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What is Corporate Venture Capital and How It Works

Kison Patel

Kison Patel is the Founder and CEO of DealRoom, a Chicago-based diligence management software that uses Agile principles to innovate and modernize the finance industry. As a former M&A advisor with over a decade of experience, Kison developed DealRoom after seeing first hand a number of deep-seated, industry-wide structural issues and inefficiencies.

CEO and Founder of DealRoom
“Any company, at the stage in their growth process, that is considering M&A, should also warrant looking at the VC initiative.”

Traditional venture capital versus corporate venture capital

In this episode of M&A Science, Kison interviews John Orbe, Associate General Counsel of M&A at Emerson, about corporate venture capital, what it is, why you should consider it for your organization, and the challenges you may face.

John explains how to identify your strategic goal, set objectives, and how to assemble your VC team. He then goes on to explain the deal structure of corporate venture capital transactions.

John and Kison briefly touch on the difference between LOIs and term sheets, negotiations during corporate VC, and convertible notes versus straight equity. They then go on to explain all the details of how corporate venture capital differs from traditional venture capital.

John says the primary goal of a VC is to seek financial gain, unlike corporate VC which is strategy. Because of this, the exit scenario matters a lot to the VC and will be heavily negotiated. The interview ends with John's experience of the craziest thing he's seen in M&A.

Show notes:

00.00- Intro

1.38.52- Background

3.48.61- What is Corporate Venture Capital

5.57.85- Identify Your Strategic Goal for the VC

10.20.00- Assembling Your Team for the VC

14.25.55- Setting Objectives for Your Corporate VC

15.49.73- The Deal Structure of a VC

19.29.90- Difference Between LOI and Term Sheet

20.33.20- Negotiations During Corporate VC

21.22.25- Convertible Notes vs. Straight Equity

23.43.46- Traditional VC vs. Corporate VC

27.39.93- Biggest Challenge Working with Startups

29.39.39- Which is Better? Traditional VC or Corporate VC?

31.53.65- Q&A Portion

38.42.26- Craziest Thing in M&A

peanut butter

Test version of the interview

John's background

My role here is that I am the attorney. I partner with our corporate development team and our other M&A functional lead.

We really helped drive our M&A process here as far as doing our acquisitions, our divestitures, and our venture minority investments, which we're going to talk about a little bit today.

You have to be on the legal side and really hope to coordinate due diligence efforts, the actual document drafting, contract negotiation, serving along with our corporate development, a quarterback for organizing our M&A efforts, and yet to the goal line of scope. 

What's the most interesting deal you've worked on?

I was in a law firm for about a year when I joined Emerson.

So this would be before my Emerson experience, but when it comes to Missouri, any good St. Louis boy is a Cardinals fan. 

I had an opportunity at my old law firm to work in NatGeo, and the Cardinals acquired their AAA affiliate, Memphis Redburn.

For a kid who grew up in Bush stadium, combining that with my M&A practice was pretty special.

What are corporate ventures? When do corporations think about investing?

What I mean by corporate venture and corporate VC (people might be familiar with venture capital traditional firms that are investing in startups) is seeking to return on their capital. 

When we talk about corporate venture capital, what we're really talking about is a strategic or large company/ large firm making those minority investments. An example would be a company like Emerson, a big company whose focus isn't necessarily investing in little companies, but they do that as part of their strategy. 

And in terms of when people should think about investing, any company considering M&A should also warrant looking at the VC initiative. 

There are a lot of advantages to getting involved in venture deals and minority investments. It can really push your company, especially with an older, long-established company, by getting involved in the VC process. 

So we'll get a front seat to innovation from the new startups and the new disruptive technologies that are coming out by engaging in a VC process. It really puts you in the front seat of the innovation exposure; their companies are always trying to adapt and evolve.

You want to see what the latest and greatest venture process that continued investment puts there. 

Then there are other advantages of getting involved in venture investments and growing companies. You can look for a commercial synergy, partnering, a new market, or combining your product with their products. 

You can develop a potential M&A pipeline by getting involved with a company early. One, you could potentially get it at discount down the road. You can test your hypothesis and make sure it is a good company. 

If you're not quite ready to acquire them, you can learn along with them.

