Over the last couple of years, corporates have increasingly started launching specialized startup investment funds, accelerators and other financial vehicles- competing directly with VCs to invest in the hottest startups and tech. In 2016 alone, corporate investors (CVCs) invested $32.2 billion across 1,203 startup deals, nearly one third of the total $71.6 billion venture capital activity reported in the US that year and contributed to 14.1% of closed deals.
More and more, startups are turning towards CVCs as a desirable- if not preferred source of funding. Despite the complicit ‘strings attached‘ that goes hand-in-hand with corporate investment- it also opens up the doors to leveraging company assets, markets, knowledge and networks- a compelling value proposition compared to traditional VC firms.
Despite venture capital activity cooling slightly, startup valuations remain at an all time high, and are showing no signs of declining. In fact, according to the latest Pitchbook data, not only have valuations continued to rise- but we’re seeing the highest pre-money valuation medians in a decade. In the first quarter of 2017, late-stage pre-money valuations hit a median of $65 million, whilst early-stage (Series A & B) saw medians of $20 million. In parallel, whilst angel and seed hit pre-money valuations of just $1.53 million- this is in stark contrast to the pre-money valuation of startups undertaking their first VC rounds- peaking at $7.3 million. Why? The most probable factor is that startups are bootstrapping longer, and raising money later- increasing their valuations across all venture stages. In addition, despite VC deals having slowed down- venture capital firms have been able to raise an unprecedented amount of capital in 2016-17. More resilient ventures, and more money to boot equals more excessive valuations?
So in the age of sky-high valuations, what does corporate venturing have to do with it?
First, let’s keep in mind that the investment priorities of corporate investors differ from their traditional VC counterparts. Whilst the first invests to generate financial returns, CVCs are more inclined to be driven by short to long-term strategic factors that will affect how they build their investment portfolio.
By nature, corporates are slow to embrace change, and their growth has stagnated with the emergence of new technology giants and startup disrupters. Not only do they innovate more slowly, but their R&D costs represents potentially risky, and perpetuated sunk costs that are carried forward from balance sheet to balance sheet. Coupled with a shifting consumer landscape, changing demographics and the rise of consumer spending from West to East- corporate venturing has become popular for a reason. Not only does it provide access to new products, markets and consumer categories- it enables a corporate to experiment with an alternative financial vehicle that has a limited risk profile for the company. Ultimately, investing in startups greatly lowers the cost of R&D and innovation- and as most corporate units aren’t written into a balance sheet- it gives it more room to scale its R&D and technology activities.
The added benefit? The startup has probably done most of the hard work for you already, and the corporate get’s to look like it’s keeping up with the millennials.
But the very same strategic factors that are driving corporates to invest in startups are pushing pre-money valuations up.
If we look more deeply into Pitchbook’s valuation data, we can see that early-stage rounds which include a CVC investor have a median valuation of $26 million in 2016. In contrast, early-stage rounds backed by VC’s ‘only‘ see a median valuation of $16.5 million.
A similar, if not heftier gap can be witnessed in late-stage investments. With traditional VC’s on-board, the median valuation is $41.8 million. Add a corporate investor to the mix, and this doubles to $80.6 million- or $100 million if we count the first quarter of 2017.
This begs the question: do CVCs bring such value to a startup that the price tag becomes justified; or does a lack of financial motivation eradicate their common sense?
To answer this question, we have to start by looking at the performance of startups that have received corporate venturing capital.
Research based on a sample of European CVC and VC backed high-tech startups shows that the overall economic performance (growth, sales, channels and production) is 50% higher for CVC-backed startups, compared to 41% for VC-backed ventures. However, VC-backed startups witness much better short-term performance (26%) than their CVC counterparts- who in turn, perform 67% better in the long-term, compared to 58% for traditional VC-backed firms.
This is indicative of the long-term investment strategy typically deployed by CVC when investing in startups, and clearly demonstrates that startups can make better use of corporate resources when investment is conducted within a long-term horizon.
There also seems to exist positive ties between startup innovation performance and CVC- however- this is influenced by previous ability to raise capital as well as IP. What does this mean? Put simply, corporate investments increase a startups innovation value, if- and only if– the venture has already raised a previous VC-backed round, and has IP to speak of. In addition, another study found that raising a CVC round in the first three years will increase the startup’s patenting rate- however, not only will this dramatically diminish over time, but negatively impacts the venture’s long-term innovation capabilities as well as exit outcomes.
