Corporate Venture Capital: From Venturing to Partnering
Joseph A. McCahery, Erik P.M. Vermeulen and Andrew M. Banks
1.
Introduction
In the aftermath of the financial crisis, governments seek to replicate the success of Silicon Valley’s venture
capital industry to stimulate economic growth (Lerner 2009, Cumming and Armour 2006). There is a
widespread belief that high-growth firms will fuel job growth after the recession. With these efforts, priority
has been given to establishing alternative stock markets and portals that cater to high growth companies,
such as NASDAQ in the United States or the Alternative Investment Market (AIM) in the United Kingdom
(Mendoza and Vermeulen, forthcoming). It is true that venture capitalists typically prefer to exit high growth
ventures through an initial public offering (IPO), and entrepreneurs could recoup control over their
companies after a successful IPO. It could therefore be argued that the design of an effective exit mechanism
would eventually spur entrepreneurship. However, venture capitalists and entrepreneurs have been very well
able to entirely bypass their local exchange when floating a company’s shares, resulting altogether in a
disappointing outcome of these reforms. Even if a country has been able to create a relatively vibrant IPO
market, such as Japan, the venture capital industry surprisingly still tends to lag behind Silicon Valley when
it comes to encouraging entrepreneurship and developing innovative growth companies (Nakamoto 2010). It
is therefore important to understand the ingredients that made the Valley what it is today to explain
governments’ role in engineering a robust venture capital market.
The rise of Silicon Valley is mainly attributed to the growth and commercialization of research and
development (R&D) activities by Stanford University and its graduates. Their belief that a symbiotic
relationship between industry and university research would emerge in a campus-like environment was
paramount to the success of the Valley and the development of applicable, market-relevant and innovative
technologies (Khanna 1997). The fact that California courts historically refuse to enforce post-employment
covenants not to compete surely helps explain the rapid growth of the high-tech district compared to other
regions with high-technology universities (Gilson 1999). Others give a more sexual explanation for the
differences between Silicon Valley and other high-growth technology centers (Representative Blog, 2009).
They reason that a poor public transportation system and a lack of bars in the Valley encourage nerdy
1
activities and, subsequently, innovation and technological inventions. The truth is that many, not easily to
replicate, economic and social factors contribute to the difference in the relative performance of the Valley
compared to other high-tech clusters around the world (Vermeulen 2001).
While the idea of the clustering of firms has taken hold as one of the most significant sources of
rapidly innovation, there is little doubt that the more subtle role of the legal industry and institutions has also
been a key input to the success of Silicon Valley. Not only are law firms and individual lawyers responsible
for drafting innovative contractual provisions that protect high-risk investors, for instance angel investors
and venture capitalists, from the relational and performance risks associated with investing in young
entrepreneurs and their innovative ideas. The lawyers’ broad network and involvement in both non-legal and
legal activities, such as dealmaking, matchmaking, gatekeeping, and conciliating, serve as an effective
sorting device for entrepreneurs that need more than just an investor to fertilize their start-up businesses
(Bernstein 1995). The contractual mechanisms and the lawyer-dominated market for reputation reduce the
information asymmetries between the entrepreneurs and venture capitalists and, as such, are necessary to
effectively bring the demand-side and supply-side of venture capital together. The underestimated and oftenneglected contribution of local law firms to institutionalization of venture capital and venture capital
contracting helps explain the relative success of venture capital and, more particularly, high-tech clusters
compared to the Valley. 1 All of which takes us back to a call for policymakers to take a closer look at the
market for reputation and the information disseminating function of law firms in their efforts to replicate the
infrastructure of Silicon Valley.
Not surprisingly, with the financial crunch and the subsequent economic downturn having taken its
toll, governments are set to play a new role in the evolution of the venture capital industry. We already see
that governments, aware of the fact that the financial crisis offers new opportunities, increasingly partner
with corporations to kick-start entrepreneurship. Due to risk averse behavior on the part of traditional venture
capital firms and the slowdown of the corporate debt and securities market, we slowly but surely see a
revival of corporate venture capital initiatives after the burst of the internet bubble in 2000. First, the scarce
and tight availability of venture capital force company start-ups to look increasingly to other investment
1
See for information disseminating effect of Silicon Valley law firms, (1) Fenwick & West LLP, Venture Capital
Survey Silicon Valley Fourth Quarter 2009, Trends in Terms of Venture Financings in the San Francisco Bay Area
(available at http://www.fenwick.com/publications/6.12.1.asp?vid=12&WT.mc_id=2009.Q4_BK_email) and Cooley,
Godward Kronish LLP, Venture Financing Report, 2009 Venture Financing in Review- A Challenging Year Ends with
Reasons fro Optimism (available athttp://www.cooley.com/files/75608_VF2009Q4.pdf).
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resources, such as corporate venture initiatives, as a means to growth. Second, in a sluggish stock market,
venture capital funds rely mostly on trade sales to exit their portfolio companies. By entering into a
partnership-type relationship with a corporation, it not only creates strategic exit opportunities, but, at the
same time, allows the venture capitalist to work closely with corporations on the selection of start-ups
innovations and the spin-off of non-core technologies from the corporation’s business, Third, the financial
crisis encourages large corporations to get more creative in their efforts of attracting and integrating outside
innovations, thereby looking more closely to young companies. 2 At the same time, the emphasis on “open
innovation” has rekindled the interest for corporate venturing and corporate venture capital in both the
academic (Narayanan, Yang and Zahra 2009) 3 and professional world (Chesbrough and Garman 2009). The
new corporate venture capital dynamic, based on a network rich architecture of shifting alliance partners,
may influence the way corporations leverage their resources with respect to exploiting existing technology
and gather the resources and capabilities to enter new markets and make new investments.
The goal of this chapter is to consider and assess the ingredients of successful entrepreneurial
activities in order to diagnose possible shortcomings of current government initiatives, such as technology
clusters and state-sponsored investment funds. As corporate venture investors rapidly gain importance and
visibility in selecting, funding, monitoring and exiting future start-ups, the traditional rules of the game with
its tried and tested contractual arrangements may need reconsideration and revision. To be sure, corporations
have a long track record of passively investing or co-investing in start-ups and/or venture capital funds.
However, these investments are becoming of more strategic importance to both the corporations themselves,
the venture capital funds and the entrepreneurs, arguably shifting the negotiation and contracting
considerations more to corporate investors. When these investors become more actively involved in the
operations of both venture capital funds and their portfolio companies, the information and transaction costs
become more eminent. A new active player in the venture capital game could change the equilibrium
between implicit and explicit contractual mechanisms. The question arises whether new arrangements and
institutions are necessary to increase the observability and verifiability of opportunistic behavior. Indeed,
corporations may have strategic interests that differ from the investee company that can lead to cumbersome
2
In this context, Cisco, a worldwide leader in networking and network solutions, engaged in a strategy that would
ensure their being on the forefront of technological breakthroughs. Cisco looked closely at the development of start-up
and early stage companies. Upon the first signs of success, Cisco then acquired the company, the entrepreneurs and the
innovative technology. See Gilson (2010).
3
See Narayanan, Yang and Zahra (2009). According to this study, the scholarly interest in corporate venture capital is
growing rapidly, but it has not led to a consistent and coherent body of literature.
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and disruptive conflicts. More importantly, a start-up receiving - directly or indirectly - funding from a
competitive corporation could have a counterproductive effect if it decides to preempt possible
misappropriation and other opportunistic behavior from the side of the investor by engaging in shirking
behavior. This leads to two adjacent questions: Could we foresee the emergence and routinization of new
contractual practices? Could lawyers or another group of professionals act as catalysts in the establishment
of new geographical or perhaps sector specific high-tech clusters? Or alternatively, could governments be
involved in these activities to structure the framework for a new venture capital era?
