This is the first of a three-part series following a corporate venturer’s evolution from in-house balance sheet investor of pet projects into a full-blown venture capital house with third-party investors.
This series will describe some of the legal, tax and financial structures employed in this evolutionary process. Clearly not all corporate venturers will walk this path, but many will consider and implement aspects of this journey.
This first article will consider the typical corporate structure and some of its advantages, with suggestions on structural improvement, through on and off balance-sheet methods, and onshore and offshore structures.
The second article will show the corporate’s move to raise additional rounds of money in its new burgeoning portfolio, from itself and third parties directly into the portfolio companies, and into funds and onshore and offshore special purpose vehicles.
The third article will describe the structure and oper-ations of a fully formed venture capital fund manager, captive or semi-captive to the corporate.
Why be a corporate venturer? The firststeps on the corporate venturing evolutionary path often begin when a corporate decides either to create a business around an in-house idea or intellectual property, or to invest in a promising external opportunity relevant to its core business.
Forming corporate venturing relationships can be a way for a corporate to develop and broaden its business without the commitment and finance required to acquire other businesses, and it can be a way for smaller companies to grow and gain access to investment, expertise, contacts and market knowledge at a greater pace than they may otherwise be able to achieve.
It can also be part of a more strategic discipline, such as tracking technology that could influenceor enhance one’s core business, finding future competitors, or for public relations value or to counter perceived prejudice. (see graphic by clicking here)
Next stage
Once a corporate has been investing on an ad hoc basis for a period of time, it may begin to develop investment strategies that form a systematic process, so that it specifically seeks out potential investments within an agreed business area.
In this instance, it will begin to evolve from ad-hoc investments to a way of making money and expecting a return. This may lead to the creation of an investment team.
One common challenge is then to deal with an almost inevitable set of conflicts of interest that arise, both commercially and legally, when officials of the corporate become part of portfolio companies. Dealing with such conflicts can include establishing a process for definitions of conflict – giving examples and relating it directly to the business – and by appointing a committee, whereby directors can resolve disputes.
Directors facing potential conflicts of interest cannot vote but may attend and speak. It is important that such committees resolve disputes only on conflicts of interest and decisions on investing are left to the full board. In addition, taxation issues can arise for officers or employees of the corporate in taking board seats or quasi-employee roles in the portfolio company.
That said, there are potential economic benefits in taking portfolio company stock or options.
Structuring opportunities
Offshore: The main advantage is tax, although it must be recognised that the administration costs of setting up off-shore may sometimes outweigh the tax benefits gained. In addition to tax benefits, other advantages include lower levels of regulation, more diversification and privac.
Off balance sheet: Advantages can include moving tax outside the corporate group (although start-up company tax losses can be advantageous), accounting creativity, repositioning the portfolio company as an investment, isolating potential conflictsof interest, and presenting the asset externally as a third party business rather than as core.
Negotiation
Valuation: This is inherently tricky, especially if you end up negotiating against yourself or ex-colleagues. Seeking third-party valuation validation or strong comparables can be useful.
Other Investors: Ideally you should seek to lead all the rounds of financeand set price and strategy, as well as board initiative and composition.
Management team: These people are likely to be the most significat provider or destroyer of value. Ideally add repeat entrepreneurs to your own people.
Intellectual property rights ownership (IPR): Should the portfolio company own or licence the IPR from you?
Conclusions
Understanding the reasons the corporate is undertaking venture is perhaps the most interesting issue. Is it solely to garner investment profit,or to drive long-term core business profits? Is it to findor to squash? Is it to nurture or to starve? For increasing social responsibility or to enhance internal or external public relations? Or is it just a clever redundancy programme?
Often, from an external perspective, a corporate can emit confusing messages, which ultimately can reduce value. In defining the elements for obtaining commercial success, some groups swear by everything being based on the strength of management, others by the IPR or the disruptive nature of the business model. One overlooked factor is speed, and especially speed to market. This becomes a significant issue also if the investment team moves more towards a fund management model or the corporate spends increasing time negotiating with fixed-life venture capital funds.
UK tax advantages:
The UK government recognises the importance of investing in small to medium-sized businesses (SMEs) and has therefore developed research and development (R&D) tax credits, which are made available either as a tax deduction based on R&D spending or in some instances it may be possible for certain loss-making SMEs to surrender their losses in return for a cash payment from the tax office.
The government is currently undertak-ing a consultation in relation to corporation tax, which could have a significant impact on the sector. It is also considering introducing a "patent box" regime, which would allow profitsarising from patents to be subject to a lower rate of 10%. This new regime is intended to apply from April 1, 2013, and would reform the controlled foreign company rules in relation to intellectual property-rich companies and the R&D tax credits mentioned above.
The substantial shareholder exemption exempts the gain on a sale of a trading subsidiary by a trading group, provided the subsidiary was in the group and has traded for at least 12 months.
The Enterprise Investment Scheme allows for tax deferral and payment relief, and was designed to encourage investment in SMEs.