Corporates Investing in Startups: Choosing the Right Vehicle

Investing and collaborating with startups is a no-brainer opportunity for corporations to develop additional vehicles for growth through corporate venture capital (CVC). Just, consider these few examples of the benefits that this model can bring to organizations: 

• Complement or replace part of the traditional research and development (R&D) model, allowing a faster move into the market.

• Structure emerging businesses that enable new sources of income generation.

• Integrate market and technology trends that lead to new consumer adoption models.

• Design new platforms for the development of products and services.

• Revamp corporate capabilities that strengthen the company's strategy.

• Enter into new market segments.

• Identify opportunities for improvement of current products and processes.

In most cases, that’s why companies like Intel, Arla Foods and Mercedes-Benz, among many others and from practically all sectors, decide to create investment arms to have minority stakes or make complete acquisitions of startups that strengthen their business models, allow a strategic renewal or even produce a transformation of the organization's core business. According to CB Insights, in 2021, 221 new CVC funds emerged in the world and US$169.3 billion was invested in startups, 142% more than in 2020, which totaled US$70.1 billion.

However, when a corporation decides to invest in startups, it faces several considerations that it must clearly resolve. One is to define the structure the investment fund should assume, since there are several that can be useful depending on the purpose. Hence, the corporate must have a clear vision of the growth objectives of the organization and how it expects the fund to contribute to that growth, including:

• The company's strategic and financial objectives – Establish an ambition of market positioning, including segmentation, as well as revenue generation for the following years. Define clearly how much of that income will come from business as usual (BAU) and how much will come from new sources of revenue.

• Market trends – Analyze the market trends, as well as the technologies that will enable their development and consumer adoption. In this analysis, it is also important to understand how the different consumer generations relate with products through technology.

• Current customers and new generations – Identify the profile of your current and future customers; as well as develop a deep understanding of what their needs are and how they hope to satisfy them in order to define the type of products they require.

• The level of innovation or disruption expected – Therefore, establish the level of innovation that the sector requires and that allows the company to differentiate itself or create barriers to entry for other players.

• Expectation and frequency of investments – Considering the above, we can also define how investments in startups contribute to improving existing products and services; as well as the development of new businesses. And ultimately, how often should we invest in these sorts of companies and the level of innovation or disruption that is required; as well as the amounts to invest in them.

• Calculate the financial return compared to the strategic return - Setting goals on the expected return on investments should go both ways, since some investments may have an exit, but others can be measured in terms of the contribution generated by new income or savings generated for the organization.

Although there are several types of fund structures, all of them are determined by the lifetime and the type of structure as well as the origin of its resources to invest, which determines the governance of the fund, alignment of interests and compensation, among other things.

The Fund Lifetime 

Evergreen Funds: These funds are designed to be ongoing, with no fixed end date. It means that the fund can continue to make investments and generate returns for an indefinite period of time. Evergreen funds are typically set up as limited partnerships, with a general partner (GP) who manages the fund and makes investment decisions. The GP is typically a team of experienced venture investors who are responsible for evaluating investment opportunities and managing the portfolio.

One of the main advantages of evergreen funds is that they can take a longer-term view of investments. Since there is no set completion date, the GP can take the time to carefully evaluate opportunities and invest in companies that have the potential to generate strong returns over the long term. Additionally, they can be more flexible in terms of how they allocate capital by adjusting the fund's investment strategy based on market conditions and the needs of portfolio companies. This can be particularly beneficial for companies looking to build a strong portfolio of startups that drive value for the organization.

Closed-end funds: On the other hand, closed-end funds have a fixed end date. This means that the fund has a predetermined useful life, which is typically around 10 years. Once the life of the fund ends, the GP is responsible for liquidating the fund and returning the remaining capital to the limited partners (LPs), who are those who invested in the fund.

One of the main advantages of closed-end funds is that since there is a fixed end date, LPs can easily assess the performance of the fund and decide whether to continue investing in it. This can help to build trust between both parties, as the GP is more transparent and accountable for the performance of the fund.

The Fund Structure

Corporate Investment Arms: These are internal units of CVC that are owned and operated by and with resources directly from the corporation. These CVC funds are focused on identifying and investing in new ventures that are aligned with the corporation's strategic objectives.

Corporate Sponsored: These are external funds that are sponsored by a single company, which provides all or most of the capital. The corporation generally has a significant level of control over the fund and the investments it makes.

Corporate Backed: A fund managed by a team of outside investors but funded by multiple companies rather than just one. This allows investment in a wide variety of industries. These types of funds are structured as limited companies; in turn, they can have a broader investment spectrum than internal funds, since these are not limited by the specific objectives of the organization.

Hybrid: A hybrid fund combines elements of both the inside and outside funds. The fund may be managed by a combination of the corporate team; as well as external people, having, in turn, strategic and nonstrategic investments.

In addition, there are combinations of structures derived from these, such as corporate funds that in turn invest in other funds, or so-called funds of funds (FoF). But without a doubt, clearly establishing the purpose of investments in startups makes it easier to define the appropriate vehicle for each corporation.

Luis Hernández Alburquerque is an expert leader in Corporate Venturing and Corporate Venture Capital (CVC) focused on transforming mindsets to build growing organizations based on innovation, technology and venture investments.