Previous posts on this blog have discussed the structure and business terms of traditional US and non-US venture capital funds, including common US fund structures, common offshore fund structures, Dodd-Frank investment adviser reporting requirements and what it means to have a fund based on capital commitments. But another kind of venture capitalist has been growing in prominence in the last few years as the traditional venture capital industry has been contracting—namely corporations investing in external ventures as VCs.
Corporate VC is Widespread and Growing
In the past five years, corporate VCs participated in 16% of all VC deals, investing about $2 billion per year, which amounted to 8% of VC dollars overall. And the trend has moved solidly upwards from 2009 through the end of 2011. A recent survey also suggested a dramatically increased interest among certain companies in seeking investments from corporate VCs.
Many prominent companies in a wide range of industries are active VC investors, including Intel, Google, Microsoft, Disney, Eli Lilly, J&J, P&G, Unilever, BP, Chevron, UPS, Visa, Amazon.com, Dupont, Sony, Motorola, Samsung, Nike and Adidas. Many have significant capital in play. Intel Capital has invested more than $10 billion since 1991, with a current portfolio valued at over $2 billion.
In 2011, while some VCs struggled to raise funds, there were several announcements regarding new corporate VC funds. Merck is reportedly associated with two new funds amounting to $500 million, and BMW formed a $100 million fund in early 2011. In just the past few months, Nike has set up a new VC operation, Intel Capital has formed a new $250 million India fund, Riyadh-based SABIC, the world’s largest petrochemicals maker, launched a new fund, and AstraZeneca committed an additional $100 million to its now $400 million corporate VC fund.
Why do Corporations Become VCs?
Traditional VCs have one goal: to maximize financial returns for investors. Similarly, corporations may at times, or in part, engage in VC investing for financial returns. For example, Google Ventures has claimed that it is completely focused on financial returns.
However, corporate VCs almost always have different goals than independent VC firms. Most companies’ VC operations have strategic goals that are at least as important as financial returns, especially gaining access to external, entrepreneurial innovation. In other words, big companies can use VC investing to address the concern that, as Vinod Khosla provocatively said, “Only small companies do impressive things.” Strategically oriented corporate VC models can allow companies to gain access to innovation earlier, quicker, cheaper, and with less risk than acquisitions of early-stage companies.
In addition, certain industries, like pharma and clean energy, are a better fit for corporate VCs than traditional VCs. Traditional VCs need to realize financial returns on a relatively short timeline. But pharma and clean energy companies, especially those with products in the early stages of development, require very significant amounts of money and time to develop their products before they can go to market, as compared to, say, Internet companies. Corporate VCs that are in industries like pharma and energy are of course accustomed to very lengthy and expensive R&D investment strategies, so they will have less competition in these markets from traditional VCs.
How are Corporate VCs Structured?
Traditional US VC funds are almost always structured as limited partnerships in which investors are limited partners (LPs) and the principals control the fund through a general partner (GP) and manage the fund’s investments through a separate management company on a contractual basis. The fund pays a management fee to the management company and, if it is profitable, distributes to the GP a carried interest. This is typical of the structure of many traditional venture capital funds.
In contrast, corporate VC operations are built on a variety of structures, some of which are quite simple, and some of which resemble the traditional GP/LP structure, but many of which are novel and innovative. The simplest way to structure a corporate VC operation is for the corporation to invest as a VC directly from corporate treasury, with employees managing the investment activities. This structure may be suitable for a company that is new to corporate VC, that does not have specific strategic goals in mind, and that is comfortable being the sole source of capital for its VC investments (the virtual sole LP).
However, a corporation engaging in VC investing may face different issues than traditional VCs, like accounting, tax and compensation issues that are particular to corporate VCs. Internal corporate politics may pose additional challenges. Often, these issues and challenges can be solved or mitigated through creative structural or contractual arrangements. In addition, corporate VC operations can be custom tailored in innovative ways to help achieve the corporation’s strategic goals and obtain competitive advantage.
For example, in order to obtain or retain top talent to manage investment activities, a corporate VC operation can be organized as an independent or semi-independent fund so that the fund managers can receive “market” VC compensation (such as carried interest), which is often difficult to replicate within the corporate structure.
A corporate VC fund can also obtain advantages over competing investors by tapping the corporate sponsor’s internal technical expertise, both to analyze potential investments and to provide ongoing technical advice or services to portfolio companies. In addition, some corporate VCs may benefit from including outside investors in their corporate VC fund so as to leverage that outside money to pursue the corporate sponsor’s own strategic goals.
Corporate VC funds can even appeal to outside investors by building in put or call rights, which would require or allow the corporate sponsor to acquire portfolio companies upon their achievement of milestones. This concept is becoming more widespread in pharma corporate VC deals, where it fits particularly well given the importance of milestones in drug development.
These are just a few examples of how corporate VC funds might be structured to address challenges faced by the corporate sponsor and to maximize the strategic advantages that corporate VC operations can be designed to achieve.