DSF Policy Paper Series
Venture Capital Beyond the Financial
Crisis: How Corporate Venturing
Boosts New Entrepreneurial Clusters
(and Assists Governments in Their
Innovation Efforts)
Joseph A. McCahery and
Erik P.M. Vermeulen
May 2010
DSF Policy Paper, No. 7
Venture Capital Beyond the Financial Crisis: How Corporate Venturing
Boosts New Entrepreneurial Clusters (and Assists Governments in Their
Innovation Efforts)
Joseph A. McCahery and Erik P.M. Vermeulen*
Abstract
In his book, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and
Venture Capital Have Failed - and What to Do about It, Harvard Business School Professor
Josh Lerner explains that governments can only play a limited role in spurring innovation and
entrepreneurship. Government initiatives are usually characterized by poor design and a lack of
understanding for the venture capital process. He argues that governments better limit their role
as catalysts by: (1) ensuring that the economic environment is conducive to entrepreneurial
activity; and (2) providing direct investments. In this paper, we investigate the recent examples
of governments that have followed either one of these suggestions. Relying on standard
measures of success, we find that the participation of multinationals plays a crucial role in
realizing the success of these initiatives. In the aftermath of the financial crisis, there is a
worldwide revival of corporate venturing activities. We can now see that, insofar as it operates
through corporate venture capital investments, the venture capital market is getting its magic
back - and that when corporations participate in the process, it gives both strategic and financial
benefits to the parties involved, such as governments, traditional venture capitalists, and
entrepreneurs. The paper shows a shift in the fundamental nature of corporate venture capital
and provides an account of the governance structures and contractual characteristics that
encourage successful alliances between corporations and venture capital funds and their
portfolio companies.
* Duisenberg school of finance & Tilburg University, Tilburg University & Philips International B.V.
Venture Capital Beyond the Financial Crisis: How Corporate Venturing Boosts New
Entrepreneurial Clusters (and Assists Governments in Their Innovation Efforts)
Joseph A. McCahery and Erik P.M. Vermeulen1
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.2 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.3 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.4 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.5 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
1
Joseph A. McCahery is professor of International Economic Law at Tilburg University and Erik P.M. Vermeulen is
professor of Business Law at Tilburg University and Vice President at the Corporate Legal Department of Philips. The
views expressed in this article are the personal views of the authors. We would like to thank Janke Dittmer for his
comments and suggestions. We would also like to thank Karina Toxqui Jaimes and Julian Motta for their research
assistance.
2
See Josh Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital
Have Failed - and What to Do About It, Princeton University Press, 2009. See also John Armour and Douglas
Cumming, The Legislative Road to Silicon Valley, Oxford Economic Papers, Vol. 58, pp. 596-635, 2006.
3
See Jose Miguel Mendoza and Erik P.M. Vermeulen, Venture Capital and Stock Market Transplants: The Design of
an Effective Exit Mechanism, working paper on file with the authors.
4
See Bernard S. Black and Ronald J. Gilson, Venture Capital and The Structure of Capital Markets: Banks versus Stock
Markets, Journal of Financial Economics, Vol. 47, pp. 243-277.
5
See The Financial Times (by Michiyo Nakamoto), More than just an investor, 11 May 2010.
1
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.6 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 hightechnology universities.7 Others give a more sexual explanation for the differences between Silicon Valley
and other high-growth technology centers.8 They reason that a poor public transportation system and a lack
of bars in the Valley encourage nerdy 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.9
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.10
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 often-neglected
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
6
See Dan M. Khanna, The Rise, Decline, and Renewal of Silicon Valley’s High Technology Industry, Routledge,
February 1997.
7
See Ronald J. Gilson, The Legal Infrastructure of High technology Industrial Districts: Silicon Valley, Route 128, and
Covenants Not To Compete, New York University Law Review, Vol 75, pp. 575-629, 1999.
8
The Representative Agent blog, A Sexual Explanation for the Success of Silicon Valley, 25 June 2009
(http://representativeagent.wordpress.com/2009/06/).
9
See Erik P.M. Vermeulen, Towards A New ‘Company’ Structure For High Tech Start-ups in Europe, Maastricht
Journal of European and Comparative Law, Vol. 8, p. 233-275, 2001.
10
See Lisa Bernstein, The Silicon Valley Lawyer as Transaction Cost Engineer, Oregon Law Review, Vol. 74, pp. 239255, 1995.
