Sources of Capital: Strategic Or Industry Investors - Corporate Venture Capital and Merchant Banks

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al

A strategic investor is one that can benefit from an investment in ways other than just a direct financial return. These investors are typically companies or holding companies that either invest directly into a portfolio business or have established an investment subsidiary to do the same. Some of these subsidiaries are formalized as corporate venture capital (CVC) arms of the business while others are less formal and reside under a business development or corporate development function. There is a distinction between companies that have formal venture investing businesses or programs that systematically seek out and routinely invest as part of an ongoing strategy of growth and innovation, and the ones that opportunistically invest or do so only to meet a certain strategic goal. From the perspective of the management of a potential portfolio company, the former will probably have a clearly defined process and criteria for target company analysis.

CVC Investments

In 2003, $1.1 billion was invested in growth oriented companies by corporate venturing groups, representing 6 percent of all venture capital investment. The amount invested by CVCs has tracked similarly to the trends of the overall venture capital industry. The 2003 figures were close to the activity seen in the last prebubble year, 1997, when corporate venturing groups invested $957 million, also representing 6 percent of total venture capital invested in that year. 1

According to Ernst & Young's Corporate Venture Capital Report, 2 a majority of the CVC groups make their investment decisions based on the investment opportunity providing a clear strategic advantage to the parent company. A smaller percentage pursue only financial objectives, and a minor portion of the CVC groups pursue both strategic and financial goals. The number one strategic objective cited in the report was to create a window into technology development outside their company.

These venture funds usually invest in companies that are in development stages or have begun shipping product. Sometimes they are the lead investor, but more often they will be one in a syndicate of investors. This correlates with the data indicating that the majority of their investments are in second round or later stage opportunities, though some investments are made in first rounds. CVCs typically do not invest in start-ups or early stage rounds. 3

CVC Value Add

An interesting observation is that the valuation of a deal with a strategic investor tends to be more than double that of the same stage transaction without a CVC. In addition to potentially providing cheaper capital, the CVC can pull expertise and resources from the parent company to help accelerate the growth of the portfolio business. The brand of the parent and market validation provided by having the parent invest often lends significant credibility to the emerging company. Among other potential synergies are the availability of technologies from the parent and potential operations support and resources in the United States or overseas, when multinational corporations participate.

Potential Downside

The drawback of having a CVC involved is the potential for the portfolio company to begin to shape its activities based on the influence of the CVC, and not listen to the market in whole. In addition, some potential customers of the portfolio company may not materialize if they are competitors of the CVC's parent, thus limiting the market size of the company. Strategic investors generally increase the valuation of the company and provide capital on more favorable terms, and may provide an exit for early investors if they choose to eventually purchase the company, but they can also prevent the company from realizing its ultimate potential.

The CEO of a software start-up in discussions with several CVCs noted:

In working with a couple of these groups there is not necessarily commonality of objectives in trying to get venture funding. While it is true that they are seeking "deals" that would enhance their market position and/or revenues, how they get there can cause debate. In one case, our software model did not fit the direction of their strategic marketing group. We do not know exactly why, but we suspect it had to do with our promotion of open standards. In the other case, it was probably that the internal product groups were having difficulty agreeing on what was their product approach; this was probably because of the natural competition between these groups. So I guess my caution is that there is a lot of money available in the CVC groups . . . [but] getting to the end game (funding) is perhaps more tedious than traditional VC funding.4

How Do CVCs Get Deals?

Unlike traditional venture capital firms, only a small portion of their deal flow comes from professional service providers like accountants and attorneys. A significant portion of CVC deal flow is directly from entrepreneurs, traditional venture capitalists, parent company employees, and opportunities that the CVC identified itself. 5

Non-CVC Strategic Investments

See the first section of this chapter on bootstrapping and customer and supplier/vendor investments.

Merchant Banks

A merchant bank is a firm that provides investment banking services and makes direct investments, typically private equity or mezzanine financing. As an investment bank, it acts as an agent for the client company, while as an investor it takes the role of principal. This business model came from the nineteenth-century merchant banks founded by businessmen like Baring, Warburg, Grenfell, and the Brown brothers.6 In our research we obtained information from 18 firms that made a range of investments from $500 thousand to more than $100 million in support of an ongoing relationship with their portfolio companies. Some of these firms had industry expertise and extensive analysis and research support in a particular area.

Some of the merchant banks provide investment banking services and accept payment of their fees in the form of equity in the transaction (i.e., investing in the deal). Others co-invest with a buyer or investor in their client's transaction to maintain the relationship seeking longer-term financial gains. In some instances, the merchant bank has funds to invest to facilitate a transaction.

We did find some instances where a merchant bank had multiple funds such as a venture fund, a mezzanine fund, and a buyout fund. Most expressed interest in public and private companies.

When establishing a relationship with a merchant bank, it is important to quickly assess what role they are working from, as an agent or as a principal. For additional information on both, see the appropriate section in this handbook.

1. PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree Survey.

2. Ernst & Young Corporate Venture Capital Report, Fall 2002, p. 9.

3. Ibid., p. 4.

4. Written interview with Bruce Kasson, CEO, eXOS, Inc., 2004.

5. Ernst & Young, p. 8.

6. Interview with James Rutherfurd, executive vice president and managing director, Veronis Suhler Stevenson, August 26, 2004.

The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.