But also, by developing that pipeline, you might block a competitor from acquiring something that could be potentially lucrative down the road. 

There are a lot of reasons to get involved, but helping drive your growth and innovation are two main reasons to consider investing. 

What is corporate venture capital strategy?

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

What did you want to do? What do you want to accomplish? Otherwise, you're just throwing money at shiny objects. You need to form your overall investment thesis of why you're doing this. 

You need to add the outset and decide why you're doing it. Know what your strategy is and what success would look like, and then stick to that strategy. You need to balance your strategic goals and your financial goals.

Obviously, it's great to get a financial return out of this investment. That's generally not the typical goal or main goal for a corporate VC deal. 

  • What kind of commercial partnerships are you hoping to get out of it? 
  • Are you just wanting to like a board seat, like a seat at the table to learn about this new technology?
  • Are you wanting to get a right of first refusal to potentially acquire this company down the road? 

Are you looking for access to M&A?

That's actually a secondary goal for most of the deals. For some of these, you're making an investment, and it might not be a suitable full-on acquisition.

It might be tangential to your space. 

So you just want to be bottled to know what's going on. It's why you really need to form your actual goal because it could be more than just potential M&A targets.

You could see examples of technology, and it seems really interesting. 

Can you commercialize it in this partnering with a startup company? This can be a way of learning and seeing if it can be commercialized. You can gain access to innovation and learn what's going on.

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

That’s a good reason to consider a venture deal and heavy minority investment goal or objective. If you're learning about these companies, if you're talking to these people mixing in the space, opportunities will arise. 

How do corporate venture capitalists work?

The first thing you want to do is build your team.

It's a different team and in my experience in your traditional M&A team, a company like Emerson has a strong M&A history and M&A team. We bring an army to the deal sometimes. 

For a venture deal, you need a much smaller team.

You need your lead development person and your lawyer. You may have an in-house legal resource as we do, but either way, you really need to make sure you have a good outside counsel that knows the venture deal is going to know what the market is.

Don't just open up a phone book and get a lawyer. Get somebody that knows what they're doing in the state. 

Then you need a couple of specialists, obviously doing your financial and tax due diligence. You want your legal doing your corporate due diligence. IT is a lot of innovation and learning about new technologies.

You want to have an IT person on the team. You might want an employment person, especially if the target company has options. 

You want your employment specialist to look at that. You want to craft your specialized team for that. And then what's really important is defining your goals and your strategies.

You want to have a playbook showing what you're going to do and how you're going to do it. Develop your company's approach to these. 

You also want to develop your own due diligence approach. Due diligence on these deals is a lot different than full-on due diligence for an acquisition.

If you're actually acquiring the company, your concerns might not be the same. You generally want to take a lighter approach with these. 

These are companies that you're not going to control, and they need to still function and do their day-to-day objectives, especially because they're usually pretty small. 

You have to be conscious about not completely diverting them off their business path. Develop a focused, lighter touch due diligence approach. 

Another resource or consideration is how are you going to fund these acquisitions for a big company? Sometimes you're meeting quarterly or yearly goals. 

Does the venture investment usually have a five to seven-year time horizon? How does that play into an organization that has to meet quarterly and annual targets?

You can decide how you measure success. It's easier for a traditional VC where you measure success on your return on capital and how much money you get out of the deal.

If a financial goal isn’t your primary goal, you need to decide what is going to be the measure of success. 

If you have a small team, how come your M&A folks don't want them to lead this effort?

Every organization is different. You may have a very lean M&A team to start. Your entire M&A team might be just what I described, including a financial person, a business lead lawyer, and IT.

If you have a large team of 40 people, I'm turning every rock and identifying every single potential issue. That type of massive working group list is not needed here. 

It’s a smaller focus team and if that's your full M&A team, then run with it. The people on your VC team will most likely be on the M&A team as well. But some on the M&A team might not be on the VC team.

How do you set objectives for the corporate venture organization and how do you measure results?

It could really be talking to the businesses. Ultimately you're going to have buy-in from a business as to why you're doing this deal. You really need to discuss with them.

I think it's really driven by the business. I know every company development is different, but the development person really needs to work hand in hand with the actual business and see how they want it to interplay with our company.