2
Valley.11 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.12
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
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.13 At the same time, the emphasis on “open
innovation” has rekindled the interest for corporate venturing and corporate venture capital in both the
academic,14 and professional world.15 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
11
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).
12
See Mark C. Suchman, The Contracting Universe: Law Firms and the Evolution of Venture Capital Financing in
Silicon Valley, working paper available at http://www.ssc.wisc.edu/~suchman/drafts/kuniverse.web.pdf.
13
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 Ronald J. Gilson, Locating Innovation: The Endogeneity of Technology, Organizational
Structure and Financial Contracting, Columbia Law Review, Vol. 110, pp. 885-917, 2010.
14
See V.K. Narayanan, Yi Yang and Shaker A. Zahra, Corporate venturing and value creation: A review and proposed
framework, Research Policy, Vol. 38, pp. 58-76, 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.
15
See Henry W. Chesbrough and Andrew R. Garman, Use Open Innovation to Cope in a Downturn, Harvard Business
Review, June 2009.
3
respect to exploiting existing technology and gather the resources and capabilities to enter new markets and
make new investments.
The goal of this paper 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. As mentioned, corporations may have
strategic interests that differ from the investee company and may lead to cumbersome 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 essay 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
4
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 study 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. Finally, we endeavor to 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
study holds important lessons for governments that so far have failed to emulate Silicon Valley’s success.
Section 4 concludes.
2.
The Venture Capital Industry
This section examines the steps that governments have taken to design an infrastructure supportive to 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. They
have tried to implement the United States’ flexible legal and economic institutions that inevitably contribute
to the relative performance of a venture capital market. Indeed, 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
The Legal Infrastructure of the Venture Capital Industry
We first turn to analyze the relationships among the traditional players of the venture capital game. There are
roughly three types of players in this game: Entrepreneurs, which form the supply-side, and venture
capitalists and their investors, which together form the demand-side of venture capital (see Figure 1). It is
recognized that to a certain extent the venture capital market has to deal with a ‘double-sided moral hazard
5
problem’ and to provide incentives for each party to contribute resources so as to maximize their joint
wealth. Venture capitalists use the investors’ capital to back entrepreneurs about whose abilities they have
less than perfect knowledge. Problems of shirking and opportunism abound in the seed, start-up, expansion
and exit stages. The impossibility of complete risk diversification emphasizes the importance of monitoring.
Yet, the venture capital market is characterized by intangible assets, substantial growth options and high
asset specificity, which make direct monitoring not only costly, but also largely ineffective. Nevertheless,
venture capitalists tend to monitor their investments through active participation, namely by due diligence,
establishing a relationship with the start-up businesses’ managers and by sitting on their board of directors.
Whilst involvement in key corporate functions tends to limit moral hazard problems, information
asymmetries are likely to persist and can potentially create significant value dilution for investors.
Information asymmetries arise from two principal sources: (a) the entrepreneur has information unavailable
to the venture capitalist, and (b) the entrepreneur’s information is often distorted by overestimating his
chances. The first kind of information concerns the actual product, technology and market, as well as the
quality, ethics and fortitude of the entrepreneurial team, whereas the second kind could diverge dramatically
from reality due to the entrepreneur’s personal attachment to the venture and the feeling that his bright idea
will definitely yield the expected wealth.
6
It follows from this discussion that the internal governance structure of venture capital funds and start-up
firms proves decisive in the eventual development of venture capital industry as it plays a crucial role at
several stages of the financing and development of high-growth companies. It is submitted that if governance
structures and contractual arrangements are effective in limiting opportunism and controlling the level of
risk, investors are more likely to contribute capital to start-up firms through venture capital funds. The
argument is that problems stemming from information asymmetries can be reduced by selecting an efficient
legal form that sets the contracting framework and assists in aligning the parties’ conflicting interests.
2.2
The Limited Partnership
Empirical work has focused on how venture capital funds around the world predominantly employ the
limited partnership form. Even in countries, where the limited partnership form was not enacted, this
business form was recently introduced to benefit, among other things, the venture capital industry. For
instance, a Limited Partnership Act was only promulgated in Singapore in 2009. The Company Legislation
and Regulatory Framework Committee (CLRFC) spurred the introduction of a limited partnership to offer a
tested and effective legal framework to venture capital and private equity funds. In the United Kingdom,
where the limited partnership form under the Limited partnership Act 1907 was seldom used, this form
enjoys unusual prominence. There are a variety of reasons for this, such as tax benefits, the flexibility
surrounding its structure and terms. Individuals and institutions who invest in a limited partnership choose to
delegate investment and monitoring decisions to the venture capitalists, who acts as the general partner.
