Contrary to what you may have heard, corporate venture capital is alive and surprisingly well. Despite the mistakes venture capitalists of all kinds made during the bubble years, the innovation needed to sustain many industries continues to develop outside major companies. In recent years we've seen new corporate entrants into venture capital (such as Eli Lilly and Co.), as well as established corporate venturers like Intel Corp. stepping up their activities. In February, the National Venture Capital Association formed a corporate venture capital division.

These are signs that corporate VC has matured and become an accepted part of corporate strategy. For example, having experimented with various models (investing indirectly through traditional VC funds, investing in special "corporate" funds and setting up their own funds to invest directly), most corporations have found that their strategic goals are best achieved by direct investments made by a dedicated team. To be sure, indirect investments can be a route to dealflow and wider market exposure and remain a part of venture strategy at some corporations.

As corporate venturers have gained experience, they've learned more about how to collaborate with traditional VCs. They know that VC is a highly specialized area of private equity, with its own legal rules and surprisingly rigid expectations; that venture capitalists expect to invest in a series of preferred stock, with founders owning common stock and later employees owning options for common stock; and that they have to be sensitive to these expectations of future investors.

At the same time, corporate venturers have learned to ensure that their unique concerns are addressed in investment documents and elsewhere. They've faced up to major issues such as:

The need to confirm the strategic relationship

Corporate VCs care about financial returns, but strategic ties -- such as early access to new products, preferential distribution terms, joint marketing agreements or help in establishing new markets -- are usually paramount. Good agreements include regular status meetings between designated managers for the relationship (frequently the CEO of the startup) and serve a critical role in setting out the expectations of the parties.

Confidentiality

The disclosure needs of traditional and corporate VCs are very different. The traditional VC generally has a small number of partners and reports financial results only to investors. Corporate VCs need to provide information to the CFO, to business units and sometimes to auditors. Experienced corporate VCs make sure that their disclosure needs are recognized in the stock purchase agreement and that these rights are not trumped by confidentiality agreements that other parts of the corporation may sign with the startup. They also establish an internal compliance program to ensure that they meet these obligations - and can prove it.

Board participation

Traditional VCs prefer to have a board seat, enabling them to vote on critical corporate matters. Some corporate VCs also take board seats, but for them, this approach is riskier. Corporate law imposes two broad fiduciary duties that directors owe to all of a startup's stockholders: the duty of care and the duty of loyalty. Both can conflict with the natural desire of the corporate VC to serve his employer.

Many sophisticated corporations prefer to have board observers, with rights set by contract rather than statute. They ensure that their observers are treated as much like directors as possible, with the right to be notified of and attend all board meetings, and that they receive all of the information directors get. Any exceptions to these rights are kept narrow and few.

When corporate VCs do decide to have a board member, the experienced ones train the director to understand his responsibilities and protect him against claims by shareholders with an indemnification agreement (separately, or in company bylaws or articles) backed up by directors and officers' insurance.

Acquisitions

Corporate investors often want to ensure that they can acquire a startup if it is successful. Intel and Cisco Systems Inc. have made many such acquisitions. Yet formal provisions permitting them can be very difficult to negotiate, because they limit potential exit strategies for other investors. One way to bridge the gap: a right of first negotiation.

The body of best practices in corporate venture capital is now a large one. For a good sense of how far the field has come and a persuasive argument on why it's important for so many companies to participate, consult Heidi Mason and Tim Rohner's "The Venture Imperative: A New Model for Corporate Innovation" (Harvard Business School Press, 2002). The NVCA's Web site offers resources as well. The message is this: Corporate venturing is an important tool for managing innovation and, with increasing experience on the operational and legal fronts, an increasingly effective one. - Mark Radcliffe

Mark F. Radcliffe is a partner with Gray Cary Ware & Freidenrich LLP in Palo Alto, Calif. and is chair of the firm's corporate venture practice.

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