by Laurence Hayward
It’s common to think of strategic investors, or strategics, as large established corporations that make equity investments in entrepreneurial ventures (and that is precisely how the Kauffman Foundation defines it). However, the reasons they make these investments vary and are more subtle than the definition implies.
The obvious reason is to gain a strategic or operational advantage by investing in emerging technologies. But let’s give it a bit more color.
- To serve as a single contact point for emerging technologies, which historically can get lost in the organization.
- To fill the gap in the capital markets where meaningful innovation needs to occur.
- To align interests between several technology companies, which bring value to the corporate enterprise.
Corporations also create open innovation programs and becoming limited partners in independently managed venture capital funds. A corporation need not have a dedicated fund division to be actively involved in the world of venture-backed companies.
A strategic, in many cases, wants just the opposite of the typical venture capital operation. A VC fund is operated by a team of professional asset managers backed by limited partners as part of a financial return strategy. Much like the average investor in stocks and bonds, one doesn’t tell his mutual fund manager what to do. Like the average investor, limited partners often want little or no connection to the assets managed. They seek capital gains, not strategic or operational benefits.
This distinction was not always so clear. In the heat of the late 90s, corporations caught the private equity bug and many large companies entered the venture game—with or without venture experience. Companies often targeted companies not strategically aligned in product or service. It didn’t end well and many of these initiatives terminated. Today, I see corporate investors making significant efforts to ensure business unit alignment—seeking an operational benefit in addition to a financial one.
Today, corporate venture capital is experiencing a renaissance, but one more circumspect than in the past. This marks the strongest year since the crash of 2000. According to National Venture Capital Association, corporate venture groups invested $5.4B in 2014 accounting for 11% of all venture dollars invested.
Large corporations are playing an increasingly critical role in financing important technologies. There is a distinct lack of non-strategic investment in vital sectors such as Cleantech, Agriculture, Material Science and Advanced Manufacturing. (Cleantech investors themselves want more competition.) Because companies in these sectors tend to be capital intensive, with extended sales cycles, financial venture firms are straying back to traditional areas of focus such as Infotech.
Fortunately, strategic investors have stepped in where financial investors have exited. This is important. Many of these companies are commercializing breakthrough innovations that benefit mankind. Government research dollars alone cannot bring them all to market. I’m reminded of a cover of MIT Technology Review featuring Buzz Aldrin saying, “You promised me Mars Colonies. Instead, I got Facebook.”
Types of Strategics
Many entrepreneurs in underfunded sectors ask how to work with strategics. Just like other types of investors (angels, family offices, venture capital firms, etc.) there is a wide spectrum. They don’t all approach deals the same way.
Many strategic investors begin by making investments from their balance sheets through operating divisions within the company. This important activity may not be captured in the industry statistics, which represent more formalized venture funding.
Other firms set up a separate venture capital unit, in some instances as a separate corporate entity or business unit. This is done for a variety of reasons including internal organizational considerations for the strategic, but it is also done to address a key concern of the entrepreneurs, such as, “Will the strategic attempt to tie me up in some way?” Separate venture capital units are designed to avoid these concerns.
In most of strategic transactions, the investor seeks some special rights in addition to the purchase of equity. These can come in the form of distribution and supply agreements, license agreements, exclusive rights to product/technology, right of first refusals (ROFRs) for sale of the acquired company, preferred pricing arrangements and so on. It is critical for the entrepreneur and any co-investing financial investor to understand the implications of the agreement before beginning discussions with a strategic. These terms can make a significant impact on a company’s ability to pivot, its opportunity to exit, and ultimately its valuation.
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 entirely impractical. Why would a competitive buyer delve deep into diligence if they know the company holding the ROFR can sweep the deal away from them at the last minute? The potential buyer will also wonder how deeply entrenched the company is with the strategic owner and be concerned with competitive disclosure issues. The ROFR can restrict an entrepreneur’s ability to maximize value in an exit and inhibit 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 possible.
Separating Equity from Everything Else
Many strategic investors in formally run venture capital units do not necessarily seek to become eventual acquirers of the companies in which they invest. And they often avoid conflicts such as ROFRs. Strategic and operational gains can be found in other ways.
For example, the gain can be a customer, distributor, supplier, etc. It can be first to market with a new technology. A distribution or supply agreement can be of great benefit. For example, imagine a small company that quickly gains access to global distribution of a large corporate enterprise. Therefore, a key consideration is the value of any arrangement outside of or in addition to the exchange of equity.
It’s important to account for any exchange of value above-and-beyond the equity. For example, a license provides value via access to technology. Such agreements often include upfront payments and royalties for the value of the technology to the strategic. A company will want to clearly capture and specify this value.
Too Many Cooks
An entrepreneurial venture will require multiple types of investors over time. If an angel, a 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 a major competitive advantage in the marketplace. Then again, the strategic investor might bring added value that the angel investor can’t. What is one to do?
The answer is to account for each unique benefit with a discrete standalone agreement, separated from the equity arrangement. For example, if there is access to technology, then structure a separate license 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.
At some point, equity interest and operational interest may 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 license with the company. If those are intermingled in the original agreement, separating them may become a challenge.
In short, meticulous accounting is required for operational and strategic benefits. 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.
Laurence Hayward | firstname.lastname@example.org | VentureLab | 2100 Sanders Road | Northbrook, IL 60062
Copyright 2015. The VentureLab
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