The relationship between the limited partners and the general partners can be characterized as a
principal-agent relationship, in which the principal is required to take precautionary measures to ensure that
the agent will be less inclined to act opportunistically. The flexibility of the limited partnership form allows
the investors and fund managers to enter into covenants and schemes that align their incentives and reduce
agency costs. The contractual arrangements in venture capital limited partnerships can roughly be split in
three separate categories.16 The first category focuses on fund formation and operation provisions, such as
limits on the fund-raising period, the lifespan of the fund, and the required managers’ contribution. The
second category includes provisions on management fees and carried interest. The compensation of the
venture capitalist is comprised of two main sources for managing investments in each limited partnership.
16
See Dow Jones Private Equity Partnership Terms & Conditions, 2009 Edition.
7
Venture capitalists are typically entitled to receive 20 per cent of the profits generated by each of the funds.
In addition, venture capitalists charge management fees to each venture. Due to information asymmetries and
bounded rationality which limit the ability of the managers and investors to foresee all future contingencies
and enter into an all-encompassing agreement, a third category of contractual clauses addresses the
governance structure to ensure that the fund is organized and managed in the most effective manner. For
instance, limited partners are usually permitted, despite restrictions on their managerial rights, to vote on
important issues such as amendments of the partnership agreement, dissolution of the partnership agreement,
extension of the fund’s life, removal of a general partner, and the valuation of the portfolio.
We have seen that the flexibility of the limited partnership plays a critical role in aligning the interests of
venture capitalists and investors.17 Despite several drawbacks, such as inefficiencies to publicly trade limited
partnership shares and the archaic law governing this form, limited partnerships have become the standard
structure used by both US and European venture capitalists. However, differences exist between a number of
17
Even if a different, but flexible, business form is used, the limited partnership is model for the governance and
structure of the venture capital fund.
8
contractual clauses that govern the limited partnership and its participants in the United States and Europe. A
closer look at the provisions in the limited partnership agreement shows that the investors in European funds
demand more protective clauses (see Figure 2). A possible explanation for this is the underdeveloped market
for reputation in Europe. The attention to the contractual and organizational structure of the fund arguably
increases when the venture capital market, which is prone to violent cyclical movements, lacks implicit
mechanisms that prevent opportunistic behavior and misappropriation, and experiences more difficulties in
attracting investors and raising funds (see Figure 3).
Figure 2 shows that European funds can be distinguished from their US counterparts in terms of the strict
rules regarding the distribution of profits to managers, the preferred return to the investors, the possibility to
remove the managers or dissolve the fund, the inclusion of key-person provisions, and less severe penalties
for defaulting limited partners. Moreover, given the lack of reputation effects and implicit contracts,
European funds are required to use specific valuation guidelines to reduce the information asymmetries.
Another difference is the limit on the fund-raising period, which is more common in European fund
arrangements. The fact that US firms need less time to raise their intended funds could also be explained by
9
the well-working market for reputation. Yet, despite these differences, the evidence shows that contractual
arrangements in European and US are converging in a number of important ways. A similar trend is
observed in the relationship and dealings between venture capitalists and the entrepreneurs. In this context,
the venture capitalists are the suppliers of capital that entrepreneurs use to grow and develop the company.
Once venture capitalists are hooked, they tend to demand that the entrepreneur cede control. Yet, venture
capitalists will not typically depose an entrepreneur by acquiring a majority of the company’s common
shares. This is considered to be counterproductive since discrepancies that arise between venture capitalists
and entrepreneurs would most certainly imply an increase in agency costs. Allocating a substantial equity
stake in the firm to the entrepreneur and other key employees, which is akin to a stock option compensation
system, fortifies the incentive to conduct the business diligently and discourages shirking and opportunism.
Instead of seeking a majority of the corporation’s equity, venture capitalists obtain control by utilizing
complicated contractual mechanisms in their relationship with the entrepreneurial team. The contractual
terms and provisions are discussed in the next section.
