Annual review 2017

Bold investments

Big companies across sectors are becoming active minority investors in early stage tech companies, calculating that this is the best way to gain access to new technologies and keep disruptive forces in their markets at bay. For many this is new ground and they are increasingly turning to us for help.

Simon Toms

Partner, Allen & Overy

Disruption has become a fact of life across almost every sector of the economy and established businesses and, with their market dominance under threat like never before, they are having to find new ways to fight back.

In planning their response, a growing number of businesses have come to a similar conclusion – that the best way to beat disruption is to embrace it, and the quickest way to embrace it is to invest in the very companies and technologies that threaten to disrupt them.

As Simon Toms, a corporate partner in our London office, puts it: “These big businesses could choose to change their business models or adjust their behaviour to emulate the disruptors. They could invest in building a fully-fledged tech capability of their own.

“But all that’s pretty hard to do if you’re a large company even if you’ve got a growing number of nimble challengers disrupting your existing markets,” he says.

“They’re conscious too that early stage companies can grow very fast in this environment, where Google, Facebook, PayPal and eBay barely existed 15 years ago. They know they need to move quickly.”

By becoming providers of growth capital through corporate venturing they are actually following a fairly well-trodden path.

For the last ten years or more, some of the most successful businesses in the tech and life sciences sector have been carefully building their competitiveness and capabilities by making carefully selected investments in niche start-up businesses to gain access to market-changing ideas, intellectual property and talented people.

Now this is becoming the strategy of choice for companies in a diverse range of sectors. Companies are setting up corporate venture funds, incubators and accelerators to make strategic minority investments in promising technologies and the entrepreneurs behind them.

“They know that by making a series of such investments they will gain a unique view of where key technologies are going and which ones have the best chance of making a difference,” says Simon.

“Of course some transactions might not be successful, but by making a series of small targeted investments the calculation is that they will see many more things than they would ever see if they’d tried it alone.”

In addition, it allows companies to work with talented people who might not normally be interested in working in a big corporate environment. Indeed, many tech entrepreneurs are people who have deliberately stepped away from the corporate world to work in the more relaxed and unstructured start-up environment.

And the relationship, if properly established, is a symbiotic one. Big company investors can offer other things of great value on top of much needed capital to start-ups that are not only pre-profit but also often pre-revenue and hard-pressed to raise more conventional bank financing.

“They bring industry, customer and product knowledge, access to other players in the market, a ready environment in which to try out their ideas and the ability to give the new company a credibility and scale it could not hope to have as a start-up standing alone,” says Simon.

Unfamiliar territoryRead more

The difficulty is that this is new ground for both buyers and sellers.

Big companies, though perhaps adept at completing large strategic M&A transactions, will often have no experience of minority investing in start-up companies. Similarly, entrepreneurs may be at an equal loss to know how to deal with a big corporate investor on acceptable terms.

The potential for misunderstanding and culture clash is great, and that raises the risk of investments backfiring.

As Simon puts it: “A big company used to having clear policies, committees, handbooks and all the good things it has to have can pretty easily put a small start-up off by trying to impose its culture. And that’s where we can come in and bridge the gap, not just from a legal perspective but by trying to explain that a minority investor relationship is different, more like a joint venture and a long-term partnership than trying to impose control.”

This is fertile ground for A&O because there is a growing recognition that such deals, even if relatively speculative, require careful planning, appropriate legal structuring and specialist due diligence ahead of and throughout the lifecycle of the transaction if they are to have a chance of long-term success, says Simon.

“We are now working with clients in sectors as diverse as financial services, aerospace, retailing and automotive and across a wide range of jurisdictions, including the UK, France, Germany, Australia, Singapore and China, helping them to frame investments that are sustainable and create value for both sides of the deal.”

Addressing issuesRead more

Simon highlights some of the issues big investors need to be thinking about.

“It’s essential that corporate investors have the right governance procedures in place, including efficient processes to gain clearance for a deal. Unlike private equity (PE) houses and venture capital firms (VCs), they rarely have investment committees. Without them they can move too slowly or, worse still, make ill-judged investment decisions.”

Establishing the true long-term value of a start-up is always tricky, often requiring convertible preference share or loan note structures to push the question of valuation further down the road and to guarantee the right returns for investors.

While there might be a temptation to seek exclusivity over a technology being developed by the start-up, investors need to be realistic. The business case for the technology might well depend on broad market adoption including, potentially, by competitors of the investor.

Due diligence is critical, but necessarily different in these deals. Since the start-up may not yet have a customer base, there will be less need to scrutinise material customer contracts. Instead the diligence needs to focus primarily on issues such as regulatory risk for new products and ownership of intellectual property (IP) to make sure that the start-up really owns what is often the key value driver for the business in the long term. Such issues will be a major feature of the investment terms drawn up to support the deal.

Establishing real trust is also worth investing time and effort in, says Simon. Big companies are often investing in the founders of the company who are, and are likely to remain, a key asset. Strong clauses guaranteeing a fair return for all investors and covering founders leaving the company will be essential.

“Key members of the team may be vital to the value of the company. Taking care to incentivise important members of the team as part of the bigger organisation can pay huge dividends.”

As an adviser and as an investor in our own right, we have common cause with our clients here.

“Companies making these investments want to do things right because they’ve got policies, procedures, a legal team, a board. Even if they are making a relatively small and sometimes speculative investment, they need to dot the ‘i’s and cross the ‘t’s.”

“Getting that right requires careful thought,” says Simon. “But having a good governance structure in place will ultimately mean investors remain nimble, agile and, hopefully, ahead of their competitors.”

For the last ten years or more, some of the most successful businesses in the tech and life sciences sector have been carefully building their competitiveness and capabilities by making carefully selected investments in niche start-up businesses to gain access to market-changing ideas, intellectual property and talented people.