Investments in start-ups – opportunities and hurdles

Established companies – so-called corporates – can tap into innovative technologies and new business areas by investing in a start-up. But beware: start-up investments differ from other M&A activities in several ways. Those who enter the race with a standard approach accept unnecessary hurdles.

The typical start-up is dynamic, innovative and risk-taking. Many of these young companies are focusing on technologies such as artificial intelligence, autonomous driving, data & analytics, Industry 4.0, blockchain or virtual reality. They develop applications to market maturity and build business areas that corporates do not yet occupy. For these, start-ups can therefore represent an attractive cooperation partner, often in combination with financial participation.

If many corporates are nevertheless holding back on their involvement with startups, it’s partly because they need to venture into uncharted territory. Start-up investments differ from other M&A processes in terms of preparation and execution. Only those who know the specific challenges will master them and achieve the desired success.

Due Diligence – own focus

When investing in a start-up, due diligence must focus on particular areas. This is for four reasons:

– Start-ups usually focus on dynamic growth. Problems are solved pragmatically and with as little consulting effort as possible. Therefore, there may be significant undetected risks. These should be uncovered prior to the transaction.
– The business model is often limited to a single technology. If the start-up does not have all rights to this technology or is not entitled to the sole right to fully exploit this technology commercially, the basis required for the investment is missing. Similarly significant effects may exist if the innovative business model disregards regulatory requirements, such as lacking public law approvals (for example, a banking license) or bypassing legal restrictions (for example, in the area of data protection).
– The budget for due diligence is usually smaller than for other M&A transactions. Despite the risk nature of the investment, the consultant must therefore limit his due diligence. This requires a good level of experience and a cooperative working relationship during due diligence with the client and founders.
– Founders do provide guarantees about the status of the company in the transaction agreements. Unlike M&A transactions, however, these are often of little value – when push comes to shove.

Involvement of the founders – participation versus takeover

In a complete acquisition, there is a temptation to integrate and assimilate the start-up into the acquiring company. The founders then become normal employees and lose their previous – entrepreneurial – position. This change of role is typically not in line with how they see themselves and can be detrimental to the operational success of the investment.

In most cases, therefore, corporates only take a minority stake, which leaves the founders greater decision-making leeway and entrepreneurial incentive. The corporate can secure the necessary influence on decision-making by means of qualified majority requirements, which give it a say in the shareholders’ meeting and reservations of approval for certain management measures. He is thus actively involved in shaping the corporate governance of the start-up.

Since the corporate usually wants to use its share in start-ups in particular in the medium to long term, it must protect itself against the founders leaving the start-up or breaching agreements. The Corporate achieves this with a so-called vesting agreement. These are contractual provisions that obligate the founder to transfer his shares in the start-up to the corporate should the founder leave prematurely or violate agreements. Depending on the length of the founder’s activity for the start-up, the sum of the business shares to be (re)transferred by the founder decreases.

The schedule – cooperation instead of exit

In contrast to venture capital funds or business angels, a corporate usually invests in a start-up with staying power. Typically, he does not pursue a short-term profit interest, but would like to work with the start-up in the long term and use its creativity, dynamism and technology for himself.

Therefore, a corporate does not aim for an exit after three to five years, but usually contractually agrees on a longer-term cooperation with the start-up. Depending on the business model, R&D, licensing, supply and distribution agreements may be considered here. From the corporate’s point of view, this is often the central element of the investment, which is sensibly hedged by other arrangements such as rights of first refusal or call options. This is also in the interest of the founders, who often need know-how and market access in addition to fresh capital and also pursue a long time horizon.