2.3
Convertible Preferred Stock
In early stage ventures, the most suitable type of security to use is convertible preferred stock. It is
considered optimal because it secures downside protection for venture capitalists by providing seniority over
straight equity, while it supplies entrepreneurs with sufficient incentives to take risks in order to create
higher final firm value. Convertible preferred stock gives the venture capitalist a fixed claim on the returns of
the venture in the form of a dividend. The terms could state that the unpaid dividends accrue and must be
paid to the convertible preferred equity holders before the dividend is paid out to common stock holders.
Common shares provide incentives to the entrepreneur as compensation and are thus based on the
performance of the venture. Using convertible preferred stock also gives venture capitalists a senior claim on
cash flow and distributions in the case where the venture is liquidated. There are a number of explanations
for the popularity of convertible preferred equity. One possible explanation for this pattern is that convertible
preferred stock - which confers a voting right - ensures venture capitalists protection against burdensome
amendments that favor other classes of investors. Furthermore, this class voting mechanism allows holders
of preferred stock to elect half or more of the board of directors, which gives the venture capitalist
substantial control over the board. If the venture capitalist gains control through the board of directors, he
10
can thus opt to replace the management team. Next, we note that with convertible preferred stock investors
have the option to convert their preferred shares into common shares, which allows them to capture part of
the firm’s upside gains. The conversion price is usually set equal to the purchase price of the security,
insuring a one-to-one conversion. In addition, the contract contains anti-dilution protections that alter the
conversion ratio thereby limiting opportunistic behavior by entrepreneurs. Another often cited reason is that
convertible preferred stock is made redeemable at the option of the venture capitalist, which ensures that
they will secure some compensation for their investment.
From a theoretical perspective, some economists argue that convertible preferred stock provides an
efficient means for dealing with the double-sided moral hazard problem. Convertible securities can also be
used to allocate cash flow rights contingent on the state of nature and the entrepreneur’s efforts. As such, this
contract reduces the double-sided moral hazard problem by inducing both the venture capitalist and the
entrepreneur to invest optimally in the project. A critical assumption is that a positive relationship exists
between the ultimate success of the project, project quality, the efforts of the entrepreneur, and the
commitment of the venture capitalist. Convertible preferred stock seems to outperform all other mixtures of
debt and equity. This explains why convertible preferred stock is the dominant form of security used by
venture capitalists in the United States. This may be due to the standardization of the legal documents, such
as the term sheet, stock purchase agreement and the certificate of incorporation. Recently a number of
empirical studies have confirmed the importance of convertible preferred stock in the United States.
In contrast to the United States’ flexible corporate law framework, forming a company is usually
more expensive and often involves complex formalities in Europe and Asia. It can take one or more weeks to
actually set up a company, whereas in the United States the formation of a general corporation may take only
one or two business days. Time-consuming incorporation procedures tend to hinder early-stage start-ups,
which often possess few resources and expertise and to whom speed is everything. For instance, the
relationship between venture capitalists and entrepreneurs is, besides the stock purchase agreement or
shareholders agreement, governed by the statutes’ provisions and the articles of incorporation. Corporation
laws are often mandatory in nature and require firms to disclose essential information in their filed articles of
incorporation, such as the capital structure, the firm’s objectives and the deviations from the default rules
supplied by law (e.g., the system of voting, supervision and regulations concerning the conduct of the
shareholders’ general meeting). As a result, lawyers, who specialize in incorporations, often struggle to
11
translate the parties’ wishes into the comprehensive set of articles of incorporation. For example, a stock
purchase agreement, which is largely incorporated in the articles in the United States, is not easily inserted
into the articles of incorporation due to the restrictive quality of corporation laws. In the event of a conflict
between the venture capitalists and the entrepreneur, provisions of the articles will trump the terms set forth
in the stock purchase agreement. The upshot is that unless the venture capitalists take control of the board,
such conflicts may dilute the value of the agreement for the start-up. To be sure, legal practitioners have
often found ways to emulate terms and provisions that were tested and proven successfully in Silicon Valley
in the dealings with local entrepreneurs.18 In jurisdictions, such as Japan, where the issuance of preferred
shares was initially restricted, policymakers, in an attempt to encourage venture capital investments,
amended the corporate law statute to enable start-up companies to procure funding from venture capitalists.19
18
In the Netherlands, for instance, standardized articles of association are employed in venture capital deals. Yet, it
remains a time-consuming procedure to translate the term sheet in the legal documents. See Janke Dittmer, Joseph A.