It's important to outline at the beginning of the deal what it is that you want to accomplish. So you can say we wanted a board seat to learn about the new technology. 

And in three years, you can just say, because of this deal and this board seat, we were able to learn X Y Z. Or you can say our goal of bringing around these investments is we want to acquire and learn about three commercially viable companies to acquire them. 

Then you can say three, five years later, these are the new companies in our portfolio that we were able to acquire because of our venture practice. It becomes a way to measure success outside of just the financial return. 

Can you generalize and describe the 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 from your business.

  • They know about new technology. 
  • They're in plush with a new company that's coming up.
  • You can also come from bankers. 
  • A company has hired a financial advisor to actually go out and fundraise for a round. And because of your involvement in departments, you're able to leverage that and get connections. 

Once there was actually a thesis, you do initial high-level due diligence. You want to understand the:

  • Cap table 
  • Governing documents
  • How would you fit in 
  • What rights you might have
  • What is the current lay of the land of the company? 

Once you have a good understanding of that, you move on to either an LOI or a term sheet. 

Very often, venture capital deals don't do a term sheet where you find out the high-level issues. Negotiate those ahead of time when you go to draft the documents. You'll go through the deal points: 

  • What are you investing dollar-wise?
  • What percentage of the company? 
  • What kind of rights are they going to have as an investor? 
  • What are you going to have a veto right on? 
  • Are you going to have a board seat or be an actual director? Will you get a board observer? 
  • If you are very interested in your financial return, what's your liquidation preference? Do you get paid out before other investors? 
  • Are you going to have a preferred dividend return?

Lay out those big overarching terms in the LOI or a term sheet. You have a deal, so hopefully they get some exclusivity in there as well. That way 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 on the lighter touch due diligence to uncover any problematic areas, anything that needs to be addressed. There's kind of 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 just 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.

You go through the due diligence. Towards the due diligence, sometimes simultaneously or maybe after due diligence, you begin drafting the actual transaction document of your purchase agreement, but then you have to usually revise a lot of their org docs. 

Like any shareholder agreement, that's a certificate of incorporation to incorporate the terms you had agreed to at the LOI term sheet stage.

These days, a lot of the negotiation of national documents has really been taken out by the NBCA form. The National Venture Capital Association have 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 set out the main agreed principles in the term sheet.

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

If you're taking a passive stance as the board observer, are you sitting back and learning, or is there a real partnership there?

Are you involved in this company and helping commercialize it? That's where a lot of the fun starts after it leaves our M&A place. It goes to the business and how they can make the business grow. 

Is there a difference between a letter of intent and a term sheet? 

There is a difference, and in my experience, the term sheet will detail what the actual main terms are. 

They'll say these are the specifics; we can go different ways. You could say high-level in terms sheet, but often we'll say these are the specific detail rights we get.

These are the specific pre-emptive rights. These are the specific provisions that are going to be incorporated in documents that have all been spelled out in the term sheet. 

Other times, an LOI might be more general or high level.

You still set out like the price and the percentage of your acquirer. You have to have that before you move forward and make sure there's agreement there. 

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

Usually, the term sheets are more specific, and the LOI is not as specific. But they both achieve the goal of formalizing that we have an agreement to do a deal and should go forward to make it happen.

You tend to use convertible notes or straight equity. You'd take a board seat. Do you use options right of first refusal?

More often than not, what I've dealt with is straight equity investment. I certainly see the convertible notes often when I've seen it. 

Somebody will initially do an equity investment and then the convertible notes later when more funding is needed. Convertible notes are really coming from existing shareholders. 

Now options, I haven't really seen that. Sometimes you can acquire a warrant as part of your investment.

There are all different strategies for how you get the deal. I think the main thing that I've seen is trading equity investments. 

There are so many things you can do. You can do warrants, convertible notes, or 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 money and you agree to the equity that you're going to get down the road. 

It is a little open-ended. That's why I don't necessarily agree to 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 the equity worth. 

It's like an alternative to convertible notes. Are you using options or right of first refusal?

Sometimes the right of first refusal is often desired by the company of the corporate VC. 

They're often resisted by the startup because of the thought that if the investor has the right of first refusal, it could cool interest from other potential buyers.

The startups/target companies often resist but obviously, if a corporate VC can get a right of first refusal then that's great. 

