exitEvery founder of a growth startup dreams of a big, successful exit — a sale of the company for millions of dollars. But that dream could be shattered if the investors are able to cause the company to be sold prematurely with proceeds only equal to or barely exceeding the investors’ liquidation preferences, leaving little or nothing for the founders. Such a proposed deal will almost always be opposed by the founders, believing that the company could achieve a much higher valuation if it remained independent for a bit longer. Whether or not such a deal gets consummated over the objections of the founders depends on state law provisions and negotiated contractual terms that combined will determine the one factor that ultimately matters: control over the deal process.

Background: Liquidation Preference and Investment Horizon

In a typical round of venture funding, the investors receive a liquidation preference, i.e., the right to receive first dollars (after creditors are paid) up to an agreed amount in any sale of the company. In a company’s first institutional funding round (typically designated as Series A), a liquidation preference of 1X plus annual dividends of 8% is “market”, i.e., the investors get an amount off the top equal to the amount they invested plus accumulated dividends before the common shareholders receive anything. Later rounds (Series B, Series C, etc.) may have liquidation preferences of higher multiples of dollars invested, e.g., 1.5X, 2X, etc. A more investor friendly variation is what’s called participating preferred, in which the investors, after receiving their liquidation preference, then share pro rata in the remaining proceeds with the common shareholders, often up to some maximum amount.

So if a VC is not sanguine about a portfolio company’s long term prospects, he may be happy to sell the company for an amount equal to his liquidation preference, particularly at a point several years into the investment. In this regard, the time horizons of founders and institutional investors are inherently in conflict. A venture fund’s limited partnership agreement will typically limit the fund’s life tomoney vs. time ten years, with the initial three years designated for sourcing investments and the remaining seven for exits. With certain exceptions, a fund manager is required to distribute any profits to the fund’s limited partners by the expiration of that ten-year period, which is why a VC’s investment horizon in any given portfolio company is typically three to seven years. Consequently, a VC will often favor a quick exit because it offers a higher risk-adjusted return, and eliminates further risk to their investment. In other words, the VC might believe there’s some likelihood the company’s valuation may increase, but why risk it if he’s entitled to his liquidation preference, particularly if the wind-down of his fund is imminent? Free of such timing constraints, a founder on the other hand would almost always prefer to buy more time, particularly when the company’s projections show an upward trajectory. The founder’s problem, though, is that acquirors will generally value a company based primarily upon historical data, and will either ignore or heavily discount projected metrics.

State Law

So in a sale of the company proposed by the investors and opposed by the founders, who determines whether the deal gets consummated? The starting point is state law. The corporate statute of the state of the company’s incorporation will dictate the minimum vote threshold needed from shareholders. Some state statutes are more protective of common shareholders (founders almost always hold common shares) by requiring approval of the common holders voting separately as a class, essentially a group veto, and/or may require a supermajority vote, which gives the common the ability to block a deal if they collectively own enough shares to prevent the majority from meeting the vote threshold. States that are less protective of common shareholders will require only approval of a simple majority of holders of all shares outstanding, without requiring a separate class vote. That’s the Delaware model. New York voting rightscorporations organized before 1998 must secure a two-thirds majority of all holders unless their charter provides for a simple majority (simple majority for post-1998 corporations), and a separate class vote is required to approve a merger if the shareholders receive stock of the acquiror or another entity containing attributes not included in the target’s charter for which the target’s shareholders would have been required to approve in a separate class vote under New York law.

Another source of state law that impacts control over the deal process is case law regarding a director’s fiduciary duty. Before a proposed acquisition even gets to a shareholder vote, it must be approved first by a majority of the target company’s board, whose actions must be consistent with the directors’ fiduciary obligations. These include primarily the duty of care (generally, the obligation to be informed and diligent) and the duty of loyalty (essentially, the obligation to put the interests of the company and the shareholders above a director’s personal interests and not have any conflicts). Shareholders have a right to sue directors for breaches of fiduciary duty, and common shareholders will have a stronger or weaker case in attacking approval of the sale of a company as a violation of fiduciary duty depending on how favorable a particular state’s fiduciary duty case law is to the common holders. Delaware fiduciary duty case law is regarded as board friendly.

