Corporate Venture Capital’s Role in Disruptive Innovation Part 1: Institutional VC Disruption

Trident-ES-1234By Evangelos Simoudis

A large corporation recently requested my advice on how to set up and structure their venture fund, which they wanted to base in Silicon Valley. This corporation had initially set up a venture fund in the late ‘90s to invest in Internet startups, but by 2002 they closed it down after determining that the portfolio companies had lost their financial value and had created little intellectual property of interest. But the startup activity of the last four years and the disruptions caused by startups in the company’s industry are leading it to re-establish its fund.

This demonstrates a recurring theme of the past three years: corporations from a variety of industries are establishing — or re-establishing — venture funds in Silicon Valley and other innovation clusters, and are aggressively participating in startup financing rounds. According to Global Corporate Venturing, the number of funds has doubled since 2009. Today 1,100 corporations have active venture funds, 475 of which have been established since 2010. VentureSource reported that corporate venture capital firms (CVCs) invested $5 billion during 2014, up 45% from a year earlier and the highest level since the dot-com era. The emergence of corporate venture capital as a major source of startup funding has been the result of two factors, the first accidental and the second intentional.

First, because institutional venture capital is being disrupted, corporate venture capital is able to operate in a more level playing field.  Along with a new generation of institutional venture firms, corporate VCs can fill some of the void being created and emerge as an important startup-financing source. Second, as corporations realize the dire need to reinvent their innovation models, they are starting to demonstrate that they intend to access externally developed disruptive innovations by financing startups. The good news — but also a challenge at the same time — is that due to the large number of startups being created globally, corporate VCs have an ever-expanding set of investment opportunities to consider.

This post examines what CVCs need to understand about the institutional venture capital disruption in order to best capitalize on the opportunities it will create.

Institutional VC Disruption

I am not the first person to comment on the disruption experienced by incumbent institutional VCs (IVCs). Others (and here) have commented extensively. However, my 15-year experience as an institutional investor and the data I collected from recent interactions with large corporations and their CVCs provide me with a unique perspective on how corporate venture investors can capitalize on this disruption and become long-term, value-add contributors to the evolving investor ecosystem. CVCs will need to continue relying on and collaborating with IVCs in order to achieve their investment goals. They must understand what is causing the disruption, as well as the venture investment ecosystem that is emerging as a result of the disruption.

Incumbent IVCs have been disrupted for three reasons:

  • Over the last 10-12 years, incumbent IVCs have experienced disappointing returns from early stage investments, which led institutional LPs to make smaller venture allocations to these investors. As a result, many incumbent IVCs have shrunk, closed their firms, or completely changed their investment strategy.
  • New types of investors, as well as a new generation of IVCs, are introducing innovations that are disrupting incumbent IVCs.
  • Entrepreneurs are demanding more than money from their venture investors and are increasingly working only with investors who can address all their needs.

CVCs can also become disruptors. For the most part they don’t have to worry about investment returns. They must be able to innovate, fit in the emerging venture ecosystem, and try to meet the needs of the new generation of entrepreneurs, as the other new types of investors appear to be doing.

LP Disappointment

In 1991 I started working with VCs as an entrepreneur. In 2000, I joined a venture firm as a partner and have been a VC since. Through these two different lenses I saw that until four or so years ago there has been little innovation in the institutional VC model. Every three or four years, a venture partnership would raise a new fund from LPs that usually included endowments, foundations, pension funds and family offices. The basic terms under which LPs invested remained unchanged from fund to fund (10-year fund life, with a 5-year investment period, 2.5% annual management fee, and 20% carry). During the period from 1995-2000 (the dot-com era) the model kicked into high gear; many new firms were established, including around 500 corporate VCs, and more institutional funds were raised with larger amounts (see Figure 1). Unfortunately most of these funds produced lackluster venture returns for over a decade following the 2001 recession (see Figure 2).

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Figure 1: Number of funds raised by U.S. technology VC firms (Prequin)

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Figure 2: Net IRR outperformance versus Russell 3000 Index

After the recession, most LPs moved away from the venture asset class, leading many incumbent IVCs to shrink and change investment strategy; become private equity or growth equity funds; close down altogether; or become “zombies” (and here) on their way to closing down. Flag Capital estimated that by 2010 only about 75 of the IVCs that existed in 2000 were able to raise new pools of capital (see Figure 3). Of the 500 CVCs that were established during the dot-com era, 200 had closed down by 2004.

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Figure 3: Number of active U.S. institutional venture firms (Flag Capital analysis)

Little Change for Top-Tier IVCs

Not all the incumbent IVCs were impacted by the shrinking LP venture allocations. In fact, the firms included in the bar chart of Figure 3 are actually split into two groups: the top tier group and the second tier group. The top tier group saw little change in the allocations they were receiving from their LPs. This group includes approximately 20 IVCs such as Sequoia, NEA, Benchmark, and Greylock and has remained largely unchanged, with only few exceptions such as the addition of Andreessen-Horowitz. The members of this group continue to capture the majority of the capital allocated by institutional LPs to the venture asset class. Because of the strong LP demand, they can raise new pools of capital almost at will and under the same terms as in the past because they consistently provide superior returns. Their LPs allow them to use the capital they raise to employ different strategies and create specialized investment vehicles as they see fit, such as Andreesen’s Google Glass fund, Accel’s Big Data fund, and Greylock’s Growth fund.

