If you asked a dozen professionals involved in corporate venturing "How should your corporation structure its corporate venturing program?", the answer might remind you a bit of the parable about the blind men and the elephant, with each describing a vastly differing program depending upon their position in the organization and the specific organizational goals they seek to implement.
While each may accurately describe a structure tailored to their individual goals, few are likely to describe a program with the attributes necessary to achieve all of the strategic goals which their corporation is seeking to achieve through its venture activities. In order to successfully engage in corporate venturing, management needs to identify the goals which may be achieved through corporate venturing and employ program and transaction structures to achieve those goals.
In this article several top partners at Baker McKenzie, the global law firm, attempt to give a brief, high-level summary of some of the key distinctions, issues and complexities involved in a corporate venture capital.
What is Corporate Venturing and Why are Corporations Involved?
At its most simple, corporate venturing involves partnering with parties outside of the corporate family to help achieve the corporation's goals. This rather broad definition encompasses a wide range of activities, from investments in externally managed venture capital funds to the formation of stand-alone joint ventures. The more important question than "What is corporate venturing?" is "Why are corporations involved in corporate venturing?" The motivations vary and include:
Financial Return. A basic goal of corporations is to seek a cash on cash return on investment. Many corporations, seeing the success of venture capitalists and believing that because of their position in the market that they could identify successful investment targets, established corporate venture funds in the late 1990's to mimic the financial returns of a venture fund. Many of these same corporate funds have since closed their doors, due in part to the corporation's inability to implement the incentives and structures which have made venture capital funds so successful.
Monitoring Technological Developments. With the rapid pace of change in the world of technology it is impractical for internal research and development and product development teams to stay on top of all of the developments which may be relevant to the corporation. As a result, many corporations partner with third parties, such as venture capital funds, to stay informed regarding new technological developments created by entrepreneurs.
Base Research and Technology Development. In order to move the corporation and its product offerings into the future, many companies seek to augment their basic research and development budgets through third party collaborations. In certain areas where the research involves the creation of industry standards, third party collaboration may be necessary to ensure that market participants will work together to create a platform on which they can all continue to compete. In other areas such as biotechnology, third party collaborations serve a much broader array of corporate purposes.
Risk Sharing. Where the costs to develop and produce certain products or introduce new services are high, companies often establish joint ventures or other corporate ventures to help spread the overall risk associated with the project. This has been the predominant model for development in the pharmaceutical and petrochemical industries which require large up-front investments in research, development and infrastructure.
Product Development and Acquisition. Given the demands for corporate growth and product offerings, many companies seek to acquire product offerings from third parties as a supplement to their own existing product lines. These transactions typically combine some form of investment paired with commercial agreements related to the development and acquisition of additional products, or the grant of distribution or commercialization rights. The commercial portion of these transactions may involve sponsored research, porting agreements, outsourcing agreements, private label manufacturing agreements, reseller agreements, distribution arrangements and other agreements intended to give the corporate investor the ability to add to their product and service offerings.
Leverage of existing assets. Corporate venturing offers many companies the opportunity to leverage existing assets outside of the existing corporate structure. Typical deals may include spinouts of underutilized technology, or leveraging of brand names in non-core markets.
Market penetration. Often a partner is needed to help a corporation enter into a new market segment or geographic region, particularly across national borders. Through investments in third parties, a corporation can get access to its partners' customer base or gain local presence and market knowledge.
Sales Enhancement. Investments in partners can be used to support product sales, either directly to the corporate partner or to its end customers through exclusivity or preferred provider arrangements.
Cross-pollination with the entrepreneurial approach. A more nebulous but often stated goal of many corporations is to expose their own staff and organization to the entrepreneurial approach to business characteristic of new venture backed companies, with the hopes that they will themselves learn important lessons from this experience.
