We get phone calls from corporate types with this question all the time at Kruze Consulting. Corporate spin-outs can lead to huge companies. I’ve been a part of funding a few in the Life Sciences world while I was doing Venture Debt at Lighthouse. The biggest spinout turned awesome company is probably VMware which was spun out of EMC. So a Corporate Spinout Startup can become an incredible company.
A Spin-out startup needs to be properly capitalized, just like a more standard startup. Often corporations that are spinning out a company want to limit their invested capital because they already own most of it. Any dollar they invest in a spin-out effectively “buys back their own stock.” There is no entrepreneur to dilute, they are diluting themselves.
Therefore, the Corporate loves the idea of using debt to fund the company. They see an opportunity to retain their ownership and not have to put their own money in either. Sounds great but in practice, this is not a good situation for the Venture Lender.
A Venture Lender is betting on further financing support from equity providers, usually VC’s. The Venture Lender & VC partnership is repeated over and over again. If either acts poorly, the other party will not work with them again. This repetitive game keeps both parties honest. With a Corporate entity, it’s very unlikely the two parties will work together again in the near term. Therefore, it’s harder for the Venture Lender to get comfortable. The Corporate could just walk on the Startup when it needs more money, and the Lender would suffer a big loss.
A Corporate entity that wants Venture Debt for its spin-out is going to need to partner with a VC and let that VC invest in Newco. This is usually fine as it’s a high quality deal signal, helps the startup recruit and creates a check and balance at the Board which the CEO will like. With that VC equity investment comes a greater likelihood of accessing Venture Debt.