Structuring Corporate Venture Capital Deals

Kison sits down with John Orbe, Associate General Counsel - M&A at Emerson to talk about corporate VC deals, what the process looks like, and how to navigate challenges you may encounter.

Structuring Corporate Venture Capital Deals

10 Feb
with 
John Orbe
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Structuring Corporate Venture Capital Deals

Structuring Corporate Venture Capital Deals


"Any company, at the stage in their growth process, that is considering M&A, should also warrant looking at the VC initiative." - John Orbe.

In this episode, John Orbe, Associate General Counsel of M&A at Emerson, explains corporate venture capital. 

John clarifies the difference between venture capital and corporate venture capital, the resources needed, and the biggest challenge in corporate venture capital.

special guests

John Orbe
Associate General Counsel - M&A at Emerson

Hosted by

Kison Patel

Episode Transcript

Text Version of the Interview

When to do Corporate Venture Capital?

So people might be familiar with venture capital, traditional firms investing in startups, seeking returns on their capital. 

When we talk about corporate venture capital, we're really talking about a strategic or a larger company making minority investments. Big companies whose focus isn't necessarily investing in little companies do that as part of their strategy. 

Any company that is considering M&A should consider VC initiatives. By getting involved in the VC process, you get a front seat at innovation from the new startups and the new disruptive technologies coming out. 

Another advantage is growing companies; you can look for a commercial synergy, partnering, getting into a new market, combining your product with their products. 

You can develop a potential M&A pipeline by getting involved in a company early. One of the advantages includes getting it at a discount down the road. You can also test your hypothesis and make sure it is a good company.

You might also block a competitor from acquiring something that could be potentially lucrative down the road. 

Shaping the Strategy

Shaping the strategy, especially for a corporate VC, is one of the most important things you need to do. You need to have an investment thesis and investment rationale, and goals of what your corporate VC department looks like. 

You need to form your overall investment thesis of why you're doing this, what your strategy is, and what success would look like.  Otherwise, you're just throwing money at shiny objects. 

When it comes to strategy, traditional VC's main focus is a return on capital. On the strategic side, you need to balance your strategic goals and your financial goals. 

It's great to get a financial return out of this investment. But it's not the main goal for a corporate VC. 

What drives Corporate Ventures? 

For most deals, they are not suitable for full-on acquisition. So you just want to be bottled to know what's going on. It might be tangential to your space. It's why you need to form your actual goal because it could be other than just potential M&A targets.

I've seen companies get involved in VC investments trying to prop up the entire industry because if the industry rises, their business rise as well. They could also test the water to commercialize a specific technology or gain access to it. 

There are a lot of end goals other than just potentially acquiring them.

Considerations and Resources Needed?

The first thing you want to do is to build your team. It's a different team than your M&A team. For a venture deal, you need a smaller team. 

You need your lead development person and your lawyer. Whether you have an in-house legal resource or outside counsel. Just make sure he knows what venture deal is and what the market is.

You need a couple of specialists, people doing your financial and tax due diligence. You want your legal doing your corporate due diligence. IP is needed a lot if this is around innovation and learning about new technologies.

You might also want an employment person, especially if the target company gives their employees options. But the most important thing is defining your goals and your strategies.

You want to have a  playbook like this is what we're going to do, and this is how we're going to do it. Develop your company's approach to these. 

You also want to develop your own due diligence approach because due diligence on these deals is a lot different than full-on due diligence for an acquisition. If you're acquiring the company, your concerns might not be the same thing.

Another thing to consider is funding these investments. For a big company, sometimes you're meeting quarterly or yearly goals, how does that play out in your annual targets because venture investments have a 5 to 7 years time horizon. 

You also need to decide how you measure success. It's easier for a traditional VC to measure success on your return on capital and how much money you get out of the deal. But if the financial goal isn't your primary goal, you need to decide what will be the measure of success. 

Why not use your M&A team?

It depends on every organization. If you have a very lean M&A team, there's nothing wrong with using the same team. But if you have a huge M&A team, there's no sense bringing everyone to a VC. You need a smaller focus team. 

Measuring Success 

Ultimately you're going to have buy-in from the business as to why you're doing this deal. You need to discuss with them what do they want to get out of this. 

I know every company development is different, but the development person needs to work hand in hand with the actual business and see how we want the deal to interplay with our company.

It's important to outline that at the beginning of the deal, what it is that you want to accomplish, and then it becomes a way to measure success outside of just the financial return. 

Transaction structure

It's similar to an M&A deal. The first step is deal sourcing, and that can come in a variety of ways. The most common ones are from your business and bankers. 

Once there is a thesis, and there might be something there, you do an initial high-level due diligence. Once you have a good understanding, you move on to either an LOI or a term sheet

Venture capital deals often don't do a term sheet where you hammer out high-level issues; negotiate those ahead of time when you go draft the documents, not that controversial. You'll go through the things like the main deal points. 

  • What are you investing dollar-wise?
  • What percentage of the company? 
  • What kind of rights they're going to have as an investor? 
  • What are you going to veto right on? 
  • Are you going to have a board seat? 
  • If you are very interested in your financial return, what's your liquidation preference? Do you get paid out before other investors, or where you sit in the waterfall? 
  • Are you going to have a preferred dividend return? Whereas you might get paid X on your investment before other people.

Layout those big overarching terms in the LOI or a term sheet, and then once that's signed up, you have a deal. Hopefully, you get some exclusivity in there as well. So you know they're not out shopping for other people at the same time. 

