The Rise of Corporate Venture Capital
As Corporate Venture Capital increasingly becomes an important part of the venture capital community, particularly across the technology and life sciences sectors, this article looks at recent trends, some of the deals done so far in 2013, and some of the issues commonly encountered when structuring a corporate venture capital transaction.
What is Corporate Venture Capital?
Corporate Venture Capital ("CVC") refers to the scenario where a large organisation (or its venture capital arm) makes a direct equity investment into a smaller (often privately held) company by taking a minority stake. The investment is usually driven by strategic goals, enabling the larger company to quickly access innovative technologies, creative output and to share R&D, whilst enabling a start-up company to access not just funding, but a wealth of marketing and buying power, distribution channels and product validation from a potential customer/partner (or indeed a potential acquirer).
A distinction should be made between Corporate Venture Capital and other forms of non-equity based corporate venturing. For example, a common form of corporate venturing used for R&D development may be structured by way of a collaboration agreement whereby the larger corporate provides funding in return for royalty rights or the right to share in the foreground intellectual property generated during the R&D collaboration.
This article looks at Corporate Venture Capital as an equity based investment, rather than non-equity based structures.
The Rise of the Corporate Venture Capital
Corporate Venture Capital is of course not a new concept and has been around for over 40 years. But from a somewhat chequered and volatile past, when Corporate Venture Capitalists ("CVCs") tended to invest at the end of an economic cycle, CVCs are becoming increasingly prominent and sophisticated, and are active in the early stages of the current economic cycle, particularly seen in the digital technology sector. Whilst CVCs continue to invest in later stage companies, they are also nurturing start-ups and plugging a gap in early stage and Series A deals which has been left by VC firms who, struggling to raise funds from their LPs, have adjusted their investment strategies in favour of less-risky later stage revenue-generative companies. It is perhaps symbolic of the existing venture capital ecosystem that the largest European VC fund to be raised in the first half of 2013 was Unilever's Venture II Fund, raising €350m and accounting for 39% of all funds raised for Q2 2013 1.
Tech and telecom
As we move towards an internet of things and smart digital technology, it is unsurprising that of the 126 CVC deals in the first half of 2013 surveyed by CB Insights, 4 out of every 10 deals funded the internet sector, hitting a five quarter high in Q2 2013. On a year on year basis, the number of deals in mobile technologies by CVCs was up 35% and the funding to that sector up 41% versus 20122. Google Ventures, Intel Capital, Samsung Ventures, Qualcomm Ventures, Comcast Ventures… there is a multitude of CVCs in this sector who are actively pursuing the next generation technologies.
Google Ventures is currently ranked the most active CVC investor. Its investments in OpenCoin in May 2013 (which was reportedly less than $200,000) and in Uber, a mobile technology and transportation business, in August 2013 (€258 million), shows that CVCs will invest both development capital in more mature businesses by way of Series C rounds and also provide more risky seed and Series A capital for unproven, pre-revenue start-ups.
An upward trend for Life Sciences Corporate Venture
In its analysis of private merger or acquisition transactions of US-based, venture capital-backed companies between 2005 and 2012, Silicon Valley Bank recently highlighted that CVC was part of the investor syndicate in 30% of all biotech Series A equity financings in 2012, twice that of the previous two years3. That upward trend has continued into 2013, with corporate venture capital funding to healthcare companies up 34% in Q1 2013 versus Q1 2012, with 39% more deals being funded in the same period.
In fact, over one third of the most active CVCs are healthcare focussed, with Novartis Ventures, GlaxoSmithKline, Merck and Johnson & Johnson amongst others actively investing in start-ups to stimulate promising, early-stage R&D innovation. GlaxoSmithKline's newly launched Action Potential Venture Capital fund in August 2013, a new $50 million strategic venture capital fund that will invest in companies that pioneer bioelectronic medicines and technologies, is a good example of a CVC investing in innovation as a way of sourcing new technologies and transformative medicines. The fund’s first investment will be in SetPoint Medical, a developer of implantable devices for treating inflammatory diseases.
Structuring a Corporate Venture Capital deal
To a certain extent the structure of a Corporate Venture Capital deal looks and feels very similar to, and in most cases is the same as, a more traditional venture capital investment from a VC. On that basis, the standard documentation required to implement the transaction will usually be:
i. the initial term sheet;
ii. a subscription and shareholders agreement;
iii. a new set of articles of association to be adopted by the investee company on completion;
iv. disclosure letter (against the warranties contained in the subscription and shareholder agreement);
v. assignments of intellectual property from founders and other developers (if required); and
vi. service agreements for management and key employees.