In order to address these questions, this chapter canvasses the development and the current status of
the traditional venture capital industry in the United States, Europe and Asia. Section 2 looks at the affect of
the widespread downturn in financial markets and its detrimental impact on the growth of the venture capital
market. We have seen that venture capital firms are reluctant in selecting and funding entrepreneurs in an
unstable economic environment. As a consequence, investors have virtually little or no appetite for making
their money available for the investment in start-up companies. As a result, entrepreneurs have looked for
alternative sources of funding for their ventures. Corporate venture capital has re-emerged as a leading
option for start-ups and fast-growing firms. In section 3, we build on the law and economics literature on
alliances and joint ventures and analyze the various types of investment arrangements that corporations
create with high-growth companies and venture capitalists. The chapter examines the recent trends in
corporate venturing and explains how large corporations offer venture capitalists and their portfolio
companies new opportunities. Our analysis shows that large corporations increasingly pursue a strategic
alliance with venture capital firms and portfolio companies rather than pursuing the old strategy of creating
their own traditional venture capital funds. We examine the impact of the increased strategic involvement of
corporations in the venture capital industry and predict a trend from geographical clusters towards
international sector specific clusters of businesses operating within the same industry or market. The
remainder of this chapter examines the differences between CVC investments and traditional VC deals and
critically evaluates the key variables that have been identified as determinants of a CVC investment’s
success. In section 4, we attempt to answer the question, based on a preliminary analysis, whether there is a
positive correlation between CVC-related announcements and positive or above average stock returns and
the determinations of any discernable positive market reaction. In order to address these questions, we use
data collected manually from companies’ websites and commercial databases to analyze the stock market
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impact of CVC announcements from 36 of the largest corporate venture capital firms across the world during
the 2005-2010 period, and the differences in magnitude of stock market reaction. In section 5, we assess the
impact of the increasing involvement of traditional VC funds in partnership with CVCs and entrepreneurs.
The sharp increase in this model of contracting may prove very valuable for CVCs and independent venture
capital as they are not only share information on technology and strategic perspectives but co-invest in
companies to maximize financial returns. The last section concludes.
2.
The Venture Capital Industry and Government Initiatives
This section focuses on the steps that governments have taken to establish an infrastructure that encourages
and supports the development of venture capital markets. Governments have inevitably looked to the United
States’ venture capital environment so as to ascertain which institutions were best suited to replicate Silicon
Valley. Many governments have tried to implement the United States’ flexible legal and economic
institutions that inevitably contribute to the relative performance of a venture capital market. In overview,
venture capital markets in Europe and Asia were long constrained by regulatory hurdles that limit early-stage
investment, and capital market structures that limit the ability of venture capital funds to liquidate their
positions in innovative start-ups. However, a central problem for governments remains how to encourage
investors and venture capitalists to actually invest in start-up firms, and at the same time stimulate a steady
supply of entrepreneurs.
2.1
A Look Forward: Government Initiatives
It is increasingly clear that the contractual convergence story neglects the fact that, in order for a venture to
succeed, the (leading) venture capitalist must be willing to provide the entrepreneur with ‘value-added’
services (Hellmann and Puri 2000). Value-added services involve identifying and evaluating business
opportunities, including management, entry or growth strategies, negotiating further investments, tracking
the portfolio firm and coaching the firm founders, providing technical and management assistance, and
attracting additional capital, directors, management, suppliers and other key stakeholders and resources. The
importance of these services is, for instance, demonstrated by the fact that a technology advanced country, as
Japan, has so far only been able to fertilize a few promising ventures (Shishido 2009). Japanese venture
capital firms pursue a risk diversification approach by investing in a relatively large number of start-up
companies without engaging in management assistance. It is not a coincidence that the modest number of
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successes in the Japanese venture capital industry has been able to attract foreign capital from funds that
were more than just investors.
But, there are signs that more than a few governments are aware of the non-financial role that
venture capitalists have in spurring innovation. Jitters in the financial market have altered the governments’
hand-off attitude and re-enforced the importance of governmental intervention in the recovery of the
economy. These interventions are, among other things, directed to the establishment of knowledge-intensive
service clusters. The hope is that clustering will eventually lead to the formation of formal and informal
networks of entrepreneurs and other economic actors. A cluster could also provide the starting point for the
creation of a market for reputation that effectively prevents investors, venture capitalists and entrepreneurs
from acting opportunistically. For instance, the Dutch government supports the development of a publicprivate partnership initiative, such as Brainport. In an effort to stimulate innovation, Brainport, which is a
business location that is centered around Eindhoven in the Netherlands, was established as an ecosystem for
collaboration among large companies, start-ups, universities, knowledge and research institutions, and the
government. This initiative is considered successful in terms of R&D spending and the production of patents.
In 2008, companies invested €1,8 billion in research and innovation, which resulted in the production of a
majority of the total patents that were registered in the Netherlands. The High Tech Campus in Eindhoven,
once established by Philips, has become the cornerstone of the Brainport region (Chesbrough and Gaman
2009). It is a breeding ground for innovation shared by more than 7,000 R&D engineers from more than 90
companies, including over 40 start-up companies. In terms of benchmarking the success of Brainport, it has
generated more than 50,000 jobs and attracted support from government and industry sponsors for its
innovative track record. But, it is probably too soon to know what the effects of the Brainport initiative will
be on the management of innovative and strategic change of the firms in the area. Clearly Brainport has
supported and encouraged firms that focus on excellence in research and development without a sector
specific focus. It seems quite possible, on the one hand, that the firms in these industries will experiment
with new alliance partners that influences their survival, performance and growth. On the other hand, there is
a concern that the Brainport hub may not realize its expectations unless there is some focus in investment
and strategy, which is considered crucial to success in this area. Further, to the extent that two important
ingredients of innovation seem to be absent, namely venture capitalists and intermediaries, such as law firms,
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there are concerns as well about the support and capacity for development of the firms operating in this
setting.
In this respect, it is worthwhile to look at the launch of another initiative that should spur the
integration of universities, companies and governmental agencies into formal and informal networks: the
Innovation Network Corporation of Japan (INCJ). This public-private partnership has features of a
traditional venture capital fund. It has a total size of 90.5 billion yen and was able to obtain commitments in
the amount of 8.5 billion yen from 16 companies, including Sharp Corporation, Nippon Oil Corporation,
Takeda Pharmaceutical Company Limited, Panasonic Corporation, Hitachi, Ltd., and General Electric
Company. Besides injecting 82 billion yen, the government has granted guarantees up to a total op 800
billion yen to INCJ. The total lifetime of the ‘fund’ is 15 years. INCJ aims to foster innovation by providing
not only capital, but also managerial support to high-growth start-up companies. Note that the Japanese
initiative can be distinguished from Brainport in terms of its focus on growth capital and the promise to
provide management support to drive the commercialization of new technologies. Despite these differences,
Brainport and INCJ are crucial to the economic growth plans of the respective governments and offer a
means for large companies to kick-start entrepreneurship. The governments have made some of the right
choices in designing these projects. First, these initiatives ensure that the economic environment is conducive
to entrepreneurial activity (Brainport). Second, they provide direct investments in entrepreneurial activities
(INCJ) (Lerner 2009). Both elements are crucial to sustaining a positive entrepreneurial environment. It
remains to be seen, however, if these new initiatives, absent clear sector specific focus and the catalytic
function of professional intermediaries, can achieve the long-term coveted effects.