McCahery and Erik P.M. Vermeulen, Trends in Corporate Venturing, van ‘venturing’ naar ‘partnering’, Tijdschrift voor
de Ondernemingsrechtpraktijk, 2010.
19
See Zenichi Shishido, Why Japanese Entrepreneurs Don’t Give Up Control to Venture Capitalists, ExpressO,
Available at: http://works.bepress.com/zenichi_shishido/4, 2009. Despite the 2001 reforms, convertible preferred stock
is still unutilized due largely to control issues.
12
This leads to the questions whether the move towards contractual convergence at both the level of the
venture capital fund and the portfolio company has been sufficient to promote efficiencies, spur innovation
and foster the development of a robust venture capital market in other parts of the world. Convergence can
be demonstrated in terms of a number of considerations, including the predominance of the limited
partnership structure and the possibility to provide the venture capitalists with preferred rights and privileges.
However, no matter how appealing the prospects of convergence may seem, a lack of understanding for the
entrepreneurial process has prevented the complete replication of Silicon Valley in terms of deals and
investments (see Figure 4) and exit opportunities, such as trade sales (Figure 5) and IPOs (Figure 6)
2.4
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.20 Value-added services involve identifying and evaluating business opportunities, including
20
See Thomas Hellmann and Manju Puri, The Interaction Between Product Market and Financing strategy: The Role of
Venture Capital, Review of Financial Studies, Vol. 13, pp. 959-984, 2000.
13
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.21 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 successes in the Japanese venture capital
industry have been able to attract foreign capital from funds that were more than just investors.
There are signs that 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
21
See Zenichi Shishido, Why Japanese Entrepreneurs Don’t Give Up Control to Venture Capitalists, ExpressO,
Available at: http://works.bepress.com/zenichi_shishido/4, 2009.
14
economic actors. A cluster could also provide the starting point for the creation of a market for reputation
that effectively prevent investors, venture capitalists and entrepreneurs from acting opportunistically. For
instance, the Dutch government supports the development of a public-private 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.22 The High Tech Campus in Eindhoven, once established by Philips, has
become the cornerstone of the Brainport region.23 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.24 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, 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).25 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
22
See www.brainport.nl.
See Henry W. Chesbrough and Andrew R. Garman, Use Open Innovation to Cope in a Downturn, Harvard Business
Review, June 2009.
24
See www.hightechcampus.nl.
25
See www.incj.co.jp.
23
15
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 (see Figure 7). 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).26 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.27 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.28 The 1975-fund was funded 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
26
See Josh Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital
Have Failed - and What to Do about It, Princeton University Press, 2009.
27
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.
28
See Ralf Becker and Thomas Hellmann, The Genesis of Venture Capital: Lessons from the German Experience, in C.
Keuschnigg and V. Kanniainen (eds.), Venture Capital, Entrepreneurship and Public Policy, MIT Press, 2005. See also
Ronald J. Gilson, Engineering a Venture Capital Market: Lessons From the American Experience, Stanford Law
Review, Vol. 55, pp. 1067-1103, 2003.
16
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 (see Table 1). 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
17
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.29 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.
Table 1: Historical (2006-1Q 2010) Investments High-Tech Gründerfonds per industry (% of Total)
Industries
Cons/Bus Services
15%
Media/Content/Info.
1%
% of Total
Information Technology
Other
Communications & Networks
4%
Electronics & Computers
5%
Energy
3%
Information Services
3%
Other Companies
5%
Semiconductors
2%
Software
28%
Biopharmaceuticals
13%
Medical Devices/Equipment
13%
Medical Software & IS
2%
Source: VentureSource
Healthcare
Business/Consumer/Retail
Cons/Bus Products
6%
29
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/.
18
3.
The Revival of Corporate Venture Capital
In the previous section, we have seen that there is currently 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. 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 corporate venture
capital (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,30 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.31 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 startup companies with adjacent and competing technologies. Empirical research shows that in such cases startup companies were more reluctant to award board power to CVC investors and, instead, retained more board
seats for themselves.32 But there is more. The fear of opportunistic behavior of the investors when a direct
30
See Paul Gompers and Josh Lerner, The Venture Capital Cycle, The MIT Press, 1999.
See Ernst & Young, Global corporate venture capital survey 2008-09, Benchmarking programs and practices, 2009.
32
See Ronald W. Masulis and Rajarishi Nahata, Financial contracting with strategic investors: Evidence from corporate
venture capital backed IPOs, Journal of Financial Intermediation, Vol. 18, pp. 599-631, 2009.