Contractual Terms

Some of the most important terms negotiated by VCs in a venture investment are the ones impacting control, both at the board level and the shareholder level. As mentioned above, a sale of the company must first be approved by a majority of the directors. The allocation of board seats is determined by negotiation during each round of funding. Although a fair outcome would be for investors to receive board representation in proportion to their share ownership (e.g., two of five seats when owning 40% of the outstanding shares), the investors will often negotiate for and receive disproportionate representation on the board and sometimes even a majority. A typical board composition arrangement might be a five-person board consisting of two directors designated by the investors, two directors selected by the common shareholders and one independent industry expert mutually selected by the common holders and the investors. But if the industry expert is someone with whom the investors have a preexisting relationship, human nature is such that he will view the investors as a source of future opportunities and tend to side with them, thus giving the investors an effective majority.

Other key control rights negotiated for by VCs are so-called protective provisions, which give the investors a veto over major decisions, including a sale of the company. Here, the battle is over what transactions or decisions make the list, and what vote threshold is required within the class of preferred. But a veto is only a right to block, not a right to approve. It doesn’t give the preferred the right to compel the company to consummate a deal opposed by the requisite holders. That’s where drag-along rights come into play.

Drag-along rights give investors the power to require other holders to vote in drag alongfavor of a deal the investors are proposing, sometimes conditioned on board approval. If a sufficient number of shares are so encumbered, the investors can ensure that holders of a requisite percentage of the outstanding shares or close enough to it vote to approve a deal favored by the investors.

So Who Controls the Deal Process?

Putting it all together, investors are more likely to control the deal process if all or at least some of the following are true: the company is incorporated in a state that does not require a class vote of the common to approve a sale of the company, the state has fiduciary duty case law favorable to directors, the investors have an actual or effective majority of the board and the investors control the cap table either outright or through a combination of ownership and drag along rights. In limited cases, the common shareholders will nevertheless be able to negotiate for a share of the proceeds in sub-liquidation preference deals, getting the preferred to relinquish some of the amount they’re otherwise contractually entitled to. Such an outcome is more likely to occur where the investors are able to approve a deal at the board level, but the common shareholders have one or more of the other factors in their favor, such as ownership of enough shares to block the vote or the benefit of common shareholder favorable fiduciary duty state case law. Or sometimes, the VCs just want to sweeten the pot to create the appearance of fairness to preserve a good reputation. But the VCs will rarely just give anything anyway; they’ll likely condition any common shareholder liquidation preference carveout on the recipients signing a release.

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 google Vtraditional 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.

intel capitalBig 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 cisco investmentsarrival 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 salesforce vtechnologies 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 comcast venturesappropriate 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 microsoft venturesoff 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 GE Venturesadditional 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.

Advantages

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.

Disadvantages

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.

Final Thought

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.

 

Are VCs incentivized to lose money?  This is the provocative assertion made recently (and again) by Kaufman Foundation Senior Fellow Diane Mulcahy in the Harvard Business Review.  Some of us who are interested in this issue probably recall the equally incendiary piece she co-authored in 2012 for KF boldly entitled “We Have Met The Enemy… And He Is Us”.

In a nutshell, Ms. Mulcahy contends that the VC industry has performed terribly for more than a decade, but individual VCs are nevertheless richly compensated because of asset based management fees. She cites performance data from Cambridge Associates showing the VC asset class underperforming the S&P 500, NASDAQ and the Russell 2000 in all periods over the five years ended December 31, 2013.