One interesting example of a government initiated venture capital fund that could teach us more
about the prospect of the public-private partnerships is the High-Tech Gründerfonds that undoubtedly acted
as a model for the Japanese INCJ. The German fund was founded as a limited partnership on 31 December
2005 and, currently, its total assets under management amount to approximately US$ 327 million.4 To be
sure, this was not the first time that the German government was involved in an effort to foster
entrepreneurship. In 1975, the Deutsche Wagnisfinanzierungsgesellschaft (WFG) was established with an
eye on creating a national venture capital market( Becker and Hellmann 2005). The 1975-fund was funded
4
See http://www.en.high-tech-gruenderfonds.de/, The official name is High-Tech Gründerfonds GmbH & Co KG,
which is a hybrid business form between the limited partnership and a corporation. The latter plays the role of the
general partner.
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by 29 German banks up to an amount of DM 10 million (later increased to DM 50 million). The
government’s role was limited to guaranteeing up to 75% of the fund’s losses, thereby reducing the
managers’ incentives to be actively involved in supporting the start-up companies. It is obvious that without
the value-added services these companies did not stand a chance. The dampened incentives for the fund
managers, together with a convoluted governance system that was characterized by comprises, resulted in
significant financial losses up to 1984 when the government pulled the plug on subsidizing the WFG.
However, the differences with the current initiative are enormous. First, the High-Tech
Gründerfonds is not only backed by financial institutions and the German government (Bundesministerium
für Wirtschaft und Technologie), but also by large companies, such as the kfw Bankengruppe, BASF,
Siemens, Deutsche Telecom, Daimler, Bosch and Zeiss. The involvement of these corporations is important
to give innovative, market and financial support to the entrepreneurial businesses. The fund claims that this
new approach entails beneficial effects that could lead to a leap forward in entrepreneurial performance in
Germany. Here are a few details. So far, the High-Tech Gründerfonds has invested in more than 175 mainly
German companies in a wide range of industries. It focuses primarily on first round investments (53%),
followed by seed round investments (25%) and second round investments (9%). This is a clear distinction
from the traditional corporate venture capital investments that are discussed in the next section. The HighTech Gründerfonds invests up to EUR 500,000 upon the acquisition of approximately 15% nominal share of
the start-up company. These terms may differ in the event of the participation of other investors. In order to
reduce agency costs, the fund requires the entrepreneurs to put in at least a cash amount equal to 20% of the
fund’s investment. 5 The fact that it has been able to attract this large number of portfolio companies during
the financial crisis shows that a government initiative followed by the involvement of corporations could
indeed lead to an outcome that benefits all the parties involved. Since its inception, the fund had two
successful exits through a trade sale for an undisclosed amount in 2008 and 2010. Two of its portfolio
companies ceased their operations in 2008 and 2009 respectively. One High-Tech Gründerfonds’ backed
company filed for bankruptcy in 2009. It is therefore to early to predict with certitude that this partnership
between large corporations and the government will be able to create a long-lasting German hub of
innovation.
5
This percentage is 10% for entrepreneurs from the former East German states. It is allowed that the entrepreneurs
attract half of their required contribution from other investors. See http://www.en.high-techgruenderfonds.de/financing/financingterms/.
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3.
The Revival of Corporate Venture Capital
As it happens, there is a keen awareness on the part of large corporations of the need for involvement in high
potential firms that could spur their own innovation and lead to growth after the recession. Yet the
involvement of large corporations in start-ups is not new. Driven by the success of traditional venture capital
firms, large companies decided already in the early nineties to financially back young entrepreneurial
companies. To this end, multinationals established CVC divisions, usually as corporate subsidiaries of the
listed parent company, with the instruction to take minority positions in strategic and financially attractive
businesses. Despite a number of success stories, such as the case of Xerox Technology Ventures (Gompers
and Lerner 1999), these investment efforts usually failed or ended in a disillusion for three reasons. First, the
scope of the corporate venture capital divisions was often unclear. Investments were made in a relatively
large number of start-up companies: some for purely financial reasons, in other cases because of the
expected strategic benefits. These mixed strategies, together with the often difficult to determine objectives
and success factors, have led to confusion and frustration within the multinational. As a result, management
usually pulled the plug on the short-lived CVC initiatives.
A second reason for the disappointing results was the lack of expertise of venture capital investments
and dedication to the portfolio companies within large corporations. Generally, investing in risky businesses
and high-growth companies does not belong to a multinational’s core business. This explains why most of
the corporate venture capital investments piggybacked on traditional venture capital funds’ decisions. Large
corporations mostly formed syndicates with renowned venture capital funds to come to the selection of
superior investment opportunities (Ernst and Young 2009). An additional benefit from this strategy was that
CVC divisions could learn from the experience of the traditional funds. However, the ‘innocent’
participation had several unforeseen consequences that eventually affected the decision to enter into a
syndicate with corporate venture capitalists. In particular, there was a negative spillover effect when
corporations co-invested in start-up companies with adjacent and competing technologies. Empirical
research shows that in such cases start-up companies were more reluctant to award board power to CVC
investors and, instead, retained more board seats for themselves (Masulis and Nahata 2009). But there is
more. The fear of opportunistic behavior of the investors when a direct competitor is involved often leads to
higher pre-money valuations. The syndicate has to accept a higher price per share, which usually results in
the issuance of a lower number of preferred shares. Thus seen, corporate venture capital is more successful
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in the event of investments made in complementary technologies. Yet, from a strategic perspective,
corporations are particularly interested in competing technologies.
A third reason for lagging results of corporate venture capital divisions was ineffective governance
structures and compensation systems within the division itself (Dushnitsky and Shapira 2008). As discussed
above, corporations usually set up special subsidiaries, rather than limited partnership structures, to act as
corporate venture capitalists and invest in risky high-growth companies. The upshot of not awarding CVC
division managers with incentive mechanisms that general partners in limited partnership arrangements
receive is that CVC investments were usually characterized by risk averse behavior. Corporations tend to
invest in later financing rounds. The benefit is that the probability of a successful investment increased, at
the cost, however, of becoming involved in the venture capital game with its groundbreaking innovations
(too) late. When corporations decided, for whatever cost-saving reason, not to participate in later financing
rounds, pay-to-play provisions could even oblige them to convert their preferred shares into common shares,
thereby foregoing their privileges and transforming a strategic participation into a mere financial investment.
These shortcomings can be explained further by the fact that CVCs differ from traditional venture
capitalists in three important respects. First, limited partnerships are independent since the limited partners
cannot interfere with the day-to-day management responsibilities of management. In order to mitigate
agency problems inherent in the investment of institutional investor capital by the limited partnership’s
management, the limited partnership agreement contains, as we have seen, assignment of rights and
responsibilities for a period of around ten years. CVCs, on the other hand, are reliant on the ongoing
sponsorship of their corporate owners, and can be abandoned without due cause, for reasons entirely
disconnected with the operations of the CVC fund itself. Their duration is thus significantly shorter, and
much more volatile. Secondly, while venture capitalists offer 1‐2% fixed fees plus 20% of fund profits to
their managers, CVCs do not usually offer performance fees of this nature, since they are included in
corporate fee‐structure plans. For this reason, top fund‐management talent is frequently tempted away from
successful CVC funds to more profitable venture capital funds. Third, CVCs tend to operate in a much
narrower field, largely dictated by their parent company’s operations. A CVC manager has less freedom and
the fund is much less diversified as a result. Since their motivation is a real‐option model, CVCs are more
inclined to make use of drag‐along and redemption rights to control the terms of an exit strategy rather than
allow entrepreneurs their preferred IPO exit. Indeed, the evidence confirms that CVC investment returns tend
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to be lower than those of VC funds. This is due to a number of factors including the fact that venture
capitalists can write more sophisticated contracts than can CVCs, have a more independent fund structure,
and can incentivize their fund managers sufficiently to ensure that fund goals are realized.