31
19
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 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.33 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 (see
Figure 8). 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-toplay 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 10 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
33
See Gary Dushnitsky and Zur B. Shapira, Entrepreneurial Finance Meet Organizational Reality: Comparing
Investment Practices by Corporate and Independent Venture Capitalists, Academic Management Proceedings, 2008.
20
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
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.
That said, it should come as no surprise that, given the structural and organizational shortcomings of CVC
programs, the CVC share of total venture capital investment reduced from 16% to approximately 7% after
the internet bubble burst in 2000.34 Still corporate venture capital persisted at a much lower level, but never
disappeared. In fact, even though investors are cautious during the recent downturn, corporate venture
capitalists continue to invest actively in innovative technology companies, thereby regaining ‘market share’
34
See Ian MacMillan, Edward Roberts, Val Livada and Andrew Wang, Corporate Venture Capital (CVC), Seeking
Innovation and Strategic Growth, Recent patterns in CVC mission, structure, and investment, NIST (National Institute
of Standards and Technology, U.S. Department of Commerce, June 2008.
21
(see Figure 9). There are many explanations for the ‘revival’ of corporate venture capital initiatives. For
instance, some commentators argue that the fact that corporate venture capital organizations do not have to
attract money from third party investors makes them less vulnerable in a financial crisis.35 At the same time,
since limited partnership investors tend to be reluctant to invest in an economic slowdown is associated with
a more risk-averse behavior on the venture capitalists side. More severe regulation on investment funds, such
as the proposed EU Alternative Investment Fund Managers Directive (AIFMD), will exacerbate this effect.
A recent study shows that most active institutional investors will diminish their investments in venture
capital funds as a result of increased regulation.36 Similarly, the Obama administration’s proposed tax on
carried interest for investment funds from the current 15 percent to 39.6% threatens to dry up longer-term
investment for those companies involved in innovative technology.
These measures do not affect corporate venture capital and consequently it can only to be expected that the
CVC share of the total venture capital investment will peak again in the near future. Google Ventures, which
35
See Namitha Jagadeesh, Corporate venture investors remain active in downturn, available at
http://www.livemint.com/Articles/2009/02/23234456/Corporate-venture-investors-re.html.
36
EVCA, EU Regulation Will Destroy Key Source of Finance For Innovation, 15 March 2010 (available at
http://www.evca.eu/uploadedFiles/News1/News_Items/2010-03-15-PR_LPsurvey.pdf).
22
was announced in 2009, is an example of the rekindled interest in corporate venture capital. The venture
capital arm of Google is particularly interested in investing in innovative entrepreneurs in a wide range of
industries not purely for strategic purposes. Others argue that corporate venture capital managers more and
more realize that they should not be viewed as managers of ‘dumb money’ that is available to co-invest in
later financing rounds. The financial crisis forces corporations to cut back on corporate R&D. In order to
maintain the flow from ideas in a lab to actual products/services in the market, corporations are calling upon
their knowledge, expertise and resources when making investment and portfolio decisions.37 The next section
explains the transformation of corporate venture capitalists into more active players in the venture capital
industry.
3.1
Corporate Venturing
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.38 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.39
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
37
See Venture Capital Dispatch, Corporate Venture Investors, The New Early Birds, 19 February 2010 (available at
http://blogs.wsj.com/venturecapital/2010/02/19/corporate-venture-investors-the-new-early-birds/tab/print/).
38
See Paul Milgrom and John Roberts, Economics, Organization & Management, Prentice Hall, 1992.
39
See Pier A. Abetti, The Birth and Growth of Toshiba’s Laptop and Notebook Computers: A Case Study in Japanese
Corporate Venturing, Journal of Business Venturing, Vol. 12, pp. 507-529, 1997.
23
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.40 Figure
10 below illustrates the sequence of steps involved in this incubation process, 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 incubator 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
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.
40
See Georges Haour, Resolving the Innovation Paradox, Enhancing Growth in Technology Companies, Palgrave
MacMillan, 2004.
24
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 corporate venture capital 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.41 The framework in Figure 11 integrates this view. The first quadrant includes the incubator
process. Corporate venture capital initiatives are typically located in the fourth quadrant. Since incubator and
CVC activities could have both strategic and financial benefits, each quadrant is divided into two parts,
reflecting the strategic and financial focus.
