Corporate venture capital is hot…really hot. U.S. funding levels spiked in Q2 2014 to nearly $1.2 billion and public tech companies are sitting on massive cash balances. These companies are looking to parley their huge cash positions into new growth opportunities through their own venture groups in order to try and keep up with the accelerating pace of innovation.
The first three quarters of early stage venture investing activity has already more than surprised last year’s total activity. Q3 2014 also represents the 6th consecutive quarter of 1,000+ deals completed. Software continues to be the favorite destination of the venture community garnering more than 50% of all investment dollars through the first 3 quarters of 2014. Similarly, the Corporate Venture Community (CVC) has been active. Simply stated, more and more corporations are looking outside their organizations to keep pace with the accelerating pace of innovation. As seen below, CVC is on pace to increase the total dollars invested from $3.1B in 2013 to $4.2B in2014, representing a 34% yoy increase.
One example of a new entrant into the CVC world is the launch of Autodesk’s new $100M fund to invest in 3D opportunities. The Spark Investment Fund, which will be managed within Autodesk, is the first of its kind for the 3D printing industry with plans to invest in entrepreneurs, startups, and researchers who are pushing the boundaries of 3D printing technology and accelerating the third industrial revolution.
Why Consider Strategic Investment
Many solid reasons exist for considering corporate venture monies as part of your financing strategy. These motivations can be segmented into five general areas:
- Channel: If your go-to-market strategy relies heavily on penetrating specific channels, joining forces with a more established corporation can be the most expeditious way to drive growth. Likewise, if you’re operating in a channel that is very noisy, a strategic investment from a larger channel player is a viable way to cut through the chatter.
- Geographic market: The potential for emerging markets such as India and China to play a key role in any technology firm’s success is huge. The straightest route into these markets may be through taking in investment dollars from corporations that are already making inroads overseas.
- Credibility: One lingering piece of fallout from the tech bubble bursting is that more discerning IT buyers screen for vendor viability. Regardless of your size or operating history, having an established corporate investor is a fast track to being viewed as a credible player.
- Product-integration: One of the strongest reasons for taking in corporate investment dollars arises in situations where you can clearly add value to the partner’s existing product set and install base. In essence, this investment is partner-funded R&D.
- Advisory: Along with a flow of corporate investment dollars should come domain expertise and a new and different–and therefore valuable– perspective on industry and technology issues. Corporate investors should also bring valuable insights into how best to position your company to other strategic players for exit.
Doing Your Due Diligence
If any of these motivations strikes a chord with you, then one of your first steps should be to carefully think through what you will need to know to choose wisely among potential corporate investors. Having the answers to these critical due diligence questions will help you increase the probability of building and maintaining a successful relationship with your corporate investor partner:
- What motivates the partner? What its investment objective and how does your firm fit in with that? Just as you need to thoroughly understand your own reasons for entering into a deal, you also need to know why the folks on the other side of the table are interested in backing your organization.
Key areas to explore regarding motivation include whether the potential investor has made other investments in your space or whether your firm is operating in a white space on which the investor is anxious to capitalize. If the investor has already invested significant dollars in a market space, it will be more wed to a particular strategic direction. You need to know if this direction is consistent with your view; if it’s not, it might limit the viability and benefit of a relationship to your particular business.
One way to explore whether the potential partner’s investment objectives and business expectations are a good fit for your company is to identify explicit relationship milestones, timelines, clearly delineated responsibilities and deliverables.
A red flag to a potential mismatch in motivations arises when a potential investor puts forth onerous deal terms that will limit your operational freedom. Be wary of requests for exclusivity, right of first refusal for downstream acquisitions, and veto powers.
Along these same lines, ask questions about who will own the intellectual property that arises out of the relationship. More experienced and savvy corporate venture professionals recognize the importance of such questions and can assure you that a Chinese wall will be in place to prevent cross contamination of intellectual property.
Another area of motivation to look into involves the corporate sales force. When the strategy involves having the investor’s team sell the new product or service into their customer base, the incentives for making that happen must be made clear. Many a strategic partnership has failed because the corporate sales force never really understood the new product or service, how it fit their customer base or how they would benefit by making the sale.