3.1 Research on Corporate Venturing
In this section, we canvass the main research issues on CVC, and provide an outline of the competing
viewpoint in the well-defined streams of CVC research. While there is scant secondary literature on the
government involvement and CVC alliances, there is a broad literature that examines the conditions under
which CVCs are efficient and empirical studies that consider formal contracts, governance structures and
investment strategy. In attempting to provide an overview of the view, some scholars have looked to the
literature on ‘corporate entrepreneurship’ (CE), a larger category of similar phenomenon encompassing all
‘new’ means by which corporations seek to develop innovations (Narayanan, Yang and Zahra 2009).
Relevant categorizations include the nature of the contract between the corporation and a third entity through
which the innovation is made possible, i.e., joint venture, alliance, licensing arrangement, external start-up
firm or internally created spin-off. Despite the importance of the categorization methodology, those
concerned with CVC performance have looked to the environment and origin of the relevant innovation, and
focus on whether CVC activities result in internally or externally motivated innovations.
3.1.1 Strategic v. Financial Investments
Along similar line, most of the literature tends to discuss either the particular characteristics of CVC
investment and their differentiation from traditional VC investments or explanations for these differences.
Typically a CVC investment relies on internal capital, proprietary technology and management skills, and
existing market access. CVC investments therefore carry lower risk, and hence lower returns.6 At the outset,
an important consideration is the strategic fit of the investee with the corporate parent. This element has
consistently been identified as crucial in determining the profitability of start-ups.
Following Gompers and Lerner’s (1999) initial finding that CVCs are only profitable as private VC
funds if there exists a ‘strategic fit’ between target firms and the corporate parents, there is emerging
6
This does not mean, however, that market reactions should be lower for ‘strategic’ investments as for ‘financial’: a
sophisticated market would factor in strategic corporate gains which ultimately can potentially be more leveraging for
future corporate returns (merely not beneficial for the entrepreneurial unit itself).
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evidence that CVCs add value when start-ups have a strategic fit with the operations of the parent, which is
attributed to CVCs’ providing both support and consulting services. For instance, Ivanov and Xie (2008) find
higher valuations at IPO than or pure VC-backed startups, and higher premiums at acquisition, both of which
are not explained by better project selection abilities on the part of CVC funds, and which only manifest
where there is a strategic fit with the parent corporation. This result shows that value-added services,
including R&D, marketing, sales and distribution channels, are a relevant feature of CVC investments and
bolsters the financial outcomes of CVC investments.7 In the context of value added services, Riyanto and
Schwienbacher (2005) attempt to answer the question of whether CVC is adopted in furtherance of the
corporate goal of securing demand for a corporations’ product that is expected to arise as a result of a given
entrepreneurial innovation, at the expense of competitive products. They point to an ‘expropriation problem’,
whereby a lack of incentive on the part of an entrepreneur to invest in value-adding activities within a given
venture in the presence of a risk of corporate takeover, which CVC alleviates by insulating the venture from
the corporation. Similarly, direct corporate involvement in the form of consulting services and other
personnel disperses this risk. The likelihood of corporations adopting CVC increases with the size of the new
market (in the form of potential profits), and the level of competitive pressure.
3.1.2 Characteristics of Successful CVC Ventures
A further key area of focus in CVC literature is the industry characteristics under which CVC is profitable.
As might be expected, CVC can be beneficial even in a hostile external market (Zahra and Covin 2005).
Most empirical work in this area has identified the typical CVC parent as technology-driven (specifically the
high-tech or pharmaceutical sectors) (Dushnitsky and Lexon 2005) seeking to expand into new (emerging)
markets for its products, or develop new relationships (Maula, Auto and Murray 2005). The success of CVC
activities has been found to be dependent on the experience and sophistication of internal management
models and its adaptability to the different approaches demanded of entrepreneurial ventures Narayanan,
Yang and Zahra 2009).
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In their sample, 30% of start-ups have supplier relationships with their CVC sponsors, while 26% are customers; 27%
are involved in joint product development; 18% are involved in joint research programs (primarily in the biotech and
pharmaceutical sectors); 35% are have marketing, sales, and distribution agreements with their parents. These
agreements are significantly more prevalent in the pharmaceutical and biotech sectors (around two thirds of the
sample), with supplier relationships also prevalent in computer and hardware sectors (around one third).
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Corporations seeking to innovate in high-technology, high-growth industries, with high levels of
competition and lower acquisition activity, are more likely to create CVC programs. In their study of a
corporations in high technology, Basu, Phelps and Kotha (2009) show that high-growth industries with high
levels of competition and lower acquisition activity are more likely to create DVC programs. Firms with
strong technology and marketing departments also involve themselves more frequently in CVC. In terms of
the investments studied, 88% were made by CVC funds, most of which were new entrants into the VC
market. Technology and marketing resources comprised the corporations’ ‘admission ticket’ into investing in
entrepreneurial firms. In a similar analysis, encompassing a wider international list of companies, S, Gbadji,
Gailly and Schwienbacher (2009) find that 20% of Fortune 500 companies have a CVC program. Building
upon this survey, they show that the incidence of ‘financial VCs’ set up by financial institutions, which
comprise a combination of the characteristics of CVCs and traditional VCs, tend to have strategic fit
objectives in mind, and see VC as a diversifier.
Furthermore, Bertoni, Colombo and Croce (2006) find, in a study examining the performance of new
technology firms, that since these firms rely more on internal financing, traditional VC-backed financing
performs better in this area of business. These results support the earlier empirical studies (Gompers and
Lerner 1998) on the beneficial effects that VC financing has on the growth of portfolio firms, which are
attributed largely to the scouting, monitoring and coaching activities performed by this type of investor.
However, Chemmanur and Loutskina (2006) show that CVCs create value through early and more risky
investments in new-technology start-ups. CVCs also perform an important service to traditional VCs in
signaling value and thus facilitating later-stage co-investment, and to institutional investors, underwriters and
analysts who can benefit from signaling when firms go to IPO. By contrast, traditional VCs have a better
track record of ‘professionalizing’ firms, and a more refined ability to facilitate capital market access through
connections with investment banks, investors, and analysts. Arguably this misses the point somewhat since
CVC-backed firms can realize value directly through acquisition from their corporate parent. Overall, CVC
funds invest larger amounts per financing round, at higher valuations, and that the probability of a successful
exit through either IPO or acquisition is higher within CVC. 8
8
Specifically, Cemmanur and Loutskina (2006) find that 18% of CVC firms achieved IPO, and 11% were acquired,
while 13% and 8% of traditional VC-backed firms achieved these, respectively; firms with CVC financing have lower
operating results for five years immediately following IPO, by 23% of profit margin and 27% of sales margin,
13
3.1.3 Deal Terms
In general, CVCs write less sophisticated contracts and therefore enjoy lower returns than traditional VCs.
Cumming (2006) finds that CVC investments have less upside potential, and consequently a reduced
incentive for funds to take a partial ownership stake, thus their contracts focus to a much larger extent on
downside protection. Contract structures (via control rights) relate closely to the anticipated exit outcome:
the traditional VC fund prefers a strategy with the highest financial reward, while the entrepreneur may want
to go to IPO for non-financially motivated pursuits – acquisitions are therefore more likely when VCs have
higher control rights. CVCs, by contrast, are more likely to use veto rights.
