Corporate Venturing
This article was originally published in Start Up
Executive Summary
Advice of Counsel addresses whether pharamaceutical and device companies are good sources of venture capital for early-stage companies.
Question: Are pharmaceutical and medical device companies a good source of venture capital for early-stage companies?
Answer: Although corporate venture capital may sound like an oxymoron, it is once again in vogue. Corporations such as BioChem Pharma Inc. , Corange Ltd. division Boehringer Mannheim GMBH , and Boston Scientific Corp. have recently set up dedicated venture capital funds.
On the other hand, from a historical standpoint, most corporate venture programs in the pharmaceutical (as well as other) sectors have had a disappointing record and have usually been discontinued, with a life span paralleling that of the CEO of a typical public biotechnology company.
Why is this the case? The difficulties with corporate venture capital programs fall into a few categories. The greatest problem with previous programs is that they were not established as truly free-standing operations free from influence from the mother company. This had several implications.
First, it was hard to attract experienced venture capital personnel, without the "carrot" of a 20% carried interest in the capital gains which the fund would realize. Salaries tended to be along the lines of the typical corporate pay scale, rather than the partner-level pay of $300,000 and more made possible in traditional funds by virtue of a 2.5% management fee. Not surprisingly, venture capitalists are an extremelyfinancially motivated group of people, and a corporate compensation structure did not suit their needs when judged against venture fund opportunities.
The second problem arising from the less than free-standing nature of these corporate funds was that the "deal flow" which they received from venture funds was poor. This is because the funds had their doubts about whether the corporate investor could be counted on to participate in multiple rounds of financing, or whether it would simply be a one-time player. Most venture funds have a ten to twelve year lifespan, a far longer timeframe than those accustomed to the vicissitudes of corporate life. Also, deal flow is intended to flow in two directions; experienced venture capitalists will only share their "best" deals with a recipient who is likely to provide equivalent quality deals in return. One solution to this problem for several corporations has been to have their venture funds managed by well-established venture firms with pre-existing deal flow, thereby providing the reciprocity needed to attract good deals from other investors.
A further difficulty with corporate venture funds has been the ever-present potential for conflicts of interest. Very often, the corporate investor would insist upon a seat on the portfolio company's Board of Directors, thereby potentially permitting exposure to sensitive information of potentially strategic importance. Alternatively, many corporate investors have asked for rights of first offer, first refusal, or similar rights of a strategic nature with respect to corporate partnering deals by portfolio companies.
On account of their (by definition) strategic orientation, corporate venture funds have tended not to be judged by the same investment criteria by which most venture capital funds are evaluated. In other words, the normal venture capital fund must plan on raising a new fund every three to five years, a process which takes at least a year and which involves numerous presentations to highly sophisticated pension funds and insurance companies, as well as various "gatekeeper" organizations which represent the interests of these entities. These investors have strict standards concerning internal rate of return, liquidity, and other financial issues, which provide the most important basis for their decision of whether or not to invest. Corporate venture funds have not typically been judged by similarly rigorous criteria.
Although all of this sounds quite negative, it is worth noting that the "new" corporate venture funds referred to above havebeen established as free-standing entities. Their sponsors have recruited personnel with significant venture industry experience. Each of the initiatives involves an independent "fund", which should have the capability to make multiple follow-on investments in the same portfolio company as it continues to grow and require further infusions of capital. Finally, the corporate sponsor of each fund has, to my knowledge, no special rights of access to technology or confidential information of a portfolio company.
Although the jury is very much still out on the viability of corporate venture capital, each of these new attempts seem to have learned from the mistakes of the past, hopefully giving each of them a much better likelihood of succeeding.
Michael Lytton is Chairman of the Technology Group at the Boston-based law firm, Palmer & Dodge. If you have any questions you'd like addressed in this column, or if you have comments, e-mail directly to mlytton @ palmerdodge.com.