That's a great thing for venture capital to have if somebody wants to buy this company and you've grown with it, you have an option to buy it as well.

Can you explain to me the difference between traditional VC deals and corporate venture deals? 

The number one difference is the traditional VC deal is all about the financial return. They're there to make money.  

Their rationale is to deploy capital, multiply their investment, and make money to further fund their investors and partners.

Whereas with corporate deals, there's more strategy and more to it than just multiplying your investment. 

It's much more strategic on traditional venture capital to figure out what your multiple is going to be in an exit scenario. That might not be as important for a corporate deal where they have more strategic goals. 

Traditional VC might do more deals. I think corporate VC, by nature, is a little bit more cautious. Would they make a little bit safer bet if you will? 

Traditional VC can be a little more aggressive and take more risks in the hope of getting that high exit. A VC will usually try to have at least one board seat because they want to have a say in what the company is doing. Whereas a corporate VC might not necessarily take the board seat.

And another difference is the VC often takes a large chunk of 15, 20%, maybe more. Corporate VC could be that high but often was much lower. 

What are the considerations for both types of deals? 

It’s a discussion of financial aspects, and a lot of times VC will also bring expertise to a startup. This will happen especially if it's a niche fee that they only invest in certain types of companies. But at the end of the day, they're really concerned with their exit. 

Corporate considerations are a lot different. It's all the strategic rationale and how it can help your business.

I haven't touched on this so far, but I kept talking about why you might get involved in what these companies can do for you as corporate venture capital. But you also, a big company also offers a lot to these venture companies,

One, it gives them credibility. Look, we have a fortune 500 company that has invested in us. They believe in us. 

They lend credibility to customers and potential fundraising. There's a lot of benefit for them there. 

With their fortune 500 company, you have people that are experts in their fields and they know how to drive this business. How to grow a business. 

And you can bring some of your own expertise to the startup company. Who's maybe just making their way in the world. 

You guys probably have great ideas, but they combine your business expertise with great innovation. There's really a two-way street benefit in the relationship.

What are some of the challenges of doing a VC deal with startups?

One of the biggest challenges is that the nature of a startup company can be unsophisticated compared to the public fortune 500.

  • They might be in full-out growth mode that they're just churning and burning
  • They're not really paying attention to some of the corporate formalities the lawyers might obsess over
  • They might not have checked their cap table
  • They might have given away things in their documents that they just didn't care or think about

When it comes to due diligence, you need to dig in and make sure everything's on the up. And if it's not, figure out a way to solve it. 

There can be some complications with unsophisticated people. I've also seen situations where they might be brilliant engineers or would have brilliant ideas, but they're not M&A people.

They don't know how to do venture deals where terms 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, and that's something to consider. Often a smaller startup company might only be a couple of employees at this point. 

They may not have the resources to fully devote their attention to your venture capital deal.

Whereas with the corporate VC, you have a deal team.

The startup's job is to grow their business, win customers, and develop their technology. Doing this can sometimes take them away from deal negotiating, and answering your due diligence questions in a timely manner can be challenging.

You need to balance out getting the deal done in a quick and effective manner with the right amount of diligence but not overwhelming your people. If you completely take them off the business plan, then you inadvertently interrupted business for four or five months and set it back a year or two. You'll need to get a real balance there.

On the other hand, is it going to limit my exit opportunities down the road? Would one of your competitors would be put off by the fact that you're an investor?

Since the traditional VC side is a bit more aggressive, they might be willing to get in bed with a company earlier in the process than a corporate VC. 

They might provide access to capital.

At a certain stage of your company, they might be willing to give you more money. Traditional VC might be more motivated to stay committed to the startups because they're driving for that exit in a few years.

Whereas corporate VC might do their initial investment, and if you go south, they're going to walk away. That's something that needs to be evaluated on a case-by-case basis. 

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

How do you value these early-stage companies? 

It all comes down to what their sales forecast is. They need to demonstrate to you what they think their company's worth is and their rationale. How are they going to hit these numbers, and how are sales going to grow? 

Pretty much every one of them says sales are going to grow exponentially. They need to demonstrate why that is the case. 

You need to look at their burn rate and figure out what they've given you in their forecast. Use your own experience and what your financial team thinks.

