Corporate Venture Capital’s Role in Disruptive Innovation Part 2: Will Big Numbers Result In Big Success This Time?

Trident-ES-1234By Evangelos Simoudis

I started writing this series with the hypothesis that today’s corporations must reinvent the traditional R&D model in their effort to innovate. They must augment their R&D efforts with venture investments, acquisitions, strategic partnerships and startup incubation. Corporate VCs (CVCs) will play a big role in this innovation quest because a CVC can move faster with more flexibility and fewer expenses than traditional R&D to help a corporation respond to changes in technologies and business models.

With that in mind, corporations are establishing CVCs in record numbers, including corporations from industries that have not traditionally worked with venture capital. These corporations have been providing their venture organizations with significant funds to manage, with expectations they will invest in companies of various stages and geographies.

Corporations are establishing CVCs in record numbers, including corporations from industries that have not traditionally worked with venture capital. These corporations have been providing their venture organizations with significant funds to manage, with expectations they will invest in companies of various stages and geographies.

Today’s CVC prominence can result in many advantages for entrepreneurs and co-investment partners, but it also carries risks, many of which are due to the way CVCs are set up and operate within the broader corporate structure. In the last post I examined how the disruption of institutional VCs (IVCs) can impact corporate VCs. In this post I examine the different types of corporate VCs; compare the characteristics of today’s corporate venture groups with those from the ‘90s; and describe the areas where CVCs must focus in order to succeed. In the next post I will provide ideas on how to best set up a CVC organization based on my work with such organizations.

A Short Historical Perspective

CVCs first entered the startup ecosystem in the mid-60s, according to BCG. The main driver at the time was financial returns rather than innovation even though that period was also characterized by technological advancement and strong corporate performance. CVCs re-entered the very small startup ecosystem in the early ‘80s, again motivated by financial gains. The first institutional VC firms (IVCs), as we know them today, were also formed at that time, though that foray came to an abrupt end with the stock market crash of 1987. Ten years later — from the dot-com era until the 2001 recession — technological innovation and the stock market performance lured CVCs back to the startup ecosystem. This was significant because it was the first time investing in innovation was a motivating factor in addition to the drive for financial returns.

The most recent wave of CVC group formation started in 2006 but picked up steam in 2009. As I mentioned in my previous post, Global Corporate Venturing estimates that 1,100 corporations now have active venture funds. The average CVC program is only four years old, with most investing members participating for less than three years. Based on my conversations with several corporate executives, CVC group formation is now driven by the potential for technology and business model disruption that threatens most corporations.

CVCs in the Dot-Com Era (And Why They Failed)

Most CVCs from the dot-com era were part of U.S. companies in one of three industries: high technology, pharmaceuticals and telecommunications. They were staffed with corporate executives (rather than investment professionals) and invested large sums of money (maybe as high as $15B/year) primarily in late-stage rounds they wanted to lead alone. These CVCs were mainly interested in Internet technologies for connectivity and communication.

While the 2001 recession hastened their demise, the dot-com CVC wave came to an end for five underlying reasons:

  1. Culture clash: Many corporate parents lacked what Gary Hamel calls innovation culture. Culture influences behavior and for this reason is a very important issue for corporate innovation. Part of innovation culture includes embracing risk and accepting failures. Ultimately, corporations must understand which type of risk they are willing to take and accept the fact that in the same way most startups fail, so too can their own innovation efforts.

As Google and its venture group Google Ventures clearly demonstrate, the CVC group’s culture must be a reflection of the corporate parent’s innovation culture and still be consistent with the group’s goals. If the corporate venture group’s goal is to achieve top financial returns, then the CVC must adopt a culture that is similar to that of institutional VCs, particularly the new-style VCs.

  1. Impractical timelines: CVCs didn’t establish realistic timelines for achieving the innovation-KPIs associated with their venture investing objectives. Figure 1 below depicts the typical timelines associated with acquisitions, venture investing, and startup incubation. These timelines for investments and incubation are consistent with what I and other VCs use for our early, expansion, and growth stage investments. We assume that early stage investments, not unlike incubation, typically have a 7+ year horizon to maturity and exit. Expansion stage investments — where there is a product robust enough to be sold in a repeatable manner and a business model around which the company can scale — typicallyhave a 4-6 year horizon to exit. Finally, growth stage companies are more mature and have a 2-4 year horizon to exit.

