Corporations: A New Player In The Venture Capital World Of Start-Ups

Thursday, December 12, 2013 - 16:31

The Editor interviews Judith M. O’Brien, Partner in the Silicon Valley office of King & Spalding LLP.

Editor: Please tell us about your background.

O’Brien: In addition to being a partner and a member of the firm’s Corporate Practice Group, I head King & Spalding’s Emerging Company Practice Group. 

I was at Wilson Sonsini for many years in the 1980s and ’90s, where my practice was venture capital. I then co-founded a venture firm in 2001 followed by acting as general counsel at a fast-growing start-up before returning to King & Spalding in November 2012.

Editor: What new phenomena are you seeing in the venture capital industry?

O’Brien: As the number of venture capital firms is diminishing and the amount of money being raised by venture firms is shrinking, we’re seeing many corporate investors coming into the venture market and making strategic investments. Many of the small companies we’re working with are increasingly taking money from large corporations rather than from the venture capital industry and many of our large clients are forming venture funds and investing in start-ups. According to an article recently in The San Jose Mercury-News, in the first nine months of this year, corporate investors invested approximately $5 billion in the venture industry, which is up considerably from prior years. That number was around $1 billion for all of 2012.

Editor: What is the motivation for companies to invest directly in small start-ups?

O’Brien: Corporations are finding they need to innovate with new business models, new business methods, innovations to existing products and services and new products and features in order to grow. This may mean a new manufacturing technique, or a new marketing technique – whether it’s using social media, leveraging an aspect of Big Data or developing their e-commerce. Corporations are seeing that they can benefit from knowing what’s happening in the start-up community and identifying technologies to solve their requirements, then investing early in the companies developing those technologies.

We’ve witnessed this phenomenon a great deal in the automotive industry. Cars today employ many different kinds of semiconductor technology, and they’re equipped with wifi, bluetooth and other media. They are looking for ways to improve braking systems, fuel efficiency and many other requirements. The so-called connected car is becoming more and more real. In the not-too-distant future, apps will enable the car to self-diagnose mechanical problems or guide the driver away from heavy traffic. These features will require all kinds of other technologies, including traffic information, automation, etc., along with new manufacturing techniques to build them.

Editor: Are corporations confining their search to the West Coast?

O’Brien: No, they are looking globally. I see many of the car companies in Silicon Valley, but they are in Atlanta as well as many states particularly in the southeastern U.S., and I’m sure they’re looking all over the world.

Editor: Are companies working through the venture capital companies or on their own?

O’Brien: They’re using many avenues. Some are working through their corporate development or business development groups, while others are setting up venture capital firms internally that may behave as captive funds (in which the managers are employees of the corporation) or as more external entities with their own independent structure, as with GE, CitiBank and Nokia.

The managers come to the Valley to meet with venture capitalists and visit tech incubators. We’re sending companies to a number of the venture funds that we’re working with. One of the challenges, of course, is finding the right technology.

A company called Startgrid, which recently opened in the Valley, is addressing this need. Startgrid is establishing a network for start-up companies that enables them to access talent, consultants and other resources. It’s a little bit like LinkedIn for start-up companies. But more importantly, Startgrid will give large corporations a mechanism for finding out who is solving the technical issues they’re facing. They’ll be able to investigate the 10 or 20 different solutions to their particular problem offered by sources around the country. When it’s up and running, Startgrid will be a very powerful tool for identifying the technologies – and the right investments – that these large companies need.

Editors: How are these corporations financing these deals?

O’Brien: My understanding is that they are largely financed by cash on balance sheets. Investing in a start-up that already has, or is working on, a desired solution becomes an alternative to investing in internal R&D.

Editor: Are they investing with an eye to acquiring these companies?

O’Brien: Occasionally – but acquisition is not necessarily the goal. These investments are really about accessing desired technology. And sometimes the corporation isn’t interested in owning that technology; they just want to make sure they have preferential or early access to it. Often they will seek exclusive relationships. We’re handling a handful of these strategic deals right now, and all of them involve some kind of commercial supplier relationship with the large company that’s making the investment. This might be a supplier agreement in which the investor has the right to purchase a product or technology, or it might be a license agreement. The relationship comes in various forms.

