Editor’s note: this is a guest post penned by James Baillieu and Mark Rundall, partners in the Corporate team at international law firm Bird & Bird specialising in advising CVCs, VCs, and tech startups. Also check out the recent op-ed on liquity, challenges and opportunities for European tech startups by partner Martin von Haller Grønbæk.
In recent years, there has been a significant increase in the number of investments by large corporates in early-stage and growth companies, including in European tech companies.
According to CB Insights, 2019 was a record year for corporate venture capital (or CVC) both in terms of the number of investments and the amount of capital deployed by corporates, with 3,234 deals being completed globally worth a total of $57.1 billion. Of these, 608 deals were in Europe raising over $7.5 billion. And over half of these European deals were in the UK or Germany, the most active CVC markets in Europe.
Despite the current COVID-19 pandemic, we expect this trend to continue in the long term.
Investors of all kinds find Europe’s tech scene highly attractive. After all, the European tech scene is home to some of the world’s most dynamic startups across a number of sectors including fintech, proptech, insurtech, AI, virtual reality, blockchain, healthcare, life sciences, retail, autonomous vehicles, to name just a few!
The region’s strong regulatory and competitive environments, robust intellectual property regimes, large market size and significant tax incentives, all help to make investing in the region’s tech startups highly attractive.
Within this, the increase in CVC activity has been driven by a number of factors. Large corporates are often cash rich (or can access capital fairly easily) and wish to deploy their considerable resources to acquire cutting-edge or disruptive technologies (and intellectual property) being developed by more nimble startups, that are often found in Europe’s various tech centres.
At the same time, corporates can also respond to innovation challenges in their own businesses by risking comparatively small amounts of capital on each investment, effectively outsourcing or supplementing their own R&D efforts.
Investing early also allows corporates to closely assess a startup’s technology – often as both a customer as well as an investor – and assist with the development of products and/or services. This enables the investee company to benefit from the synergies that the corporate investor can access by virtue of its own size and buying power, which can add significant value above-and-beyond simply being a financial investor.
Some – but by no means all – corporate investors may also be interested in acquiring a minority stake with a view to subsequently acquiring successful companies in the longer term if the underlying technology is validated. Taking a minority stake in this way can be a cost effective way of de-risking any eventual acquisition while risking a relatively small amount of capital upfront.
For European tech startups, CVC is often seen as attractive because corporates often provide “value added services” and commercial synergies in addition to capital. These vary but include assistance with product design, introductions to potential customers/vendors, brand association and the provision of regulatory or technical support in specialist areas which the startup might not otherwise have easy access to.
So what are the investment terms CVCs may ask for?
Similar to venture capital firms, CVCs tend to invest on an international basis. You might therefore expect there to be significant differences in deal terms depending on the jurisdictions involved; however, that’s often not the case. While it’s certainly true that many investors (and CVCs are no different here) tend to view the world through the lens of their home jurisdiction, it’s rarely the case that this results in a fundamental difference in approach when it comes to deals. It’s more often a case of appreciating the different terminologies used in different jurisdictions, and the legal means by which the same result can be achieved.
The bigger differences between CVC and venture capital firms really come from the different commercial perspectives. Corporate investors typically (though not always) invest for strategic and synergistic – as well as financial – reasons. This often impacts the terms on which they invest. It is therefore important for tech companies to know what to expect when seeking investment from large corporates.
Here are a few common differences we see when corporates – as opposed to purely financial venture capital firms –invest:
1) Control and Consent
While both financial and corporate investors require consent rights, corporates often require different consent rights. For example, some corporate investors require additional consent rights over the investee company entering into contracts with competitors (see below). Similarly, corporates may require more extensive control over compliance issues (for example requiring the company to adhere to the corporate’s anti-bribery, corporate social responsibility and ethics policies).
Furthermore, as corporates invest for strategic reasons they often invest with a longer-term investment horizon than venture capital investors (which generally seek an exit within around 3-5 years). As a result, corporates often require additional rights over an exit.
In contrast, some corporate investors may require lighter consent rights compared to a typical VC as the corporate investor may be constrained by competition and/or accounting policies which mean they will want to avoid controlling the investee company, whether by virtue of positive consent rights (i.e. the investor approving certain actions) or negative control rights (i.e. the investor being able to block certain actions).
2) Competitor Restrictions
As corporate investors often invest for strategic reasons, they may want to restrict the ability of competitors to access the investee company. Some corporate investors therefore seek to include a number of restrictions on investee companies. These include limits on the disclosure of information to, the provision of goods or services to, or transfers of equity to, competitors. Competitors are sometimes defined by reference to a specific list of competitors while at other times it may include a more general description.
3) Rights of First Refusal, Offer and Negotiation
Many corporate investors require rights over future merger and acquisition activity. Corporates regularly request a right of first refusal (or ROFR), which provides the investor with a right to be offered any shares being sold by other shareholders in the investee company after the selling shareholder has solicited an offer for their shares from a third party. These are often resisted by companies because they can be seen to make a company potentially less valuable as a potential acquirer may be reluctant to make any offer if their offer can be matched by the corporate investor.
