Doing Deals With The Devil? A Corporate Venture Capitalist Speaks Up For The Value Of CVC

Re-posting an article I had written for CB Insights:

At the risk of stating the obvious, Fred Wilson is an investment superstar. His funds have generated incredible returns for his limited partners and like most technology investors around the world, I’ve followed every word that he has written on AVC and spoken at conferences, looking for insights into his thinking and investment process. This includes his remarks at the CB Insights Future of Fintech Conference. Here’s what Fred said:

[Corporate investing] is dumb. I think corporations should buy companies. Investing in companies makes no sense. Don’t waste your money being a minority investor in something you don’t control. You’re a corporation! You want the asset? Buy it.

This one time, I disagree with Fred. Having worked as a private equity investor and more recently as a corporate VC (CVC), I have analyzed acquisitions and minority investments both from financial and strategic perspectives.

Let’s first talk about why corporations may not want to (or should not) acquire a business outright and, instead, be a minority investor.

The Corporation May Not Be The Right Home For The Startup

It’s important for any corporation to acknowledge what they can and, more importantly, cannot do. That requires management to understand what kind of culture they have, what are their capabilities (and limitations) and whether they can successfully integrate a business they acquire. Unfortunately, many corporations do not get this aspect of acquisitions correct, which, as we’ve all too often witnessed, leads to startup founders leaving shortly after the acquisition (or as soon as their contracts allow for it).

The Corporation May Not Have The Resources To Acquire And Integrate The Business

It’s easy to look to the “fab five” (Google, Facebook, Microsoft, Amazon and Apple), who collectively acquire dozens of companies a year — each has billions in annual free cash flows, which gives them a “little” foot-fault room for acquisition-mistakes, and they have legions dedicated to post-acquisition integration. Financial investors naturally love them for providing M&A exits every year, but relatively smaller tech players don’t have the resources to invest in the core business while simultaneously dedicating resources to recurring acquisitions.

It May Not Be The Right Stage For The Corporation To Acquire The Startup

The founders may still be scaling, they may not desire a complete exit at that point, or their initial product is great, but still a lot to do on the roadmap before the CVC can justify acquiring at the price demanded.

If, for the reasons above, a corporation isn’t ready to make acquisitions, why should a corporation make a minority investment?

We Can’t Do Everything Ourselves

Barring a few exceptions, I believe most corporations are one (or two) trick ponies — we presumably can address spaces complementary to our core businesses, but tackling a new vertical requires a team that is passionate about that vertical and is thinking 24/7 about solving the problems in it. At the same time, we have to balance our desire to enter a new vertical, via an acquisition, with the risk of stifling the creativity and vision of a startup’s founders — hence minority investments are often the right solution.

Plain Vanilla Commercial Agreements (generally) Suck

If the startup and corporation are OK with the startup’s product simply being sold “as is” — with virtually no collaboration between the two — please proceed directly to signing a commercial agreement. If, however, both parties plan to work together to launch something for a given customer base, and if they want to collaborate on product roadmaps, share data and insights freely, then an equity agreement creates a clear alignment between both firms. Corporations have divisions run by people with varying incentives, and I have found that telling our internal teams that we are shareholders in a partner has helped move various initiatives forward and driven decisions that take into account the interests of both the startup and the corporation.

Being A Part Of The Value Creation

When we work with our portfolio companies (11 and counting at this point), we help them access tens of millions of customers through our distribution network. We almost certainly would not have been able to build these products ourselves and, therefore, would have captured 0% of the value if we didn’t partner with the startup. Through the minority investment route, we realize a portion of the value that we are helping to create (and, as a reminder, see above if you’re wondering why we wouldn’t just outright acquire the startup, in the hope of capturing 100% of the value created).

So, to recap, CVCs are strategic partners (i.e., we’re able to provide a platform, in addition to capital) who are happy to let founders be founders. What’s not to like, from a founder’s point of view? Well, working with a CVC is not all fun and games — after all, Fred did note that you’re “doing business with the devil.” So at the risk of outing the playbook, let me go one step further and highlight some of the challenges founders may face with a CVC (and advice on how to address them).

Be Wary Of Terms Restricting Your Business Or Eventual Exit

Some CVCs will ask for rights of first refusal, or ROFRs, before you try to sell the business, they may restrict your ability to work with their competitors, they may seek a period of exclusivity and so on. Push back on any exclusivity periods or restrictions unless the CVC is ready to sign up to the strategic value they will provide, and have an escape clause if they cannot provide this value within a particular time period. Your lawyers can advise you on how to dilute, or provide an alternate to, a ROFR, for example.

Minimize The Gap Between Value-promised And Value Actually Delivered

Fred’s frustrations with CVCs perhaps, in part, stem from instances where there was a lack of value-add delivered by a CVC (despite much value having been promised). While this is a fair criticism of some, but of course not all, CVCs, let’s first not forget that founders equally can (and do) level a similar complaint against financial investors. “Value-add” is a two-way street: founders need to be able to “value extract” as well. Our portfolio company founders call me multiple times a week to, putting it nicely, “voice concerns” when they get stuck in our system, and part of my CVC role is to make sure that I decongest our system, both to help our founder-partners and to help our investments. So make sure you have an internal champion within the CVC, as this will be critical to extracting the promised value from a strategic investor.

On a final note — not all startups have the privilege of receiving capital from top-tier VCs. CVCs play their part in providing capital to companies that may not have appealed to mainstream VCs or whose value was not immediately apparent to them.

When done right, CVC programs can be valuable enablers to the startup ecosystem — and not just by providing exits for financial investors. We have helped our portfolio companies access, and delight, tens of millions of customers and propelled founders on their journeys to realize upon big, audacious ideas, in turn creating value for all shareholders — both ourselves and our VC co-investors.

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