Corporate venture capital – transforming funding of technology innovation?
June 2015 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
Corporate Venture Capital (CVC) is understood to refer to equity investment by a corporation into start-up companies, either directly or through the corporate’s own venture capital arm. Investment typically occurs at an early stage in the investee’s lifecycle, with over 60 percent of CVC deals in H2 2014 being at either seed stage, series A or series B.
As companies reach maturity following initial phases of high growth and expansion, they can often find themselves being displaced by disruptive market entrants. Internal research and development (R&D) may not always produce innovative solutions. R&D investment requires deep pockets, and process-driven R&D (necessary when big sums are involved) leaves little space for ground-breaking innovation.
CVC offers corporates direct investment into emerging companies and the solutions they offer; it allows for early identification of critical threats and an opportunity to adapt or participate in the success of the investee companies and technologies.
With CVC having emerged in the 1960s, we are currently experiencing the fourth wave of CVC investment, according to the British Private Equity and Venture Capital Association. The first wave was brought to an end by the 1970s oil shocks and collapse of the IPO market. The second wave ended with the 1987 financial crash, and the third with the end of the dotcom boom in the early 2000s. The prevailing opinion is that the current wave of CVC is likely to be the most successful yet. CVC investors have become more sophisticated, aligning their objectives with those of the relevant corporate and focusing on investing in businesses which complement the corporate’s own strategic objectives.
CVC activity saw a substantial increase in 2014, with 25 percent year-on-year growth in the number of deals closed (654) and a 76 percent year-on-year increase in funds invested ($12.3bn). This latest wave of CVC activity has been fuelled by several external factors – in particular the worldwide increase in tech start-up activity (and therefore the availability of new technology), itself powered by investments in infrastructure, including in innovation hubs and internet and mobile technology, which has improved connectivity to consumers. The internet and mobile sectors were responsible for over 50 percent of the number of CVC deals in each quarter of 2014.
Corporates seeking innovation have diversified away from internal R&D, in favour of direct investment in third party sources of innovation. Corporates have also been seen to respond acquisitively when challenged by disruptive technologies, seeking to acquire disruptors rather than to compete directly. Large cash reserves on corporate balance sheets have helped fill the vacuum created by the restricted access to bank lending, particularly in the technology industry.
So who are these CVC investors, and which disruptive technologies are benefitting from their investments? Google Ventures was the biggest CVC investor in 2014, by number of firms invested into, and number of exits. Intel Capital was second in both categories. One of Google Ventures’ more headline making and typically disruptive investees is Uber, the mobile transportation network provider, into which Google Ventures invested €258m in August 2013.
Differences to the private venture capital model
Strategically, CVC is not bound by the overriding objective of private venture capital investment, which is to provide above market financial returns. CVC investors, with cash directly accessible from their own balance sheets, may be more open to risk taking in exchange for potential higher financial returns. Not being subject to the constraints of any underlying fund, they may be more likely to wait for a start-up to reach its full potential before seeking to capitalise on any investment. There may be less imperative for an early exit to deliver an immediate or short term financial return, enabling investors to focus instead on business or strategic synergies. Investees may benefit from the capabilities of the corporate investor access to the corporate’s market knowledge or distribution channels may facilitate the investee in scaling up its business more rapidly.
CVC investment is structured differently to private venture capital; an investor may act as either general partner, limited partner, or both. Reed Elsevier, a multinational media and information company, has its own venture capital arm, Reed Elsevier Ventures (REV), in which Reed Elsevier Ventures Fund is a limited partner. REV is run by a small team of venture capitalists, invests in disruptive technologies in the internet, media and technology sectors, and encourages collaboration between the Reed Elsevier group and the start-up investees. Bosch utilises the same model using Robert Bosch Venture Capital.
