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When it works and when it doesn't

By Professor James Henderson - October, 2007

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Why and when should your company get involved in corporate venture capital? And once it has, how do you make it work so that it maximizes your return on investment?

Corporate venture capital is the corporate world’s answer to investing in entrepreneurial start-ups. Rather than relying on their own innovation, corporate venture capital is an attempt to benefit from innovations from the market place to sustain profitable growth.

Get in early
Unfortunately corporate venture capital has tended to follow the much larger venture capital market, albeit with a lag. Why the lag? Venture capital is not a corporation’s core business. By the time the decision to take the plunge has been made, the markets are often “very” healthy with increasing numbers of IPOs. Increasing interest in this area during this upswing often means higher initial investments in the start-ups. And the less easy, three or four years down the road, to actually liquidate them through IPO or acquisition markets.

If one looks at the history of corporate venture capital over the last 30 years or so, the first clear message is that timing is of the essence. If you want to take the plunge, take it early rather than late in the cycle. Better yet, take it when no other companies in your market are considering it. At least you will then find very attractive investment opportunities.

Focus on start-ups which can help the corporation
Often companies start corporate venture capital programs with a “one size fits all” approach. However, corporate venture capital investments can in fact be categorized into three different types: hedging, capability upgrading and capability leveraging.

Hedging investments are simply ones which where you are trying to play an option should the world turn out in a different way than the corporation anticipates. Thus Microsoft’s investment in SCO Unix during the mid-1980s could be considered a hedging play, where the company had an option in the UNIX operating system space were UNIX to have become the industry standard.

Capability upgrading investments are those where the corporation is truly benefiting from the start-up that helps upgrade the level of capabilities inside the corporation be it a new technology, a new market segment, or a new distribution channel. A good example of this would be Intel Capital investing in Linux technology which helped Intel in building its capabilities in this operating system and to sell more of its server microprocessors.

Capability leveraging, on the other hand, occurs when the corporation has an existing distribution channel or industry contacts or technological support with which the startup can be provided to assist it in moving forward with its own business.

We examined approximately 500 start-up investments over a 25 year period by 30 different corporate venture capital programs in the pharmaceutical and network operator based industries. We coded whether the investments were hedging, capability upgrading or leveraging. What we found was that capability based - in particular upgrading investments - have a significantly higher likelihood of going IPO or being acquired. While this result is not the only performance metric for a company, it is, currently the best measure available to show that capability leveraging and upgrading have a significant benefit – especially over hedging investments.

Why capability upgrading? Because it is a great win-win situation for a business unit general manager somewhere in the corporation and the start-up. The general manager boosts his revenue potential and profits from the new technology, new distribution channel or new drug as the case may be. In turn, the start-up benefits from the use and endorsement of the corporation itself and from the ensuing relationship with the business unit.

Making corporate venture capital work
Clearly, corporate venture capital programs should not focus on those start-ups that simply give the best return. Rather, consider outsourcing your hedging investments to independent venture capitalists and focus your corporate venture capital mission to capability leveraging and upgrading investments.

But if you think getting in early and investing in capability leveraging and upgrading investments is all that it takes to make corporate venture capital work, think again. Corporate venture capital is fraught with obstacles, especially when relationships with start-up companies and the business unit general managers are required.

First, commitment to the program often follows the profitability swings of the corporation. If corporate profits are up, great; if profits are down, however, corporate venture capital programs are often scrapped or de-emphasized to the detriment of all the hard work done with the start ups. Clearly a long term commitment to the program is an absolute must to fully benefit from the innovations from these start-up ventures.

Second, business unit managers are often not incentivized or motivated to establish relationships with start-up ventures. After all, these ventures are many times smaller than the business units. But based on discussions with many corporate venture capital programs, we found that the business units were in fact critical to their success. We argue that business units should be the source of the investment ideas; look typically to later-round ventures which will indeed benefit them; be fully involved in the due diligence and negotiation process with the ventures; formally commit to working with the start-ups as part of their management objectives and finally engage in on-going monitoring of the ventures’ performance.

Third, corporate venture capitalists often view themselves in the same light as venture capitalists. As such, corporate venture capitalists often think that their programs and funds should be managed and rewarded in a similar way. However, earning a percentage on the capital gains of the investment for their work (what is called carried interest and is typically 20% in the independent venture capital industry) often creates animosity within the corporation. Why should they earn such a fee when the value created has come from the business unit – start- up relationship? Furthermore, in order to best help the start-up, the corporate venture capital team should have a broad and deep network within the organization.

Key messages
Get in early and stay in. Outsource hedging investments. Focus on capability leveraging and upgrading investments. Engage the main stakeholders in the process: the business units. The companies that have truly benefited are those have been in it for a long time and realize their cyclical nature; firms such as Intel Capital, Nokia Ventures or T-Ventures which have been committed to the program for at least the last ten years.

James Henderson is Professor of Strategic Management at IMD. He teaches on the Orchestrating Winning Performance (OWP) program where, next June, we will dedicate sessions to Making Corporate Venturing Work.

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