The Pros and Cons of Taking Investment from Corporate VCs

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The NY Times recently published a great article on the increasing number of corporate venture capital groups. Per a recent USA Today article, corporate VCs participated in 23.5% of all venture deals in Q1 2016. We’ve seen it here in Pittsburgh, both in local corporations launching venture funds such as UPMC Enterprises, Alcoa, and Highmark — and in local startups receiving investments from the venture arms of firms like GE, Salesforce, Nordstrom, and Google. Corporate VCs can be tremendous partners, but different firms have dramatically different approaches and it’s important to be diligent in understanding how the relationship will work. As a starting point, it’s helpful to look at some of the pros and cons of taking investment from corporate VCs.

Pros

• They may be more patient and have a longer-term investment horizon than traditional VC investors. A corporate VC may get its funding from the parent company’s balance sheet and may not be beholden to limited partners or a 10-year fund lifetime like traditional VCs. As a result, they may be more patient and willing to take a longer-term view on building value.
• They may have fewer (or at least different) control provisions than purely financial investors. Most will only take a stake <20% in order to avoid GAAP rules that would require them to report their share of earnings and losses and quite frequently do NOT take a board seat in order to avoid the appearance of control which can require consolidation on financial statements.
• Receiving an investment from a corporate VC in your market can create instant credibility and potentially serves as a strong industry-related endorsement of your company that can be leveraged to attract talent and customers.
• You can be laying the groundwork for a future acquisition by building a relationship with a potential acquirer now.
• Perhaps most importantly, a corporate partner can add a ton of value. The parent company brings significant domain expertise, connections, talent, etc. to the table and can provide channel access, product integration, and other benefits to help accelerate product development and market penetration.

Cons

• Many corporate VCs are not purely financial investors, but also have strategic directives handed down by the parent company, and as such, may be misaligned with other purely financial investors. We’ve seen corporate VCs block acquisition offers and financing rounds that would have been advantageous from a financial standpoint, but didn’t align with their strategic interests.
• Corporate VCs aren’t always lead investors and in many cases financial investors are driving the terms. However, in cases where a corporate VC is the lead or only investor, there is a threat of your company being overvalued. This can deter potential co-investors and make it difficult to raise subsequent financing rounds at a higher valuation, which can lead to a down round and all of the ugly things that come with it.
• Corporate VCs sometimes include non-standard terms in their deals. A fairly common, and potentially damaging, term is a Right of First Refusal to acquire your company. This can limit your options down the road and scare off other potential acquirers who don’t want to go through the trouble of issuing an LOI or conducting due diligence only to be preempted by your investor who has a Right of First Refusal.
• Having a major strategic investor can be a turnoff to potential customers or business partners who view themselves as competitors to your strategic investor.
• If the corporate VC receives an annual allocation of funds from the parent, as opposed to a fund of a committed size to invest over a given period, the availability of follow-on funding may be tied to the fortunes and changing interests of the parent company. In other words, if you receive your first investment when the parent company is performing well, but its performance later takes a dive, the corporate VC may not have capital available to participate in subsequent financing rounds in your company.

A Couple of Examples:

Here are two case studies of real companies we’ve worked with that received funding from corporate VCs.

Good Outcome

The startup received an investment from a corporate VC which included a built-in exit. If the startup hit certain milestones, the investor’s parent company would acquire it at a set price. This wasn’t a right of first refusal as much as an option that the startup could take and a clear path to an exit without a prolonged investment banking process, negotiations, etc. The company hit the milestones and was acquired at a price that provided a great outcome for the founders and their other investors.

Bad Outcome

A corporate VC was the lead in mid-sized round. The corporate VC valued the startup at a price that was at least 2X the normal market value of a company at its stage and level of traction and as a result the startup was unable to attract additional investors to fill out the round.

Because they raised less than their target amount, the startup was unable to execute on its full plan for growth and had to focus much of its efforts on initiatives with the corporate VC’s parent company. That large corporation ran into tough economic times and reduced the size of its workforce dramatically, including the primary advocates for the startup within the organization. As a result, the startup was left “orphaned” and struggled to raise money given its high post-money valuation and lack of traction. The company ultimately had to raise a significant down round that create a lot of negative effects within its investor base.

Tips and Suggestions

This post isn’t meant to be an indictment or an endorsement of corporate VC, but rather a balanced look at the issues you should consider when deciding whether to approach corporate VCs for funding. If you’re going to pursue corporate VCs, and in many cases it’s a great idea, here are a few suggestions:

• Find out how the VC arm and the corporation work together. How is the VC group evaluated? Are they purely ROI-driven or do they have strategic directives from the parent company? How do they make decisions? The more they behave and are judged as a financial investor the better alignment you’ll have among your investor base.
• Understand the structure of the fund and its ability to follow-on in future funding rounds. How do they establish and maintain reserves?
• Push for standard terms and avoid Rights of First Refusal on acquisition or other non-standard terms that may limit your options down the road.
• Be clear about what other benefits (channel development, product integration, etc.) you’d like to get out of the relationship. Some corporate VCs are very detached from the parent company and may not be able to add this type of value so it’s important to establish clear expectations early.
• If possible, speak with the CEOs of some other companies they’ve funded to get a better feel for what kind of investor and partner they’re going to be. This is good advice for purely financial investors as well.

In closing, it’s important to keep in mind that the mission, goals and objectives of corporate VCs vary dramatically between firms and it’s important for to do your homework before pursuing investment. As with any financial transaction, I also strongly recommend that you consult with your attorneys and other advisors.