Welcome everyone to another edition of my China Tech Law Newsletter. As I discussed in a previous post, times are still difficult for startups to raise funding from traditional venture capital investors. What are called institutional or financial venture capital. One alternative for tech startups, of course, is to seek investment from corporate venture capital. Strategic players in the industry which setup a venture capital arm to invest in promising companies with new technologies or business models. It has been slowing down as well, but it is surprisingly still out there looking for good targets.
Corporate VC tends to invest with different goals and different timelines in mind. So what are some of the pros and cons of working with corporate VC?
(1) Synergies vs. Ecosystem Traps
Early stage companies tapping into the corporate investor’s network and gaining a stamp of approval from the investor can go a long way. If you’re going to be picky, work with an investor who is not necessarily your direct customer but one who is more of a partner that can lead you to other customers. Think for example of an IBM that has become more of a service company now working with other corporate customers across all different industries. This is as opposed to an investor which might want your technology for themselves and only themselves one day.
We’ve seen over the years, for example in China, Alibaba and Tencent to be very active corporate investors - but tending from the beginning to force companies to choose one of their two ecosystems over the other right from the beginning. This has been a dominant feature of Chinese venture capital. Despite government regulations to try to break these ecosystem moats, at some point you’ll likely have to choose because you need access to those marketplace networks of Alibaba and Tencent. They are still major gatekeepers, and often you need to choose one or the other.
(2) Investor timeline and exit pressure / growth push
Taking a step back, of course there is the risk that your technology is not the right fit for the corporate VC. In an ideal world, the corporate VC is a small minority investor and simply takes a hands off approach to let you work with other customers, find other sources of capital, and continue on your way.
Most financial investors these days are pushing their portfolio companies to be profitable as soon as possible, not to grow at all costs as in the past. Corporate VC doesn't really follow either path.
The issue of course is that some corporate VC investors actually take larger stakes than traditional investors (say even more than 20%). They’re not really just corporate investors at that point, they’re almost more like joint venture partners. Are they going to scare off other investors who think - why doesn’t this company believe in the startup’s technology and have a deeper collaboration? Or if I can get past that, are they truly still a passive investor now?
If I’m a financial investor, I might worry a corporate venture capital investor holding so many shares, are they really going to want to exit to sell the business the same time I and hopefully the founders are ready to sell? Will their corporate decision process slow everything down?
Institutional venture capital has a ticking clock on calculating their internal rate of return (IRR), the benchmark that all funds are judged by and as a rule of thumb needs to be higher than 25%. If that corporate investor has customary veto rights over major strategic decisions, and are not fully engaged, that can be a problem. The problem is exacerbated by the fact the decision to invest or to decide on anything (like most big corporations) needs to have a corporate champion inside the company to push through the process (or bureaucracy). Its quite possible that the original person who championed investing in your company in the beginning has moved on to another role in the company or has left the company entirely, leaving you an orphaned portfolio company in some ways without an internal sponsor.
So watch for the interplay of customary veto rights held by a corporate investor and other decisions it needs to be involved in versus the timeline pressures of an institutional financial investor driving you hard and fast towards an exit through M&A or IPO.
So you’ve got a general concern about slow decision making process for a corporate VC investor both on the front end at the diligence and internal approval stage. For these reasons, its best to have a corporate investor come on following the lead of an institutional investor who can drive the deal from term sheet to closing. Let the corporate VC lead the round, and you’ll have to adjust your expectations on timing. While financial investors do have multiple deals they’re looking at at once, they are generally working with long-term committed funds invested over a 3 or 4 year investment period so you should know how much capital they have and how long they have to deploy it. Versus a corporate VC which may have certain funds allocated per year more in line with a typical annual budget process (and often can be the first thing cut in an downturn).
(3) Puts and Calls to break up deadlock
Don’t get me wrong, I understand the temptation - if a big fancy company is willing to offer you all the funding you’re going to need for the next couple years, its hard to turn down especially these days. And on top of that, they may not ask for that full laundry list of venture capital terms on preferred economic rights especially if they’re taking a very large stake more like a JV partner.
But do beware of taking too much investment from them. You’re going to run into a fluctuating budget to commit more capital in the future compounded by a slow decision making process and a perception that you belong to their ecosystem - all impediments to allow any other investors in when the company is at an inflection point and needs new capital and new direction.
I counsel clients to think about this contingency and negotiate now to have put and call options in place where certain conditions will force a corporate investor to act. For example, if the company hits certain financial projections, the founders have a right to sell some or all of their shares to the corporate investor. Of course again, if you’re locked into an ecosystem or there are other ties up with the investor (such as an exclusive supply arrangement), you’re financials may be in some part dependent on them. Watch out for this conflict of interest.
Or if the investor refuses to allow new external fundraising under certain conditions, the company itself will be forced to put in more money or again, buy your shares.
Basically a founder is looking to avoid a situation where for all reasons we discussed, they cannot grow the company to a place where they themselves can get out, and where the investor’s inaction allows the company to wither away without any return for the years of sweat of the founders.
OK that's all for this edition, just sharing some experience I've accumulated over time as I surprisingly hear more clients asking about corporate investors instead of institutional lately.