With the advance of digitalisation in almost all worlds of life and business, the importance of tech M&A transactions has also noticeably increased – a trend that is set to intensify in the coming years. Established business models of traditional industrial companies are being challenged by digital, easily scalable offerings; and institutional investors and financial investors, struggling with low or negative interest rates, are looking for suitable, lucrative investment opportunities while minimising risk amid the prevailing “money glut”. As a result, companies and financial investors alike are welcoming emerging start-ups, especially in the IT/software and healthcare sectors, with open arms: In 2020 alone, according to PitchBook (European Venture Report 2020), European start-ups raised almost € 43 billion in investor funds, of which almost € 20 billion came from strategic investors – both records that will (most likely) be set again in 2021.
Interests and instruments
In their (co-) investments in start-ups, financial investors primarily pursue the highest possible financial return, which they realise in the event of an exit, i.e. a sale or IPO of the respective company. Depending on the respective industry and company phase focus, corresponding venture capital funds are set up and invest in selected start-ups over a certain period of time. The motives of industrial companies, on the other hand, are more complex, but mainly strategically driven and aim, among other things, at access to new, innovative technologies, a strengthening of the innovation pipeline or, in general, “learning effects” and / or presence in the newly emerging sector-specific ecosystem of market participants. Companies can cooperate with start-ups or participate in them in different ways. Depending on the strategic objective and the sector, the following can be considered: (Technology) development and cooperation agreements, licensing agreements, joint ventures, incubation/accelerator programmes or investments in start-ups for which companies receive a minority stake in return. Companies usually invest through specially set up investment vehicles (so-called “corporate venture capital”), but sometimes also directly “from the balance sheet”. In Germany and Europe, corporate venture capital is nowadays an integral part of the (external) innovation strategy of corporations.
Structuring of (co-) investments
Financial investors and strategic investors who invest in tech companies usually aim for a minority stake of 10-25%. Depending on the stage of development or liquidity needs of the start-up in question, convertible notes are issued as an alternative, enabling the investor to become a shareholder in the company in a subsequent financing round at a capped company valuation (plus any discount). Financial investors are primarily exit-oriented in their investments and tend to interfere less in the operational issues of the management. In contrast, strategic investors attach particular importance to contractual regulations that enable them to acquire the start-up completely at a later date, or at least grant them a veto right with regard to the sale to competitor companies, as well as active influence and involvement in relevant decision-making processes, which is reflected accordingly in the governance of the start-up. However, the contractual fixation of acquisition rights in favour of strategic investors is a double-edged sword: it limits the start-up to a concrete exit option and can therefore have a negative impact on its valuation (realisable in an exit case) in the long term.
Special features of tech investments
The essential value of tech companies lies in the technology they have developed, their know-how and key employees. Therefore, the “protection” of these essential assets plays a major role in tech investments. This is done, on the one hand, through contractual guarantees with which the respective company (and the founders behind it) assure that the rights to the relevant software and the source code behind it belong to the company and that the possible use of “open source” software does not oblige the company to disclose its source code („copy-left“ effect). However, such standard guarantees are often not worth much in the case of start-ups (and corresponding W&I insurance policies has not yet become established). Depending on the size of the specific investment, it may therefore make sense to subject the start-up to an in-depth IP/IT due diligence and, for example, to identify risks with regard to the use of open source software by means of a so-called “back duck” due diligence as well as to analyse the existing IT infrastructure(s) and data protection management systems. In order to “stretch” the risks to a certain extent, financial and strategic investors also make their investments in tech companies whose technology is still at the beginning of its development and commercialisation dependent on the achievement of certain technological and/or commercial milestones – and only when these milestones are reached are contractually agreed tranches of the total investment due. Finally, creating incentives for the founders and other key employees as well as their retention in the company is of particular importance in tech investments. Particular attention should therefore be paid to appropriate provisions for binding the key employees to the start-up as well as usual non-competition clauses (and their underpinning by appropriate contractual penalties) in the event of leaving the company.
Success factors for tech investments
Key structural success factors for investment strategies for tech investments, especially by industrial companies in the context of their corporate venture capital activities, are: A team with proven industry experts who not only have excellent connections and networks in the venture capital scene, but are also well networked in the parent company itself; a clear investment focus aligned with the strategy of the industrial company as well as clear success indicators according to which tech investments in the company are assessed (and, if necessary, terminated); fast decision-making processes with regard to (follow-up) investments that are not influenced by hierarchical levels; and finally, the establishment of organisational and personnel “bridges” between the start-up and the company, which on the one hand enable the start-up to access critical resources and experts of the company, and on the other hand enable the knowledge gained from the tech investment for the company to be utilised in the best possible way and at the right place in the company.
(Co-) investments in tech companies open up great opportunities for financial investors and strategic investors to participate financially and/or strategically in current growth trends. At the same time, the structuring of such investments entails a complexity that should not be underestimated. Due to lowered thresholds (according to the currently valid 17th amendment to the German Foreign Trade and Payments Ordinance, already from an acquisition of 10% or 20% of the shares) and a further expansion into security-relevant areas – especially tech-relevant areas such as artificial intelligence, autonomous driving, robotics or cyber security – depending on the origin of the investor, foreign trade law hurdles must increasingly be taken into account and addressed in tech investments – a development that is likely to intensify in the coming years in view of the struggle between the USA, China and Europe for global supremacy in key technological industries.