Several competing hypotheses emerge from the literature on this subject. Chemla and de Bettignies
(2003), for example, address ‘contractual incompleteness’ in the context of intellectual property, arguing that
weak protection affects CVC positively, and higher returns (in line with their earlier finding that at a certain
point these cause a ‘switch’ to a CVC approach from a typical-corporation structure) cause corporations to
award higher control rights to the manager. This would also, presumably, reflect the latter’s higher
bargaining power from carrying a successful venture. Hence, it is argued that CVCs backed by private VC
will offer better protection and preferential deal terms to entrepreneurs, which should be reflected in lower
exploitation by corporate parents and thus a lesser impact on firm value. This should be reflected in a lower
observed market reaction to CVC-related announcements (by comparison to traditional VC or generally).
In this context, Dushnitsky and Shapira (2009) show that the difference in performance of CVC and
traditional VC investments is correlated with compensation schemes chosen by CVCs. They find a
relationship between incentives, individual management actions, and finally investment performance,
suggesting that CVCs that can implement a carried-interest framework (or more loosely, ‘performance-pay’)
will better incentivise managers and provide superior returns. This is an alternative to the involvement of
traditional VC in individual deals as it incorporates directly the benefits of these arrangements through the
provision of similar incentives on an ongoing basis. The design and influence of compensation schemes
provides additional theoretical and empirical evidence that traditional VC involvement increases value in
CVC deals.
controlling for industry, size and year, though performance converges after the initial 5 years; and CVC firms have
higher expenditure on R&D and fixed assets, culminating in higher valuation at IPO for CVC-backed firms.
14
Other perceptive authors have looked at the effect of VC involvement in CVC deals. For example,
Masulis and Nahata (2009) find that insider board representation (including in early-stage VC funding)
increases with the degree to which the parent company is a potential competitor. Their study also
demonstrates this effect in valuations at exit, which increase where the corporate parent is a potential
competitor, since bargaining power is higher. They attribute this observation to the unique diversion of
incentives between CVC fund and entrepreneur that does not apply to traditional VC funds: their own profit
is paramount such that a CVC fund wants to influence the development of a start-up in a way not necessarily
aligned to the latter’s design. In other words, value-maximization respectively at corporate and investee level
is not aligned. Furthermore, a CVC fund may want to facilitate early exit via acquisition if the start-up’s
technology becomes strategically important for the parent’s operations, thus voting rights are crucial
(Cumming and Johan 2008). Certainly, where CVC power is checked by the involvement of traditional VC
funds, through superior contracting techniques and consequently more equitable balance of parties’ rights
and obligations, interests are better aligned and value creation is maximized, which tends to support the
prevailing hypothesis.
3.1.4 Market Reactions to CVC Announcements
In this section, we examine the market reaction to the announcement of a CVC related investment. In light of
prior empirical research, discussed in section 3 above, we attempt to address the question whether there is a
positive correlation between CVC-related announcements and positive or above average returns and what are
the determinants of any discernible positive market reaction.
In this context, data were collected manually from companies’ websites and two databases (Factiva
and Crunchbase) for a sample of 36 corporate venture capital firms representing the largest of these across
the world. The sample is described in an appendix with the basis for each firms’ inclusion. The firms were
identified primarily from Ernst and Young’s (2010) 2008-09 Global Corporate Venture Capital survey,
which lists the top 10 CVC firms in each continent. This was augmented by a top-10 list included in
McCahery and Vermeulen (2009). This approach captures those corporations that demonstrate the most
activity in the CVC industry, the highest deal flow, and the most transactions during the sample period9 as
well as a reasonable geographical spread. Key variables collected include, firstly, the ‘type’ of investment
9 As demonstrated by their inclusion in the Ernst and Young (2010).
15
made, whether strategic or financial, which was determined based on a subjective view of the motivation for
the deal as described in the corporate announcement. A second key variable is the incidence of backing from
private venture capital. As described in detail above, this is the most important proxy for better-negotiated
and more preferential deal terms, which yield better returns for the corporate parent and thus a more marked
stock price reaction (Ernst and Young 2010). Other data points sourced from Crunchbase were the
investment stage, value, and number of participants. Finally, a statistic measuring the relative size of the
venture capital fund to the size of the corporate parent, computed as the total market capitalization of the
firm divided by the total size of its venture capital arm, was included in regressions in order to control for the
relative (un)importance of each announcement.
[TABLE I]
Table I contains summary data on the announcements used in the analysis. 512 data points were
gathered for the 36 corporations included in the survey, ranging from 1-2 announcements to 50 or more for
several corporations. Panel A demonstrates that 2009 was the busiest year during this period (more data were
available for that year). Panel B shows the type of announcements in each of five categories. The second part
of panel B looks at the percentage of investments that were backed by private venture capital. Insofar as data
were available, this column presents the proportion of deals that were publicized to be backed by private
venture capital firms. Many firms almost exclusively participated in financing that included private venture
capital; most more experienced and sophisticated CVC investors participated jointly with private VC at least
two thirds of the time. Generally, specialist firms such as the pharmaceutical corporations included in the
sample rarely participated alongside private VC. Panel C of Table 1 examines whether the deals were
strategic or financial in nature, derived primarily from wording used in the announcements, and secondarily
on the purpose and objectives of the corporation’s venture capital arm. Panel D of Table I examines the
financing round of each investment. The prevalence of B-round financing suggests that the predominant
strategy is to refrain from entering a start-up at a very early stage, and rather to wait until its potential is to
some extent proven and to enter when the start-up is seeking higher levels of capital, and management is
probably surrendering more power. This is consistent with the findings of Basu et al (2009) and Chemmanur
and Loutskina (2006) that early-stage financing generally allows corporations to secure better deal terms and
16
thus more value for their investment. The CVC fund thus maximizes its leverage and is able to confidently
inject a sufficient amount of funds to make the investment worthwhile from the perspective of a larger fund
with limited resources and a reluctance to become excessively involved in small transactions. Similarly, the
number of later-stage deals is significantly smaller as CVC funds attempt to avoid transactions where the
start-up is already committed to liquidation and redemption preferences of earlier investors: these
investments are almost exclusively in support of existing investees.
[TABLE II]
Table II contains the results of regressions on the individual firms’ stock returns against the
incidence of an observed announcement. Of the 31 corporations included in the sample following exclusions,
five display positive correlations that are significant to 99% confidence; a further five show positive results
significant to 95% confidence, and an additional three to 90% confidence. On the right-hand side of the table
is the ratio of each corporation’s market capitalisation to the size of its venture capital fund. This measure
captures the degree to which announcements pertaining to the venture capital fund influence the company’s
overall performance and hence are visible in its stock price. However, the size of the fund says little about
the relative importance, or size, of individual deals made by the fund. While it is hoped that on aggregate
data collected over the five-year sample period contains announcements corresponding to almost the entire
fund (since most funds are relatively young and therefore can be expected to turn over substantially all of
their capital in this period), the aggregation of individual deals will still distort the import of this
computation. Secondly, the basis of this research is to consider whether the market recognizes strategic gain
over and above the initial value of the investment or the start-up in which a given investment is made; thus it
does not matter how comparatively small the investee or investment is, since the focus is on a strategic goal
that can be realized at relatively low cost. The regression included at the bottom of table II confirms that as
funds increase in size relative to the size of the company, the impact of individual announcements on stock
price is more pronounced.
