Need More Than Money? Find A Big White Knight
(FORTUNE Small Business) – Last year when Keith Brown decided to transform his software company, BuildSoft Inc., into a B2B exchange that links residential builders, suppliers, and subcontractors over the Internet, he knew success hinged on his ability to build the virtual hub at breakneck speed. Besides capital, Brown needed powerful industry partners that had the products, marketing, and distribution capabilities his fledgling, BuildNet, needed. So after snaring $35 million in capital for his Raleigh venture in May 1999, he went on the prowl for corporate financiers. Seven months later, the 41-year-old engineered a $104 million private placement. Among investors were nearly a dozen industry titans, including homebuilder Lennar and building-materials manufacturer Owens Corning. The corporate knights' charge: to fund development and help find users for the cyberexchange.
Brown's financial coup is not unusual in today's world of corporate finance. Increasingly, newbie tech companies--especially dot-coms--are aligning themselves with corporate investors who not only provide everything from seed to mezzanine finance but also help catapult a portfolio company's products and services into the marketplace. Enticed by an opportunity to get access to R&D and develop new business ventures, corporations of all kinds (not just the brassiest technology giants such as Cisco Systems and Intel) have taken up the VC practice. Today's investors include not only Owens Corning but also such blue chips as Chevron and General Electric as well as dot-coms and insurers.
According to the National Venture Capital Association, more than 900 corporations dabble in the VC industry, up from 65 five years ago. Their imprint on the venture capital market is impressive. Last year, 30% of all venture capital raised came from corporations, up from 5% in the early 1990s. Although some, such as GE, Intel, and Lucent, have dedicated venture arms, others such as Owens Corning invest ad hoc through their various business units.
Entrepreneurs feel empowered by the trend, because there are many advantages when hooking a strategic partner. The right mate can share technical information, help an owner make business decisions, introduce him to new customers, and lend a hand in marketing and distribution. In BuildNet's case, corporate partners are diligently trying to get the building industry to adopt the system by linking their own suppliers and customers to the exchange, which should roll out by year's end.
Just as important, corporate partners give a startup credibility, and they can open doors otherwise locked to entrepreneurs. When two former insurance litigators, Charles Brofman and James Burchetta, went hunting for seed capital for their New York City startup Cybersettle.com two years ago, they knew they needed corporate investors who could help market their Web tool to the insurance industry. Their concept was unique: Through a blind bid-and-offer process on their site, insurance companies could settle claims with accident victims.
To find a corporate knight, the duo turned to a middleman with connections. They chose the Kaye Group, an insurance brokerage also based in New York City, with which they had worked before. The group anted up $500,000 in exchange for a minority holding and introduced the founders to ING Barings Furman Selz, an investment bank that could help find potential corporate VCs.
In just over a month, ING Barings got NAC Reinsurance (now part of XL Capital, a financial-services company in Bermuda) to invest $8.5 million in Cybersettle.com. Although the founders had to give up a 51% equity stake of their startup to clinch the deal, it was worth it. "NAC Re's management team knew everyone at the helm of all our potential insurance clients," says Burchetta, "and could get us in the door so we could make the case for our service." To date, Cybersettle has signed 180 insurance companies.
Another benefit of becoming partners with a corporate VC investor is that many accept flexible, creative financial terms. Although NAC Re took a 51% preferred stock holding in Cybersettle.com, it allowed the founders to retain what's called supermajority veto power, which means they have equal say with NAC Re on all financial and company control issues. In BuildNet's case, most of its corporate VCs took warrants instead of common shares. The warrants vest on a sliding schedule based on how the corporate partners market the exchange and drive adoption of the system among builders, suppliers, and manufacturers.
So how should entrepreneurs choose a partner? "First, find an investor that has strategic goals that complement yours," says Roy Martinez, a VC investor at Intel Capital. At times corporate VCs invest in concerns as a precursor to an acquisition. Others do it to get access to a portfolio company's intellectual property and know-how. That's why it's critical to research their hidden agenda.
Every entrepreneur's goal should be to avoid any unhappy surprises after clinching a deal. Just ask Ken Burke, CEO of Multimedia Live Inc., a Website-development firm in Petaluma, Calif. After nine months of heated negotiations with printing giant R.R. Donnelley & Sons, he got $3.5 million in venture capital to expand his firm. He never imagined it would take so long, because he had a preexisting marketing agreement with Donnelley (which called for Multimedia to design sites for some of its partner's clients) and knew its top managers.
But after the deal closed, Burke claims that Donnelley outsourced fewer services from Multimedia. That's because Donnelley became familiar with the Web firm's know-how and trained its own staff to offer similar services, Burke says.
His mistake was that he had no separate strategic partnership agreement with his corporate VCs outlining extra services Donnelley would give Multimedia and the consulting assistance Multimedia would provide its partner. "I never thought I needed one," Burke says.
According to Intel's Martinez, entrepreneurs should secure some kind of "prenuptial" agreement with a corporate VC before signing a deal. Ideally, it should be linked to the terms of the VC financing. That's because these marriages can't work if both partners aren't clear about their roles in the relationship from day one.
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