Corporations continue to look to innovation to increase value and expand capabilities. Traditionally, corporations focused on internal research and development (“R&D”) and acquisitions of strategic targets. Yet, innovation through R&D can have its limitations as it is funded internally and can be restricted by internal policies and procedures that may hinder innovation. Innovation through acquisition also has its risks, as the purchaser may not identify all of the potential issues of the target when conducting its due diligence. A purchaser may also face issues when attempting to integrate the target into its existing business—particularly when the purchaser is a multinational corporation and the target is an emerging company.
To address these concerns, corporations have increasingly looked to establish a corporate venture capital (“CVC”) program to support and complement their innovation strategies and outsource strategic alignments to stay competitive. Corporations that have established a CVC program can gain invaluable market intelligence, as well as invest in and understand future acquisition targets. For emerging companies and start-ups, CVC programs offer funding as with traditional venture capital funds but can also provide such companies with market and development support. CVC programs can also form alliances with emerging companies that may be potential customers or strategic partners.
Corporate Venture Capital Programs Defined
CVC, a subset of and different from traditional venture capital, is the investment of corporate funds directly into emerging companies. CVC programs allow companies to gain insight and access to new markets, trends, and technologies.
The term CVC both broadly captures strategic investments made by large and established corporations in emerging companies and also more narrowly refers to investments that a corporation makes through a related CVC arm dedicated to sourcing and making investments in start-ups, rather than through direct strategic investments.
Objectives of a CVC Program
CVC programs are similar to traditional venture capital funds in that the goal is to invest in emerging high-growth companies that drive value back to the company. Both CVC programs and traditional venture capital funds are driven by financial returns.
However, CVC programs, once known as strategic investments, also strive to advance the company’s strategic objectives. In addition to financial returns, the other goals of a CVC program could be to (i) identify and capitalize on synergies between the corporation and emerging company, (ii) develop the corporation’s technology, (iii) acquire the emerging company’s technology, and/or (iv) create commercial partnerships.
For the emerging company, and in addition to funding, a CVC program can offer (i) access to resources, (ii) access to customers, (iii) market knowledge, (iv) brand validation, and (v) wider networks.
As such, CVC programs may look to invest in emerging companies that operate in the same or complementary industries.
Choosing a Legal Structure
A CVC program’s strategic and financial objectives will inform how closely the program will coordinate with the corporation’s current operations—that is, its legal structure. There are three main types of legal structures for CVC programs: limited partnerships, investment via an affiliate, and fully integrated programs. Many factors should be considered when establishing the appropriate structure for a CVC program, including tax considerations. These considerations are beyond the scope of this article.
1. Limited Partnerships
A CVC program can be structured as a limited partnership operating as a separate legal entity from the parent company. A limited partnership is made up of at least one general partner (“GP”) and one limited partner (“LP”). In any partnership, the GP or GPs manage the partnership. CVC programs may utilize this model of investment in two ways. First, they may look to form an independent limited partnership. Second, they may invest in a venture capital fund as a limited partner.
(a) Formation of a Limited Partnership
A corporation may look to form an independent limited partnership in which the parent company is the sole LP and a separate entity is incorporated that is the GP. Under this approach, the corporation can set the investment criteria and strategic direction of the limited partnership. This means that the CVC program can be focused on investing in portfolio companies that directly benefit the corporation. This approach can offer tax advantages, but these are beyond the scope of this article. The disadvantage is that this approach requires substantial capital investment for the corporation, and conflicts may still exist between the parent company and the investment arm.
(b) Investment as a Limited Partner
Alternatively, the corporation can invest as a limited partner in one or more independent venture capital funds. By joining as a limited partner, the corporation has quick and easy access to deal flow, invests in areas farther away from the corporation’s core business, and relies on the venture capital fund to make investment decisions. However, this structure also means limited influence and autonomy on the investments and fewer strategic incentives for the corporation. In addition, the CVC program will have limited access to information relating to the day-to-day operations of the portfolio companies.