[TABLE III]
17
This is incorporated in the results shown in table III containing regressions run for all deals in the
sample. Panel A of table III shows the results of regressions of various (logs of) return data against the type
of deal being announced.10 The results suggest that a stronger market reaction is elicited following
investment announcements than for other deal types, though in most cases coefficients, though negative, are
not significant to 90% confidence. ‘Exit’ is the only announcement type that shows a significantly negative
relation. These results are consistent with the view that investments are considered more strategically
important and are therefore met with a positive market reaction. Panel B of table III explores the differences
between strategic and financial investments, and shows, significant to 90% confidence, that the returns for
strategic investments (for which the dummy variable equals 1) are higher than those for financial
investments (0). This is consistent with the findings of Gompers and Lerner (1999) and Ivanov and Xie
(2009) reviewed above. Panel C of table III examines the relationship between deal terms used in venture
capital contracts and market perception. The results suggest that the incidence of private VC-backing is
negatively correlated with returns, significant to 90% confidence. This finding is consistent with the Chemla
and de Bettignies (2006) view that the involvement of private venture capital is beneficial from an
entrepreneur’s perspective and reduces the ability of the corporate parent to exploit the start-up. The market,
based on these findings, views this as a negative development for the corporation since it redistributes value
from the deal toward the start-up and reduces the potential profits of the corporation in future integration or
appropriation of innovations and technology. Panel D of table III considers the impact of the investment
stage in the market perception of CVC announcements., dividing investments into late-stage and early-stage
(defined as A, B, or C or seed rounds in the displayed regressions).11 From this it can be concluded that
there is no significant relationship between various investment stages and returns. This contradicts the view
described above and developed in Masulis and Nahata (2009) that deal terms, which tend to favour the
investor to a larger extent, are preferential in earlier investment rounds.12
Both of these analyses supported the conclusion that market reactions to CVC announcements were,
on average, more positive than average stock returns over the sample period. Though less clearly based on
individual corporation analyses, findings were not inconsistent with the view that strategic-investment
10 It should be noted here that the data set is predominantly comprised of investment announcements.
11 Regressions using alternative definitions of seed and A, seed to B, etc, were also computed and run with similar
results.
12 Or, more accurately, that the market fails to perceive this distinction in forming stock prices. It is, in fact,
unsurprising that the market would take into account this level of detail in forming prices.
18
announcements elicited superior market reactions than those of financial investments. Further regressions
were run on the 512 announcement data points, which confirmed the superior market reaction to strategic
investments. It was also proposed that transactions with more sophisticated deal terms leading to optimal
contracting would elicit a more positive market response than those entered into by corporate investors will
little experience in venture capital contracting. Here, results do not definitively conclude that more
sophisticated terms are recognised by the market and reflected in higher stock price movements. This could
be the result of two alternative problems in the model: the market could in fact not recognise the benefit to
corporations of the superior balancing of interests pursued by traditional VC contracts, in line with Chemla
and de Bettignies’s (2006) theory; or, consistent with the hypothesis proposed and the wealth of literature
reviewed, the market could fail to examine transactions closely enough to make this distinction. Finally,
based on the research of Basu et al (2009) and Chemmanur and Loutskina (2006), it was suggested that
early-stage investments enabled corporations to add greater value. Although raw data suggested that on
average this was the case, regressions demonstrated no significant relationship between investment stage and
stock returns. Thus, while it is probable that, again, the market simply fails to distinguish between
investment stages to any significant degree, it is also conceivable that this trend is caused by the presence in
the data of late-stage investments in investees that are already substantially owned, through single or
multiple prior investments, by corporate parents, a useful subject of future research. Assuming the market
recognises these rather subtle distinctions, the consolidation of interest in existing investees may elicit an
equally positive response, while late-stage investments in new investees might trigger little or no response.
4.
History of Corporate Venturing
In this section, we begin with an overview of the recent history of corporate venturing, and trend toward
increasing involvement of traditional VC funds in corporate venturing. This movement from ‘venturing’ to
‘partnering’ is recently visible in projects launched for example by Google, Siemens, Merck, and Lilly
Ventures. In this context, we will examine the use of a triangular model of contracting with a traditional VC
fund supplying both financing and contractual expertise, a CVC investor providing capital, additional
services and alternative exit strategies, and the entrepreneur benefitting from a wider pool of capital while
avoiding the adverse consequences of being tied to the whims of an individual corporation’s strategy.
19
In the seventies and eighties, large multinational corporations preferred developing their own
technologies and innovations. In order to save on transaction costs, the multinationals became wealthy
conglomerates with a multidivisional organization. Each division was responsible for a particular product,
market, region or technology (Milgrom and Roberts 1992). The powerful forces of globalization and
technological development in the nineties ran the conglomerate structure of corporations with its often
incoherent divisions obsolete and led to a large number of reorganizations. Multinationals started to define
and focus on their core business. Business units that did not belong to the core business were either sold or
closed. The streamlining of organizations, however, had one major counterproductive effect. Some viable
ideas and business cases that were invented and developed within R&D departments would not fall within
the defined core business of a corporation and would thus not be supported and exploited by management.
The Toshiba laptop computer is an example of an innovation that was vetoed twice by management. Luckily
a group of entrepreneurs within Toshiba concealed its development internally and turned it eventually into
one of the corporation’s successes (Abetti 1997).
In most cases, however, the Toshiba story would turn out differently and result into a loss-making
innovation. This explains why, in order to get at least some return on these R&D investments and ideas,
corporations increasingly sell innovation projects and/or spin off ventures to third parties. Since the
beginning of this century, this practice gained momentum as corporations set up ‘incubator programs and
processes’. It appears that the process of turning R&D projects into an incorporated company takes 18
months on average. During this period, corporate managers help turn engineers into entrepreneurs (Haour
2004). Typically, the business incubation process involves a sequence of steps, from selecting the ventures,
formulating the value proposition and business case, preparing a business plan, setting up the company and
looking for investors. Evidence from several case studies (e.g., Generics and British Telecom) confirms that
selection council teams will have the best results if they evaluate a project's potential with somewhat the
perspective of venture capitalists reviewing the presentation of a business plan. The incubation process will
end with an exit scenario: (1) the project is stopped, (2) the innovation project will be spun-up - the
innovation fits within the core business and will become part of the organization, (3) The innovation project
will be spun out - the start-up company will remain financially or operationally bound to the spin-out
company usually through a shareholding, or (4) a spin-off will be considered as the right strategy. In the
20
latter case, a strategic or private equity investor is usually the main shareholder of the newly-formed
company, the remaining (minority) shares are owned by the entrepreneur-engineers.
Both the incubator process and corporate venture capital initiatives fall within the term ‘corporate
venturing’. However, in contrast to the traditional corporate venture capital initiatives, which had a strong
exploitative focus on generating financial returns through sharing in the profits of a successful exit scenario,
the incubator process is generally more explorative in nature. That is to say that innovative ideas and
business cases are selected with a view to eventually spinning it up to the business divisions. But there is
more to corporate venturing: as CVC investments become more strategic, they may be described as an
outside-in movement where corporations hope to piggyback on or acquire technologies that were developed
outside the corporation. The spin-out and spin-off of companies constitute an inside-out movement
(Chesbrough and Gaman 2009). 13
This seems to suggest that CVC activities have both strategic and financial benefits. In this vein,
corporations do not completely have to explain their corporate venture capital relationships solely in terms of
return on investment. For corporations, it is often easier to explain their corporate venture capital
investments to shareholders as a means to promote diversification and leveraging synergies. In addition, the
investment of the firm’s resources could be portrayed as a means to boost shareholder value. However, it is
well know that firms that pursue diversification strategies are often punished by a market discount. The
critical question for the corporate strategist is why would leading companies so readily embrace such
investment strategies? In fact, corporate managers have soon come to realize that the potential costs in
decreased share value may be easily offset by other benefits, such as access to patent and other intellectual
property rights that offer not simply the transfer of technology and skills across the network, but the
capabilities to compete effectively and improve financial performance. As we have mentioned earlier, the
financial crisis and enhanced regulatory framework for private equity not only point in the direction to a
stronger position of corporate venture capital divisions that pursue a strategy that combines strategic and
financial considerations, but may also involve a degree of exploration of an innovative technology. It goes
without saying that the new early-bird approach to CVC strategies will make these investments more
explorative in nature and revolve around the ‘how can we help you help us’ theme. This leads to an
13
There are four identifying factors that fall between varying degrees of financial and strategic objectives in which
corporate venture capitalists make their investment decisions: (1) driving investments, (2) enabling investments; (3)
emergent investments; and (4) passive investments.
