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Do not forget corporate venture groups when you are looking for capital

September 2019  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2019 Issue


Early stage technology companies should not overlook large corporations when looking for early stage capital. Corporate venture capital (CVC) groups regularly invest in new technologies that are compatible with or disruptive to their existing operations.

CVC investments can offer significant advantages to young technology companies, as CVCs can offer significant support for their investments by providing resources in addition to pure capital, such as access to new markets, distribution and technology expertise that traditional venture capital cannot provide. But, these groups take many forms, and, as with all sources of funding, there are potential pitfalls for the unwary.

Corporate venturing exists to augment in-house research & development (R&D), as the pace of innovation is so rapid that large corporates often cannot keep pace with nimble entrepreneurial start-ups. CVCs are becoming a larger part of the venture capital landscape, with 264 new CVCs investing for the first time in 2018, according to CB Insights. The total number of CVCs has almost quadrupled over the last five years, as these investors are eager to find and support technologies that enable or disrupt their core businesses.

Additionally, corporate venturing runs in cycles and, as such, corporations often change how they invest. A corporation might start by dipping its toe in the water with select investments done on its balance sheet and executed by its corporate development teams and business units. These corporations may also invest as limited partners in other funds as a means to getting started. With some success, this may lead the corporation to create a standalone fund managed by a small venture team and ultimately even into a more evergreen standalone fund.

Henkel AG & Company is a good example of a company which is willing to make investments off its balance sheet. It identifies areas of strategic importance to the company and actively reaches out to promising startups in those markets. Decisions on investments and which markets and technologies to analyse are typically in the hands of the business units and R&D groups, rather than dedicated investment professionals. These teams often have limited bandwidth to evaluate new investments and tend to be very selective in what they will evaluate. One disadvantage of this approach is these corporations might be overlooked by promising startups that may not recognise them as potential investors.

Not all corporations start with direct investing. Instead, they make investments into existing funds as a limited partner. Pangaea Ventures and Franklin Templeton’s Blackhorse Fund are two excellent examples. Both funds are backed by corporate limited partners, rather than by traditional large institutional and high net worth investors.

These funds are an interesting hybrid approach as they offer the start-ups some limited access to their corporate limited partners, unlike traditional financial venture capital funds. However, since these funds are financially driven, they typically do not come with potentially onerous terms that some strategic corporate investors might ask for, such as a right of first refusal on future exits. These funds can be a very positive way for corporates to get involved in a larger number of deals than they would be exposed to on their own, and minimise their management oversight with the fund taking on such responsibilities. The one limitation is when there is a strong strategic overlap with one limited partner, where that partner may only get minimal exposure due to the fund acting as an intermediary.

To overcome the limitations of one-off investing or only minimal involvement through third-party managed funds, corporations often migrate to institutionalising the investment process with the establishment of an internal venture group. Mitsubishi Chemical, Solvay and Evonik are all investors in Pangaea Ventures, but each maintains its own internal venture fund as well. Boeing Horizon X represents a great example of a more recent internal CVC fund, which hit the ground running in early 2017 and has made over 20 investments since.

Boeing Horizon X has a dedicated team that formally manages and overseas its investment process, yet also works hand in hand with its operating business units to evaluate investment opportunities. These internal CVC funds make investment decisions that are closely tied to corporate needs but, ultimately, investment professionals are rewarded on the returns they generate out of the fund, rather than the effect the investment may have on the underlying company.

There are also large, well-known CVC funds that are independently managed, such as GV, the investment arm of Alphabet Inc., Intel Capital, the investment arm of Intel, and Next47, the investment arm of Siemens AG. GV has been the most active CVC over the last three years. These groups often consider themselves pure VCs rather than part of a corporate group and, accordingly, approach investments more like a purely financially focused VC. Nevertheless, these groups usually have a strong connection back to their corporate sponsors and their interests often align completely with their parent.

In addition to the corporation’s decision on how to structure its investment vehicle, there are a wide variety of other factors to consider when approaching corporate venture groups. The size of the fund and their individual investment size are an important consideration. For example, some smaller CVC groups such as Evonik Ventures or Solvay Ventures have a sweet spot investment of $500,000 to $5m, while other large funds, such as Next47 or Koch Disruptive Technologies, prefer to invest significantly larger amounts given the size of their funds.

As with traditional VCs, funds range from early stage seed funds to late stage growth funds. Many smaller CVCs often like earlier stage investments where they can have a meaningful ownership stake and ability to influence the company, while some larger funds want more mature companies with established market traction and less technology risk. Another issue is whether the CVC will lead a round. A common misconception is that CVCs will not lead.

Although it is true that most internal CVC funds and balance sheet investors are looking to stay under 20 percent ownership so that they do not have to consolidate financials, many CVCs are now stepping up to lead rounds where there is strong strategic interest. CVC groups can also have differing investment horizons, often dependent on whether the investment professionals get graded on their investments or not. Where some insist on incorporating exit planning into their investments like financially motivated VCs, others are more interested in technology development and therefore are not as concerned by a return of capital over the longer term.

Despite the differences between varied corporate venture investors, most look at investments similarly. Like traditional VCs, corporate investors look at key factors in deciding where to invest. First and foremost, investors invest in people, not technology. Consequently, no matter what source of capital is being pursued, companies that have great management teams will be more successful fundraising than companies that do not. CVCs often lament over the number of opportunities they see with unique technology being marketed by a team of PhDs without a sound business plan or strategy.

When it comes to evaluating technologies, CVCs typically have a great advantage over financial investors. Venture investing, by its nature, is about disruptive technologies and processes, not incremental technologies. This is important to note as incremental technologies that are mature can be good acquisition targets but will likely fall short for the investment teams on venture funds. Finally, companies seeking investment should understand and be prepared to explain the risks associated with the investment, including protecting intellectual property (IP), competition and scaling the technology.

While corporate investors can be a great alternative for early stage technology companies seeking capital, there can be unattractive pitfalls as well.

As most investors are investing because of their strategic or competitive interest in the technology, they often attempt to retain rights to further control the investment in the future. It is not uncommon for corporate investors to seek rights of first refusal, exclusivity arrangements or similar mechanisms, or to tie business requirements, such as distribution rights or purchase obligations, to the investment. Depending on the company’s future plans, these entanglements can make a corporate investment unattractive.

In addition to pure investment, corporate investors can also be great sources of non-dilutive funding. Companies looking for corporate investment should also consider whether corporations might also be interested in other ways to jointly develop a new technology. Nonrecurring engineering payments, joint development agreements, grants and similar arrangements are common ways for large corporations to support a strategically important new technology, even when an investment may not work.

Overall, early stage technology companies seeking to raise capital should evaluate whether corporate venture groups are an appropriate source of capital. In the right circumstances, these smart money investors can significantly benefit young companies far in excess of the amount of their investment.

 

Michael Schwerdtfeger and Danny Piper are principals at NewCap Partners. Mr Schwerdtfeger can be contacted on +1 (310) 541 4851 or by email: schwerdtfeger@newcap.com. Mr Piper can be contacted on +1 (310) 645 7900 ext 24 or by email: piper@newcap.com.

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