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Figure 1: Acquisition, venture investment and incubation timelines

To understand the timelines associated with each activity it is important to also understand the objectives of each activity, e.g., support existing business models, create partner ecosystems around new platforms, or innovate. For example, since 2000, IBM has completed 138 acquisitions, of which at least 13 were done in support of its big data management and analytics business unit (see Figure 2). Such acquisition-related investments, depending on the stage of the company being acquired, can produce an ROI within 2-5 years.

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Figure 2: Acquisition and venture investment by IBM since 2000

More recently IBM started investing in startups, and here, with the goal of developing a partner ecosystem for its Watson platform (see Figure 2). Such investments, being in earlier stage companies with less well defined business models, in conjunction with the newness of the platform itself, e.g., Watson, need a longer period before backers can realize an ROI commensurate with the risk at the time of investment.

On the other hand, by reviewing Salesforce.com’s corresponding acquisition and investment record, parts of which are shown in Figure 3, one can see that more of the company’s transactions were driven by innovations goals, e.g., data as a service (Jigsaw, Duetto), social marketing and support (Radian6, BuddyMedia, Assistly, Rypple), rather than to support existing business units (Exact Target, InsightSquared).

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Figure 3: Acquisition and venture investment by Salesforce.com since 2000

During the dot-com period, many CVCs, motivated by shorter-term financial gain rather than innovation, invested in private companies they perceived as leaders in major emerging Internet-related markets. For this reason they invested under terms that would provide risk-adjusted ROI multiples typically associated with late-stage investments within a period of 3-4 years. These investors did not realize they were investing in companies with early stage characteristics, including risk, but late stage valuations. While most technology-driven disruptive innovations require a 5-7 year time horizon to reach the industry impact stage, most corporate venture investors with whom I have spoken told me they tended to invest with a 3-5 year ROI horizon, a practice that many continue to this day. There are two reasons for this. First, such time horizons fit with the general corporate ROI timelines that favor shorter-term results. Second, these horizons are consistent with the average tenure of public company CEOs (3.5 years) and other corporate executives (5 years). Therefore, CVCs were investing in early stage startups while assuming they were taking the lower risk associated with later stage companies.  Moreover, they expected to realize the higher returns associated with early stage companies within a much shorter time frame than is typical for companies of such stage.

  1. Wrong talent: Many corporations at the time felt their CVC groups needed individuals with a strong corporate background and understanding of business processes, so they staffed CVC teams with corporate executives rather than experienced venture investment professionals. The corporations also failed to develop compensation plans that would have been attractive to venture investment professionals, such as packages with carried interest. As a result, they couldn’t attract talent with institutional VC experience.
  1. Varying objectives: Many CVCs co-invested with institutional venture investors who had different economic and risk objectives than the CVCs. In many of the IVC/CVC syndicates, IVCs often viewed CVCs as “easy money.” In addition, many IVCs operated under the assumption (and still do) that if an early stage company accepts a corporate venture investment, then future partnerships with other corporations or potential acquisition options may be constrained. For this reason institutional VCs tended not to engage CVCs with their early stage portfolios, and when they did, they hesitated to show them the best companies.
  1. Insufficient partnership with business units: Dot-com era CVCs could not convince corporate business units of their value in providing over-the-horizon visibility to innovation. One reason for this perception was because little or no knowledge was transferred through the CVC groups and their portfolio of investments to corporate business units. There were very few instances of CVC portfolio companies forming strong partnerships with the parent corporation’s business units.

Corporate Venture Capital Today

I organize CVCs into two broad types: strategic CVCs and financially driven CVCs.

Strategic CVCs: The first and largest category includes the strategic CVCs (also called business development-driven CVCs). The goal of strategic CVCs is threefold:

  • To use investments as a means to develop closer relations with startups in order to identify potential partners for the company’s business units or even future acquisition targets.
  • To monitor the development and evolution of new technologies and business models.
  • To better understand new markets.

Four examples of strategic CVCs include Citi Ventures, Verizon Ventures, Dell Ventures, and Unilever Ventures.