21
interesting interplay between corporations, venture capitalists and entrepreneurs with innovative projects.
First, corporations could decide to spin-out a technology by establishing a new entity that acquires the
technology and issues new shares to another corporation that pursues an outside-in strategy. Second, venture
capitalists could select spin-out/spin-off companies of a corporation as its portfolio companies. For example,
the New Venture Partners invested in a number of spin-out and spin-off companies from Lucent Bell Labs,
British Telecom, and Philips. By doing so, it hopes to bridge the gap between technology corporations,
entrepreneurs and traditional venture capital.14 Finally, corporations could decide to actively approach
venture capital funds or young innovative companies to help act as a catalyst or offer managerial support. If
corporations start to play a more active and strategic role in the venture capital industry, the question arises
whether there is still a need to focus on the development of a Silicon Valley type cluster.
4.1
From ‘Venturing’ to ‘Partnering’
Related questions involve the role of the government and professional intermediaries. In this section, we will
discuss a framework for this new “how can we help you help us” approach that could usher in a new venture
capital era.
We have emphasized in the previous section that corporate venture capital initiatives are altering
their investment strategies from mere financial participations in a promising start-up to more explorative and
strategic investment modes. If we take a closer look at recent corporate venture capital initiatives, we can
also see a transformation from ‘venturing’ to ‘partnering’: 15 corporations are looking for synergies between
their businesses, venture capital funds and start-up companies. Siemens Venture Capital is a good example
of the new generation of corporate venture capitalists. It puts itself in the market as an attractive partner that,
at the request of entrepreneurs or venture capital funds, provides advice to start-up companies and assists
them in the development of the new technology. Through an independent and supportive attitude Siemens
hopes to develop partnerships that can lead to a joint development of new products for new markets.
This trend has spread rapidly to other sectors. In the pharmaceutical industry, Merck Serono
Ventures, which was founded in 2008, reflects the new cooperative and explorative approach. It is a
14
See http://www.nvpllc.com/
See, for instance, Anne-Marie Roussel, Corporate Venture vs Corporate Innovation Strategy, available at
http://www.microsoftstartupzone.com/Blogs/anne-marie_roussel/Lists/Posts/Post.aspx?ID=95.
15
22
corporate venture capital fund that is mainly interested in strategic benefits from its investments in fastgrowing biotechnology companies. At Lilly Ventures, the venture capital division of Eli Lilly & Co., they
have taken this one step further. On 1 May 2009, Eli Lilly & Co divested Lilly Ventures because its
remuneration policy prohibited profit sharing and hence the payment of a carried interest to its fund
managers similar to traditional venture capital funds. Lilly Ventures secured an investment from its new
investor and former parent company, Eli Lilly & Co, to find new groundbreaking portfolio companies and
support its existing investments. The trend to invest in venture capital funds is not new. For instance, in
2002, Unilever took, besides investments in its own ‘independent’ venture capital funds, a position as
sponsor and lead investor in Langholm Capital Partners Fund to target investments in the consumer-facing
business in Europe. In 2007, Unilever expanded this idea even further by divesting one of its ‘independent’
corporate venture capital arms, Unilever Technology Ventures, which was at that time structured as a limited
partnership with Unilever as its sole limited partner. It replaced this structure by the tested model in which
Unilever became an anchor investor in Physic Ventures, an early stage venture capital fund based in San
Francisco, which is set to invest in consumer-driven health, wellness and sustainable living. These
relationships between corporations and venture capitalists have the potential to lead to a "win-win" situation:
On the one hand can Unilever benefit from the experience and expertise of the fund managers, whereas on
the other hand Langholm Capital and Physic Ventures can profit from an active corporate investor that may
not only prove helpful in selecting the right portfolio companies, but may also provide the necessary support
to the development of these start-up businesses. Perhaps more importantly, Unilever provides a possible exit
opportunity in the event of it being interested in acquiring the venture capital backed technology. Moreover,
working closely with multinationals could also create real investment options to spin-out or spin-off
companies. Finally, this strategy is targeted to opening doors to innovative technology companies in
emerging markets with strong growth potential. A recent example is Cisco's decision to make a $30 million
anchor investment in Almaz Capital Russia Fund in 2008.This investment, which arises out of a long-term
partnering arrangement with Almaz Capital, is designed to exploit the position of Cisco’s technological
position in global markets and to signal the reliability of Almaz to both entrepreneurs and markets investors.
In this regard, the Almaz Capital/Cisco Russia Fund I invested recently in two Russian-based investments,
namely Apollo, an early stage company involved in social networking, and Parallels, a later stage marketleading firm involved in automated software, that have high growth potential and returns for shareholders.
23
The unique role of corporations in the venture capital market arguably has an impact on the
development of the terms and conditions of venture capital financing - and the legal intermediaries involved
in drafting these arrangements. A CVC investment through a strategic‐alliance vehicle has been shown to be
more successful than a direct corporate investment, offering higher returns through use of a vehicle that
manages the venture on an ongoing basis rather than attempt to liquidate through sale or cash-out. Again,
this relies on the nature of the innovation as being inherently strategic to the investing corporate. For this
reason most CVC investments surveyed in 2007 were made primarily for strategic value, with the additional
requirement of financial returns; while only 15% were made solely for financial return. Moreover, a high
percentage of CVC deals are aimed towards finding new technologies and directions for business strategy, or
to support existing business. The formation of alliances may very well facilitate and complement CVC
investments, in contrast to the majority of prior work which views the corporate venture capital investments
and the formation of alliances as alternative means of achieving the same goals. As the examples discussed
thus far show, corporations, though still mainly separating their alliance and CVC operations, increasingly
recognize that these functions organizationally rely on the same decisions. They demonstrate the
reinforcement between alliances and CVC activities that is conditional on firm-specific characteristics, but
eventually resolve to an established inter-firm relationship.
4.2. Structuring CVC Alliances
How should CVC alliances then be structured? It is obvious that a clear structure for decision-making is
needed to create an environment of trust between the corporation (as anchor investor), the venture capital
fund, the other investors in the fund, and, of course, the entrepreneurs. Here we could build on the law and
economics literature on alliances and joint ventures. Similar to the inter-firm relationships, the success of
investment decisions of corporations depends on their ability to lever the resources, skills and capabilities
that define their distinct competitive advantage. In the current economic environment, companies have to
incorporate a high degree of uncertainty in their decisions-making process. The near collapse of the financial
system and the subsequent economic crisis as well as long-term trends such as deregulation and the ongoing
globalization make it difficult for companies to assess to what extent an investment strategy will generate
economic rents.
24
One way to resolve the uncertainty is by undertaking investments and measuring their outcomes. In a
rapidly changing economic environment, corporations need flexibility to counter threats and to create
opportunities. In this context, inter-firm alliances are a way for corporate managers to manage uncertain
environments and to deal with their resource needs. Firms entering alliances will have moral hazard and
adverse selection concerns. They will need contractual mechanisms that help formalize the unpredictability
of partners’ behavior and the costs of the opportunism that they will encounter in alliance relationships.