The key principles will also be similar, in that the CVC taking a minority stake will want a board seat and veto rights over key commercial and corporate decision making. It will probably want to lock the management's shares in for a period, usually under good leaver/bad leaver provisions, and will want rights of first refusal over any further funding of the company, and potentially anti-dilution protection on any future down-round. The parties will also want to negotiate the class of shares to be issued to the CVC and the rights attached to such shares. Usually these would consist of a Preferred class of share giving the CVC a liquidation preference and a cumulative fixed dividend on its investment: a CVC will want to protect its downside as much as a traditional VC does if the company it is investing in does not turn out to be a success.
There will however in most cases be distinguishing features to the transaction which differentiate it from a more traditional VC fundraise, due to the CVC investing for strategic purposes. Each transaction will differ according to the specifics of the product, technology or market involved. For example, an internet or lifesciences CVC investing in a new innovative tech R&D company (with an eye on potentially acquiring that technology, or the company, in the future) may look to negotiate one or more of the following provisions:
Where the investee company has manufactured products or platforms by way of a technical patented process, the R&D cost of which has been provided by the CVC, the CVC may want to both put in place a collaboration/knowledge sharing agreement during the R&D process and also a right of first refusal over the licensing of that technology. Some of the issues to be careful of when negotiating these arrangements can include:
- ensuring there are robust confidentiality provisions in place dealing with the sharing of information, and a clear purpose for which that information can be used (and not in competition);
- ensuring each party retains the rights in all of its background IP and that a party is not inadvertently given any rights in the other's background IP other than by way of non-exclusive licence for the purposes of the project;
- negotiating licence terms regarding the foreground IP that arises during the R&D process. It is preferable to avoid joint ownership of foreground IP and care should be taken that foreground IP remains owned by the company, and that the CVC is only granted a licence to use such IP. This would usually be on an exclusive basis but founders will want to be careful that they do not unduly restrict the ability of the company to commercially exploit its IP with other parties in other markets and jurisdictions (or that appropriate exclusivity fees are agreed);
- who will be responsible for filing, prosecution and enforcement of the patents and other IPRs?
Rights of first look over commercial output & distribution
Similarly, where the company has developed products or creative output which requires distribution (in particular to new markets and jurisdictions), the CVC will likely wish to negotiate first look rights over the distribution of that product/output across its channels. This may well of course have been the raison d'être for the investment having been offered and accepted in the first place, as a means for the company to achieve faster and higher growth by accessing the CVCs distribution channels, and the CVC to acquire new innovative products without having to devote resources to organic development. A few of the issues to bear in mind when negotiating the distribution arrangements will include:
- the basis of the appointment and the extent of the territory. The CVC is likely to want for this to be exclusive in the main jurisdictions in which it operates but care should be taken that the company is not restricting its ability to commercially exploit its products and services through other channels (or that it is being adequately compensated by way of exclusivity fees if it is);
- will there be any minimum purchase obligations in respect of any of the products or output?
- what obligations will be imposed (if any) on the CVC in maintaining its distribution channels in the relevant territories, and will this be subject to minimum requirements;
- care should be taken to comply with EU and UK competition laws, in particular avoiding any re-sale price maintenance or influencing the CVCs on-sale pricing.
Exit provisions & Call options
One of the main advantages of taking an investment from a larger corporation is that they are often not hamstrung by the vagaries of the term of life that LP structured funds are subject to (for example, most LPs operate over a 10 year lifespan and have to
wind down the fund and liquidate its investments, which can lead to a forced exit at an inappropriate time). Whilst of course this may also apply to the investment arm of a CVC which has structured itself as a more traditional LP, a larger corporate investing on its own balance sheet will not be required to exit or liquidate its investments at the end of a fixed period. A CVC can potentially therefore take a more flexible approach to the timing of an exit, and look to effect this when it is in its best interests to do so.
Whilst a more traditional VC would usually be looking for an economic exit, whether by way of a sale of its minority stake to a secondary investor, trade sale, IPO or a redemption of its Preferred shares, a strategic CVC investor may be more focussed on acquiring the company once the technology has been proven (following R&D) or once the company has reached a certain level of market penetration or profitability. Given the fast pace of current technological development, corporations are usually forced to make acquisitive decisions over a much shorter timescale, and therefore may at the outset have one eye firmly on acquiring the company over the short term and wish to adopt a flexible structure so that they can implement the acquisition at their option in an ever-changing market.