Imminent Disruption for Second-Tier IVCs

The second tier group has been impacted the most. The returns of the firms belonging to this group, particularly those attributed to early stage investments, have been inconsistent and weak. LPs are funding fewer of these firms — and giving them smaller allocations when they do fund them — and in return demanding economic terms that attempt to provide better alignment between LP and GP.

For example, LPs ask for several terms unheard of in the past: smaller management fees; smaller fund size, a higher investment rate in the existing fund before raising a new fund; a higher contribution to the fund from the GPs; close scrutiny of the board seat capacity of each investing partner; requirements for side-by-side investing; clearer definition on when the GP can take carry; and a few others. Smaller allocations, a demand for higher transparency, and more restrictive terms set the stage for the disruption of the second tier incumbent IVCs.

New Venture Investors: A New Class of Competitors

These days an entrepreneur can start an information technology-based company (software, Internet, hardware) for significantly less capital than was required five or so years ago.

This efficiency combined with globally abundant capital and the interest by LPs in new investment ideas and structures has led to the arrival of new types of investors that compete with incumbent IVCs in general and the second-tier group in particular.

These days an entrepreneur can start an information technology-based company (software, Internet, hardware) for significantly less capital than was required five or so years ago.

Six types of competitors have emerged:

  1. Crowd-funding platforms such as Kickstarter and Indigogo.
  2. Accelerators
  3. Superangels (and here) that also use platforms like AngelList through its syndicates feature to support their efforts
  4. Micro-VC funds that raise smaller pools of capital than IVCs — typically less than $50M — and invest in seed stage companies. These firms bridge the gap between angel and Series A investments and oftentimes have a single GP. CB Insights estimates that today there are already 135 micro-VC firms (see examples in Figure 4).
  5. Emerging venture managers that raise $100-200M per fund primarily from institutional LPs and typically build their firms around deep sector expertise such as SaaS, digital media, or consumer Internet. This includes firms such as Emergence Capital, Shasta Ventures, Union Square Ventures, and Greycroft Partners.
  6. LPs, both institutional and family offices, such as Top Tier Capital Partners and Aeris Capital, that have set up direct investment groups or are expecting to invest side-by-side with the GPs they support.

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Figure 4: Sample set of micro-VC firms (Samir Kaji and CB Insights survey)

New-Style VCs: Introducing Innovations to the Venture World

The first five of these investor types, let’s call them new-style VCs, not only create competition to incumbent IVCs, but they have also introduced disruptive innovations that are having a big impact on the venture ecosystem. These innovations include:

  • Investor-generated deal flow: These new investors create deal flow by reaching out to entrepreneurs, often using big data methods and other technology-enabled approaches their portfolio companies use to sell their solutions.
  • Greater collaboration within portfolio companies: VCs are providing value-added services to each portfolio company by developing community and maximizing collaboration among the portfolio companies to allow entrepreneurs and management teams to learn from their successes and failures.
  • Agile management strategies: Investors are creating larger portfolios of smaller investments, but they are ready to quickly terminate support to underperforming portfolio companies and increase support to the ones that perform well.
  • Entrepreneurial GPs: New-style GPs tend to be ex-entrepreneurs with technology and/or product background and knowledge on how to start and build companies in today’s business environment. They want to share the risk and the upside of making each startup a success.
  • Progressive approaches: Concepts such as lean startup, minimum viable product, business model canvas, agile development and design thinking are revolutionizing startup creation and are being broadly embraced by new-style VCs and their portfolio companies.

But Why Is This Innovative?

I view these as innovations because they represent a significant change from the way old-style VCs operate, and, I believe these changes led to the demonstrated improved financial performance of the new-style VCs. Looking at the majority of the old-style VCs, one comes to realize that they develop their deal flow either with inbound requests for money or by networking with other venture investors they know well, such as bankers and other intermediaries.

When selling themselves to entrepreneurs, old-style VCs emphasize their investment experience and legacy, financial expertise and thought leadership in the VC ecosystem. These investors tend to interact with their management teams primarily in board meetings. Finally, they often continue investing in portfolio companies even when they are underperforming over the long term, because they believe abandoning such companies will negatively impact their reputation. In fairness, there have been situations where long-term support of a venture-backed company that was underperforming for some period was handsomely rewarded by the market, but these cases are exceptions.

