We all know companies like DiDi, Tesla, Airbnb and Zoom, but what is one of the elements that all of them have in common? The answer is that they all raised venture capital at the beginning of their operations. Venture capital is often directed to new and small projects, or companies that have great growth potential but a very high level of uncertainty and risk. Participants include corporate venture capital (CVC) funds and independent venture capital (IVC) funds.
Initially established to serve the long-term strategy of the group, CVC funds have gradually evolved into a corporate fund that invests in external startups. Currently, CVC funds endorse the following investment models: Forward-looking investment; complementary investment; ecological investment; whole industry-chain investment; and diversified investment.
The main ways for group companies to develop CVC funds, at present, are as follows: (1) to set up a strategic investment department internally; (2) to separately set up a wholly-owned subsidiary; (3) to launch and set up a CVC fund; and (4) to allocate related parties, as limited partnerships, to hold shares in the venture capital funds constituted by specialised investment institutions.
CVC v IVC
Original intension. Aiming to serve the long-term development strategy of the enterprise group, short-term revenue is not the primary concern of CVC funds, hence it shows a higher tolerance for investment risk. On the other hand, the core objective for IVC funds is to maximise financial investment returns and satisfy investors, so it prefers a more precise control of investment risk.
Funding sources. CVC fund investments are mostly carried out by self-owned capital, while IVC funds investments are mainly via fund raising.
Investment horizon. Most of the CVC fund investments are made with self-owned capital and for long-term strategic layout, meaning they do not have a fixed term. The typical investment horizon of an IVC fund, on the other hand, is three to five years (closed-end).
Operating model. A CVC fund focuses on industry incubation and cultivation to assist group companies completing their long-term strategic layout, so they have no reluctance to leverage the group companies’ own resources and platforms to benefit their portfolio companies. On the other hand, the main focus area of an IVC fund is to optimise and grow companies they invest in, with the purpose of achieving an exit (i.e., IPO or M&A transaction) for the firms at the highest value possible.
Why choose CVC?
For opportunities. During the dynamic of industry development, the enterprise’s industrial value chain may encounter bottlenecks in some aspects, while other aspects may contain opportunities, hence the proactive search for development opportunities is more conducive to the long-term development of enterprises.
For cost-effectiveness. Long-term business development may have a diminishing marginal effect on the business behaviour of an enterprise. In order to make a cost performance index more efficient, CVC funds are a beneficial option.
For future. In the context of the “Internet-plus” era, technological innovation and industrial revolution have become a realistic situation for contemporary enterprises. Only by proactive strategic deployment can they maintain their market position in the new economic normal.
Alert on risks
Risk points to be considered by enterprise groups:
Risk control. The keywords to risk control are due diligence and post-investment management. Before any investment, detailed due diligence should be conducted on the invested company, with particular attention paid to core assets and intellectual property rights to avoid hard facts such as defects in the rights.
It is also necessary to fully evaluate the profit model of the invested company. After investment, a sound internal risk control system should be established to adjust related behaviour base on corresponding situation.
Horizontal competition. Although the current capital market is more tolerant of horizontal competition than before, it is still advisable to avoid potential market competition. The investment portfolios should be flexible, diversified, as well as conducive to strategic planning of the enterprise groups.
Capital issues. Essentially, a CVC fund is a long-term fund investment, which is a large expense for the company. Therefore, in order to make prudent decisions, the financial situation and operations conditions should be carefully reviewed. Meanwhile, the use of funds for the invested company should be monitored and managed to avoid further risks.
Incubation & Breeding. The investment of CVC funds is not a static investment act, but a dynamic incubation and cultivation process. In order to fully explore the infinite possibilities of the future during the CVC investment operation, talented minds should be directed to the invested company. In addition, comprehensive coaching and support should be provided to the invested company.
Risk points to be considered by the invested company:
Organisational culture. For the invested company, receiving financial support may also mean accepting the management and constraints of the enterprise group, including its corporate culture and internal rules and regulations.
Sharing of core assets. Investment by an enterprise group may come with conditions, including sharing the patent technology, copyrights and other IP rights of the invested company, which may imply potential market segmentation, as well as benefit sharing.
Trading restrictions. The enterprise group, in order to maintain its market position, may impose restrictive terms to interfere with the transaction choices of the invested company, which may have an impact on the potential cost expenditure and transaction efficiency of the invested company.
Performance requirements. The objective of any investment can be ultimately ascribed to the rate of return, therefore some group companies may require performance commitments from their investees, such as a valuation adjustment mechanism.
The invested company should carefully consider whether the adverse consequences of performance commitments terms are within its acceptable range. At the same time, the invested enterprises is also recommend to negotiate with counterpart enterprises on performance commitment terms based on their actual circumstances, and ultimately achieve a win-win situation.
Carlton Yuan is a partner at V&T Law Firm. He can be contacted on +86 139 1123 4370 or by email at firstname.lastname@example.org