The most simplistic way in which the parties can deal with this without negotiating the detailed terms of the acquisition at the point of investment is to include a right of first refusal for the benefit of the investor over any proposed sale of the Company. This could also include the negotiation of a right for the investor to match any third party offer and to make any Drag rights in the articles of association conditional on the investor being given a window and opportunity to purchase the company itself. However, in some cases it may be in the CVCs interests to have more certainty over the terms of the acquisition, particularly if the CVC is sensitive to competition and wishes to control the timing of the acquisition. In such circumstances the CVC may wish to negotiate a "call" option over the shares held by the founders and other shareholders to enable it to become the 100% owner at a future date. In a similar fashion, the founder(s) may want the corresponding right to "put" their shares to the CVC in order to require it to buy them out on similar terms). This can be an attractive position for founder(s) as it gives them a natural exit opportunity by selling out to the CVC under the option arrangements. Whilst this gives both parties a degree of certainty over the sale and acquisition of the business, it does of course mean that when negotiating the investment the founder(s) must bear in mind that they are also potentially negotiating the eventual sale of the company, and locking-themselves in to a sale to one suitor, when there may be more interested parties, and a more competitive process, later on in the company's lifecycle.
A Call Option granted in favour of the CVC will give it the right to acquire the remaining shares in the company at future date and at an agreed valuation. Some of the potential issues to consider when negotiating the put & call options will be:
- how and when will the Call option be capable of being exercised? Will this be at the investor's election at any time following the investment or should there be a period of time during which the options cannot be exercised? Alternatively the option could become exercisable on the occurrence of a predefined event, such as successful completion of R&D, clinical trials, product launch or otherwise once the company has reached a certain level of sales, profitability or market penetration;
- care should be taken to ensure that any conditions to exercise are capable of being easily measured and independently verified, and that they are realistically achievable;
- how is the company to be valued at the time the option is exercised? If the company is generating revenues and profit, will the valuation be calculated by reference to EBITDA or sales, and in either case, over what timeframe? For R&D companies a valuation defined by EBITDA or sales figures are unlikely to appropriate and more complex considerations should be had in terms of valuing the IP which is being acquired;
- should there be any minimum or maximum floor to the valuation given to the company under the option? Whilst a maximum floor may give a CVC certainty that it will pay no more than a certain amount to acquire the company, it is likely to act as a disincentive to founder(s) and preferably should be avoided;
- the grant and exercise (and disposal) of options can also give rise to complex tax issues. For example, if care is not taken with the structuring of put and call options, the founder(s) may be deemed to have disposed of their shares at the date of grant of the options and become liable to tax. Careful consideration should therefore be given to the tax structuring and specialist tax advice should be taken.
Corporate Venture Capital in 2014
Given that the figures released for 2012 and for the first half of 2013 show a continued increase in the amount of Corporate Venture Capital in early stage and development capital deals, it is likely that CVC will continue to play an important role in the US and European venture landscape, alongside traditional VCs and business angels.
In the UK, there have been recent calls4 for the UK Government to bring back a scheme similar to the previous Corporate Venturing Scheme ("CVS") which was abandoned in March 2010. The CVS was introduced in 2000 to incentivise and encourage CVC activity in the UK and provided tax reliefs for corporate equity investment in the same types of companies as those qualifying under the current Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) scheme.
Primarily, if the qualifying criteria for CVS were met, the company making the investment would benefit from:
(A) Investment Relief: relief against corporation tax of up to 20% of the amount subscribed for full risk ordinary shares;
(B) Deferral Relief: deferral of tax on chargeable gains arising on the disposal for shares on which investment relief has been obtained, if the gains are reinvested in new shares for which investment relief is obtained; and
(C) Loss relief: relief against income for capital losses arising on disposals of shares on which investment relief has been obtained, net of the investment relief.
Having expired at the end of March 2010, the scheme was not renewed in the following Budget due to poor take up; however, with the deployment of corporate venturing again on the agenda of companies looking to access the innovation of the UK's technology and life sciences community, and with VCs focussing on later stage investments, an effective economic and fiscal policy on Corporate Venturing would likely prove to be a boost for the venture capital ecosystem.