Some commentators have questioned the reliability of the data cited by Ms. Mulcahey and thus challenge her premise that VCs have underperformed the major indexes.  Dan Primack of Fortune.com, for example, contends that the 93 VC funds in the sample constitute less than 25% of the total number of funds raised in the years covered (2009 -2011), and since Cambridge Associates will not disclose the names of the included funds, there is no way of knowing whether the sample is skewed toward the larger funds whose performance tends to trail that of smaller funds.   In any event, although VC performance has lagged large and small public company indexes in all periods over the five years ended December 31, 2013, the Cambridge Associates study also shows that venture has significantly outperformed public equities over the longer term.

At the heart of Ms. Mulcahey’s indictment is the annual management fee that almost every GP receives, which is typically 2% of funds committed (which often shifts after the expiration of a three-four year investment period to 2% of investments held).  Although funds also pay GPs carried interest of usually 20% of profits, this fee is directly tied to investment performance, is seldom earned and not paid until several years after the fund is raised.  Ms. Mulcahey argues that the management fee distorts incentives and misaligns interests between GPs and LPs, particularly as fund size increases.  She contends that the management fee motivates GPs to seek to raise larger funds to generate higher management fees.

“Given the persistent poor performance of the industry, there are many VCs who haven’t received a carry check in a decade, or if they are newer to the industry, ever. These VCs live entirely on the [management] fee stream. [Management] fees, it turns out, are the lifeblood of the VC industry, not the blockbuster returns and carry that the traditional VC narrative suggests.”

 “VCs have a great gig. They raise a fund, and lock in a minimum of 10 years of fixed, fee-based compensation. Three or four years later they raise a second fund, based largely on unrealized returns of the existing fund. Usually the subsequent fund is larger, so the VC locks in another 10 years of larger, fixed, fee-based compensation in addition to the remaining fees from the current fund. And so on.”

All this, it seems, is a vindication of the smaller VC fund model.  Smaller funds deliver superior results at least in part because their GPs cannot rely solely on the 2% management fee and remain highly incentivized to create profitable fund returns.  This is particularly the case with respect to GPs with meaningful skin in the game in the form of larger capital commitments (i.e., higher than the 1% benchmark).  Conversely, large fund GPs can earn significantly greater compensation per GP partner from the 2% annual management fee and are theoretically less motivated by the prospect of carried interest.  Another point here is that inasmuch as large funds need to return billions of dollars to beat the indexes, there is a perverse incentive for them to go for home runs in the form of billion-dollar exits, and thus the specter of spectacular losses is far greater.

The incentive  to create larger funds only exists if the number of the fund firm’s partners remains the same: higher management fee dollars spread over the same number of partners equals higher management fees per partner.  But the reality is that VC funds don’t scale very well (which is ironic in that VCs seek to invest in companies that do).  The reason is that, assuming the number of GP partners remains the same or doesn’t grow proportionately with any increase in LP committed capital in the fund, a larger fund will either have to invest more dollars per portfolio company (and keep the number of portfolio company investments the same) or invest in more portfolio companies.  The larger investments strategy would necessarily mean later stage companies with much higher valuations and lower reward potential.  Conversely, investing in more portfolio companies would mean less GP partner time that could be devoted to each portfolio company which in turn theoretically means less value to the companies.

So, can the VC industry innovate from within by creating fee structures that better align the interests of LPs and GPs while still preserving enough incentives for VCs to create funds and invest in innovative young companies?  The reality is that innovation is not likely to originate with the LPs, even though they seemingly have the most to gain from reform, because there remains enormous competition to get into the top performing funds which tend to be oversubscribed.  LPs would rather stay silent on the management fee issue than risk being shut out of those funds.  Reform is not likely to originate with GPs either, and not only because it would be against their self-interest to reduce their management fees.  There’s a sort of Catch-22 for non-brand name fund organizers, who believe offering a lower percentage management fee or some practical, budget based fee would convey an impression of inexperience or undesirability, and make it more challenging to raise a fund.