Successful strategic investments: how large corporates can partner with fast-growth companies (and vice versa)

November 2021 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

November 2021 Issue

As economies around the world continue to emerge from the coronavirus (COVID-19) pandemic, we are at the beginning of a significant wave in corporate venture capital (CVC) investment. Data from CB Insights for H1 2021 shows a 133 percent surge in CVC deals, with some 2099 deals for a total value of $79bn across that period. The pace of technological change means that corporates no longer see investments in innovative start-ups as discretionary. As we live, work and play in new and ever more digital ways, the demand for disruptive new ideas will accelerate, particularly as the global economy rebounds. These new ideas will be brought to market by a generation of entrepreneurs that want to change the world and will be seeking significant capital (and other resources) to do so.

Despite this backdrop, we know that these partnerships are not easy to execute. EY’s Fast Growth Report highlights that 57 percent of fast-growth companies want a supplier relationship with large corporates and 55 percent want to partner with them, but nearly a third experience difficulties in agreeing contractual terms. Entrepreneurs and their existing traditional venture capital investors can occasionally be wary of CVC, with a perception that the involvement of a corporate on the capitalisation table may restrict their options in the future, outweighing the anticipated benefits of a partnership. However, with the benefit of clear objectives on both sides, empathy with all parties’ approach, anticipation of terms and experienced professional advice, the platform for a very successful partnership can be achieved.

Know thy counterparty

The world of CVC is hugely diverse, with a broad spectrum of approaches to funding, structure, the professionals involved and ultimately what success looks like. This ranges from corporates investing directly from their own balance sheet, the objective being to gain direct business and technology experience in emerging areas, with financial return being less important than the direct strategic objectives. Others will run an internal dedicated fund, still funded 100 percent by the corporate, but with more autonomy regarding its operations, and with financial returns being more important (although strategic aims remain). Corporates can also invest in external funds, to develop internal VC capabilities while gaining market awareness and understanding, where a return on financial investment is key (very much like any other limited partner investor). It is vital for fast-growth companies to understand what sort of CVC investor they are engaging with, and therefore what can realistically be expected from the partnership and ultimately what success looks like on both sides.

Focus on the objectives

CVC is perhaps one of the riskiest activities a corporate will undertake with its capital, and so a laser focus on the objective for the investment is critical. Is the partnership intended to create new intellectual property (IP) through research and development (R&D) collaboration, or open up a new sales channel or market? Equally, what does the fast-growth company want to achieve beyond securing capital for its next stage of development? One of the key differences between CVC and traditional VC is that the corporate is likely to be, or at least perceived to be, a potential buyer of the business (while the VC is always a seller at some point). Is this a scenario that either party is considering, and if so what sort of timescale is envisaged on either side?

Anticipate the key areas

The objectives of the partnership will drive the key terms to be negotiated to make the deal happen. All deals are of course bespoke, but some common areas that emerge are outlined below.

Information and confidentiality. The CVC investor will want to receive typical financial information for a VC investment, such as monthly management accounts, budgets and board packs. However, depending on the extent of the fast-growth company’s activities in that industry, certain types of information (such as likely sales deals with competitors) can lead to a conflict of interest, in addition to competition law concerns, particularly in markets where regulators are already focused on the power of a handful of key players. Consideration must be given to the type of information that is inappropriate to be shared, and both legal and operational safeguards included.

Board and observer rights. Depending on the size and stage of the investment, and the style of operation of the CVC, a representative of the CVC may be appointed as a non-executive director. Board composition is a critical area to get right in a fast-growth company, with the size and balance between non-executives and entrepreneurs, together with personal chemistry, being key ingredients. Non-voting observers are a way to avoid changing the power dynamic, but their influence can still be significant. Ultimately, like the overall partnership itself, clarity at the outset on what sort of contribution can be expected from such a position will avoid this being a source of friction in the future.

Consent matters. Nearly all private company investments come with a list of matters that require the consent of the investors, and the CVC world is no different. The CVC is often joining the cap table at a later stage, when existing investors already have the benefit of these rights, so balancing the interests of all investors (by reference to weight of money invested, equity stake and wider objectives) is a delicate art. At the same time, entrepreneurs will be keen to ensure the nimble decision making that has made them successful to date is not unduly impinged, and a mechanism will need to be agreed so that in addition to getting the nature and number of matters right, consent can be considered and provided in commercial timescales.

Positive undertakings. In addition to ensuring that the fast-growth company is properly protecting its IP and adhering to applicable laws, the CVC will also be mindful of the corporate’s own approach to key matters such as environmental, social and corporate governance (ESG) and diversity and inclusion (D&I), and keen to ensure that the fast-growth company’s activities do not conflict in any way. Entrepreneurs can therefore expect a focus in this area – again, balancing ‘best in class’ against the structure and stage of the fast-growth company will be important to get right.

Regulatory and reputational ‘ripchords’. CVC investors in regulated industries (such as audit or financial services) will always need an ability to exit their shareholding if regulatory change or determination mean it is unlawful to continue to hold their shares. Given the corporate will be keen to ensure that its brand is not tainted in any way by the collaboration, entrepreneurs should also expect the corporate to seek a right to exit for reputational reasons. The subjectivity and materiality of these triggers are key areas to balance in negotiations. The ability to exit also requires a willing counterparty – companies and their other shareholders will not want to accept shares being ‘put’ upon them for value they may not be willing (or able) to fund, and the impact on the cap table of the corporate leaving the structure also needs to be considered. There are common solutions to this issue, but entrepreneurs can sometimes be surprised that corporates look for these rights.

Exit rights. The position of the corporate as a potential buyer can lead to bespoke (and private) terms being agreed. A ‘right of first offer’ (ROFO) will give the corporate a period of time to put forward an offer (which the company and its shareholders are free to reject) within a defined structure (for example, a 30-day period after a decision to look to exit). This should be distinguished from a ‘right of first refusal’ (ROFR), which essentially means that if the corporate matches the price offered by a third party, the corporate has the right to make the acquisition. This can deter competitive tension and is viewed as less favourable to the other shareholders. At the same time, those shareholders will want to be clear that the corporate cannot frustrate the exit for its own purposes, so the terms of any drag along rights, which force the minority to sell on the same terms as the majority, will be keenly negotiated.

Links to commercial collaboration. Alongside the equity investment, there is often a commercial agreement, particularly if it is a balance sheet investment. The linkage between these relationships is vital to get right – is the corporate (and fast-growth company) prepared for the shareholding to ‘outlive’ the commercial relationship, and what happens if the commercial collaboration is not as successful as hoped?

Making it happen

These are just some of the features that make partnerships between CVC investors and fast-growth companies fascinating to bring together and execute. In addition to the commercial and legal interface, the cultural and psychological fit between the ‘disruptors’ and those whose market is being disrupted is another reason why this area is so interesting. At the same time, the interdependencies of fast-growth companies and large corporates are clear, with huge synergies to be unlocked from the scale, customer base and expertise of the corporates, and the agility and innovation from the next generation of companies. The potential value to be created through such partnerships is clearly demonstrated by the recent surge in activity, and we expect this to accelerate further in the years to come.

Jon Gill is a partner at Eversheds Sutherland (International) LLP. He can be contacted on +44 (0)7787 221 532 or by email: jongill2@eversheds-sutherland.com.

Jon Gill

Eversheds Sutherland (International) LLP