Monday, September 20, 2010

The Challenge of Adding a Corporate Investor

The corporate VC is the unicorn of high risk investing: while many sing of them, few have ever really seen one up close. This is why I recommend to start-ups who find themselves dealing with corporate investor that they should assume they are engaged in a business development exercise and frame their disclosures and their deal terms accordingly. Here's why:

With the exception of a notable few (Dell, AT&T), few corporations establish separate corporate venture funds. More often, companies establish venture "programs" for which specific funds are notionally budgeted, but not reserved. Investments are tightly linked to corporate strategy, and often made to test out new lines of business and/or as a first step in an acquisition.

This loose structure makes most corporate venturing models inherently unpredictable. In some cases, taking investment from a large corporate investor can ultimately cost you market share. Just ask Craiglist, which has for the last few years been locked in a litigation battle with its shareholder, eBay.

On Sept. 9, the Delaware Chancery Court issued the latest ruling in the ongoing dispute between Craigslist, its founders, and eBay, which had invested $32 million in Craigslist in 2004 in exchange for a 28.4% stake in the business.

eBay's investment had a typical structure: it received a board seat and special approval rights over certain corporate decisions. The stockholders agreement even provided that if eBay opened a business that competed with Craiglist, eBay would lose forfeit its approval rights, leaving the founders free to remove eBay's board seat and to run the business.

The problem with these terms is that they did not incent the investor to grow Craigslist. There do not appear to be restrictions in the stockholders agreement on who eBay's could place on the Craigslist board, nor on who at eBay could access confidential information about Craigslist, its technology or its business model. The absence of any controls in some ways incented eBay to create its own alternative to Craigslist.

When a corporation places one of its employees on an investee board, a clash of cultures often results. I've seen this happen time and again: nominees from mature companies often equate the looser startup atmosphere with incompetency. This often leads to the inevitable "we could do it better ourselves" way of thinking. The board books distributed to directors each month enable this further, by providing nominee directors with the kind of information that, coincidentally enough, is the same information an employee would want to collect in order to draft the business case for an internal new product proposal at his business.

eBay's investment in Craigslist seems to have taken this course. According to Business Net, eBay even admited that it used the confidential information it obtained as a board member and investor about Craigslist to help Kijiiji, eBay's competitive classified service. The lawsuits continue.

For me, Craigslist is a cautionary tale on the problems that come if you assume that a corporate investor should be treated in the same fashion as any other institutional investor. Corporate investor 101:

1. Do your homework and understand what kind of investor you are dealing with.

2. Unless you are dealing with the fabled unicorn, you need to assume that there is a risk your shareholder will become a competitor.

3. Insist on a Chinese wall between those who are managing the investment in your business, and those in your investor's operations who might compete with that business. The two worlds should never co-mingle.

4. Avoid corporate investors who could easily displace your company if their corporate strategy shifted. The bigger the partner, the bigger the risk to you if they set up their own competitive business. It may not be enough to reduce their shareholder role in the business if your investor has cannibalized your position in the marketplace.