Corporate venture capital—venture investing by large corporations and other institutions for both financial and strategic objectives—has grown significantly over the last decade and has become an integral part of the innovation and growth strategy for a broad range of companies. According to Global Corporate Venturing Analytics, in 2019 there were 1,854 active CVC units worldwide who invested over $130 billion globally in over 3,300 investment transactions (compared to 382 CVC units investing $22 billion globally in roughly 850 investment transactions in 2011). As part of this significant expansion, CVC units have gained a greater understanding of the startup and venture capital ecosystem and how to build collaborative investment partnerships, which in turn has led to broader acceptance of CVC participants as value-added contributors to a startup’s investment syndicate. In addition to the significant increase in new CVC units, existing units have gained traction and influence within their parent companies, leading not only to a greater number of transactions, but also to transactions of significant complexity where commercial relationships and critical intellectual property considerations are an increasingly integral part of the overall transaction.
It is still too early to tell how the recent market downturn resulting from the novel coronavirus will impact the overall CVC ecosystem, but based on discussions with numerous CVC clients and others in the industry we believe most CVC units will continue to drive forward in search of valuable investment partnerships to help their parent companies innovate through the challenging times ahead. During this time, supporting and developing valuable commercial relationships and properly addressing key IP considerations in evaluating investment transactions will likely play an even more critical role in building successful investment partnerships. We explore the key IP and commercial due diligence areas that need to be evaluated in connection with such transactions below.
First, Understand the Strategic Objectives
What motivates a CVC unit’s behavior in any particular transaction depends on the objectives underlying such investment. While traditional venture capital and CVC investments both desire to achieve positive financial results, CVC units and their parent organizations often have equally important strategic objectives for their investment programs. The range of desired strategic benefits to a CVC and its parent company of a particular investment often include one or more of the following:
- Obtaining direct access to innovations to enhance existing IP assets, technologies, products and services through potential future commercial agreements or acquisitions
- Seeding an ecosystem to build demand for its own IP assets, technologies, products and services
- Exploring new technologies and businesses without diverting its own R&D resources
- Participating in business segments it may not be able to engage in directly
- Branding itself as innovative by engaging with noteworthy emerging technologies or business sectors
- Establishing or enhancing an internal culture of innovation
- Monitoring technology and industry trends
The path to achieving these strategic objectives will vary, depending on the depth of the relationship between the portfolio company, the CVC and its parent organization. At the one extreme, the relationship between a portfolio company and the CVC’s parent organization may be more passive because a financial objective dominates or strategic objectives are less direct. That relationship often becomes more intentional and integrated as one moves along the continuum toward transactions with greater strategic alignment, in particular when a future commercial relationship or the possibility of licensing or acquiring IP or data assets (or entire businesses) down the road are critical to the investment’s potential strategic success. The CVC’s strategic objectives for a given transaction will define how it approaches IP and commercial due diligence when evaluating an investment opportunity.
Next, Align IP and Commercial Due Diligence Considerations with Strategic Intent
Regardless of an investment’s objectives, we can expect that a CVC transaction will include a baseline level of IP and commercial due diligence similar to the due diligence required in traditional venture capital deals:
- IP Ownership. At a minimum, the CVC unit will want to ensure that the company, to the extent it has developed any existing IP assets, has clear title to its intellectual property, and that there are no actual or potential third-party ownership claims. This means ensuring a proper chain of title such that the founders and any other employees or consultants have cleanly assigned to the company all rights they may have in any pre-existing intellectual property (and any intellectual property that such personnel develop during the course of providing services to the company) that is used in or relates to the company’s business, as well as ensuring that no third party may have competing claims to that intellectual property—for example, if the intellectual property at issue was created at a time when the founder was employed by or acting as a consultant to another company. This includes situations where a founder may have developed technology under the auspices of a university or government-funded research program. Special attention will also be paid to situations where the company has engaged in bespoke or joint-development efforts with third parties to ensure that the company has retained all relevant IP rights.
- IP Protection. Like traditional venture capital firms, CVCs will look to see what steps the company has taken to protect core IP assets, such as applying for patent protection for innovative technology and safeguarding trade secret information. While it is less common for companies to register copyrights in software, a CVC will want assurances that a company appropriately stores, monitors and restricts access to source code and any other valuable data the company may own. Likewise, sensitive business and other technical information should be protected by confidentiality agreements and disseminated in a responsible way. Finally, it is essential particularly in the consumer context that the company has diligently managed its brand, including by seeking trademark registrations in key markets and undertaking a thoughtful monitoring and enforcement program.
- Data Protection and Compliance. For many businesses, data is itself a separate and critical IP asset that a company needs to develop, properly collect and secure, and maintain and use in compliance with an expanding set of applicable regulations. Baseline diligence for any company where data is an applicable IP asset (and, more importantly, for data-centric companies) involves identifying a company’s sources and uses of different types of data; evaluating a company’s privacy policies and its processes for collecting and storing different types of data; and reviewing the implementation and effectiveness of a company’s compliance programs for the various local, federal and international regulations that apply to the company’s business (as well as any plans to remediate existing compliance breaches and/or plans to adapt to new compliance regimes that might become applicable when entering new markets).