This body of evidence correlates with the CVC valuation trends we are seeing- and why they occur. They help explain why CVCs are increasingly moving towards later-stage investments (due to the correlation between age, performance and innovation capacity) as well as the long-term strategic factors that drive valuations up.
But here’s the kicker- valuations aren’t just driven by the future value and performance of a startup- they’re driven by what motivates corporates to invest in the first place.
Which takes us back to the start. Corporate venturing deals are continuously growing, as are the number of CVC funds. Some are old hands at these types of deals, detaining a successful track-record in M&A transactions- whilst others have good intentions- but lack the appropriate vehicles, governance and structure to strategically invest in startups. As a result, this significantly impacts on the valuations and their ability to generate value for their portfolio.
For example, CVCs that build a startup investment portfolio that has a strong strategic direction, and is aligned with the long-term vision of the company are less likely to assign high-valuations to startups. They are also much more likely to be able to manage their assets to create value-added for their portfolio, meaning that startups that benefit from their investment are willing to negotiate a discounted valuation in exchange for much more rapid growth.
In contrast, CVCs that have an unfocused strategic motivation (be it financial, analytical, innovation etc.) are much more likely to pay over-the-roof valuations for startups. Not only is it a lack of experience (it’s easy to get caught up in the hype), but their lack of direction makes them unattractive investment candidates for startups that are shopping around. Therefore, as a trade-off, these types of CVCs make themselves more desirable by being willing to pay higher valuations (a theory supported by Fred Wilson of Union Square Ventures). In addition, the risk and uncertainty over potential value-added can be swung in favour of the startup- who is more likely to push for a higher valuation when raising the next round, and may have the added benefit of being less ‘locked-into‘ the relationship.
So yes, the ‘corporate stampede’ plays a role in sustaining the startup valuation bubble.
According to the GCVA, at year-end 2015, there was over 1,500 CVC units globally, and 801 active CVC funds (who had at least made one investment in the last year). That’s up 79% from the paltry 448 active CVCs in 2011.
Globally, the average value of a CVC Series A rose from $4M in 2012, to $7M in 2015. But the biggest jump is also shown here in late-stage rounds. Series D deal size doubles over three years from an average value of $20 million to $40 million, whilst Series E and above jumps from $25 million, to $65 million.
So these heightened valuations must mean better exits?
The likelihood of an exit is very much tied to the startup life-cycle in which the CVC invested. The earlier the stage of investment, the less likely the startup is going to exit or have an IPO. A study goes even so far as to suggest that CVC funds have a detrimental impact on first-time founders, with incentives and strategic direction provided by the company inadvertently ‘tying-in‘ the founders regardless of equity or exit opportunities.
It’s not much better in the IPO market. Another study of 437 VC and CVC-backed startups that went on to IPO found there was no difference in the valuation between both VC and CVC-backed startups. This means that corporate-backed startups are not perceived by market investors as being more valuable, resilient or trustworthy than other types of investments- and were on the contrary typically marked down by 20% on opening day.
Maybe Fred Wilson does have it right.
If CVC investments are mostly strategic, and they are driving astronomical valuations- why don’t they just acquire the startups rather than remain a minority shareholder?
The answer to this of course is three-fold:
- It doesn’t look as good on paper;
- It looks even worst on a balance sheet;
- The corporate train would drain the startup of its innovative capacity faster than you can say Hyperloop.
Note from the author:
For all the new corporate venturing funds out-there: Clearly outline your underlying strategic motivations for launching a fund, and be realistic of how and where you can allocate your resources to drive startup value and performance. Understand that the return on your investment will drive long-term sales value and competitiveness for your company, rather than a significant financial gain. Keep in mind that the likelihood of an acquisition (by you or a third party) is more likely to occur than the startup going public (as cool as that may sound).
Which brings us to another important factor: Always have exit vehicles in place- you are no different than traditional VCs in this manner. At some point, you either have to eat the startup, or set them free. And please, if you’re conducting your first investments, don’t make yourself more attractive by overvaluing your startup. Not only does it make little financial sense, but you’re potentially locking-out any future investors through a terrible cap table. If you do this, you may as well acquire it. Build a track-record as part of a syndicate instead and then launch a dedicated fund.