Structuring a CVC: do not request strategic rights

Many executives that want to initiate corporate venturing activities already struggle answering the question how to set up a CVC organisation for success. The six guiding principles described in this series of articles are supposed to help answer this question.

Guiding Principle 1: create a traditional venture capital fund structure

Guiding Principle 2: define a clear investment focus

Guiding Principle 3: embrace fast decision-making

Guiding Principle 4: ensure long-term commitment

Guiding Principle 5: invest on market terms

Guiding Principle 6: do not Request Strategic Rights

As we pointed out in our last article in connection with guiding principle 5 (“Invest on market terms”), some CVCs tend to overpay. While overpaying may enable them to invest in some companies, not investing on market terms will haunt the CVC unit in the long run.

Some CVC units do not only tend to pay more, they often additionally ask for contractual rights that secure their strategic interests. Examples of such strategic rights are requests for exclusivity and rights to buy the whole company later on, especially on pre-determined terms (such as call-options, matching rights and rights of first refusal).

The problem with these strategic rights is that they may also have a severe detrimental impact on the likelihood that the startup can be sold for the highest price possible.

Exclusivity requests forbid the startup to cooperate with the corporation’s competitors and thereby naturally restrict business opportunities and the startup’s long-term valuation.

Rights to acquire all shares in the company may have the same effect. They may prevent other potential buyers to engage at all, because such potential other buyers will expect the CVC unit to exercise its rights to acquire the company (less competition on the deal, lower price). Such rights are usually exercised if the startup is successful and if the (pre-determined) purchase price is lower than the market price (lower price). If the CVC unit decides not to buy the company, this usually signals to the market that something may be wrong (less interest, less competition, lower price).

Since founders and traditional VCs usually strive for achieving the highest exit price possible, they are reluctant to accept financing from these “strategic investors”, at least if they can easily find investors willing to invest without these strategic strings attached. Requesting strategic rights may thus lead to an adverse selection where the CVC unit  ends up investing only in startups that cannot find other investors willing to further fund the respective venture.

We hence recommend refraining from asking for non-market standard strategic rights at all. If the CVC activities are conducted as a first step towards an acquisition of portfolio companies, being a shareholder in the respective company should always generate an opportunity to acquire the company anyway, although on market terms and not on predefined terms that are beneficial for the corporation but disadvantageous for founders and co-investors.

Patrick Flesner’s high-growth handbook FastScaling is available here.