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Corporate invesments; the view from the entrepreneur’s side September 5, 2007

Posted by jeremyliew in corporate investing, start-up, startups, strategic investment, VC, Venture Capital.
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Businessweek has an article about Google’s venture capital investments. It notes that corporate venture investing has been on the upswing recently, calling out Intel, Cisco and Motorola (in addition to Google) as other active corporate investors.

Companies that aren’t full-time investors pumped $1.3 billion into 390 venture capital deals in the first half of 2007, up 30% from the $1 billion invested in about 350 deals a year earlier, according to an Aug. 30 report by PricewaterhouseCoopers and the National Venture Capital Assn. (NVCA), based on data from Thompson Financial (TOC). That’s the most invested since 2001, just before the bottom fell out of the tech industry.

As Paid Content notes:

Aside from increasing their presence in growing markets, corporate VC activity gives companies like Google another advantage: by funding early stage companies, corporate VCs tend to buy these companies outright for a cheaper price than they would otherwise pay regular VCs down the road.

This is certainly consistent with my experience. When I was VP of Strategic Planning at IAC earlier this decade, when we invested in a startup we would always think about a “path to control”. We always asked for a call option to buy the rest of the company at a certain date and price in the future so that we knew that we could own the company outright in the future.

An entrepreneur should bear in mind the implications of accepting an investment from a strategic investor, especially understanding the motivations as laid out above. A financial investor (whether angel or VC) is looking for a maximum return on their investment. A strategic investor may be looking for a way to buy companies for less than they otherwise would.

Often strategic investments start out as business development discussions between the two companies. At some point, the big company (BigCo) says that by doing a biz dev deal with the startup(LittleCo), it will meaningfully increasing the value of LittleCo. BigCo would like to share in the value that it is helping to create. This is a perfectly reasonable position.

For LittleCo, the key is to make sure that BigCo does not end up owning so much of LittleCo that it becomes the only logical acquirer. It’s hard to get full price at an auction if there is only one bidder.

One way to think about BigCo’s ownership stake is as a discount if/when they want to acquire a LittleCo. Since BigCo already owns x% of LittleCo, BigCo will essentially be paying x% less than another acquirer (OtherCo) would have to pay.

If x is large, then OtherCo may not bother bidding. OtherCo’s corporate development team is busy, and doesn’t have the time to waste on potential acquisitions that they are not going to win. OtherCo will realize that BigCo can outbid them because of the implicit discount that BigCo gets from already owning x% of LittleCo, so OtherCo doesn’t bid at all. This can lead to lower exit valuations for LittleCo*.

The less that BigCo owns of LittleCo, the more likely OtherCo will be to bid. If OtherCo thinks that it can bring more synergy to LittleCo than BigCo can, and that LittleCo is more valuable to it than LittleCo is to BigCo, then OtherCo may still believe that they can win the auction, even with BigCo’s x% discount. In the extreme case, (x=0), all potential buyers line up at the table and all make their best bids, and exit valuations are maximized.

The implication of all of this is that entrepreneurs should be careful. When they take strategic investments from corporate venture arms, they should not give up so much ownership that they discourage other potential acquirers from bidding in a future sale process. They should keep x small. Since early stage investors usually get more ownership than later stage investors, taking strategic investment tends to make more sense in a later round of funding.

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* As an aside, similar logic applies to giving anyone (whether a strategic investor or a biz dev partner) “right of first refusal” to a sale of your company. A potential bidder won’t want to do all the work to get to a deal, only to see it matched by the party with a right of first refusal. As a result, they often don’t bother bidding. With less bidders, once again, exit valuations are not maximized.

Comments»

1. Allen - September 5, 2007

Clearly the VC game is changing. How will it look in 5 years?

2. midas - September 5, 2007

Interesting post, but more theoretical than practical. While focusing on how to maximize the value of the exit, and how to ensure a competitive bidding process on sale, you ignore the basic fact that the exit also depends on the actual intrinsic value of the business!
In some cases, a strategic investor may be able to add real value early on — e.g. as an important reference customer or distributor, etc.
Maybe Google would now be worth even more without Yahoo and AOL as early investors… and maybe not…

3. doug - September 6, 2007

how much x% do you think is too much?

4. jeremyliew - September 6, 2007

Midas,

I agree with you that the distro deals that Google did with Yahoo and AOL were crucial to the companies success. However, just before Google went public it had around 270m fully diluted shares outstanding according to its S1. AOL had warrants for 1.9m shares and Yahoo had warrant for about 1m shares. x was pretty small…

Doug,

I think there isn’t an absolute rule for how big x can be – it all depends on the synergies that other buyers can bring. But if you’re in the single digits you’re probably pretty safe

5. Arlen Ritchie - September 6, 2007

Excellent post Jeremy. Although likely a rare situation, are there any implications to consider if LittleCo creates more strategic valuie for BigCo than the other way around?


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