The Appropriate Program Structure is Dependent on the Goals Corporations, either consciously or unconsciously, employ a variety of structures in the management of their corporate venturing activities. These structures are employed at various levels of the corporation and have varying levels of integration with the day to day operations of the corporation:
(1) Investments in Externally Managed Funds. In many companies corporate venturing consists of strictly investing money in venture capital funds managed by an outside venture capital fund. While some of these funds are captive in that the corporate investor is the sole limited partner, typically corporations engaging in corporate venturing through this model spread their investments among a number of traditional multi-limited partner funds. Investments in externally managed funds can provide the corporate investor with a good overview of new technologies if the investor maintains active involvement with the fund management. This activity can and should include participation in the advisory board of investor funds, participation on the scientific advisory brands of portfolio companies, and regular meetings with appropriate senior executives of portfolio companies. This model typically serves the financial return goal as the funds are professionally managed by a general partner motivated solely by financial gain, and the corporation does not have to expend much in the way of internal resources to source deals and manage its portfolio. However, investments in externally managed funds typically produce little value in the way of actual collaboration between the portfolio companies and corporate limited partners, and have limited value for the other goals discussed above.
(2) Separate Corporate Venture Fund. To attempt to recreate the financial incentives which drive the traditional venture capital model and gain more direct interaction with early stage companies, many corporations have set up separate venture capital units, either as a separately funded subsidiary or as a group with a separately defined budget. Internal fund managers are often given carried interests in the fund to incent them to produce financial returns in the same manner as a traditional venture fund. As such, the corporate venture fund is good at producing financial returns and through its independence is able to avoid some of the internal pressures to invest in companies where the prospects for a financial return are somewhat secondary to other corporate interests. In addition, the investment is easier to justify because the return is easy to quantify. However, the independence and financial incentives which help the internal fund fulfill the corporation's financial return goals may inhibit its ability to succeed in developing synergies between the corporation and portfolio companies due to the lack of interaction between the fund managers and the business unit teams, the reluctance of the fund manager to sacrifice financial return for strategic corporate goals, or the business unit personnel's mistrust or jealousy of the independent manager.
(3) In-house Venture Groups. Many corporations engage in corporate venturing through corporate development departments or other internally budgeted groups. These in-house venture groups may be located within the executive offices, aligned with a research and development team, aligned with specific business units, or a combination of the above. In-house venture groups which are aligned with research and development or business units will have access to information which they can use to help target investments to meet the current product development or market access goals of the corporation. Furthermore, groups at this level may have additional contacts with the technical and business personnel whose post investment involvement is necessary to foster the development of the relationship with portfolio companies.
Internal venture groups which are aligned with specific business units may suffer from a lack of long term vision or tolerance necessary to make longer term investments. In addition, the returns of in-house venture groups may be difficult to measure to the extent that they are asked to pursue business goals other than or in addition to a financial return.
(4) Incubators. As an alternative to the models above, many corporations have established new business incubators to provide portfolio companies with a suite of services in an attempt to leverage the investing corporation's existing assets within the portfolio company. Incubators can do a better job of leveraging corporation assets, particularly research and development assets, and can help the corporation learn entrepreneurial lessons by staffing the incubator and the portfolio companies with internal personnel. Where incubators have suffered, however, is in their ability to generate ideas which are truly integrated with the business goals of the sponsoring corporation, and in obtaining acceptable financial returns. In addition, incubators are difficult to staff due to a reluctance of corporation personnel to step outside of the traditional corporate promotion structure, and because the added infrastructure of the incubator model tends to be more expensive to operate than corporate venture funds or more traditional corporate development arms.