When you go into that due diligence that we discussed earlier, the focus is lighter touch due diligence to uncover any problematic areas, anything that needs to be addressed. There are two levels:

  1. This is a red flag. We can't close this deal and post this draft. 
  2. They should probably do this differently. Let's close the deal, and once we're involved, we'll bring our experience as a big corporation and say, you can do this X, Y, and Z better.

Towards the due diligence, sometimes simultaneously, maybe after due diligence, you begin drafting the actual transaction document.

These days, a lot of the negotiation of national documents has really been taken out by the NVCA form. The National Venture Capital Association has forms that are the agreed-to standard of how these deal docs and venture capital deals will look.

So there's not too much deviation. You just set out the main agreed principles in the term sheet.

You go through that phase of negotiating documents. And then you sign, and you fund, then you run with the company, try to achieve those goals you set up the beginning. 

LOI vs. Term Sheet

A term sheet will detail what the actual main terms are. It's very specific. 

An LOI is a more general or high level. You still set out the price and the percentage as the acquirer because you have to have that before moving forward and making sure there's agreement there. 

Once that, you say we'll have standard and typical detailed rights, preemptive rights, and then you work on that later. 

But they both achieve the goal of formalizing that we have an agreement to do a deal, and then let's go forward and make it happen.

Convertible notes or straight equity?

More often than not. What I've dealt with is straight equity investment. Often, I've seen that somebody will initially do an equity investment, and then when more funding is needed, they use convertible notes. 

So there are so many things you can do. You can do warrants, convertible notes. You can do a face agreement, which is a newer instrument. 

I wouldn't recommend it for a corporate VC, but there are different ways to get involved in these and get money from these companies.

What's a face agreement?

Essentially, we'll give you this money and agree to what equity that will give you down the road. It is a little open-ended. That's why I don't necessarily agree with it for a strategic binding. 

It is a popular route to raise money, especially for early-stage companies where it's hard to put a value on what the equity is worth. 

Options or right of first refusal?

Big companies are the ones who want the right of first refusal, but startup companies often resist them. Mainly because if an investor has the right of first refusal, it could cool interests from other potential buyers.

But obviously, if a company, a corporate VC, can get a right of first refusal, and that's great. It's one of the great things for venture capital to have. If somebody wants to buy this company and you've grown with it, and you like it now, you got an option to buy it as well.

VC deals and Corporate Venture Deals? 

The number one difference is the traditional VC deal is all about a financial return. They're there to make money. They might have a strategic rationale, but their rationale is to deploy capital, get up multiple on their investment, and make money for their fund, investors, or partners.

On the other hand, corporate deals have a lot more strategy and more to it than just getting a multiple on your investment. 

Traditional VCs are also more aggressive in taking more risks in the hope of getting at that high exit and want to have a say in what the company is doing. At the same time, a corporate VC might not necessarily take the board seat.

It's just primarily financials when it comes to traditional VCs and how will their exit look like. They're not buying this company for the next four years. They're in for five to seven years, and they want to make sure that any exit rights are strong for them. 

Corporate considerations are a lot different because it's all about the strategy and how it can help your business. 

Another thing that is worth mentioning is that these big companies also offer a lot to these startups. For one, it gives them credibility when a fortune 500 company has invested and believed in them. 

Also, fortune 500 companies have experts in their field, and they know how to drive the business. And they can bring some of their expertise to the startup company that's just maybe making their way in the world. 

It's a two-way street relationship.

Challenges

One of the biggest challenges is that a startup company can be unsophisticated compared to a large public company. If they are too focused on growth, they might not be paying attention to the corporate formalities that lawyers obsess over. 

One reason is that due diligence is so important. You need to make sure everything's on the up and up. 

Another challenge is when they dont know how to do venture deals and the terms that are being negotiated. 

Also with different cultures, startup culture can be very different than a big company, especially where you're trying to do a partnership. There can be a clashing of cultures. 

Startup companies are also very small. They might only be a couple of people, a couple of employees at this point. They may not have the resources to devote their attention to your venture capital deal fully. Whereas the corporate VC, you have that small team whose job is to do this deal. 

A startup's job is to grow its business, win customers, and develop its technology. Sometimes to take them away from that and to try to negotiate a deal and to have an answer to your due diligence questions in a timely manner, that can be a challenge.

You need to balance out getting the deal done quickly and effectively with the right amount of diligence, but not overwhelming them. Take them off the business plan, and you inadvertently interrupt their business for four or five months and set it back a year or two. 

Another thing is that the traditional VC is more aggressive. They might be willing to get in bed with an earlier company than a corporate. They might provide access to capital at a particular stage of your company that you're not going to get from a corporate.

So while I think there's an excellent advantage for a corporate partner, there are clearly scenarios where a regular traditional VC is the right avenue for a company pursuing partnering.

Valuing Early-Stage Companies

It all comes down to forecasting what their sales case is. They need to demonstrate to you what they think their company's worth and how they will do it. Why are they going to hit these numbers? How are sales going to grow? 

You need to look at the burn rate and figure things out. That's a place where you need to have good financial diligence—a good financial team to crunch those numbers.

Internal Approval Process

It's case-by-case for different companies. Typically, what happens is, a venture team has the power to make deals under X amount of dollars. But once you exceed that threshold, it needs approval up to the CEO. 

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