Weighing the benefits of corporate venture funding vs. M&A
In the course of evaluating growth opportunities, corporate development teams frequently monitor sector trends and the competitive landscape. With much of the innovation coming from early-stage businesses, particularly in the technology sector, Corporates are likely to assess the merits of acquiring startups they deem as being, or having the potential to become, strategically important.
Startups can offer Corporates access to innovation, creativity and vision that cannot be easily replicated.
Corporates have the potential to create significant value for early-stage businesses by offering access to strategic and operational resources, such as established distribution networks or a broad customer base, that other capital providers (e.g. angel investors or venture capital firms) cannot provide. Equally, startups can offer Corporates access to innovation, creativity and vision that cannot be easily replicated. Ordinary commercial agreements cannot always capture the essence of such symbiotic relationships, particularly over the long run, and may some times result in misaligned incentives, dissonance and frustration. Hence venture-stage M&A can emerge as an attractive option for both parties.
Corporate venture funding vs. M&A
All the benefits of M&A notwithstanding, there are situations when a Corporate may be either unable or unwilling to outright acquire an early-stage company. There are several reasons why that can be the case:
- The startup company’s shareholders are not yet willing to yield control;
- The business, while promising, may not be sufficiently mature to justify the asking price on a risk-adjusted basis;
- The Corporate does not have the resources to acquire 100% of the business or the bandwidth to integrate it;
- There are significant cultural differences or other limiting factors that would hinder the proper integration of the startup into the Corporate.
There are situations when a Corporate may be either unable or unwilling to outright acquire an early-stage company.
These conditions give rise to the option that the Corporate invests capital in exchange for a minority stake in the startup. This type of corporate venture funding activity has been increasing steadily in recent years. Europe saw a record number of such deals announced in 2016. Globally, Corporates participated in over 25% of funding transactions for a second-straight quarter, with an increasing number of them maintaining activity in private markets by setting up Corporate Venture Capital (CVC) arms.
Clearly, corporate venture-stage funding presents a fundamentally different value proposition compared to regular M&A, not least because there is no change of control. Furthermore, there are motivations for venture funding that may not be worth the price, such as simply to “have a seat at the table” or gain vaguely defined insights. In certain cases, however, corporate venture funding may be a justified and even preferred alternative to outright M&A.
- Seeding a complementary startup ecosystem: The Corporate provides seed or growth capital for startups that are developing complementary products or services to those of the Corporate. The emergence of such an ecosystem is expected to ultimately create more demand for the Corporate’s main business.
- Prelude to acquiring control: A minority investment can be a tactical stepping-stone to a full acquisition of a venture-stage business, e.g. if the Corporate can secure rights of first refusal in case of the startup’s eventual sale.
- Share of long-term value creation: Corporates may be able to create material long-term value for startups that exceeds the confines of a commercial agreement. If an acquisition is not possible, a minority investment can accrue to the Corporate at least part of the long-term value that it helped create.
In certain cases, corporate venture funding may be a justified and even preferred alternative to outright M&A.
Effecting successful venture-stage investments
Partnering with a Corporate, either through commercial arrangements or venture-stage investments, can carry significant benefits for startups and act as a powerful signal for other investors. But it can also carry pitfalls. In order to effect a successful partnership, the Corporate and the startup should consider three important factors:
Firstly, the terms of the investment will set the basis for the cooperation. Often, these will include exclusivity periods or other restrictions on the startup’s course of business. It is important that such terms do not unduly stifle growth and innovation at the startup and that both parties adhere to a clearly defined and frequently reviewed action plan. Escape clauses can be a mutually beneficial mechanism for ensuring continued alignment of incentives.
Secondly, a major source of frustration can stem from the tendency among Corporates to de-prioritise activities related to venture-stage partnerships. The possibility of this happening is positively, yet not solely, correlated to the size differential between the Corporate and the startup. To mitigate this risk, Corporates should consider appointing an advocate who will oversee the venture partnership and champion the project within the organisation.
Lastly, it is important to be aware of the effects that a Corporate’s presence on the shareholder register can have on the startup’s addressable market and exit options. While in many cases these effects can be positive, they can also create barriers to doing business with the Corporate’s competitors. Furthermore, and much like the unwillingness of a VC to participate in follow-on rounds can be a negative signal for other investors, a Corporate’s inability or unwillingness to deliver the anticipated value can impact the startup’s outlook, valuation and even ability to secure follow-on funding.
Partnering with a Corporate, either through commercial arrangements or venture-stage investments, can carry significant benefits but also potential pitfalls.
Overall, there is a clear case to be made for both Corporates and startups to consider corporate venture funding. If executed properly, it can be a highly attractive alternative to M&A for creating value and accelerating growth.
About the author: Georgios Markakis is Managing Partner at Venero Capital Advisors (www.venerocapital.com), an independent corporate finance boutique providing mergers & acquisitions, strategic and capital raising advice to high growth companies in the UK and continental Europe.
