Startups and corporate partners: a relationship of hope and challenge
Author: Dr Martin Pfister, Senior Investment Manager
According to a recently published study by Wayra, the accelerator programme set up by the Spanish telecommunications operator Telefónica, major corporations founded 264 new venture capital businesses in 2018. It is interesting to note that this type of support for innovative, non-corporate projects has experienced a new boom since the 2008 financial crisis. Moreover, more and more companies are setting up accelerators, which assist external projects with structuring, financing, and often infrastructure too. They can be found in all sectors and have one thing in common: enthusiasm for startups and their innovative strength, culture and agility. High-Tech Gründerfonds too has attracted investment from 32 corporates for its hird fund. Some of these have their own corporate venture capital (CVC) arm, whilst the activities of others originate from their management or Business Development department.
The various types of collaborations, licence agreements, investments and exits between startups and their corporate partners have huge potential, but there are also pitfalls and dead ends.
A big corporation – truly your best customer?
Many startups see a customer-supplier relationship with an established business as their proof of market, especially if it offers recurring sales potential. But according to the Wayra study, startup founders are disappointed by the corporations who have invested in their business. Although the study does not give any specific reasons for this, experience has shown that the culprits are the time decision making processes take or unpaid preliminary qualification studies. Given the risk that a startup may no longer exist in two- or three-years’ time, it is perfectly reasonable when major corporations, especially those in highly regulated sectors, shy away from being supplied by one of these businesses.
According to the Wayra study, corporate investors also fall short of expectations when it comes to the sales and marketing support the young entrepreneurs had hoped to receive. But we can see that startups benefit significantly when it comes to joint developments (R&D), production, and process optimization. What is happening in the mid cap sector is also interesting: more and more of these companies, not normally very familiar with the startup ecosystem, are opening up. Lean decision-making processes often make up for any lack of dedicated structures, such as innovation scouts or venture capital. But here, everything must work out:he search for potential partners is often closely tied to their own target markets and their enthusiasm quickly disappears when they are confronted with too many uncertainties.
Investment by corporates – a ‘bear hug’?
Recent developments in the corporate venture arena have resulted in more fund of funds investments and in more money flowing directly from corporates into startups. German companies are particularly active: according to the Wayra study, about one quarter of all European deals between 2000 and 2018 involved German corporations. There is (almost) always a strategic element in these investments, i.e. it has to fit in with the parent entity’s plans. This is usually taken care of through a process whereby the Corporate Venture colleague secures internal commitment before pursuing the potential investment target any further. That can be advantageous – as long as the CVC acts like a traditional investor interested in a financial return, which is the case more and more often. This is something startups should take particular care to ensure: Winning over a major corporate partner is great for the reputation.
However, institutional VCs take a critical view of possible specific rights for strategic investors because it could restrict the flexibility required in the exit process. For instance, there should be no specific veto rights (investment = pari-passu), and any right of first refusal should be clearly limited, with a temporal element of just a few weeks that would allow the startup to explore alternative options. If a call option is already being negotiated with the corporate, it should include a drag-along clause which includes the strategic investor to sell their stake with no strings attached when sums are offered in an open M&A process that significantly exceed the sum agreed for the call option.
Royalties – licence agreements are an obstacle
As a result of negotiations with corporates that could end with the transfer of IP or a licence, the startup’s intellectual property rights will be gone through a detailed due diligence. The startup often comes under pressure in this process: Conditions, e.g. exclusive licences for the technology, were often negotiated at an very early stage in setting up the company; several academic partners were often involved in grant projects, and the set-up of a licensing technology transfer or patent agency is in many cases not professional enough.
On the other hand, we have the corporate partners with their substantial experience in knowing for instance which royalties are commercially viable for them, when a product should be launched, or whether it is even possible to show the sales figures for individual products. High payments to a third party, e.g. the university, can quickly land the negotiations in deep water. In these cases, the startup should try get the corporate to join them at the negotiating table – having a common interest often helps in the negotiation process. And the startup’s institutional investors are not interested in such long-term payment options either because this does not fit in with the runtime of their funds. They would rather be paid off early (with a discount).
The opinions expressed here are those of an investor and based on the HTGF portfolio, across all industries. What is true for good management is even more important for any talks between startups and major corporations: an open and frank conversation about their expectations of the collaboration or investment by corporate VCs; and the investor empowering the startup with an eye to the common ultimate goal: the exit.
Source: Corporate Venturing Report 2019