Accounting Matters when Innovating from the Balance Sheet
In “Funding Innovation from the Balance Sheet,” High Alpha Innovation CEO Elliott Parker introduced the idea that large organizations can utilize the Limited Partner (“LP”) / General Partner (“GP”) structure employed by most venture capital firms as an effective and efficient vehicle for creating and funding transformational corporate ventures.
The reason this structure works? Corporate balance sheet capital can be relatively patient when an investment’s expected returns are sufficiently above the corporation’s cost of capital, compared to relatively impatient operating budgets that are often set quarterly or annually. Transformational, longer-horizon, high risk/high reward investments usually get killed in the budgeting process: scarce resources favor lower-risk, higher-certainty, incremental initiatives.
So I just need to ask my CFO to fund the transformative venture from the balance sheet rather than from operating budgets then, right?
Unfortunately it’s not quite that simple. Accounting standards, specifically ASC 323 Investments—Equity Method and Joint Ventures, require corporate investors to absorb none, some, or all of the earnings or losses of portfolio companies based on a variety of factors such as portfolio company legal structure, ownership, and corporate influence on the company. As it turns out, balance sheet investments can still impact the corporate investor’s P&L!
When we at High Alpha Innovation build and launch new software companies with corporate and university partners, we like to get the finance, tax, legal, accounting, and other relevant internal stakeholders involved as early as possible to avoid surprises that could put the transformative venture at serious risk. This article is intended to arm corporate innovators with a foundational understanding of important accounting rules and implications related to equity investments in corporate ventures. Our hope is that this understanding will empower innovators to foresee potential issues pre- or post-investment, building trust and credibility with the aforementioned internal stakeholders.
At the most rudimentary level, equity investment accounting treatment decisions are determined by a set of rules (essentially “if this, then that” logic) outlined by accounting standard governing bodies like the FASB. In the real world, there can be significant gray areas in the rules, leading corporate accounting teams and their auditors to interpret the exact same rules differently.
The key determination that must be made by a CFO or corporate accounting team is whether to account for a minority equity investment using the “Fair Value Method” or the “Equity Method.” The Fair Value Method is recognized at cost (e.g. total capital investment) on the balance sheet and does not require the corporate investor to absorb earnings or losses on a quarterly basis. Any P&L impact is only recognized when the shares are sold or the investment is impaired. In contrast, the Equity Method requires a corporate investor to absorb its proportional share of earnings and losses of portfolio companies. For example, if a corporate investor owns 40% of common stock in a venture and that venture loses $1M in a year, the accounting team would recognize a $400,000 loss, typically in the Equity in Earnings or similar below-the-line item on the P&L. The good news for corporate innovators is that senior executives, in particular the CFO, are usually much less sensitive to the P&L impact from equity investments as they can typically be considered non-recurring extraordinary items that are not included in the adjusted EPS or EBITDA metrics upon which Wall Street is valuing the enterprise and executives are being compensated.
DISCLAIMER: Please speak to your internal finance and accounting teams first to understand how your specific corporation will account for equity investments. We have outlined a simplified decision tree below that summarizes the key questions your accounting team will likely need to answer to inform a Fair Market Value vs. Equity Value determination for an equity investment.
Informed by 30+ High Alpha Studio NewCo launches (as well as our recent efforts launching multiple companies with corporations and universities at High Alpha Innovation), we have formed a strong perspective on the right and wrong ways to design, launch, and fund transformational ventures that leverage corporate balance sheet capital. A deep understanding of legal, tax, and accounting frameworks -- and, more importantly, their implications -- is essential to mitigating risks and maximizing the odds of success over time. Below are a few of our best practices tied to the three questions that determine accounting treatment:
- How is the entity (the portfolio company) structured?
The High Alpha Innovation Launch Ops team nearly always recommends incorporating NewCos as Delaware C Corps. There are countless reasons for this, but the short version is that Delaware developed a series of tax and regulatory laws (notably the Delaware General Corporation Law) and court systems that are more advantageous to entrepreneurs than almost anywhere else in the country. Most investors and startup lawyers understand and prefer Delaware frameworks. When launching a venture studio, we often recommend the LP/GP structure from the “Funding Innovation from the Balance Sheet” article.
- How much ownership (voting interest) does the corporate investor have in the entity?
The corporate investor’s “ideal” ownership level depends heavily on its strategic and financial objectives, as well as the unique contributions of the founding team (typically outside entrepreneurs High Alpha Innovation sources, hires, and onboards), the amount of capital invested by the corporate partner (typically $500k-$1M) and strategic value created (e.g. IP, data, distribution, etc), and the level of support provided by High Alpha Innovation’s operating platform (e.g. legal, design/marketing, HR/recruiting, and finance resources). We typically split equity ownership among the three contributors, putting corporations as the lead minority equity investors at time of initial pre-seed investment. This level of ownership is ideal for many corporate partners as it allows them to minimize the P&L impact (and have it below-the-line) and avoid full financial statement consolidation (>50%) that often causes headaches for CFOs, corporate accounting teams, and the external venture’s leadership. This ownership level also ensures there is sufficient room on the cap table to both attract A+ entrepreneurial co-founders and create an option pool to build out the team. Finally, this starting ownership position gives corporate investors maximum flexibility in deciding whether to increase, maintain, reduce, or liquidate their shares over time.
- Does the corporate investor have “substantial influence” over the entity?
Counterintuitively, High Alpha Innovation actually wants its corporate partners to have “substantial influence,” as defined by the accounting rules, because this influence is precisely how “unfair advantages” get unlocked for the external venture. If there is such little strategic value created by the corporate investor that it avoids triggering the “substantial influence” criteria, it is likely we’d recommend not launching a NewCo and instead suggest pursuing the opportunity either as an internal venture or as a more traditional corporate venture capital investment into an existing startup, if one exists.
According to the accounting rules, “significant influence” exists when a corporate investor owns >20% of voting interest or any of the following criteria are met:
- Board seat. The corporate investor controls a seat on the NewCo’s board of directors.
- Personnel. Managerial personnel are shared between the NewCo and corporate investor.
- Policy making. The corporate investor participates in the policy making processes of the NewCo. For example, the corporate investor can affect decisions concerning distributions to shareholders.
- Technical information. Essential technical information is shared between NewCo and corporate investor.
- Transactions. There are material transactions (e.g. commercial agreements or contracts) between the NewCo and corporate investor.
If there’s one thing we’ve learned in all of this, it is that launching new ventures as external companies can be complex. With every NewCo launch, we rigorously refine our launch playbook to ensure we execute even better the next time. If you are interested in better understanding the nuances of NewCo creation, including the accounting complexities described in this article, please reach out to us at High Alpha Innovation.
High Alpha Innovation partners with the world’s leading organizations to drive innovation through startup creation, leveraging the venture studio model pioneered by High Alpha. As a Director, Mike Joslin partners with corporate leaders to guide them through the startup launch process. To learn more, visit highalphainno.com or subscribe to our newsletter on the future of corporate innovation.