In several private conversations with LPs and venture investors, I’ve heard first-hand what appears to be developing as a trend over the past three years: while the institutional LP appetite for the venture asset class is starting to increase, there is a definite preference to support smaller funds ($80-200M) that invest in new ideas, such as consumerization of the enterprise, big data infrastructure, and consumer Internet (see Figure 5). These funds allow for better LP/GP alignment and demonstrate good returns more consistently. For this reason, I expect that we will continue to see the creation of new micro-VC firms and emerging venture manager firms.

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Figure 5: VC Funds closed 11/13-4/14 (CB Insights)

More Disruption: What Entrepreneurs Want Today

In the last five to seven years, entrepreneurship has changed dramatically. Even in countries where employment in a large corporation or government agency was considered a young person’s career goal, entrepreneurship is now promoted, celebrated and starting to flourish. Today’s hyperconnectivity allows entrepreneurs from around the world to rapidly share ideas, information and best practices. They make fewer mistakes and get to market faster. Though only a small percent are backed by institutional venture capital, the information disseminated among entrepreneurs points to significant differences between what entrepreneurs want to receive today from their investors and what they have actually been receiving in the past.

Younger entrepreneurs gravitate towards the new-style VCs. To better understand the difference in perspectives between the new generation of entrepreneurs and old-style VCs, it is instructive to see the results of two surveys that were conducted 2013. The first survey (and here) is about the characteristics entrepreneurs value in a VC compared to the characteristics VCs emphasized about themselves (Figure 6).

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Figure 6: Characteristics valued by entrepreneurs and VCs (DeSantis Breindel)

The second survey (Figure 7) is about the VC characteristics entrepreneurs consider important when they are choosing a venture investor. In this survey, operational and industry experience emerge as very important characteristics in a VC along with strategic insight, scaling guidance, recruiting support, business development and customer and partner introductions.

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Figure 7: VC characteristics valued by entrepreneurs (Upfront Ventures)

Operational and industry experience emerge as very important characteristics in a VC along with strategic insight, scaling guidance, recruiting support, business development and customer and partner introductions.

The CVC Opportunity

If CVCs learn from and build on the IVC innovations being introduced, they can take advantage of the IVC disruption. To become major long-term factors in the venture investment ecosystem, CVCs must:

  1. Show consistency with their investment approach
  2. Demonstrate their value to entrepreneurs
  3. Establish strategic investment themes and theses that reflect the corporation’s innovation needs
  4. Syndicate with the right IVCs and become good investment partners by showcasing the value they can provide

CVCs are well suited for adopting the characteristics of new-style VCs. Moreover, they have the opportunity to provide additional value to entrepreneurs, making them even more attractive investors. In particular, CVCs could uniquely provide:

  • Access to company personnel who can offer business and process knowledge to help the startup build a better application
  • Connections to company executives who can offer operational support and mentorship to the startup
  • Investments with fewer conditions than a typical institutional VC because they don’t have financial objectives as IVCs do

In addition to these characteristics, CVCs will need to make a concerted effort to adopt other characteristics entrepreneurs have come to expect from their venture investors, including a defined and consistent investment culture, investment approach and support infrastructure, which to date we haven’t seen from most CVCs. Their investment culture will need to be coupled with a corporate culture that would favor moving fast to quickly assimilate the most promising innovations being funded by the CVC. The adoption of the right corporate and investment culture is the hardest issue and a topic I will address in the next post of this series.

Let’s review the factors responsible for this singular time in corporate venture capital:

  • The pace of innovation is accelerating, which is producing an extremely large set of investment opportunities in startups.
  • Corporations are reinventing their innovation models, with venture capital playing a central role in the new model.
  • Institutional venture capital is being disrupted, creating an opening for new funding sources.
  • Young entrepreneurs want to work with investors that provide value beyond capital.

Corporate VCs have the opportunity to capitalize on these circumstances and become important members of the venture ecosystem, helping their parent corporations disrupt and avoid being disrupted, while providing great value to the new generation of entrepreneurs.

Evangelos Simoudis is a seasoned venture investor and senior advisor to global corporations. His investing career started 15 years ago at Apax Partners and continued with Trident Capital. Today Evangelos invests in early and growth stage companies focusing on the enterprise in the areas of data and analytics, SaaS applications, and mobility.

A recognized thought leader on corporate innovation, big data, cloud computing, and digital marketing platforms he is a frequent speaker and contributor in these topics. In 2014 he was named a Power Player in Digital Media, and in 2012 as a top investor in online advertising.

Prior to his investing and advisory career, Evangelos had more than 20 years experience in high-technology industries, in executive roles spanning operations, marketing, sales and engineering. He was the CEO of two startups. Evangelos is a member of Caltech’s Information Science and Technology advisory board, the Science Board of Brandeis University, the Advisory Board of Brandeis International School of Business, and the advisory board of New York’s Center of Urban Science and Planning. Evangelos earned a PhD in computer science from Brandeis University and a BS in electrical engineering from Caltech. Evangelos blogs at corporate-innovation.co/.

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