In contrast, chip designer ARM has a single investment committee which oversees its internal R&D and CVC programmes. It invests in the wider ARM ecosystem, either directly or as a limited partner alongside private venture capital firms, to complement its R&D strategy and manage risks inherent in its business. At the end of December 2014, ARM’s investment portfolio was valued at £23.7m. For example, in 2013 ARM was part of a consortium of companies that acquired the patent portfolio of MIPS Technologies Inc. The rationale behind this move was to enable ARM to conduct further R&D using these patents, eliminating the risk of patent infringement action. ARM has also invested in innovative companies which operate in ARM’s key markets, such as Calxeda Inc, a no-longer trading chip designer which developed server chips based on ARM technology.
Reflecting a principal likely driver for CVC investment, namely gaining access to new technology, the CVC model will typically show some key distinctions to the commercial and exit arrangements underpinning a private venture capital transaction. The investment agreement may, for example, include a knowledge sharing agreement to enable the CVC parent to control the development and commercialisation of the technology that it sponsors. It may also provide for the right of first refusal over licensing of any new technology, distribution of the new product or any sale of shares of the investee company. This may prove particularly useful where the long-term strategy is to acquire the investee company. Alternatively, a ‘call’ option may be negotiated to enable the investor to acquire remaining shares in the investee company at a future date.
Barriers to further development?
CVC investors are typically unable to benefit from the same accounting exemptions available to investment funds in respect of the recognition of investments on their own balance sheets. Under IFRS 10, corporate investors are required to account, in respect of any ownership interest above 20 percent, for a share of the profit and/or loss of the investee in their own balance sheet. Similarly, where a CVC investor holds a controlling interest, full consolidation of income statements and balance sheets would generally be required. Nick Watson, a partner at Grant Thornton UK LLP, comments: “As many early stage investments are loss making in their initial phases of development this can have a detrimental impact on CVC investors balance sheets relative to investment funds.”
The prospect of such a direct impact upon a corporate’s balance sheet can deter potential CVC investment, or lead to unintended changes in the structure of a transaction; for instance, the CVC investor may not take up an appointment to the board of an investee. It may also prejudice the availability of R&D tax credits for the investee company.
As well as accounting concerns, CVC investors no longer benefit from the tax reliefs previously available under the UK’s corporate venturing scheme (CVS). Under the CVS, corporates making investment into qualifying companies were entitled to tax relief upon up to 20 percent of the amount subscribed for ordinary shares. Subject to chargeable gains on such shares being reinvested in similarly qualifying shares, tax on such chargeable gains was deferrable, and relief against income was available in respect of losses arising on the disposal of any such shares.
Under the CVS, corporates making investment into qualifying companies were entitled to tax relief upon up to 20 percent of the amount subscribed for ordinary shares. Subject to chargeable gains on such shares being reinvested in similarly qualifying shares, tax on such chargeable gains was deferrable, and relief against income was available in respect of losses arising on the disposal of any such shares.
Between 2000 and 2010, £132m was invested into 600 small companies under CVS. However, the scheme was eventually discontinued, criticised by a parliamentary select committee for, amongst others, containing an extensive number of restrictions.
With CVC activity on the rise, there are increasing calls for the CVS scheme to be reintroduced. Industry voices suggest a reintroduced CVS might offer higher rates of relief against corporation tax, of between 30 percent and 50 percent. It has also been suggested that CVS could be brought up to date by increasing the threshold for the size of a qualifying company to £25m, a figure which would better reflect the typical upper limit of investment from an average venture fund. It will be crucial to ensure that any such reintroduced scheme is simple enough to be workable, whilst not breaching state-aid requirements. Concerns that such investments could affect the trading status of groups for the purpose of the substantial shareholding exemption should also be addressed.
CVC has the potential to generate jobs, increase investment into early stage, innovative companies, particularly those making use of emerging and developed technologies, foster strategic alliances between growing companies and well established larger corporates, and ultimately grow GDP. An appropriate regulatory and policy framework can provide additional support to assist this fourth wave of CVC to continue its remarkable growth.
Stuart Blythe is a partner and Max Weaver is an associate at CMS. Mr Blythe can be contacted on +44 (0)20 7367 2112 or by email: email@example.com.
© Financier Worldwide
Stuart Blythe and Max Weaver