vol.5 Hybrid investment advice

０）Table of contents

・The first　Insights from my experience with VC, startups, entrepreneurship and CVC
・The second 　Why are major business companies investing in startups these days?
・The third 　Points of startup investment practice①（last time）
・The fourth　 Points of startup investment practice②
・The fifth (Planned) Co-creation between major business companies and startups

In the fifth and final installment of this series, I will explain “hybrid investing,” which I highly recommend. I will consider what effects hybrid investing has, how to utilize it, and the selection points for indirect investment (LP investment).

1）What is hybrid investing?

Hybrid investment is an investment strategy that combines direct and indirect investment.

• Direct investment (CVC investment)：Large business companies invest with their own funds (balance sheet) and pursue business synergy and financial returns by co-creating with startups (hereinafter referred to as SU). In many cases, the members of the department at the start of the venture are people from the business planning department who are knowledgeable about figures.
  
• Indirect investment (LP investment)：By participating in a VC fund as an LP (limited partner), the company will indirectly invest in SU, learn about the specialized investment activities of VCs, accumulate know-how within the company, and utilize it in direct investments.

By combining these two, you can enjoy many benefits, such as 1) covering all stages, 2) covering business areas, 3) responding to SU needs, 4) responding to SU uncertainty, and 5) reducing investment budgets.

2）Why hybrid investing works?

1.Stage coverage

main purpose of SU investment by major business companies is co-creation and business synergy (excluding major business companies that place emphasis on financial returns). Therefore, when there is no product or service yet, or the business direction is not yet solidified (seed or early stage), co-creation consideration with SUs does not progress easily. Inevitably, most of the co-creation considerations are with SUs in the middle or later stage who have entered the sales expansion phase . Going back to the basic principle of why SU investment is made, the investment target stage will be consolidated into the middle and later stages after a while . However, if you wait until SUs grow in the middle or later stages, you may lose the opportunity because a broad rival will invest and co-create first . In other words, you may find yourself in a “blocked” situation where you cannot invest or co-create now, and will not be able to do so in the future.

To avoid this situation, we build relationships with SUs in the seed and early stages through indirect investment (LP investment in VCs), and then when the time comes (middle or later stages), we make direct investments and co-create.By combining indirect and direct investments (hybrid investment) , we can approach SUs at a wide range of stages , from the seed and early stages to the middle and later stages .

2.Business Area Covered

Direct investments by major business companies are basically premised on “business synergy ,” so they tend to be biased toward investments in SUs that operate in areas close to their own business domains . However, innovation often comes from “unexpected enclaves,” and there are business domains that are overlooked through direct investment alone .

LPs (indirect investments) of a VC fund are usually multiple companies such as Company A, Company B, Company C, etc. (except for duo partnerships). The VC (known as the GP in contrast to the LP) who manages the fund considers the business areas of interest of all LPs and decides on the investment target area. For example, let’s say you invest in Company X, which is close to the business area of LP Company C. Company X’s business area is a distant “enclave” from the business area of LP Company A. However, information about Company X is available not only to Company C but also to Company A (VCs actively share information about SUs they have invested in and have contact with LPs). When Company A meets with Company X, an indirect investment target, it may come up with a co-creation idea that they had not initially thought of. Even if it does not lead to a co-creation idea, it is useful for understanding industry trends and new business seeds.

Considering co-creation with SU, which operates in an “enclave” business domain, can be called open innovation. Another advantage of hybrid investment is that it can cover not only the surrounding areas of the company, but also distant business domains (enclaves).

3.Meeting SU needs

At each stage of growth , SU has different expectations of shareholders.

• Seed/Early Stage: This is where VCs can demonstrate their strengths, providing capital policy (fundraising) advice and mentoring to entrepreneurs .
• Middle and later stages: Major business companies can demonstrate their strengths through business alliances, co-creation , and business development support to expand sales .

Large business companies may be able to build good relationships by making hybrid investments, with the former being handled by a VC with which they have a close relationship (indirect investment) and the latter being handled by the company itself (direct investment).This allows them to address the needs and concerns of SUs.

4.Dealing with SU uncertainty

Naturally, the business development and financing of SUs are much more unstable than those of large business companies. This uncertainty is even greater in the seed and early stages. In order for large business companies to prepare for the uncertainty of SUs , it may be said that indirect investment is more suitable than direct investment. Specifically, this includes impairment treatment of investment securities, shifting alliance strategies (considering co-creation) , and soft landings.

the SU’s business plan is significantly delayed, if the main business content is changed (pivot), if the representative is changed, or if financing is conducted at a stock price significantly lower than the previous financing , we will consider whether to “impair” it comprehensively. It is necessary to have a firm grasp of the SU’s internal situation, and the skills and human relationships to actively obtain sensitive information are also important.

Especially in early stage SUs, many companies still do not have a CFO or have weak management departments, so financial information is not readily available and they are not accustomed to communicating with investors, causing difficulties for the investment departments of major business companies (the departments in charge of communicating directly with SUs). Major business companies that have IPOs need to properly value their investment securities for their financial statements , so they are frequently requested by the accounting department to obtain the latest monthly trial balances of their investments.

In addition, for example, for a large business company, even an extremely small investment of 10 million yen in SUs will almost always require a proper market value valuation and impairment assessment. In the case of direct investment, the large business company must do this themselves, but in the case of indirect investment (LP investment), the VC will do it for you. From the perspective of management operations, indirect investment is suitable for SUs with high uncertainty or poor management systems .

Let’s take a look at the soft landing of a strategic alliance (co-creation consideration). For example, let’s say that beverage manufacturer A invests in a SU that has proprietary technology for a health drink called X, with the expectation of co-creation or business alliance. Despite serious discussions about a business alliance between A and X over six months, nothing came of it, and both companies gave up on the idea of forming one at that time, saying they would consider it again in a while.

