Who doesn’t know companies like Uber, Airbnb, Wize, or WeWork today? What is one of the elements that all of them have in common? They all raised Venture Capital at the beginning of their operations. This type of financing allowed them to grow at times when perhaps no one else was willing to invest in them.
Venture Capital (VC) refers, as Gompers and Lerner explain, to an important intermediary in financial markets, providing capital to firms that may otherwise have difficulty attracting funds. Capital is usually directed to new and small projects or companies with great growth potential, but a very high level of uncertainty and risk.
Venture Capital firms, such as Sequoia, Andreessen Horowitz, Accel, Kaszek, Hanaco or Jungle Ventures, among others, provide high-yield, high-risk financing by purchasing a stake in companies through equity or equity-linked securities (ie. convertible notes “CN”, Simple Agreement for Future Equity “SAFE”, etc.). Participants include Independent Venture Capital funds and Corporate Venture Capital Funds.
Independent Venture Capital (IVC) funds are organizations formed by General Partners (GPs) who manage the fund and raise third-party capital to invest, rendering to a predefined investment thesis. Some examples are Battery in the United States, Blume in India, Vertex in Israel, Monashees in Brazil.
When it comes to Corporate Venture Capital (CVC), funds are vehicles constituted by a corporation with the purpose of investing (mainly in startups, although they can also invest in IVCs) a defined amount of capital with the purpose of generating financial and, above all, strategic benefits for the organization. Some examples are Google Ventures in the United States, Samsung Ventures in Korea, Mitsui Global Investments in Japan, Scotia in Canada, among others.
The concept of CVC funding is far from new, dating back to the 1960s with companies such as Dow, DuPont, Exxon, GE, among others. In recent years, however, the importance of CVC funds has increased significantly. According to CBInsights, CVC-backed deals and funding reached a record high in 2019, growing at 8% year-over-year (YoY) to 3,234 deals worth a total of USD$57.1bn. Their share with respect to IVC investments in startups has increased from 19% in 2014 to 25% in 2019.
While both IVC and CVC funds are focused on value creation, they differ in several aspects when it comes to the objective, structure and operation of the funds. Some key differences between an Independent Venture Capital fund and a Corporate Venture Capital fund are as follows.
The main objective of IVC funds is to maximize financial investment returns as a portfolio and satisfy investors (mainly external Limited Partners “LPs”). Hence, their area of focus is to optimize and grow companies they invest in with the purpose of achieving an exit (ie. IPO or M&A transaction) for the firms at the highest value possible.
The objective for CVC funds, on the other hand, goes further than financial returns. This goes back to the motivation behind the creation of a CVC fund. Business dynamics and the degree of innovation have accelerated exponentially, which has driven several traditional corporates to allocating capital towards creating a CVC fund that can assist them in the objective of being at the forefront and ensuring their relevance in the market as an ongoing business.
Hence, while CVC funds seek financial returns, their main goal differs in that the purpose of the fund is to create strategic returns for the organization. These returns can come in various ways, such as knowledge, innovation, new technologies, development of capabilities, among others.
The typical investment horizon of an IVC fund is 10 years (closed-end), it can be extended for additional years with the authorization of the Limited Partners as per the guidelines established in the Limited Partnership Agreement. CVC funds, on the other hand, are usually open-ended, meaning they do not have a fixed term.
Measurement of performance and value added:
GPs are under pressure to generate financial returns, otherwise the probability that the GP will be able to raise a subsequent fund is low. Therefore, financial return is the main aspect in consideration when it comes to measuring performance. When it comes to the value added of an IVC fund, this involves differentiation vis a vis competition on investment track record, industry expertise, network, timely execution, and reputation.
When it comes to CVCs, financial returns are not the only indicator of fund performance. Measuring strategic returns can be less straightforward than measuring financial returns. To measure the strategic impact CVCs have on the organization, management resort to a number of different indicators such as measuring the impact having startups as suppliers, the number of pilots or programs they implement with startups, partnerships, among others. When it comes to the value added of the fund, this involves the CVC’s experience in the industry, its geographic impact, its networks, and brand recognition.
Deal sourcing and diligence:
Deal sourcing is one of the topics where IVC and CVC funds differ widely, mainly attributed to their distinct backgrounds. CVC funds are often able to access a generous source of pipeline in their respective industry through their extensive business networks and strategic partnerships. IVCs, on the other hand, usually rely on the team’s personal networks (principally the GPs’) as their main source of pipeline.
When it comes to performing due diligence on an investment opportunity, CVC programs usually engage business units and other stakeholders in their industry network. While IVC funds perform due diligence internally, they sometimes outsource certain elements such as the legal or technological part. According to Asel, Park and Velarumi, CVC funds enjoy significant advantages in the due diligence process within their industry domain relative to IVC funds because of their ability to leverage corporate and industry knowledge, technical expertise, and extensive networks.
The structure of an IVC fund is usually external, defined by the relationship between the GP and LP. The GP manages the fund and the LP provides the capital required for the investments. Typically, the fund is established in jurisdictions with tax advantages for investors.
In the case of CVCs, the structure can be external or internal. “An external structure allows more consistent investment management and greater financial autonomy with more accountability for investment performance. With internal CVC practices, corporate sponsors fund investments off their balance sheets on a deal-by-deal basis. This structure has drawbacks and benefits. Such a practice exposes the CVC program to more uncertainty and fluctuations based on corporate operating budgets and business cycles because corporate sponsors typically invest in startups from discretionary resources. Although this practice tightly ties internal CVCs to evolving corporate priorities and gives companies more funding flexibility, it also undermines the consistency required to support investments through economic cycles” (Asel, Park & Velarumi). In economic downturns, IVC funds may be able to capture more value, especially if they have significant dry powder to deploy to take advantage on market opportunities.
Fund management incentives:
Usually, IVC managers receive greater financial incentives. Typically, a GP gets an annual management fee and a profit share (carried interest) if the fund accomplish with the financial returns. In the case of CVCs, compensation typically is composed by a salary and bonus structure.
Final considerations for startups
Both successful IVC and CVC funds must develop mutually beneficial relationships with startups. The entrepreneur should consider the value added by each of them, as well as future strategic and exit alternatives.
Typically, an IVC fund will invest in a startup before a CVC fund does and may add value by assisting the startups in the capital raising process, team building, operations, commercial development, and governance. In the case of CVCs, they may also add value to startups the same way as IVC funds and in other numerous ways in addition to capital funding, such as the endorsement from a reputable corporate investor, partnerships in various forms, large and diverse networks, and pools of knowledge. As William Sahlman from HBS said “from whom you raise capital is often more important than the terms.”
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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