Editor: When did you notice the upsurge in these deals?

O’Brien: I would say it began about three or four years ago, and, as I mentioned, it’s grown very significantly this past year.

Editor: What are the issues that a general counsel needs to be aware of in this connection?

O’Brien: I think, first, they need to understand the goal of the corporation in the relationship. Is there a strategic goal or a return-on-investment goal? If it’s strategic, then the investment needs to be thought of differently than if ROI is the goal. First, general counsel must look at who’s running the internal organization and think about the appropriate structure: Should he or she be an employee of the company who receives a salary, or should he or she be a managing director of an independent entity that gets a carry on the profits? If the purpose is finding technology for the company, then what’s the best way to achieve that goal – how can the structure help the company achieve its purpose?

In addition, the GC should address conflicts of interests. Who is bringing the deal in? For example, if an employee is referring the deal to the venture fund, which in turn brings it to the company, is that employee an investor in the start-up, or is he or she being paid a fee of some sort for bringing money into the start-up?

The GC also should conduct a risk assessment of making the investment, as well as of the structure employed. For instance, in his risk assessment, the GC needs to decide what kind of control over the start-up does  the corporation want? There are legal risks and accounting requirements associated with control.  For example, if a start-up is losing money, the strategic investor probably does not want to consolidate its financial results so it wants to own less than 20 percent and does not want to control the board. If the corporation takes a board seat, its board member needs to understand that he or she is representing the shareholders in general in that role and not the strategic investor. There are many liability issues that can arise from  the structure of the investment.

Editor: In most cases, investors are not allowed to take board seats on companies even if they hold a dominant position.

O’Brien: I wouldn’t say they are not allowed to take a board seat as much as they need to think carefully about the risks of doing so. Other rights to consider include rights of first refusal to participate in future financings, rights to acquire the company and information rights. I should add that, in fact, many of these start-ups are actually not successful, and so GCs should be prepared for a write-off – i.e., they should consider the impact of writing off their investments on a quarterly basis and how that would influence their results for any particular quarter.

Editor: What procedures by way of due diligence should the GC and other management, including IT personnel, take once a target investment has been identified?

O’Brien: They need to understand the corporate structure and the rights of other shareholders. They need to understand the commercial relationships that the start-up has with other entities. And, they need to understand the intellectual property ownership and rights and make sure that the IP rights are clean and unencumbered.

There’s a balancing act to all of this from a fiscal perspective: if you’re making a small investment in a start-up company, how much do you want to spend on due diligence in terms of legal fees and your managers’ time?

Editor: Is antitrust a worry?

O’Brien: Not typically. You might have concerns if you’ve made a large investment in a company like Twitter or Facebook and you’re coming in at a later stage. Most of the companies I’m speaking of are early-stage companies into which a corporation is putting in a million dollars or so at a relatively low evaluation, so antitrust concerns typically don’t arise.

Editor: Are you seeing internal counsel of companies making this kind of strategic investment handling these deals themselves, or are they using outside counsel?

O’Brien: It’s mixed. Many of them do use outside counsel. We send them deals, and we also frequently represent them in their investments. Companies like Intel, Cisco and Google that make many of these investments typically have large internal groups who are dedicated to these kinds of deals. But the corporate newcomers are tending to use outside counsel much more.

Editor: Can you give us an example of some recent activity?

O’Brien: Walmart has had a large local group for years, but Target also now has a local group that is actively looking for new technology and innovation.  They’re looking for new technology to improve their e-commerce solutions, looking into cloud solutions, Big Data and mobile technologies to grow their marketing and advertising.

The car companies, which I mentioned before, are also quite active. The connected car concept is a big idea that’s out there, and a lot of companies are looking at different ways to participate in that industry. The fully connected car may be five or so years off, but it’s coming.

Meanwhile, we’ve got Jeff Bezos, who was quoted as saying Amazon plans to use drones for delivery, and Google is looking at using robots for its deliveries. So artificial intelligence, robots – there’s a lot of innovation in those areas that will be of great interest to large corporations.

Please email the interviewee at jmobrien@kslaw.com with questions about this interview.