41
See See Henry W. Chesbrough and Andrew R. Garman, Use Open Innovation to Cope in a Downturn, Harvard
Business Review, June 2009. 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.
25
Corporations do not completely have to explain their corporate venture capital relationships solely in terms
of return on investment. For corporations, its 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 fits into the fourth quadrant, but also to a movement of this type of investment from the fourth
quadrant to the second quadrant.42 It goes without saying that the new early-bird approach to corporate
venture capitalist 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 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.43 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. Related questions involve the role of the government and
42
The third quadrant includes the exploitation of an innovative technology belongs to the core business. The
corporation that owns the innovation could decide to fully realize its potential value by licensing it to third parties.
43
See http://www.nvpllc.com/
26
professional intermediaries. In the next 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.
3.2
From ‘Venturing’ to ‘Partnering’
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’:44 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
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
44
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.
27
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.
As is depicted in Figure 12, this 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
28
directions for business strategy, or to support existing business.45 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.46 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.
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
45
See Ian MacMillan, Edward Roberts, Val Livada and Andrew Wang, Corporate Venture Capital (CVC), Seeking
Innovation and Strategic Growth, Recent patterns in CVC mission, structure, and investment, NIST (National Institute
of Standards and Technology, U.S. Department of Commerce, June 2008.
46
See Gary Dushnitsky and Dovev Lavie, How Alliances Formation Shapes Corporate Venture Capital Investment in
the Software Industry: A Resource-Based Perspective, Strategic Entrepreneurial Journal, 2010.
29
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.
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
30
level of relational and performance risk.47 Reviewing Figure 12 again, 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
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.
3.3
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.
47
See Ard-Piter de Man and Nadine Roijakkers, Alliance Governance: Balancing Control and Trust in Dealing with
Risk, Long Range Planning, Vol. 42, pp. 75-95, 2009.
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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.48 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.
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.
48
See Alex Wilmerding, Term Sheets & Valuations, A Line by Line Look at the Intricacies of Term Sheets &
Valuations, Aspatore Books, 2005.
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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.49 With this in mind, we can now sketch an initial
and low-cost solution for government intervention. We set out six important recommendations for improving
the governance framework of CVC alliances and for aligning the incentives of the parties involved:
(1) Governments should provide direct investments through an independent venture capital fund.
Government-sponsored venture capital funds, which already emerged in Germany and Japan, hold out
the prospects of creating a dynamic and sustainable network of start-up companies and large
corporations. As the High-Tech Gründerfonds shows, these initiatives are able to attract a large number
of portfolio companies.
(2) The participation of large corporations is key for the success of the government-sponsored funds. It is
argued that collaboration between governments and large corporations could contribute to the education
of start-up companies and assure the steady and healthy growth of these businesses.
(3) However, a lack of focus and information asymmetries may prevent the emergence of effective and
optimal governance solutions within the funds. When the scope of the funds is too broad or too vague,
large corporations may fail to commit adequate financial and other resources to fuel the development of
start-up companies. This is especially true when competing corporations participate in the fund.
(4) Governments may therefore choose to make parallel investments in venture capital funds operated by
third parties. Given the recent trend, governments preferably invest in funds that (1) has both financial
and strategic investors, and (2) has a clear sector specific focus.
49
See Douglas J. Cumming and Jeffrey G. MacIntosh, Crowding Out Private Equity: Canadian Evidence, Journal of
Business venturing, Vol. 21, pp. 569-609, 2006.
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(5) If governments’ incentives are completely aligned with financial venture capitalists, they arguably
become a very attractive partner in the venture capital industry. It is, however, crucial that they
understand the importance of independence, and how venture capital investing works.
(6) By building up an investment history and reputation, governments actively contribute to the development
of national venture capital markets. as a consequence, government participation could optimally facilitate
the development of fruitful and lasting collaborations, signaling a quality fund in which parties have
ample incentives to commit to the funds’ strategy and investments decisions.
Thus, governments could play a pivotal role in building trust in the venture capital industry. Trust is key to
the success of alliances between corporations, venture capitalists and traditional investors. As the
performance risks are per definition high in the venture capital industry, trust will solve future conflicts.
Although the first empirical results arising from the initiatives in Germany and Japan show a mixed picture
on the impact on government-sponsored funds, the network creating capabilities of these initiatives confirm
the anticipated productivity effects for large corporations, venture capitalists as well as the entrepreneurs.
4. 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
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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.
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