- IP Claims. While smaller companies will typically be below a potential plaintiff’s radar and thus not have received any claims of infringement, companies can expect traditional venture capital and CVC units to dig into any actual or threatened claims. This includes patent licensing and similar letters and notices from nonpracticing entities (i.e., patent trolls); claims by former founders or employees and their former employers; cease and desist letters and opposition notices received in the exploitation or prosecution of the company’s branding; and indemnification claims tendered by customers and partners. Likewise, there will be an examination of the company’s use of third-party technology to ensure that proper licenses have been obtained and adhered to. This is particularly important for the use of open source software that is licensed under terms that include so-called “copyleft” provisions, to confirm that the company has not inadvertently exposed its own proprietary code in a manner that would require disclosing that code to the public to comply with the license terms.
- Material Commercial Agreements. Like traditional venture capital investors, CVC units will also typically conduct a baseline level of diligence on a company’s critical licenses, supplier and vendor agreements, and other material contracts. In reviewing such agreements, attention typically focuses on identifying areas of material risk and potential liability exposure (e.g., critical agreements that terminate on a sale transaction) and evaluating whether certain material agreements support key business and financial assumptions on which an investment is based (e.g., revenue-generating agreements that are terminable at-will or on short notice from the customer). Recent economic and related events stemming from the current pandemic may also force CVCs to scrutinize commercial agreements more carefully as a baseline to any investment transaction, including whether or not the company can, in fact, perform its obligations and/or how such events may impact a company’s supply chain or other business operations both now and in the future.
CVC investment offers many benefits to the portfolio company. First, the CVC and its parent organization will bring in-depth industry knowledge and experience that can help foster the company’s success. Additionally, the parent organization may later pursue a broader commercial relationship or other transaction with the company. These benefits come with the need for the company to understand the business dynamics of a large organization, where investments with greater importance or strategic alignment require the CVC to complete a deeper level of diligence before making such an investment. For example:
- Evidence of Misappropriation. While inadvertent patent infringement can often be understood as a risk of doing business, trade secret claims in particular and some copyright claims have at their core an element of scienter and intentionality. Even where the objective of a CVC investment is largely financial, a CVC and its parent organization will not want to tarnish its own brand and reputation through association with a company that carries the stigma of a bad actor. The same effect can flow from a company’s blatant or reckless misuse of open source software, particularly in consumer-oriented products where the open source community tends to be highly vocal and intolerant of noncompliance. CVCs will often look more carefully at data security and protection of any valuable customer or other data held by the company to ensure that the company is not at risk of a potential data breach, which not only potentially undermines the CVC parent’s reputation, but may also invite significant regulatory or class action risk.
- Patent Matters. CVCs in certain technology sectors will pay additional attention to a company’s positioning in patent matters. In crowded fields, CVCs may be more prone to examine the quality and strength of a company’s patent portfolio to determine if its investment is worthwhile or if others will simply be able to freely replicate the technology in the short term. On the other side of the coin, a CVC’s parent organization may have specialized knowledge and be wary of patent thickets, causing it to at least enquire about any freedom-to-operate analyses that have been conducted. In some cases (although somewhat rare) the parent organization may even require a company to undertake such analyses as a condition of investment, so there is opportunity to develop a design-around before committing large amounts of time or money to the relationship. Finally, a CVC’s parent organization with an established patent portfolio will take a long, hard look at the company’s participation and membership in standards setting organizations, multi-source agreements and similar projects that may require the parent, if a future acquisition is a desired objective, to grant patent licenses to third parties, including its competitors, on a F/RAND or any other basis, or otherwise restrict the parent from asserting its patents.
- Additional Material Commercial Agreement Considerations. Early in its lifecycle, a company may find itself granting exclusive rights or agreeing to sole supplier, most favored nations, rights of first refusal, and other restrictive contractual provisions with customers, partners and suppliers in order to gain traction. Unless such rights/restrictions are artfully cornered-off or time limited to serve their legitimate purpose, the result can be an unintended poison pill for a CVC’s parent organization that is targeting a future potential strategic partnership or acquisition. Similarly, a company’s commercial entanglements with, or dependencies on, competitors of the CVC’s parent or its group companies may sour a transaction, even if the parent’s investment motivation is largely financial.
- Important Operational and Compliance Matters. Due to market size, applicable regulatory frameworks and self-industry regulations, as well as market-based scrutiny, CVC parent organizations are continuing to develop a broad and more robust range of company-wide policies and procedures for legal, compliance and operational matters. Those policies and procedures typically apply to all subsidiaries of a CVC parent and some of those policies may also be applied from time to time in the context of building a strategic partnership with a CVC parent. In the context of a potential CVC investment where the desired intent is to develop a future strategic partnership (e.g., joint venture, material collaboration or customer relationship) or possibly acquire the business down the road, a CVC may scrutinize a company’s existing legal, compliance and operational policies and procedures and require the company to ensure that they are current with, or can in the future be brought current with, the applicable compliance requirements and needs of the CVC parent if such a transaction were to occur.
Of Course, Still Execute at “Venture-Speed”
Whether a CVC is conducting a baseline level of IP and commercial diligence similar to a traditional venture capital investor or diving more deeply for purposes of a potential investment transaction with significant strategic objectives, it is critical for the CVC unit, its parent organization and its outside advisors to be prepared to expedite the diligence process and move with efficiency and practicality to completion and closing. Such is the nature of a venture investment as well as the expectations of startup companies and their other venture investors.
Originally published in Fenwick’s Intellectual Property Bulletin on April 21, 2020.