Investment Structure Appropriate for Goals
Because corporate venture investors have goals beyond the basic financial returns sought by traditional venture capitalists, companies making corporate venturing investments should consider different transaction structures and portfolio management techniques which address their unique investing goals. When structuring and negotiating a corporate strategic investment and relationship, the corporation should consider the following investment structures:
Use of Convertible Debt and Collateral. Traditionally, corporate venturing groups would not lead an investment in a financing round in order to ensure that a portfolio company had significant outside support to finance its growth, and to take advantage of the diligence and analysis of the lead investor. As equity capital has become scarce in the last two years, many corporate investors have filled this funding void by making convertible loans to their portfolio companies. Originally structured as convertible bridge loans which would convert into preferred stock in connection with a follow on round of financing, these bridge loans are now often being structured to be repaid after a set term of time, and are convertible into preferred or common equity at the option of the investing corporation. In addition, many of these loans are secured by a lien on the assets to be developed, with a license or other rights to use the intellectual property developed by the portfolio company. The secured debt structure serves the interests of the corporate investor by creating a priority repayment to help justify the investment in a company, and by securing access to the products or other strategic assets which originally motivated the investment. In addition, the short repayment schedule can force both the portfolio company and the investing corporation to revisit the relationship instead of allowing the investment to languish in a corporate venturing portfolio. While the portfolio company may not feel comfortable issuing debt or granting a security interest in its assets, it does get access to scarce capital which might not otherwise be available and on terms which typically will not result in immediate dilution to its existing stockholders.
Setting Performance Targets, Segregated Use of Funds, In-kind Contributions and Other Alternative Investment Structures. In order to gain the strategic benefits from a corporate venture investment, the parties should define precisely what they expect from the relationship and structure the investment to foster the fulfillment of those goals. If a corporate investor is investing in a portfolio company in order to gain rights to a product or technology under development, the corporate investor may wish to tie the investment of funds to the achievement of development milestones. If the investment is being made in a portfolio company with the goal of increasing sales or market penetration, the investment funds may be segregated for use in certain joint marketing initiatives, or released upon the achievement of certain sales targets. A corporate investor can also make investments in kind, either in the form of commitments of products, personnel or access to technology, in order to limit the up-front commitment of scarce corporate capital. Where a corporation makes in-kind contributions of intellectual property or research and development, it must carefully negotiate and secure the rights of each party to the contributed assets and any derivative works. Each of these alternative structures is outside of the traditional venture capital "cash up front model" and are typically employed only where the investment is made outside of the constraints of a preferred stock round led by a traditional venture capital fund.
Acquisition Rights. Often corporate strategic investments and joint ventures are a prelude to an outright acquisition of either the portfolio company, joint venture or a specific product or service line. While most financial investors will resist any outright purchase option or right of first refusal which may limit the potential growth in the value of the company and their investment, certain more limited rights may be negotiated which not only benefit the corporate investor, but also provide some comfort to the portfolio company. For example, an exclusive distribution right coupled with a right of first refusal on a product being developed by a portfolio company will give the corporate investor enough incentive to build a distribution network around the product, without causing the restrictions to impair the long term liquidity prospects of the portfolio company.
Exclusivity Provisions. Like acquisition rights, many potential portfolio companies strongly resist granting exclusive distribution or product provider rights to the investing corporation. However, where the goals of the investing corporation are primarily to increase direct sales of product to or through the portfolio company, or where the portfolio company will facilitate market entry, such exclusive rights may be imperative. Exclusivity, however, is not necessary in all situations. Where the goals of the investment are primarily to foster base research or to create a new product offering which may be used in conjunction with competitors' products or technology platforms, allowing or even encouraging the use of competing products and relationships with competitors may enhance the value of the investment. Finally, exclusivity from an investment standpoint may not be as important as from a partnering, development or sales standpoint, as the mere existence of a preferred provider or exclusive relationship between the investing and portfolio companies will often be sufficient to dissuade another company from investing in the portfolio company.
