I have participated in transactions with strategic investors as both a co-investor and as an entrepreneur. It is perhaps most common to think of strategic investors as larger, established corporations that make equity investments in entrepreneurial ventures – precisely how the Kauffman Foundation defines it. However, the reasons they make these investments vary and are more subtle than the definition implies.
A somewhat obvious reason is that corporate investors seek to gain a strategic or operational advantage by investing in emerging technologies. A friend of mine who has worked in multiple large corporate venture groups offered a bit more colour. Corporations set up venture units to serve as a single contact point for emerging technologies, which historically could get lost in the organisation; to fill the gap in the capital markets where meaningful innovation needs to occur; and to align interests between technology companies that bring valuable innovation and the corporate enterprise.
This article focuses primarily on direct equity investments in emerging companies. However, corporations have also been active in setting up open innovation programs and becoming limited partners in independently managed venture capital funds, sometimes with co-investment rights. So a corporation need not have a dedicated fund group in order to be involved actively in the world of venture-backed companies.
Also to avoid confusion, when I refer to venture firms or venture capital funds without the word strategic or corporate in front of it, I am referring to non-strategic venture investors. These are typically venture capital funds managed by a team of professional asset managers backed by limited partners as part of a financial return strategy. I am a partner in such a venture capital fund – Independence Equity. In many cases, the limited partners want the exact opposite of strategics – little or no connection to the assets in which the managers are involved, just as the average investor does not tell his mutual fund manager what to do. These lines are blurring in some cases, so stay tuned.
Setting the stage
Corporate venture capital is experiencing a bit of a renaissance. According to US trade body the National Venture Capital Association, corporate venture groups invested $5.4bn in 2014, accounting for 11% of all venture dollars invested – the strongest year since 2000. I experienced this first-hand in the late 1990s, when seemingly everyone caught the private equity bug. Many large companies, including my former employer, entered the venture game. This time it feels different and more circumspect – it was $15bn in 2000.
My former employer was not an experienced venture investor and the targeted companies were not necessarily strategically aligned with its product and service offerings. Back then, service firms, including accounting and law, were exchanging fees for equity. It did not end well and many of these initiatives were terminated. Today, I see corporate investors making significant efforts to ensure business unit alignment – in short, to ensure there is an operational benefit in addition to a financial one.
I hope this approach proves sustainable because corporations are playing an increasingly critical role in financing important technologies. Our venture fund invests in sectors such as cleantech, agriculture, material science and advanced manufacturing. In these circles, there is regular lamenting over the availability of venture capital. Entrepreneurs in any sector might state there is not enough venture capital, but in sectors like cleantech, the investors themselves also feel this way. A combination of several factors, including capital intensity and extended sales cycles have led many venture firms away from sectors such as cleantech and back to traditional areas of focus such as infotech.
Fortunately, strategic investors have stepped in where financial investors have exited. This matters a lot, because many of these companies are commercialising breakthrough innovations that benefit mankind. And they cannot all be brought to market solely on government research dollars. So many entrepreneurs in sectors such as the aforementioned often ask me whether and how to work with these types of investors. It is important to understand that just like other types of investor – angels, family offices, venture capital firms and so on – there is a wide spectrum of strategic investors, and with it, how they approach deals.
Types of strategics
Many strategic investors begin by making investments from their balance sheets through operating divisions within the company. It is not clear to me that all these investments are captured in the aforementioned statistics, which represent more formalised venture groups. The balance sheet approach can add some complexity in terms of reporting requirements for the strategic and how entrepreneurs perceive their motivations.
Other firms have taken the step to set up a separate venturing unit, in some instances as a separate corporate entity or business unit. This is done for a variety of reasons, including internal organisational ones for the strategic, but it is also done to address a key concern of many entrepreneurs: “Will the strategic attempt to tie me up in some meaningful way?”
Separate venture capital units are, in part, designed to avoid these concerns. These dedicated units take other steps at times, such as eschewing board positions in favour of observer or advisory roles. However, this is not always the case and the concern remains a real one for many entrepreneurs.
In most of the strategic transactions in which I have been involved, the strategic sought some special rights in addition to the purchase of equity. These can come in the form of distribution and supply agreements, licence agreements, exclusivities, non-exclusive rights to product or technology, right of first refusal (ROFR) for sale of the company, preferred pricing arrangements and so on. It is critical for the entrepreneur or the co-investing financial investor to understand the implication of these agreements before beginning discussions with a strategic. Many of these agreements can have a significant impact on a company’s ability to pivot, exit opportunities and exit valuations.
For example, most venture capital funds will advise their entrepreneurs that ROFRs are a non-starter. And with good reason – a right of first refusal in the sale of the company can make a competitive bid or auction process impractical. Why would a competitive buyer delve deep into diligence if they know the deal can be swept away from them at the last minute by the company holding the ROFR? The potential buyer would also wonder how deeply entrenched the company is with the other strategic and be concerned with competitive disclosure issues. In short, an ROFR could restrict an entrepreneur’s ability to maximise value in an exit and to create a true auction-like environment.
Remember the objective of most venture-backed companies is extraordinary returns, not average returns. From the perspective of the entrepreneur and the non-strategic investors, it is not about seeking a fair price in an exit, it is about getting the best price.
While I am on this subject, I should carefully note that many of the strategic investors with formal venture capital units do not necessarily seek to become eventual acquirers of the companies in which they invest. And as highlighted previously, they often avoid some of the aforementioned conflicts by avoiding ROFRs and other issues. The strategic or operational gains can be found in other ways.
Separating equity from everything else
For example, they could be a customer, distributor or supplier. They could be first to market with a new technology. A distribution or supply agreement could be of great benefit to both parties. Imagine a small company that quickly gains access to global distribution of a large corporate enterprise. So, a key consideration becomes determining the value of any arrangement that is outside or in addition to the exchange of equity.
First, it is important to account for any exchange of value above and beyond the equity, as if the party was not an investor. For example, if there is a licence, then that licence provides some value via access to technology. Licence agreements often include upfront payments and royalties for the value of the technology to the strategic. A company will want to capture and specify this value clearly.
Second, an entrepreneurial venture will often require multiple types of investors over time. So if an angel, venture capital firm and a strategic invest in the same company, how do you ensure they have equitable value, especially if the strategic is getting extras? On the one hand, access to the emerging company technology might provide the strategic with a major competitive advantage in the marketplace. On the other hand, the strategic investor might bring added value that the angel investor cannot. What is one to do? Account for it in discrete standalone agreements separated from the equity arrangement. For example, if there is access to technology, then structure a separate licence agreement. On the flip side, if the strategic is providing access to new markets, a distribution agreement might help ensure fair compensation for selling the company’s product. In other words, price extras separately where possible.
Third, equity interest and operational interest may at some point diverge. For example, a strategic may at some point elect to exit an equity position, but might still want to have an operational relationship such as a licence with the company. If those were intermingled, separating them may be a challenge.
In short, operational or strategic benefits need to be properly accounted for and they need to be valued separately from the price of equity. After all, the price paid for equity involves a fair exchange in percentage ownership in the company just as provided to any other investor.
In the second article we will continue the discussion about alignment and how to ensure that interests are aligned between the strategic and the other company stakeholders. We will also discuss how one finds the right investor.