In April 2015, when we published “The Art of the Corporate VC Divestiture,” which detailed exit options for corporate venture capital (“CVC”), we could never have predicted how much CVC activity would grow or how important divestitures would become in the ecosystem. Since 2015, over 700 new CVCs have entered the market1 and nearly every Fortune 500 company has or is considering building a CVC arm. As the venture ecosystem continues to grow, there are more opportunities for corporate partnerships and collaboration than ever before. Startups are also more receptive than ever to CVC investment – 37% of 2023 US venture deals thus far have included a CVC on a capital invested basis2.
In that article we also pointed out that corporate venture activity tends to mirror the macroeconomic cycle. This is especially relevant today. When times are good, corporations can make longer-term investments in innovation to “future-proof” their business. In market downturns, however, corporate priorities can change quickly to address shorter-term needs. This may include increased focus on quarterly earnings, need for cash previously reserved for CVC investment, and increased scrutiny of the performance of venture activities. At the same time, liquidity in the existing CVC portfolio may dry up, due to capital markets conditions, at a time when liquidity is needed most.
There are a few ways for CVCs to manage through this increased scrutiny of costs and profitability, including hiring freezes, reductions in new and follow-on investment activity, support and focus on the existing portfolio, and lastly portfolio exits and divestiture. In this last option, it certainly is never easy to sell a portfolio or spin out a team, and it can be especially difficult to sell into a depressed market. However, we believe one should never waste a good crisis. A cycle can be used to reset a portfolio, create economic alignment for the future, incentivize the team and remove non-strategic assets. Just like the C-suite executives who need to make decisive moves during a downturn, CVCs can and should be a part of these shifting priorities.
Divestiture options
Whether it is a single asset or a basket, selling assets could be a way to refocus the corporation’s effort and capital on the most important portfolio companies. CVC is a “numbers game,” resulting in several smaller bets in hopes of creating strategic value. As the non-core companies raise follow-on capital and drift further from the core strategic priorities of the parent company, they can become a liability, especially in a downturn. According to Mike Piechalak, Partner at Rakuten Capital, “Selling a non-core portfolio can be helpful in focusing the organization’s priorities and redeploying capital in more strategic businesses.”
Furthermore, while exit valuations during a downturn may not be ideal, any cash generated from secondary sales (while M&A and IPO activity is paused) will help fund new CVC investments at a time when round valuations are also lower, particularly when re-invested into earlier-stage companies.
The spin-out option
A corporate venture spin-out is never easy, regardless of the cycle. It requires a number of key pre-conditions including team motivation, resources and capital for the spin out unit, and corporate-parent willingness. What can change significantly during a downturn is corporate willingness, due to the aforementioned changes in corporate priorities. CVCs who have lived through a change in corporate priorities know exactly how important it can be to diversify an investor base and create the right long-term economic incentives alignment. Chris Langford, Founder of Lowes Ventures and Partner at Home Technology Ventures, experienced this kind of change while at Lowes. “For CVCs who have built a portfolio that is further away from the core operations, a spin-out can be a solution as it allows the parents to generate some level of proceeds and reset CVC priorities while enabling the previous portfolio companies to find an investor base that is more likely to support them going forward.”
Of course, fundraising does become more difficult in a downturn. This is where secondary can be useful in generating liquidity for a corporate parent to reinvest as primary commitment into the spin-out entity. While any path will be difficult, any new money raised for an independent organization is going to be more rewarding for team members as carry and performance-related bonuses are incorporated to align fund managers with their LPs.
Third-party capital
There are other solutions that do not involve a full spin-out that can be tailored to suit the needs of a CVC. A continuation vehicle can be formed to transfer a CVC’s assets into a new vehicle with reset economics, without the need to fully spin out the team from the corporate parent. Bringing in third-party capital while maintaining corporate sponsorship as the anchor can help incentivize GP terms like management fee and/or carried interest, which could in turn help the corporate venture unit with retention, recruitment and financial performance. It’s important for CVCs to find an experienced partner who can offer bespoke solutions as they weigh their options.
In summary, during a downturn, it is imperative for CVC teams to adjust to parent company needs and react quickly. It’s also in the CVC unit’s best interest, as the hard work and investments made during a downturn could ultimately result in the most exciting opportunities in the future.