Research underscores the importance of developing a formal governance framework to minimize risk by
such concerns and to ensure that partners have an environment to build ties effectively. To this end,
corporations entering into such alliances will rely on reputation, standard operating procedures, incentive
systems and adequate organizational and legal safeguards, such as contracts, dispute resolution systems and
other agreements, to help coordinate tasks and decision-making structures. Trust can also be clearly linked to
limiting the search costs and related moral hazard problems and can help explain the persistence of stable,
long-term forms of cooperation between partners. Research also indicates the link between partners’ prior
contact and trust as one of the key elements of network resources. The benefit from prior alliance contact is
that it can serve as a resource, for example, when a firm enters again into an alliance with an former partner.
The upshot is that firms previous alliances can affect the types of new alliance opportunities they may
undertake and can contribute to predicting whether a firm will behave opportunistically or not.
Given the challenges for understanding the optimal governance of alliances, there has been recent
interest in integrating both theories. In attempting to help explain the situations that might explain the
importance placed on a formal contractual control component or a trust mechanism, de Man and Roijakkers
(2009) have developed a framework that connects the use of trust and control mechanisms to the predicted
level of relational and performance risk. De Man and Roijakker’s framework underscores how the
governance of alliances may be based on a variety of mechanisms. Predictably, we can expect that firms will
rely on control mechanisms set out in detailed contracts in cases where performance risk is low and
relational risk is high. Conversely, the importance of trust emerges in environments where there is low
relationship risk and high business risk since it will be difficult to foresee future eventualities and resolve
conflict situations without trust as well.
The insights of this model also can advance a theory of how to contractually design corporate
venture capital alliances that generate real strategic and investment benefits for the parties. In the next
25
section, we turn to a more detailed description of the contractual arrangements that characterize these new
alliance structures. Our development of a theory of corporate venture capital alliance collaboration uses
detailed analyzes of the real contracting risks and the contractual templates that are employed to specify the
legally enforceable obligations between the parties in the venture capital industry.
4.3
The Importance of Trust, Reputation, and the Role of Governments
We can distinguish between two types of CVC alliances. First, a large corporation can enter directly into a
strategic alliance with highly promising technology companies. One interesting example of this is the GE
Healthymagination Fund making an investment of $5M in CardioDx, a Cardiovascular Genomic Diagnostic
Company, as part of a strategic alliance to advance and co-develop diagnostic technologies. Second, large
corporations can decide to make an anchor investment in a venture capital fund for synergy reasons
explained in the previous section. CVC investments in portfolio companies and/or venture capital funds
through the establishment of strategic alliances will be very similar to the contractual arrangements that we
have described in second section of this paper. When there are information asymmetries and the relationship
is characterized by a high performance risk, CVC investors will typically seek board representation,
covenants to govern the behavior of entrepreneurs, and other key terms such as anti-dilution protection, exit
terms and redemption rights, lock-in periods, and transfer limitations. If we look at the investment of GE
Healthymagination Fund in CardioDx, we see indeed that the alliance is formed through a Series D
investment round that the GE Fund is leading.
Naturally, since CVC investors enjoy a reliable and stable investment flow, and can make additional
financing available should it be required, they enjoy superior bargaining power and can enforce these
provisions in their favor more readily. CVCs can also potentially offer a competitive advantage due to their
reputation, which they would strive at all costs to maintain. Entrepreneurs can therefore rely on them to a
greater extent as a trustworthy source of ongoing support that is costly to produce by traditional venture
capitalists. Yet, in order to ensure the entrepreneurs full commitment to the alliance, it is only to be expected
that the typical preferred stock privileges will be more company favorable. In recent deals, corporations have
indeed abandoned some of the onerous deal terms, such as the right of first refusal to acquire a the portfolio
company, that were common in the nineties.
26
A similar trend is expected in the alliance arrangements between corporate venturing or corporate
venture capital divisions and the venture capitalists. Indeed, the limited partnership agreement will govern
three relationships: (1) the relationship between the venture capitalist and the corporation, as a strategic
investor, (2) the relationship between the venture capitalist and the other financial investors, and (3) the
relationship between the strategic and financial investors. We predict that a positive correlation exists
between the demand and use of contractual control restrictions and the propensity of the venture capitalist to
behave opportunistically. Hence, in situations such as when the venture capitalist raise funds from a strategic
investor, the traditional investors will bargain for more restrictions and covenants relating to the management
of the fund, conflict of interests, and restrictions on the type of investment the fund can make. The restrictive
nature of covenants, which must make sure that all investors are treated equally, will correspond to the
uncertainty, information asymmetry and agency costs resulting from the strategic investor’s participation.
Still, the use of restrictive covenants can entail the erosion of value, as they limit the venture capitalists to
benefit from the knowledge, resources and investment opportunities of the strategic corporate investor. It
will therefore be common practice that corporations, in conjunction with the venture capitalist, endeavour to
obtain more favorable terms than other investors with respect to deal flows, portfolio selection and
monitoring, investment decisions, and co-investment rights. The reputation of the venture capitalists and the
corporation - as a strategic investor - will, of course, affect the other investors’ willingness to accept the
more favorable terms for one of their co-investors in the fund.
Here is a task for governments. When incentives are badly aligned - as could be the case if a strategic
investor enters the scene - it is arguably appropriate for governments to attempt to align the incentives
between the parties in order to stimulate corporate venturing - which could lead, as we have seen, to job
creation and economic growth and encourage corporate venture capital participation in venture deals. It
could do so by giving subsidies in the form of tax breaks to the corporations and/or the funds that ally with
them. However, research shows that government support should be carefully weighed against possible
negative effects on the development of the venture capital market. Government sponsorship could crowd out
the supply of venture capital, if it does not encourage all the players in the venture capital industry. For
instance, a tax incentive to encourage corporations to pour money into a venture capital fund, could reduce
the necessary supply of other non-strategic investments (Cumming and MacIntosh 2006).
27
5.
Conclusion
In this paper, we have argued that corporate venturing is on the resurgence as large corporations increasingly
look to young entrepreneurial businesses for innovation, but corporate venture capital initiatives are still
looking for the right formula. Corporate investors understand that, in the aftermath of the financial downturn,
they must learned from mistakes made in the past, and focus more on the strategic benefits that come with
corporate venturing activities. This was confirmed during the National Venture Capital Association’s annual
meeting in May 2010. In this respect, we have made two major claims in this paper. The first is that
corporations should pursue a strategic alliance approach when making corporate venturing decisions. For
instance, allying directly with start-up companies or, indirectly, with traditional venture capitalists could lead
to a win-win situation, provided that the incentives of the parties are aligned. The loss of trust and reputation
could impose severe penalties on those who act opportunistically.
This brings us to the second claim: governments should co-invest in venture capital funds with one
or more corporate investors. By doing so, governments pursue two main goals: (1) it signals the
trustworthiness of venture capital initiatives, and (2) it promotes the emergence of a sector-specific venture
capital market. If they abide by the general rules of the venture capital game, governments play a facilitating
role rather than a controlling one, which, as research shows, excel in poor design. The government as a
facilitator of CVC alliances will trigger entrepreneurship and subsequent growth similar to what we have
experienced in Silicon Valley some decades ago.
28
TABLE 1: SUMMARY DATA
29
TABLE II: STOCK RETURNS
30
TABLE III: ANNOUNCEMENT CHARACTERISTICS
31
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