My thanks this month to Keith Styles, partner at Arent Fox LLP, a Washington, D.C., law firm with expertise in corporate financing, mergers and acquisitions, public-private partnerships and joint ventures, for his timely insights.
Exploiting venture capital opportunities isn’t a new quest. But under the umbrella of the “new” economy, the subject deserves a careful review of key issues as they apply to corporate participation in such ventures. In fact, The Kiplinger Letter states that VC investments will rise nearly 50 percent this year, to $26 billion.
Early stage, high-growth companies are exciting, as we all know, because they thirst for innovation, are in a race against time and have a level of employee commitment that you seldom find in mature businesses. They’re also willing to take risks, critical to success.
The investment by corporations in early stage growth companies can help them respond to rapidly changing customer demand by introducing new products faster and cheaper than if they did this on their own. There are fewer barriers to entering a market and a greater chance to compete.
While corporate VCs do require an equity position through a variety of typical tools, using a joint R&D committee and assuming sales and marketing responsibilities set them apart from the classic VC model.
In a corporate VC relationship, the issue of product licensing is more complex and tense. Obviously, the corporation is going to want an exclusive relationship and the company won’t want to limit its expansion potential to just one customer. But the issue can be resolved through guarantees, sunset agreements, patent ownership and so on.
The major risk that the company faces is the old time-worn subject of control. For corporations, control is their mantra, and understandably so. For instance:
- The corporate VC sells the company’s stock to a third party.
- The corporate VC becomes a competitor, upon license breaches and other intervening unexpected events.
- The corporate VC sublicenses your technology to a competitor.
- The obligations and impartiality of corporate representatives on the company’s board can be agonizing for the company CEO.
Keith points out that these risks can be managed by addressing critical issues – such as rights of first offer, board representation and responsibilities, and derivative product rights – upfront in your initial discussions
How to avoid losing control
It begins by developing a well thought out strategic plan that the corporate VC buys into. Making the corporate VC an integral part of that plan so that you are “attached at the hip” mitigates against seemingly rogue behavior like I’ve described above.
You are the one with competitive leverage, and if the corporate VC doesn’t recognize that, then forget about doing business with them. Hence, a tightly structured investment agreement that passes every smell test imaginable and that provides a win-win for you and the corporate VC is imperative.
Try to avoid exclusive licensing and do not permit sublicensing without your prior written approval. Cross-licensing is a possibility, if it’s consistent with your strategic plan.
And, don’t forget, an initial public offering might be on your horizon. You don’t want the investment agreement to pre-empt that if the corporate VC’s five- year ROI return-on-investment objectives are met.
The agreement should cover these control issues:
- Criteria that the joint R&D committee must meet.
- Sales/marketing/distribution responsibilities.
- Your independence in other product areas.
- Board representation and responsibilities.
- Invention/patent ownership and rights.
- Bankruptcy rights by either party.
- First refusal rights for you upon sale of your licensed products to a third party, as well as co-sale rights for co-founders and employees under incentive agreements.
Our experience in TEC indicates that the most difficult pill for an entrepreneur to swallow in any kind of a VC relationship, corporate or otherwise, is that the “future of my baby is essentially in someone else’s hands.”
The demands upon you to provide accurate and timely reporting of financial results, using systems and data requirements that are foreign to your experience can be very frustrating. So can board meetings, if the VC’s representatives take issue with your management techniques, product development timelines, etc.
These issues notwithstanding, the rewards are truly worth the personal inconveniences and frustrations. Essentially, it’s a jumpstart to your growth that is probably not available through any other comparable resource. Years from now, you could easily look back upon the decision to use a corporate VC as the most positive business decision you ever made in your life.