quite some time to get boards to be functional and trustworthy. If this change of personnel happens at a critical moment, e.g. a round of funding or an exit, then it can have serious consequences.
14. Related to the last point I have had experiences with corporate venture groups where because of a restructure, or a change of strategic interest, or change in investment managers, or even a change in lawyers, it has simply been impossible to get a signature from the corporation. This can be extraordinarily frustrating when, say, a round of funding is being held up. Do not believe any guarantees by corporate venture groups that this will not happen; if they offer such a guarantee ask them for a ‘power of attorney’ in the instance they won’t provide a signature in a certain timeframe. Of course they will never agree to such a thing!
15. A key strategic issue that corporates need to understand is that corporate venturing only works when they themselves are developers and vendors of technology solutions. Corporations that are simply users of technology usually do not have the appropriate insight to start investing in alternative technologies in their own supply chain. For example, Oracle is well placed to understand the market potential of a new data mining technology, whereas one of Oracle’s customers, say a large supermarket chain, while capable of being enticed by a new data mining opportunity certainly does not have the skills to understand the risks of investing in the same. They will invariably subtract value from the investee – there is no neutral impact on startups by investors!
16. A good corporate investment group has a specific set of policies for dealing with start-ups, which also includes an investee education process. Ultimately it is simply a matter of ensuring that any lower returns to the founders of startups (by association with corporate investment) are off-set by lower risks of failure with more guaranteed, if lower, returns. Another benefit of upfront education and communication on these complex issues is time saving; what needs to be avoided, for example, is 6 month negotiations over simple supply agreements where matters such as IP sharing become sticking points. After ‘shareholder behavior’ and a shortage of capital, ‘wasted time’ is one of the greatest risk factors for start-ups.
17. A good corporate venture group needs to ensure that it is in ‘control’ of the relationship between the start-up and its own corporate operating groups. The operating groups will naturally try to ‘tie-up’ the start-up they are working with, using all sorts of complexities, such as IP contamination, exclusive license agreements, tough financial terms and the like. On a deal-by-deal basis this may seem like good practice, but averaged out over a few years it creates an environment that experienced CEOs and founders (who make these opportunities ‘real’) avoid altogether. It is really up to the corporate venture groups to create a perceived environment where start-ups are treated well, and where the balance of risk and return is for some deals equivalent to or better than the institutional venture capital sector. Rather unfairly, it takes years to build up a reputation as a corporate venturing group that is worth working with, yet one sour deal , say where a corporate operating group has behaved badly, can trash that reputation overnight in the incredibly networked entrepreneurial world.
18. A normal investment round for any start-up is effectively a two-party negotiation between the common stock holders and the participating venture capitalists. However if you introduce a corporate venture capitalist into the mix you then get a three-party negotiation because corporate venture groups have different needs and goals to institutional venture capitalists. An extreme example is where a corporate venture group wants a start-up company to execute a Covenant Not to Sue, or a first and last right to acquire the company, or some market-focused operating agreement. Each of these reflects a transaction of considerable value and hence it is unreasonable to ask a participating institutional venture capitalist to pay the same price per share as the corporate venture capitalist that is insisting on these side benefits. If and when this happens you can expect months of wrangling before a deal is closed.
19. There is a type of corporate venture groups that I think should be especially avoided and these are the ones that solely have a marketing or publicity interest. They are quite easy to spot. First they typically have super-small ‘funds’ (they actually usually invest off the corporate balance sheet) of say $5-20m. Secondly, they tend to be companies such as supermarket chains, bank or telcos that are users of technology and not suppliers of technology solutions. The reason they invest is usually to generate local publicity. Rarely do they offer any strategic value. These small corporate venture groups can act to slow down a company’s growth via offering only small seed funding rounds – in our fast moving world even 6 months of delayed capital spend can spell the difference between success and failure. In addition, without relevant venture capital apprenticeship the investment managers in these ‘funds’ can be guaranteed to distil the worst of the behaviors described in this article.
In conclusion, to entrepreneurs looking at corporate venture as a source of funds I would say three things. Firstly, there are good and bad corporate venture groups out there and it’s worthwhile checking the quality of the one you are about to deal with. To do this you simply talk to other entrepreneurs that have taken money off a specific group. Secondly, you need to understand their investment thesis and strategy, and be comfortable that is sufficiently aligned to your company and also to the interests of the other investors. And finally, keep cycling through my ‘cheat-sheet’ of critical issues as listed above to see the ‘gotchas’, either before you do a deal or after you have their money.
Or, you might just reconsider the idea altogether.
Ian A. Maxwell is a veteran Technology Entrepreneur and Venture Capitalist. He is currently CEO of BT Imaging, Chair of Instrument Works and Co-Founder of Accordia IP as well as an Adjunct Professor at RMIT. He has a PhD in Chemistry and has either founded or worked at Memtec, Allen & Buckeridge, Redfern Photonics, Sydney University Polymer Centre, James Hardie, Viva Blu, Enikos, Wriota, RPO and Instrument Works. You can connect with him on Linkedin au.linkedin.com/in/maxwellian