Future Commitments. Alliance or joint venture agreements often involve commitments to take or not to take certain actions in the future by both parties. When a corporate investor enters into an alliance agreement, especially one which involves exclusivity or preferred provider provisions, the portfolio company will often seek a similar exclusivity or preferred provider right in return. Corporations need to be mindful of the limited knowledge and control over their own activities which the corporate venturing team or sponsoring business unit possess. For example, an agreement to promote the products of a portfolio company on a preferred or exclusive basis could be violated by marketing programs established in a different geographic market unbeknownst to the venture team. To the extent the investment documentation provides the corporate investor with a put right or right to accelerate indebtedness upon a default by the portfolio company, these rights often terminate if the investing corporation breaches the alliance or joint venture agreement. As such any future commitment which could trigger a loss of recourse to the invested funds should be carefully negotiated and structured to include only those actions or restraints within the control of those persons with a continuing role in the relationship with the portfolio company.
Management and Reporting. To create a successful corporate venturing relationship, the parties need to articulate clear goals, create ongoing incentives to reach those goals, identify the parties responsible for taking necessary actions to reach those goals, and implement clear reporting mechanisms to determine whether the goals are being met. In doing so, the parties must balance the desire to have identifiable roles with the need for flexibility in implementation and growth of the relationship. As such, a typical alliance or joint venture agreement will set minimum targets with respect to investments and asset commitments as well as setting forth an outline of the areas of cooperation. Within this framework, the implementation of the relationship is left typically to a committee of representatives who are required to meet and report on the progress of the relationship. The committee governance structure creates flexibility in the implementation of the relationship, creates ownership over the relationship within the partner organizations, and creates a sense of teamwork within the alliance. From the corporate investor side, each corporate alliance or venture investment should be monitored from outside to ensure that the investment is achieving its goals and continues to serve the core business goals of the investor.
Using All of Your Tools to Produce a Successful Corporate Venturing Program
Corporate venturing is not as simple as setting up a corporate venture fund or making equity investments or loans to partners. Successful corporate venturing requires management to treat its corporate venturing programs as an extension of and tool to serve the overall business goals of the corporation. To help implement a successful goal based corporate venturing program:
Approaching corporate venturing in a disciplined and organized manner is not easy even for established and successful corporation ventures. It requires communication, planning and foresight. If properly implemented, a corporate venturing program can be a valuable asset in creating sustainable corporate growth.
Marc R. Paul, Partner
Office: Washington, D.C.
Practice Group: Corporate & Securities
Education: Harvard Univ. (A.B.) (1982); Univ. of London (M.A.) (1983); Harvard Univ. (J.D.) (1986)
Marc Paul's practice involves venture capital transactions, public and private offerings of debt and equity securities, mergers and acquisitions, joint ventures, licensing arrangements, and complex commercial transactions, both internationally and domestically. Mr. Paul acts as outside general counsel to numerous business entities, from large multinational corporations to domestic start-up companies. He specializes in legal issues relating to technology oriented companies, particularly in the Internet, software, telecommunications, media and aerospace industries.
Bruce A. Zivian, Partner
Practice Group: Corporate & Securities
Education: Stanford University (A.B.) (1981); University of Michigan (J.D.) (1984)
Mr. Zivian is a Partner in the Corporate and Securities Department of the Chicago Office of Baker & McKenzie, and serves as the Coordinator of the Firm's Global and North American Venture Capital and Private Equity Practice Groups. Mr. Zivian regularly represents corporate strategic venture investors, traditional venture capital and private equity funds, and angel investors in their investment activities. A significant portion of Mr. Zivian's work in this area focuses on the strategic investment and business activities of both brick and mortar and technology companies.
Michael J. Fieweger, Partner
Practice Group: Corporate & Securities
Education: University of Notre Dame (B.A.) (1988); Northwestern University (J.D.) (1994)
Michael Fieweger is an attorney in corporate and securities group of the Chicago office of Baker & McKenzie. His practice is focused on representing both domestic and international start-up technology companies and investors in venture capital and strategic investments. This article is provided for informational purposes only and should not be deemed as legal advice or a legal opinion.
*This article originally appeared in the 2002 Corporate Venturing Directory.
**This article is provided for informational purposes only and should not be deemed as legal advice or a legal opinion.