That's a place to have good financial diligence and a strong financial team. A good development team to really crunch those numbers, something they don't always trust the lawyers with. 

What is your internal deal approval process? Is there an executive committee to review and approve these?

It depends. Sometimes there are investment thresholds, like an investment under X dollars. The head of the venture group can do it for over X dollars. It needs to go off the chain, probably all the way up to the CEO. 

It's really a case-by-case scenario depending on the company. Typically we'll probably run-up to an executive, but sometimes a well-developed venture group will have the authority to do deals on X dollar.

What is your view on the employee option pool? How hard do you push for a high percentage before you make your investment? 

If it's just a straightforward cap table without employee options, it's much easier to deal with. Compared to giving away a large percentage of the company already or reserving a large percentage of equity for options.

That said, dealing with options is pretty standard when you're looking at startups because that's often how they improvise and retain talent when they don't have the cash.

So, it's obviously easier if it's not there, but it's something you have to learn to figure out how you're going to do it.

How do you go about ROI and IRR calculations, factoring revenue from partnerships? 

You make a forecast on the information you have, what you think that you're going to be able to bring to the partnership, and where you set goals like any M&A deal.

You say your IRR based on your forecast and what you think this company can do. Try to turn that into reality. 

You have different business cases, and doing it with a startup is no different. It might be more of an educated guess than anything without a strong track record, but that is something that you need to do when you're deciding on your investments.

There are different strategic reasons but at the end of the day, there is a certain IRR that you're aiming for. And if it's not there, there better be a day in good strategic rationale to do it without achieving a certain IRR. 

Do you tend to couple the equity investment with a commercial agreement or other strategic collaboration, day distribution agreement, or joint development? 

I can bring it down to a percentage of deals that do or don't do that, but that is a very often component and presence. And with a corporate venture deal, often there'll be a commercial synergy and a real commercial reason to do this deal. 

A distribution agreement, buy agreement, and some kind of commercial arrangement will also be part of the deal. 

So aside from the street M&A venture investment transaction at the same time, you'll also be negotiating a commercial agreement. That is very common. 

Does the investment go directly into the operation?

Typically, yes. One of the things you've set up is the use of proceeds. And one thing you don't want them to do is to take your proceeds and dividend them out to themselves right away. 

You often want to set the parameters of this is our investment, and it's going to be used for X, Y, and Z in future growth and corporate purposes.

Or you might even include veto rights on what they can do with dividends and things like that. But it should generally go into helping the operation and hoping to grow. 

How does the exit strategy match our acquisition strategy? 

It's a case-by-case scenario. Are they looking to do an exit in five to seven years? Often they are and then they weigh in on what they're willing to give away as far as a preferred dividend, things like that. 

But like I said, often, that's not as much of a concern to a corporate VC. It's hard to give a straight answer to it because it depends on the deal for what one of these parties’ goals are. 

What's the craziest thing you've seen in M&A? 

Honestly, I think the craziest thing, and everybody as M&A professionals can relate to it, but the craziest thing in M&A is the hours. 

Especially being formerly on the wall from outside the counsel. They're really married to the job, and I've seen people working around the clock, missing graduations, never really fully on vacation because they're always checking their phone and things like that.

But at the same time, it's fun. That's why we do it. It's a highly rewarding field to be in when the deal comes together when it is finalized. Especially in the last couple of days where we'll rush to get it all dotted. It's a really fun industry to be in. 

The lawyers really do that? They really tense up. They feel like they're always laid back. Half the battle is getting the different law firms to talk to each other. 

They tense up. You'd think they come off as cool, calm, and collective, right? They put in amazing hours and are not on the in-house counsel. I can really appreciate what some of the outside people go through and try to respect their time. At the end of the day, they're outside of the client service business. So you're always at the demand of your clients. I've seen some pretty extraordinary things, responding to those clients.

I know one of the other side projects you're working on is doing an Academy course with us. The goal is you're going to teach deal terms in an upcoming course. 

I wanted something like that when I started my career. Law school doesn't teach you how to do M&A deals. It's just something you learn by getting thrown into the fire, making mistakes, and learning from your mistakes. I wish there was something like this back when I started.

Ending Credits

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Views and opinions expressed on M&A science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.

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