Financially driven CVCs: The second type includes the financially driven CVCs. The goal of these organizations is to use investments to achieve financial returns for their corporate parent. Four examples of such CVCs include: Google Capital, Intel Capital, GE Capital, and Sapphire Ventures (SAP). Some strategic CVCs, such as Nokia Ventures, Qualcomm Ventures and AMEX Ventures, have financial returns as a secondary goal.

Recently we’ve started to see three different types of financially driven CVCs, depending on the source of their capital. The first type includes the CVCs that have a single LP, their corporate parent. The majority of financially driven CVCs, including the firms mentioned above, are of this type.

The second type includes firms that aggregate the resources of several corporations. They provide a bridge between these corporations and startups that want to work with them in a particular market or geography. A good example is WiL, whose corporate investors include Japanese companies such as ANA, Sony, NTT, Nissan and others. WiL helps startups work with its LPs and enter the Japanese market. Another example is European-focused Iris Capital, whose corporate investors include Orange and Publicis Groupe.

The third type includes firms that receive funding only from corporate LPs but do not have the strategic goals of the firms that belong to the second type. The best example is cybersecurity venture group Allegis Capital.

The money invested by strategic CVCs and the first type of financially driven CVCs always comes from one source. However, even then the structures of a corporate investment vehicle vary widely. They range from a traditional single LP fund structure with a sunset period of 10 years — just like in institutional venture funds — to a very loose, off-the-balance-sheet evergreen allocation or committed capital allocation.

Today corporations from around the world are establishing corporate venture capital groups in a wider variety of industries than ever before, such as automotive, logistics, manufacturing, CPG, and energy. Moreover, CVCs are pursuing investments globally.

Today’s CVCs have the following characteristics:

  • Corporations establishing CVCs include those from around the world and in a wider variety of industries than ever before, such as automotive, logistics, manufacturing, CPG, and energy. Moreover, CVCs are pursuing investments globally.
  • They invest in several different technologies, such as big data, cloud computing, cleantech, and food. These technologies may be relevant to the corporation’s core business products and services (for example, Citi Ventures investing in Square) or areas that are adjacent to its core (Tesla Motors investing in solar energy). They may also be relevant to the corporation’s enterprise capabilities, such as storage or big data, or completely outside the scope of its current business, (for example, Verizon Ventures investing in adtech company BlueKai).
  • The CVC groups are staffed differently depending on their type:
    Strategic CVCs formed within the last four years, such as Dell Ventures, are more likely to employ partners with institutional VC experience. As a result, these CVCs have become better at evaluating startup risk and feel more confident investing in early stage startups with validated aspirations for successful returns. While some older strategic CVC groups such as Verizon Ventures commonly employ corporate executives — and several are staffed by a rotating group of executives with no investment experience — the executives typically have a business development background.
    – Most financially driven CVCs are staffed with individuals who have significant institutional VC experience, and they actively recruit additional partners from IVCs.
  • They participate in early and later stage investments. Early stage investments enable them to fulfill their innovation mission by giving their corporate parents over-the-horizon visibility to new technologies and business models. CVCs have learned that in order to remain effective and influential with their early stage portfolio companies, they must be willing to participate in follow-on financing rounds. There is an extra opportunity for CVCs because of this flexibility. As a certain segment of the IVCs are being disrupted, CVCs have the unique opportunity to fit between early stage VCs (such as micro-VCs) and private equity firms and thus improve their position as long-term partners of startups. Late stage investments enable CVCs to identify strategic partners to their corporate business units (Intel’s investment in Cloudera), or opportunities to set up new business units (GE’s investment in Pivotal) along with the creation of the big data business unit. CVCs also syndicate rounds with other CVCs or institutional VCs.
  • Finally, even though CVCs invest significantly less money annually than in the past, as shown in Figure 4, their contribution to the overall VC investments is increasing (MoneyTree estimates about $3B per year but increasing to $7B+ per year based on 2014 trends).

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Figure 4: Percentage of Total VC investment coming from CVCs

Driven by the accelerating rate of innovation in technologies and business models — along with the increasing opportunities for incumbent disruption these are causing — corporations from many different industries and countries are establishing venture groups at a high rate and allocating funds of significant size. Similar past efforts have not been particularly successful for a variety of reasons, including lack of corporate innovation culture and appropriate timelines to ROI. Corporations are applying lessons from those past efforts as they set up these groups and try to improve their innovation efforts.

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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