A more company friendly but similar mechanism is a right of first offer (or ROFO). A ROFO provides an investor with the right to be offered the shares before any external solicitation takes place. If the investor refuses the offer, then the selling shareholder may solicit third party offers on the same terms that were presented to the investor.
A softer provision still is a right of first negotiation (or ROFN), which only provides the investor with the right to negotiate with a potential seller of shares for a defined period of time before those shares are offered more widely.
Agreeing a ROFR or ROFO (or both) is often one of the trickier negotiation points when dealing with corporate investors, but a workable solution is usually obtainable in most circumstances.
4) Call Options
In some cases, corporate investors may want a call option to acquire the company – often at an agreed price or a price based on a pre-determined formula – in the event that the company is successful generally or achieves certain specified milestones. In rare cases, the parties may even pre-negotiate the terms on which the acquisition will ultimately take place.
5) Put Options
Corporate investors may also require the flexibility to sell their shares in the investee company back to the company or other existing shareholders (typically for fair market value) upon the occurrence of certain trigger events. These might include the investee company failing to achieve certain performance milestones by a certain date or for regulatory or reputational reasons. For example, fintech companies regularly find that financial institutions such as banks request a ‘put option’ in order to sell their shareholding promptly should they need to do so to ensure compliance with financial regulatory requirements.
6) Investor Directors and Observer Rights
Traditional VC investors typically expect to appoint a director to the board of an investee company. Many corporate investors take up such rights too, but some take a different approach because of concerns over director’s fiduciary duties.
For corporates, their investor director will typically act as both an investor director on the board of the investee company as well as being a director (or other senior executive) within the appointing corporate group. The potential for conflicts between these two roles can require careful managing, as a course of action that is in the best interests of the investee company may conflict with what is in the best interests of the appointing investor.
Therefore, some corporate investors may instead rely on observer rights. An observer is able to attend and speak at board meetings but will not have the right to vote. This is likely to be preferable with corporate investors as they will still be able to benefit from access to the information discussed or distributed at the board meetings while avoiding potential director liability and potential conflict issues. This is often combined with a right to appoint an investor director which may not be taken up at the time of investment.
From a company perspective, it is worth considering what information an observer will be able to access. While a director is bound by fiduciary duties to the company, an observer is not, and would not be required to consider the company’s best interest in dealing with its confidential information. Likewise, there’s no requirement for an observer to excuse themselves from a meeting in the event they have a conflict (or if a conflict of interest arises during that meeting). While these issues arise in the context of any observer (whether appointed by a VC or a corporate) the potential for a conflict of interest is arguably greater when dealing with a corporate investor. For these reasons, it is fairly common for observers appointed by a corporate to be excluded from access to certain information or board meetings.
7) Information and Visitation Rights
While information rights in traditional venture capital deals are fairly common, they are more often than not limited to the provision of audited accounts and management accounts to investors. CVCs (as well as some financial investors) often require disclosure of a broader range of metrics or ‘key performance indicators’ (or KPIs). The precise KPIs are generally tailored to the business of the investee company, and take into account the information the investor wishes to assess and the specific technology or product being developed by the startup.
To further monitor their investment, some corporate investors also seek visitation rights, which essentially give them the right to attend and visit the offices of the investee company and, in some cases, interact with employees.
Many corporate investors require their investee companies to agree to specific undertakings over-and-above those commonly required by financial investors. For example, corporate investors increasingly subject their investee companies to rigorous environmental, social and governance (ESG) standards, including compliance with anti-money laundering regulations, anti-bribery and corruption, anti-modern slavery and other relevant policies.
What’s next? An evolution in CVC activity
We expect CVC activity to continue growing in the long-term, although 2020 is perhaps likely to see a significant blip in this upward trend as a result of the COVID-19 pandemic impacting deal activity generally. This will involve corporates ramping up their investment activity – in terms of both the number of investments and amount of capital deployed.
Tech startups and growth companies across Europe will benefit from this increase in capital. And we expect those corporates yet to undertake investments to commence making venture capital investments, whether by setting up a dedicated fund or by making direct investments funded from the corporate balance sheet.
We also see an evolution in CVC activity. For example, we expect some corporates to seek to exit from investee companies, perhaps because of a change in strategic focus or a need to double down on winners and exit those which no longer look promising. This trend is perhaps likely to accelerate as a result of COVID-19, as corporates respond to the pandemic by looking to raise funds by selling unwanted stakes.
Although the primary concern for European tech startups is raising capital (especially in the current environment), CVC investors can bring a number of other significant benefits, which can help founders accelerate their startups development.
That said, it is important for tech startups and their founders to ensure strategic alignment with their CVC investors. In doing so, it is necessary to carefully negotiate a number of legal terms which CVC investors may uniquely require, in addition to the standard terms that are typically required from financial investors.
Featured image credit: Jose B. Garcia Fernandez / Pixabay