One strategy for thoroughly teasing out a potential corporate investor’s motivations is to enter into a business alliance before agreeing to an actual financing deal. Such an arrangement gives both sides a chance to get to know each other and to determine whether a stronger, longer-term relationship involving a strategic investment might have merit.
Who is driving the relationship on the investor’s side? If the corporation you’re dealing with has an autonomous corporate venture group, you’re going to want to get to know the individual from that group who you’ll be dealing with, along with anyone on the operational side of the company who will be influential in making the relationship work once it’s in place. Make sure the motivations and expectations articulated by both the investment professional and operational sponsor reconcile.
Dealing with a separate CV group tends to have advantages. But, of course, not all CV groups are created equal. A long-established CV group with a proven track record will be easier to evaluate than a newer cohort. It also may have more internal power to influence its corporate parent than a newly formed investment group.
With regard to the specific individuals you’re negotiating with, look at how long they’ve been in their positions and what their experience is with respect to boards of director positions or advisory functions. Also be aware that turnover is frequent in such corporate venture positions, so inquire about what would happen if the person you’re dealing with leaves.
Similarly, look at whether the operational people you’ll be working with understand your industry and technology, and where they reside within the organization. A positive answer will have significant implications with respect to their ability to sell your technology and the broader business opportunity to colleagues as the relationship goes forward.
Potential culture clashes are also something you’ll want to explore. Culture differences can be significant between emerging companies and long-established corporations. The CEO of a company that once took money both from venture capital firms and from a strategic partner told us, “The strategic partner couldn’t believe we were talking about having stock option plans for all employees and that the pool would be 20 percent. The cultures were just so different. Conversely, the venture guys wanted us to incent employees to make the business successful.”
What’s the right timing for a corporate investment? Our experience suggests that it is better to take in corporate venture money in later stages such as B and C rounds. Why? Because, by then, your business model is more fully formed. This should not only make your organization more attractive to corporate venture groups but also should make it less likely that they will use their investment as leverage to push your business strategy in directions that benefit them but may not be in your company’s best long-term interests.
Are corporate venture groups suited to be your lead investor? The consensus on this seems to be no. A lead investor should be there for the long term and through up and down markets. The dangers with having a corporation as the lead investor are twofold: First, its investment is bound to be only a small drop in their financial bucket, so whether they’ll have an interest in sticking it out if the road gets rocky is questionable. Second, if a corporation changes strategic directions, you may suddenly be left out in the cold as their investment in your firm’s future suddenly becomes irrelevant to the investor’s own future.
Is it preferable for your strategic investment partner to sit on your board of directors or serve in an advisory role? Giving a strategic investor a board seat may exacerbate potential conflicts of interest and may allow it to exert too much control over your business’s future direction. This is especially true if the strategic investor is also going to be your customer.
Experienced CV professionals understand why accepting an advisory role might be better for all concerned. If you find yourself being pressured to give the investor a board seat, this may be a tip-off that you’re not dealing with an organization that has enough experience in corporate venture to make the deal work for you.
Negotiation Traps to Avoid
If you decide that taking in strategic money makes sense for your organization, how do you avoid some of the common negotiation pitfalls that prevent such deals from being successful? Here are three guidelines that should help:
- Go into negotiations with realistic expectations. Many entrepreneurs falsely assume that a strategic investment will instantly bump up their company’s valuation. But it’s a meaningless value because the strategic partner is not looking for financial return.
Our research shows that less than 10 percent of strategic investments end in acquisitions. So don’t assume that this investment is going to be the start of a creeping acquisition that will follow your exit strategy. In the vast majority of cases, that does not happen.
- Get operational/functional buy-in before starting to draw deal terms. Don’t start getting into the legal specifics of a deal before each side thoroughly understands the other side’s business and investment objectives. Lawyers should be brought into the negotiations only after clear agreement has been reached with your operational or functional counterparts. Once you thoroughly understand each other’s various objectives, it also becomes easier and often quicker to negotiate a good deal.
Finally, have the support of existing investors is critical. With the backing of current investors and by performing the thorough due diligence we’ve outlined above, your company can access a powerful financing vehicle to remove barriers to growth and improve corporate leverage.