Out-Law Analysis | 23 Sep 2020 | 3:02 pm | 6 min. read
CVCs are not without their challenges, but we are likely to see a continuing increase in their use, particularly in the current environment where access to cash is likely to be more difficult but with no let up on the disruptions facing these businesses. As with any alliance, the key to success is for both parties to agree what they want from their partnership at the outset; as well as how they will work together to achieve their objectives.
This article is part of a series on the subject of supply chain resilience.
CVCs are a type of collaborative investment where a company acts as a private equity or venture capital (VC) investor, taking a minority stake in a young, fast-growing business either on its own or with other investors. Traditionally, corporate investors tended to invest alongside VC funds, as they were unsure of their own target-spotting and investment process capabilities. However, now most corporate investors tend to believe that investing alongside financial investors makes the investment too complex to manage and therefore often avoid co-investments.
Partner, Head of Diversified Industrial
Taking a stake in another business through the CVC route may provide much-needed access to new technology or talent, while still allowing the target business to maintain its independence
Automotive and other industrial businesses are adapting and diversifying by making new bets on emerging technologies and new types of business models. Although many businesses will continue to rely on traditional M&A or joint venture activity, a recent Pinsent Masons survey of senior executives of fast-growing manufacturing and technology businesses in western Europe showed that taking minority stakes are increasingly popular with these businesses in particular, with almost nine in 10 (89%) having invested in this way over the past three years.
Businesses in the automotive and industrial sectors are now constantly facing technological disruption; the need for new products and services; and competition from new 'challenger' brands responding to these needs. CVC and other less formal arrangements, through which companies are able to take minority stakes in innovative businesses, allow them to experiment and to spread their net wide, without committing to a full-blown acquisition. In some cases, the alliance may ultimately lead to a formal merger while in others, one side or the other may back away.
Taking a stake in another business through the CVC route may provide much-needed access to new technology or talent, while still allowing the target business to maintain its independence. This may be important where, for example, the cultures of the two businesses are very different: there are numerous examples of large businesses buying smaller ones but failing to successfully integrate the acquisition because of a culture clash. Managing the relationship between the acquiring corporate and the smaller investee company has become one of the main objectives when attempting to maximise the success of the CVC investment.
Trade buyers often struggle to compete with private equity investors in a 'hot' M&A market. The CVC model offers an alternative, allowing the founder to continue to 'own' the business - the importance of which to a founder should not be overlooked - and to be incentivised on an equity based model.
On top of capital, corporate investors may offer the founder a reputable brand to be associated with, a ready-made customer or supply base, complementary technology or R&D experience and support. However, they will still need to convince the founder that they will be welcome and thrive in the large corporate world or that they will be kept at arm's length.
Corporate investors, as opposed to most financial VC investors, are also a potential exit partner for founders and existing investors.
Minority stakes come with risk. Difficulties can arise when, for example, the rationale for investing or the approach to the underlying product or business model is unclear or changes over the life cycle of the investment. Corporate investors have a greater focus on the strategic, rather than financial, rationale for investing - for example, the investor may require an exclusive right to use the technology being developed.
For the corporate investor, investment in a start-up may offer immediate access to know-how by way of licences or technology partnerships; or access to new innovative products in the near to long-term future. For start-ups, this type of investment may bring access to additional manufacturing and distribution capabilities, help with product certification and other regulatory requirements, access to joint R&D and otherwise inaccessible market insights and know-how outside of their core competencies.
If the commercial rationale does not ultimately prove to be successful, it can be difficult for the investor to admit 'failure' and shift its mind set to a purely financial one. Businesses that have been successful with CVCs accept that some will fail or simply not prove to be the right fit. In these circumstances, allowing the target to sell the product to a competitor or exiting the business quickly may be the right thing to do.
Corporate investors also need to be ready to deal with abrupt changes of strategy within their group, often predicated by a change in CEO. Given that CVCs often take time to deliver a return – whether financial or in terms of a technological goal - the model can fall out of favour with these groups.
Depending on the size of the stake being acquired, the corporate investor may have little or no control over the target company. Those new to CVCs can struggle with this conceptually, given the controls ordinarily placed over their group companies; and it can even leave the investor exposed to reputational or regulatory damage in the event that the smaller business behaves irresponsibly.
Even those with more significant stakes, and the associated opportunity to put in place greater controls, still face the dilemma of how to give an investee company enough space to innovate while ensuring compliance with the group's broader compliance requirements.
The corporate investor may also have limited control over who else is investing alongside it, with the risk of association with competitors or 'disreputables'. New investments or transfers of shares are often hotly negotiated given that the target will usually want the greatest flexibility to raise new funds, particularly in the early stages, while the corporate investor will be looking for some level of control to protect its brand and reputation.
Depending on the level of integration of the target with the corporate investor's business, confidentiality will be a sensitive area. Target and third party investors may be concerned that a corporate investor has access to information that may raise antitrust concerns or put it at a competitive advantage in normal trading activities or on exit, particularly if the investment comes with a seat on the board or rights of access to some or all of the target's internal knowhow. A balance may need to be struck between allowing the corporate investor sufficient information to allow it to monitor its investment, whilst also protecting the target.
When entering a CVC, either the founder, investor or both will want to consider potential exit strategies and ensure that the different scenarios are adequately catered for.
In particular, where the corporate investor is the sole investor alongside the founder, it is usual to see some form of 'put and call' option under which the corporate investor will buy out the founders on certain trigger events - time, product development milestones or similar - with an agreed pricing formula. For the founders, it will be important to ensure that they can force the corporate investor to buy them out to avoid becoming stranded with a business with no permitted or viable third party sale given its connection with, and likely reliance on, the corporate investor. If the start-up business is to be controlled tightly in its development or exit routes strongly limited, a CVC may not be an option. In that case a majority stake plus put-/call-options may be the best way forward.
In case of minority stakes, usually when additional financial investors are involved, options are not generally favoured. Given that the market is not tested at the time of the exit, options may not be the best choice in order to maximise value. In this scenario, the corporate investor will want some form of right of first refusal or offer. Commercially, this does not seem unreasonable. However, the target and other investors will have legitimate concerns that they may still depress third party appetite and therefore affect the price in a negative way. Third parties will be concerned about participating in an expensive acquisition process where the corporate investor has greater insight into the target business, meaning they can 'pip' the third party at the post. As a rule of thumb, in CVC investments, provided the corporate investor has a lever to safeguard the achievement of the investment rationale - whether by licence agreements or right of first refusal - the door to the various ways to exit should be left open as far as possible.
Having said that, CVCs will usually contain the more traditional 'good leaver' and 'bad leaver' provisions for the founders that you see in private equity investments - meaning that the founders can be forced to sell their shares if they leave the target. These will usually come with vesting and pricing terms to reflect the value achieved before or during the investors coming on board. Investors may also want to lock the founders into the investment in such a way that they cannot sell their shares to third parties. Again, there is often some flexibility allowing founders to have some sell down rights at certain times or on certain triggers, particularly where multiple investors are involved.
23 Sep 2020
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