2. Investment via an Affiliate
A CVC program may also be structured as an affiliated legal entity of the corporation or a separate business unit within the corporation. Under this approach, the day-to-day management of the CVC program can be separated from the other aspects of the corporation as the CVC program can be managed independently from the rest of the operations of the business. As such, the investment selection and decisions can be separated from the parent company. Typically, the parent company will have oversight over certain decisions by way of an executive committee.
3. Fully Integrated CVC Programs
A corporation can also form a CVC program internally, where the investment team consists of company employees. Under this structure, a specific investment department or business unit oversees and approves each investment. As this is an in-house CVC program, investments made are generally closely related to the business divisions of the parent company.
Running a Successful CVC Program
For a CVC program to succeed strategically and financially, a company should clearly define its investment goals, develop a strong program infrastructure, and establish deal sources, among other business best practices.
1. Have a Defined Investment Thesis
While strategic investments produce financial value in the long run, CVC programs often have to balance strategic and financial objectives. For instance, a CVC program’s decision to invest in a portfolio company may be driven by its interest in the portfolio company’s technology or business processes. As such, the CVC program may be willing to accept lower returns due to the potential synergies with the parent company’s operations or strategic direction. Having a clear understanding of the CVC program’s strategic direction and investment goals will inform which CVC structure would be most appropriate, though it is not critical for the CVC program to have a defined investment thesis that is aligned with the parent company’s strategy.
2. Develop a Strong Infrastructure
Once an investment thesis is established, the CVC program must have the resources and structure required to reflect the investment thesis. This includes determining the level of autonomy that the CVC program will have with respect to the parent company. Greater autonomy may allow for the CVC program to take greater risks and make investments that may fall outside of the traditional scope of the parent company’s operations. Yet, the parent company should still look to maintain a level of oversight to ensure that no conflicts of interest exist and that no investment decisions are made that might cause reputational damage to the parent company.
The parent company must also ensure that adequate resources are made available to the CVC program to support its success. This includes ensuring that individuals with expertise in venture capital financing are involved. When corporations initially consider investing in emerging companies, they may not have the internal expertise with negotiating minority investments. Without expertise in venture capital investing, corporations may treat these investments as if they were mergers and acquisitions investments. As such, the corporation may focus on ensuring that it has control of the operations and decision-making of the emerging company. In doing so, the corporation could limit the potential of an emerging company and stifle the future innovation that drove the corporation’s decision to invest in the first place.
Some additional infrastructure considerations include the following:
- Who will manage the day-to-day program operations?
- How will capital be allocated to the CVC portfolio and the targeted stages of investments?
- What will be the compensation structure for the corporate venture team?
- What will be the key performance metrics for the CVC program?
3. Establish the Deal Pipeline
The volume and quality of investment deals are important factors to a CVC program’s success. Consequently, CVC programs should establish a robust communication framework to ensure that there is an efficient investment approval process. Internal communication includes frequent meetings with the investment team and consistent oral/written connections with the parent company. External communication includes outreach efforts to relevant start-up communities and engagement with portfolio companies.
There are three main ways that CVC programs source deals:
- Institutional venture capital firms: Forming relationships with institutional firms, which have a wider network and greater deal flow, is an important way for CVC programs to grow their deal pipeline.
- Accelerators and incubators: Accelerators provide good sources for early-stage investments, because the participating start-ups have already undergone some sort of vetting process.
- Informal networks: CVC programs often have analysts who scout start-ups on research platforms, attend venture capital events, and gain referrals.
CVC programs have proven to be an effective way for companies to invest capital strategically to drive future growth and leverage disruptive innovation. The structures and points discussed herein are not an exhaustive list of considerations relating to the formation of a CVC program, but this article highlights some key issues that companies should contemplate. Companies that plan to engage in CVC should seek counsel with venture capital knowledge to guide their process.