The case against Corporate Venture Capital
Should Corporate Venture Capital (CVC) be one of the methods in your corporate innovation strategy? Let me start by giving my honest opinion right away: no.
While I am not alone with this opinion — for instance, venture capitalists such as Fred Wilson are generally critical when it comes to Corporate Venture Capital or Mark Suster sketching specific scenarios where it could make sense from a startup‘s perspective and where it doesn’t — I am trying to take a corporate‘s angle to back up my reasoning.
The strategic aspect
My answer is based on some assumptions:
- We are talking about common Venture Capital, i.e. participating in a equity-based funding round obtaining a non-controlling stake in a venture (aka startup).
- “Corporate innovation” implies that your strategy is actually not to become a holding of a portfolio of minority investments but you eventually intend to have some sort of a controlling stake so you can pursue operating goals.
- Why is this important? Well, according to general account principles, you need a controlling stake in a company in order to consolidate results (typically expressed by >50% of the voting rights). This is a simplified statement but generally holds true — please consult with the auditor of your choice.
With this in mind, I have heard many reasons what kind of benefits corporates could yield from CVC — let‘s take them one by one:
Access to the best deals early on: let us address the elephant in the room right away. In your corporate innovation strategy, you can typically group your targets into 3 buckets: core, adjacent and diversification. With a CVC approach you cannot get into “core” deals, i.e. that sort of innovations that are highly important (or disruptive) to your core business. Any decent respective founding team would not let you into the cap table, as signaling would be against them. It would limit the options to do business or to exit with your competitors. So, in “core” you can only get bad deals (adverse selection problem).
De facto “information rights” on a specific market: with an active CVC fund in the market corporates believe to be a the forefront of what is happening. Well, this implies that you see all the relevant deals — for „core“: see above. On adjacent and diversification: While the VC community is quite collaborative, you will have to show value-add in order to earn your way in and build up a decent deal flow. Providing business to the respective startups could be something I can increasingly observe to be a selling point. However, in reality this is quite difficult, as decision making within a corporate organization is more complex than that. The VC guys are typically too far away from core business to be persuasive enough. And again, in adjacent and diversification that might not be so relevant after all. I think it there are easier ways of market monitoring.
Access to technology: I don’t see why it should be necessary to invest into a company in order to get access to their technology. Every startup would be more than happy to provide you with their specific product or service against serious licensing fee dollars rather than giving away equity. If the technology, which you intend to access, is not commercialized in a product or service, your minority stake will not help you anyway.
Information rights on a specific business model or startup, e.g. board observer rights: In order to do what exactly? To learn about the business model and to make a move of your own, e.g. copying the business in a different market? To have insights into operational matters, e.g. if the startup does business with your competitor? Apart from these possible intentions being highly questionable from a business ethics point of view, they are also probably not in the interest of the startup. Again, a great founding team would not be desperate enough to accept this.
Strategic rights in term sheets in order to come to a majority stake at some point, e.g. right of first offer/refusal: these rights ensure that you either can issue the first offer or match an existing offer for any sale of an equity stake (secondary or exit). If these rights are in place, you effectively have your hand on the exit of the startup. Again, this is bad signaling and against the interest of the startup and other investors. From the perspective of a future buyer: why would you even bother to place an offer? If you make the deal, it means the rights holder has not called its option — in this case you overpaid. If you cannot make the deal because the rights holder does, you have wasted your time and effort and even have disclosed your price.
All in all, I think it makes more sense to take over startups in a proper trade sale scenario rather than tap into these misalignments of interest, especially when it comes to corporate innovation in your core business. Or you can simply build it.
The financial aspect — beyond corporate innovation
Up to this point my reasoning was purely strategic because of my assumption that corporate innovation is in the center of this. But couldn‘t you argue that a CVC‘s investment thesis can be purely based on a financial goal? Well, you could, but:
According the Kauffman Association a mean net return multiple of a Venture Capital fund is 1.3. This means that, for instance, if you put EUR 100 m into a fund, it will return you on average 130 m after all fees. Note that this in an average with a long tail of funds not reaching this performance. Assuming a common fund lifetime of 10 years, this means that your IRR is 3% p.a.<7p>Don‘t fall into the trap of assuming a 2–3x net return multiple is realistic (according to Kauffman Association only 16% reach 2x or higher). Yet this is what everybody in the market claims to be the target. Why? i) From a typical LP investor’s point of view, the minimum expectation is that a riskier VC investment beats the market by 3–5% p.a. and 2x+ typically fulfills that expectation (according to the Kauffman Association) and ii) a 3x net return multiple would be a „decent“ IRR of 12% p.a., which could hold up to your typical internal WACC considerations.
This also means that you will need to outperform the majority of the independent VCs out there. What would be your right to play? Again startups, by default, will prefer independent VCs. And signaling does play a role, meaning that under the independent VCs household brand names do have an advantage (incumbents such as Sequoia, Benchmark et al are dominating the list of leading VCs, e.g. according to the Midas List).
If this line of argumentation doesn‘t convince you, please refer to your CFO and find out whether 3% or less are in line with your company’s WACC expectations (hint: in most industries it is probably not, see this NYU analysis for reference). Even if you made the typical VC investor’s expectations of 2x resulting in approximately IRR of 7% p.a., it might not be enough from your company’s perspective as defined by your WACC.
According to CB Insights there were 773 active CVC funds in the market in 2018. Can they all be so terribly wrong?
Co-Founder & Partner