A few months later, talks of a business alliance between Company A and Company Y, a SU company that is a broad competitor of Company X, progressed smoothly and were finalized, and Company A and Company Y issued a press release. Company X, upon seeing this release, made a false claim that “Company A obtained confidential information of our company as a shareholder and under the pretense of a business alliance, and used it for a business alliance with our competitor Company Y.” Ideally, it would be safer for Company A to sell its shares in Company X before entering into a business alliance with Company Y. However, unlisted shares that have not been publicly traded have no liquidity and cannot be sold when they want to. Should Company A hold on to its shares in Company X and let its reputation spread, or should it give up on the attractive business alliance with Company Y?

The above is an extreme example (although I have had a similar experience), but when there are multiple options for partner SUs for co-creation or business alliances and the policy has not yet been solidified, I think it is better to avoid direct investment. At such times, indirect investment is more suitable in terms of relationship and distance . Indirect investment may allow for a soft landing. However, since VCs aim for financial returns (capital gains), they make investment decisions from a different perspective than business companies, such as IPO timing and market capitalization (stock price), so they may not be able to meet LPs’ SU investment wishes.

5.Compression of investment budget

When a major business company makes an SU investment for the first time, we often see them start by forming a “two-person fund” consisting of just two parties, the VC and the major business company. In most cases, the total amount of the fund is 5 billion yen, with the VC investing 100 million yen and the major business company investing 4.9 billion yen. The management fee that the VC receives is 100 to 150 million yen per year, which continues for 10 years, for a total of 1 to 1.5 billion yen. To be honest, for a VC, a “two-person fund with a total amount of 5 billion yen” is a very lucrative business (laughs) .

I won’t go into too much detail here, but rather than investing 4.9 billion yen to set up a two-person partnership fund, I think it would be better to allocate an investment budget of 2.5 billion yen to your own CVC (direct investment) department, and to supplement this, invest a total of 1 billion yen as LP in two or three VC funds that are compatible with your business field and country . You may be able to receive free lectures on a series of operational know-how related to SU investment (team member composition, sourcing, investment decision-making body composition, investment monitoring, co-creation challenges, impairment rules, etc.) from two or three VCs that have made indirect investments (LP investments) (management fees may also be considered consulting fees). You should actively consider “free services from VCs” through LP investment .

３）Key points for selecting LP investment targets

When making hybrid investments, it is important to decide which VC fund to invest in as an LP , as well as how to structure your own CVC . The following factors are important in making your selection:

1.Understanding VC’s strengths

Depending on the background of the shareholders and major investment members of the VC company, they are mainly classified into the following two types.

• Financial company VCs: For example, VC firms affiliated with banks, securities companies, accounting consulting firms, or people from these companies. They are strong in capital policy/fundraising, entrepreneur mentoring, and management monitoring (governance) , and are primarily good at seed/early stage SU investments . Depending on the fund they create, they may focus on a specific stage or business area, or they may be an all-round general fund.
  
• Business company VCs: For example, VC firms affiliated with IT companies, trading companies, manufacturers, and media companies, and people from these companies. They are strong in business development and co-creation support , and are good at investing in related businesses in which they have knowledge.

2.Fund investment policy, management structure and track record

• Business area (industry), country/region, and stage (of SU) of the investment target.
• The size of the fund . It may not be good if the fund is too small, but if it is too large, it will become one of them including other LP investors and will be lost (the value of information and opportunities for co-creation will decrease relatively) .
• The past investment and exit performance of the GP company (fund management company, general partner) .
• The cultural gap between GP and LP companies (important because we have had a long relationship for 10 years).
• GP company personnel (not only the CEO and management, but also the LP principal personnel are important)

3.Free services by GP

• To what extent will they support co -creation with SU and new business development ?
• Are you able to understand the investment objectives of LP investors and propose matching them with appropriate SUs ( rather than sending the same “SU list” to all LPs at once) ?
• Can you provide support for the formation and operation of direct investment (CVC) divisions ?
• Is there support for difficult points when making direct investments (e.g. rights and obligations in shareholder agreements, stock price valuation)?
• Is it possible for LPs (major business companies) to second employees to VCs (GP companies) to acquire know-how and undergo training?

By taking these points into consideration and making LP investments in funds that are best suited to your company , you can achieve more effective hybrid investments.

4）Towards the practice of hybrid investment

There are three key points to successful hybrid investing:

1. Have a clear investment objective

Set clear objectives, such as whether you are aiming for business synergy or market research.

2. Achieving a balance between LP investment (indirect investment) and CVC investment (direct investment)

We constantly review how much we can cover in-house and what we can leave to external VCs .

3. Thorough follow-up after investment

Whether directly or indirectly, we are serious about strengthening and improving relationships with the SUs in which we invest , and will continue to take on the challenge of co-creation .

５）Summary

　Hybrid investment is an effective method for large business companies to strengthen their relationships with SUs and accelerate new business development and innovation. By combining CVC ( direct investment ) and LP investment ( indirect investment ) , it is possible to build relationships with a wider range of startups (increasing the number of SUs with contact points = denominator for considering co-creation) .

hat this five-part series of articles will provide some hints for your investment activities and co-creation strategies . We believe that new business development by major business companies and co-creation with SU will lead to a bright future and a bright society. Our vision and mission is to solve social issues (impact) through “food x technology” and realize well-being. Make the food business one of Japan’s core industries!

bout this article , please contact us using the information below.

Food Future Fund (Kemuri Ventures Inc.)
HP：https://www.kemuriventures.co.jp/
Email：mail.kemuri@gmail.com