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Corporate venturing? Make sure it’s cautious venturing

Working with corporate venturers can provide venture capital and private equity firms with a rich source of investment opportunities. But they should be wary of a corporate’s objectives and ensure they are well protected if circumstances change, says Edengene’s Julian Wheatland.

As we emerge from what is probably the worst investment climate many of us have seen, confidence is starting to pick up and many venture capital funds are starting to think once again about making new investments.

Unfortunately, developments of the last few years have taken their toll on entrepreneurial initiative as well as investor returns. Finding good investment opportunities is as hard now as it’s ever been.

So where can shrewd investors find solid opportunities that represent both good value and an acceptable level of risk? Is there a source of early/mid-stage opportunities that comes with in-built competitive advantage, established assets and a strong market position? Corporate venturing can deliver all of these things. But before getting into bed with an 800-pound corporate gorilla, private equity investors would be well advised to think through the risks first.

Corporate ventures certainly represent an attractive investment class for private capital, and often has a built-in exit route. In 2002, independent investors put E58m into European corporate venture funds during 2002, alongside the E337m invested by corporate venturers themselves, according to the EVCA. These same corporates closed 377 deals in the period.

However, combining private and corporate capital requires careful up-front planning and in-built protections to mitigate the risks associated with the wiles of corporate policy makers.

Corporate venturing can entail different things, depending on the corporate in question. But, broadly speaking, corporate venturers divide into two camps: those that invest externally in independent, early-stage companies; and those that invest internally in creating new businesses from under-used assets.

The overall corporate objectives of these two models can be quite different, but both give rise to ventures that will normally enjoy a strategic and competitive advantage over other market players. Nevertheless, a question remains in the minds of many VC investors: is the reduction in operational and competitive risk merely replaced by exposure to corporate policy risk?

To understand the value and risks associated with corporate co-investment, and any necessary protection, it’s worth examining the corporate venturer’s objectives – typically a mix of strategic enhancement and value creation – under each model.

Diagram 1

Internally focused corporate venturers aim to find new ways to exploit their assets (physical or intangible) to create new businesses. In core markets, these new propositions are strategic and aim to generate revenue growth. In non-core markets, propositions are less strategic and more about creating a valuable venture that can be spun out.

The rationale for external corporate venturing is more confused. Many corporates simply aim to create a relationship with early-stage companies that have a technology or business proposition that is of strategic interest for the future. Some corporates have embarked on external investments to gain industry ‘inside’ knowledge.

There are many variations on this theme. Intel’s investment arm Intel Capital, for example, invests externally for primarily strategic reasons: to build new companies that will drive demand for Intel products. It also allows its investees to piggy-back its industry position and commercial relationships.

Whether the focus is internal or external investment, a corporate venture has many advantages over its independent competitors and, as such, has a lower operational risk profile. Corporate investors such as Intel bring more than just money: the greatest value from a corporate partner can be the access to industry knowledge and commercial relationships, sales and marketing support, technology sharing and brand association – and maybe even a ready-made market. Such intangible benefits create significant competitive advantage, substantially increasing the likelihood of a venture’s success and good returns for investors.

But why do corporates seek access to private capital? One reason is the investment focus of shareholders. It made sense for BT shareholders, for example, when the company chose to bring in external finance from Coller Capital earlier this year to help exploit technology assets within its BT Brightstar incubator.

A second reason lies in the wisdom of syndicating risk. This is an exact parallel to venture capital funds acting as syndicates. Few VCs like to invest on their own; it’s always comforting to have another set of eyes from a different perspective examine an investment opportunity and confirm its value.

So what of the risks? Diagram 1 shows four different domains in which a venturing corporate can operate – some attractive to private capital, some not. Yet even when the corporate is in the right mindset to make working with private capital viable, there is still a risk that is has a change of heart. For this reason, problems must be anticipated at the outset, and protections and remedies incorporated well in advance of issues arising.

The risks are not trivial. One example I have been involved with concerned a certain FTSE100 company. It proved to be frustrating for all involved. After months of planning and building a venture infrastructure, recruiting management, establishing commercial relationships and arranging private finance for a specific initiative, the parent company was suddenly acquired, and its chief executive departed. As new chief executives are prone to do, the new man came in and reviewed all the existing initiatives – particularly the non-core ones. It must be very satisfying to take over the role of chief executive and sweep away 90 per cent of the initiatives that were being pursued by your predecessor. Not only does it present the perfect opportunity to recognise exceptional ‘restructuring’ costs without loss of face, but it also sends a powerful signal to the entire organisation that there’s a new man (or woman) in town. All of this is no consolation, of course, to the private investor whose baby gets thrown out with the bath water.

Looking again at Diagram 1, there is a clear no-go area for private equity investors: quadrant 3. Where corporates are investing internally for top-line revenue growth, this is core business. While there are arguments in other quadrants for corporate shareholders who wish to syndicate the investment risk, private capital should be wary of situations where the corporate can’t (or won’t) fund its own core business growth. If the corporate isn’t sure this is a good investment, then private capital should run a mile.

Quadrants 2,3 and 4 provide better hunting grounds for venture capital and private equity, but as the example above illustrates, careful planning is required to anticipate unforeseen problems and protect against corporate risk.

Private equity or VC funds should view the activity of investing alongside a corporate partner as a form of joint venturing. Rain forests have been decimated by research attempting to identify the key to joint venturing success, but there is a simple recurring theme: alignment of objectives. With this in mind, the right hand side of the chart (quadrants 2 and 4) is more fertile ground for finding good investment opportunities: everyone’s in it to make money, but beware the corporate change of heart.

In this ‘value creation’ side of the matrix, it is important to ensure that value can still be realised – even if the corporate starts to get confused about why it is involved. Anticipate the problems before they occur. ‘Drag along’ is valuable here, for example, and can be used as a protection against a corporate that becomes ‘comfortable’ with the strategic influence its equity stake brings. Additionally, if the corporate is operating in quadrant 4 (internal investment, value creation) then make sure that there are cast iron agreements (with penalties) between the venture and the corporate, guaranteeing access to, and use of, the assets necessary for the venture success.

Good private equity firms invest in order to exit. Quadrant 1 (external investment, strategic enhancement) represents the area where investments can come with a built in exit structure. It won’t always work, but if a corporate is talking about a ‘strategic’ interest in the venture, then private capital should beware. Crafting a shareholder agreement that encompasses both put options and drag along rights will protect the private investor and potentially put a floor on the exit price.

Overall, it is clear that corporate venture investments can be an attractive source of valuable deals, with a head start and lower operational risk than independent, stand-alone companies. However, the ‘corporate’ risk is not trivial and needs to be mitigated in the deal from the outset. For the private equity/venture capital investor that gets these mechanisms right, there is a rich vein of opportunities to exploit.

Julian Wheatland is director of corporate development at Edengene, the leading growth and corporate venturing business. He is a recognised expert in corporate venture finance, with a strong track record of creating innovative financing structures that satisfy the sometimes disparate objectives of corporates, their ventures and independent capital.

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