Making Sense Of Corporate Venture Capital
In the last three years, 25% of all venture capital (VC) investments globally were made by corporates. This investment activity is known as corporate VC (CVC), and in my opinion, may be one of the smartest investment avenues today.
It is no secret that technology today is one of the most exciting asset classes. Founders and investors in technology companies have generated some of the biggest fortunes in the world. The most significant capital appreciation is enjoyed by early investors, while those who invest after a company goes public also stand the chance of making attractive returns, as evidenced by the recent performance of the world’s top tech stocks. Depending on the stage they invest, early investors are known as seed investors, angel investors, or venture capitalists. But as every wise investor knows, for every winning VC investment, there can be as many as 10 or 20 that offer little, if any, returns, as some companies get sold for no more than what the investors put into it, or fail completely. In order to emerge as a winner in the face of such challenging odds, investors should consider applying the following strategies:
1. Spread risk
Constructing a highly diversified portfolio is key. If you have less than 10 investments in your portfolio, the probabilities are stacked against you, and you could own only losers. The larger the number of investments, the better. One of the most famous global VCs, 500 Startups, has built itself up on the basis of this investment strategy.
2. Choose deals (smartly)
Careful target selection is likewise critical to skew the probabilities in favor of the investor. While the criteria for making such selections are vast, a good advisor will be able to provide you with detailed analysis, supported by reliable facts and figures, to help you make smart decisions.
3. Filter opportunities
Just as having a very diversified portfolio of startups reduces your risk, so is filtering a substantial number of targets increases your winning chances. Such a strategy will serve to sharpen the expertise and the instincts of the investor or portfolio manager. It is routine to hear VC investors saying that they review three to five different opportunities per day, while they may only make one or two investments per month. Just like in house hunting, the more you see, the more likely you are to recognize that rare gem.
4. Be efficient
The activity of filtering targets and executing investments must also be performed in a time and cost-efficient manner for it not to defy the purpose of having a portfolio of many (generally each of them small) investments. Doing so will help keep costs down, and any returns firmly intact.
5. Structure deals
Execution is, of course, key, and structuring can be very helpful here to reduce risks, and increase returns for the VC investors. After all, they are often the only ones putting actual cash into the company, while the founders are keeping the majority of the equity, in exchange for their great ideas and hard efforts. With all the excitement around technology and VC investing, it may come as an actual surprise to many to realize that the returns for VC funds are often moderate, since a smart diversification strategy automatically leads to more averaged returns. Indeed, while one investment can return many times the initial expenditure, this disproportionate return needs to pay for the many investments that fail, and the net result comes back closer to the mean.
This is particularly the case when you take into account the length of time it takes for a startup to be sold, and the fact that VC investors often need to participate in subsequent rounds (which leads to lower returns) to continue supporting their companies, and encourage additional investors to join the cap table. However, not all players in the VC game are bound by the same rules. While a financial VC investor can only bring cash to the company, as well as some expertise in the sector (subject to the VC investors time availability to support the company), corporates or family groups with diversified business interests have much more to bring to the table.
Indeed, a corporate investing in a startup in its sector or a related sector can make a fundamental change to the business plan of the startup, and in turn, significantly increase its chances of success, if not guarantee them:
1.The Startup Could Be A Supplier To The Corporate
In this scenario, the corporate can accompany its investment with a commercial agreement where the startup enjoys a guaranteed increase in its revenues and profits. The investing corporate, in turn, reaps the benefits through an appreciation in the valuation of the startup, and the dividend flow resulting from the profits. This corporate support for the startup also has a multiplier effect on other clients, who are encouraged by the corporate VC’s endorsement, and in turn become more comfortable in giving the young startup more business.
2. The Startup Could Be A Customer Of The Corporate
In this case, the corporate can lock in attractive commercial terms with a high growth new customer, which could become a significant client relatively quickly. By supporting the startup, the corporate VC is helping create new outlets for its products and services, and is getting embedded with the customers of the future ahead of its competitors. Needless to say that the influence that comes with being a principal shareholder can be leveraged to maximize the benefits of the relationship, subject of course to the appropriate corporate governance rules.
3. The Startup Could Be A Potential Competitor Of The Corporate VC Or Even A Massive Disruptor
Indeed, many behemoths of industry were taken down by startups which grew very fast and made past business models obsolete. Investing in one’s disruptors could be an excellent hedge against such 'Black Swan' events. The corporate could learn from the startup, and include some of its innovations into its business model. It can also remain a passive partner, and benefit from the startup’s success as merely an investor. Or, it could decide that the startup’s technology is essential to the corporate’s success (or even survival), and choose to acquire it completely, hence completing the investing cycle by fully integrating the startup’s team and innovations into its structure.
As you can see, in all these scenarios, the probability of success of the startup is significantly increased by receiving the investment from the corporate VC. Not only does the relationship strengthen the predictability of the startup’s cash flows, but it also reinforces its reputation in the market overall, resulting in a virtuous win-win cycle. As such, it may be surprising that there are not more corporate VC programs around the world. Of course, there are several challenges that need to be overcome to ensure the success of a CVC program:
1. Management and reporting
All the challenges faced by the traditional financial VCs also apply to the corporate VC: good target selection, portfolio diversification, and efficient execution. But there is an additional layer of execution risk that refers to the corporate VC: the commercial relationship must be managed appropriately to ensure its success. The benefits envisaged at the time of the investment need to be taken forward into execution through the life of the investment and potentially beyond, to reap the expected returns. Such implementation is not trivial as it requires a smooth coordination between the investing teams, and the commercial and operational teams. In large organizations, such as corporate VCs tend to be, these can be very disparate teams with different cultures, not to mention reporting lines. Getting these various lines of business working together requires strong leadership, clear strategy, and a commonality of vision that is found in the best in class institutions.
2. Red tape and bureaucracy
The size of the corporate backing the corporate VC, while a strength, can also be a handicap. Getting a very large, often bureaucratic, institution, to collaborate with a startup has many challenges. The startup managers get frustrated with the bureaucracy and slow pace of the corporate, and the corporate executives baulk at the chaos, disorganization, and breakneck pace that are the hallmark of successful startups.
3.Stifling innovation (instead of encouraging it)
There can also be the temptation for the corporate to take control, or even fully acquire the startup. While in some cases this has to be done (for example if the startup becomes indispensable to the corporate), this should only occur under exceptional circumstances. Corporate culture can often stifle innovation, and it may be impossible for the founders and startup managers to function efficiently in that context.
In conclusion, corporates can generate disproportionate benefits and returns by investing in technology startups via corporate VC programs. In addition to the strong returns resulting from a successful technology investment, the corporate can generate additional returns on its balance sheet via increased revenues, reduced costs, or accelerate innovation and early access to new technologies. This can only be achieved via careful execution and strong team work between the corporate’s teams and their advisors.
Ziad Awad is the CEO of Awad Capital, an independent Dubai-based, DFSA-regulated financial services firm specializing in mergers and acquisitions (M&A), corporate finance and capital markets advisory. Ziad has 24 years of investment banking experience, and has advised on around US$100 billion of M&A and half a trillion of capital markets transactions,. Prior to founding Awad Capital in 2013, Awad held a number of senior positions with Bank of America and Merrill Lynch in Dubai, and with Goldman Sachs in Dubai, London and Paris. His career spans M&A, with specializations in technology, education, healthcare, logistics, industrials, energy and power, as well as the debt capital markets and trading businesses. Follow him on Twitter @awad_ziad.