Earlier this year, Union Square Ventures Managing Partner Fred Wilson famously referred to corporate VCs as “The Devil”, when he asserted that companies should not be investing in other companies, that they should be buying other companies but not taking minority positions in them, that the “access” rationale for corporate venture is a reason why entrepreneurs should not want them in the room and that startups who take investment from them are “doing business with the devil”. Ouch! So why the hostility?
Corporate venture capital refers to venture style investments in emerging companies made by venture capital divisions of large companies, as distinguished from venture investments made by the more traditional investment funds that most people associate with venture capital. I’ve been seeing corporate VC term sheets with greater regularity lately, so I decided to blog about some of its characteristics, advantages and disadvantages relative to institutional venture capital.
Indeed, corporate VC appears to be on the rise. According to the National Venture Capital Association, corporate venture deployed over $7.5 billion in 905 deals to startups in 2015, a fifteen year high and representing 13% of all venture capital dollars invested for the year but 21% of all deals consummated. From 2011 to 2015, the number of corporate VC divisions in the United States rose nearly 50% from 1,068 to 1,501 And according to CB Insights, the average corporate VC deal size has consistently been larger than the average institutional VC deal size over the last 14 quarters ended June 2016, with corporate VC deal sizes averaging above $20 million over the previous five quarters.
Big technology and healthcare companies have long made venture style investments in startups. Google Ventures, Intel Capital, Dell Ventures and Cisco Investments are veteran corporate VCs that immediately come to mind. But it’s the relatively recent arrival of new corporate investors that have driven the growth in corporate VC, in sectors ranging from transportation (e.g., GM’s $500 million investment in Lyft) to financial services to convenience stores.
Corporate VC programs have dramatically different overall objectives than institutional VC funds. Primary among these objectives is bolstering internal research and development activities and gaining access to new technologies that complement the corporation’s product development efforts. Venture investments are also a way for corporations to gain intelligence on disruptive products and technologies that could pose a competitive threat. A minority investment could also be the first step toward an eventual acquisition of the portfolio company. More limited objectives might include establishing an OEM partner, a channel for additional company product sales or even a product integration that might drive sales for the investing company. And yes, there’s also the objective of financial returns.
If a company is considering launching a venture capital program, it’s important to choose a structure that will align with its investment objectives. Corporate VC programs can either be structured internally, where a company invests from its own balance sheet, or externally. Generally speaking, internal divisions are more appropriate for strategic investments intended to support a corporate sponsor’s core business. One downside of internal structures is that they tend to be more bureaucratic and slower in decision making. Another is that the financial capacity to invest is basically a function of the corporate sponsor’s financial health, which could fluctuate over time.
External structures are more nimble in making decisions and generally have greater flexibility to make investments that may be disruptive to the investing company’s core business. Since investments are made off the corporate sponsor’s balance sheet, external structures allow companies to pursue riskier and more disruptive R&D. They also tend to attract more experienced investment managers and so are often better able to achieve both strategic as well as financial objectives.
In terms of exit strategy, corporate VCs seek a wider range of possible outcomes from an investment. Maximizing proceeds is typically not the exit strategy. A corporate VC may just as likely view as a successful outcome the portfolio company becoming an acquisition target, an OEM partner, a channel for additional company product sales or even a product integration that would drive sales for the investing company. VC funds, on the other hand, seek one type of exit: a multiple return on their investment dollars from either an acquisition or a sale of shares following an IPO.
As I mentioned above, investments by a corporate VC are funded by the corporation’s own balance sheet, and are thus not subject to the ongoing pressure from limited partners and the ten year time restrictions of a typical VC fund’s limited partnership agreement. The result is that corporate VCs are generally more patient and have longer time horizons than VC funds.
Corporate VCs generally negotiate for less control over their portfolio companies than do VC funds. This is largely because when the investor company is deemed to have the power to influence the operating or financial decisions of the company its investing in, the investor company is required to account for its investment under the equity method of accounting, under which the investor recognizes its share of the profits and losses of the investee. If the investor has 20% or more of the voting stock of the investee, the investor is presumed to have control. Consequently, corporate VCs generally avoid taking 20% or more of a portfolio company’s voting shares. The need to avoid indicia of control is also why corporate VCs often decline board representation.
Another advantage is that, as I mentioned above, an investment from a corporate VC may be the first step toward being acquired by that corporation, thus giving the portfolio company and its founders a clear exit pathway without having to go through a prolonged investment banking process. It can also create instant credibility in the industry, which can then be leveraged to attract talent and customers. Finally, it can provide channel access, product integration and other benefits to help accelerate market penetration.
Investment from a corporate VC may have certain disadvantages, however. First, a corporate VC’s strategic objectives may conflict with a portfolio company’s financial goals, which for example may motivate the corporate VC to block a proposed acquisition or subsequent investment if the transaction does not align with the strategic goals of the corporate VC’s parent. Second, corporate VCs often negotiate for a right of first refusal or option to acquire the company which would limit the company’s options going forward and have a chilling effect on other potential acquirers. Third, it could antagonize potential customers or business partners who view themselves as competitors of the corporate VC. Fourth, corporate VC divisions often receive an annual allocation of dollars to invest, as opposed to an aggregate commitment of dollars that a fund receives to invest during the fund’s investment period, which means that the availability of follow-on funding may be tied to the financial capacity and whims of the parent company. And finally, a strategic may set the valuation higher than what the market will bear, which could make it difficult for the company to secure co-investors, which in turn could leave the company under-funded and, as mentioned just above, could leave the company vulnerable if the corporate VC parent isn’t able or interested in making follow-on investments.
So back to Fred Wilson’s choice words for corporate VCs. Perhaps the root of the antagonism is the tendency for corporate VCs to drive up valuations, which makes deals more expensive for institutional funds and may crowd them out of certain deals entirely. Wilson sort of implied as much when he stated in the same interview that a startup would only do a deal with a corporate VC if it couldn’t secure funding elsewhere or if the corporate VC was paying a higher price than he would pay.