In the first part of the series on corporate venture capital, I explored how the disruption of institutional VCs (IVCs) and the imperative for corporations to innovate provide an opportunity to corporate VCs (CVCs) to make their mark in the startup ecosystem and be viewed as viable and valuable financing sources to private companies. In the second part I provided more context on CVCs by presenting a brief history of corporate venture capital detailing the characteristics of CVCs during the dot-com period versus today. In this post, I discuss when corporations should establish venture funds, introduce a framework for creating venture funds; and examine two of the dimensions in this framework.
Three questions to ask before starting a corporate venture group
Before providing my advice I ask three questions.
- Is the CEO is ready to lead the corporation’s innovation goals? I have already discussed the CEO’s role in establishing the company’s innovation culture. The CEO’s tenure (or contract)and staying power with the corporation are two additional important factors for the success of these initiatives. Based on my experience, a new CEO who has signed a multi-year employment contract with the company — or an existing CEO in the beginning of renewed contract — typically approaches the creation of a venture group very differently from an existing CEO at the end of her employment contract. Several partners of newly established CVCs have also admitted that CEO tenure is one of their major concerns regarding the long-term prospects of their venture groups as well as the future of their investment efforts and the commitments they make to their portfolio companies.
The CEO’s staying power with the corporation is also very important. Innovations, particularly disruptive innovations, may take several years to achieve. Think of how long it has taken Amazon to develop AWS, or Apple to develop the iPhone, and how these innovations benefited from the staying power of Bezos and Jobs.
The CEO’s staying power with the corporation is also very important. Innovations, particularly disruptive innovations, may take several years to achieve. Think of how long it has taken Amazon to develop AWS, or Apple to develop the iPhone, and how these innovations benefited from the staying power of Bezos and Jobs. HP, on the other hand, has had six CEOs over the past 15 years: something that hasn’t helped it recapture its innovation roots. The CEO must be able to continue supporting the innovation initiatives regardless of the pressure she may be receiving from the markets and shareholders for short-term financial performance. This is also why in the second post of this series I spoke about timelines and how institutional VCs investing in early stage companies think in terms of 7-10 year horizons for a startup to reach maturity. Innovative companies are led by CEOs with long tenure and staying power.
- Has the corporation determined the mission of the venture group? Typically corporations create venture groups because they believe they provide the best way to invest in startup ecosystems; they are no longer forming venture groups for financial returns, as they did in the past. I have found that corporations invest in startup ecosystems for the following reasons:
- To create a company acquisition pipeline, including identifying opportunities for procuring talent.
- To support existing or prospective partners, including accelerating the creation of a partner ecosystem around a particular platform. For example, IBM’s Watson Fund supports the Watson cognitive computing platform; SAP’s HANA Fund supports the HANA big data platform; and Microsoft’s Azure Fund supports the Azure cloud computing platform.
- To understand a sector and the associated market with its dynamics.
- To provide an over-the-horizon view of new technologies and business models.
It is important to understand which of these reasons are important to the corporation and how they relate to its innovation goals. Depending on how a corporation prioritizes the four investment reasons provided above, conflicting behaviors can arise that diffuse the efficacy of the corporate venture group. For example, business units within the same corporation may not share the same over-the-horizon perspective about a particular technology. Moreover, central R&D organizations always believe they have the best and most updated perspective on a technology. Therefore, before creating a corporate venture group, the list of reasons provided above not only has to be created, but it has to be prioritized.
- Has the corporation considered all its innovation-seeking investment options? Corporations have four investment options as they pursue innovation outside their four walls. They can invest:
- Off the corporate balance sheet: For example, Intel’s $740M investment in Cloudera.
- Directly from a business unit: For example, Cisco’s investment in Mavenir Systems, and Cisco’s and VMWare’s investment in Hytrust.
- As LPs in an institutional venture firm: For example, ten corporations invested in the Java fund that was managed by Kleiner Perkins, and many other corporations have invested in their institutional venture funds.
- Through their corporate venture arm: For example, Intel Capital’s big data investments, such as Guavus, MongoDB and other private companies.
Assuming that the corporation decides to create a venture group and allocate an investment fund, it must consider the following recommendations that relate to the group’s mission:
- Acquisition pipeline and business partners: If the creation of an acquisition pipeline and the recruiting of business partners are of high priority, then in addition to the venture group the corporation must invest in IVCs whose focus is consistent with the corporation’s acquisition interests.
- Sector understanding: If understanding sectors in breadth is very important, then in addition to the venture group the corporation must invest as an LP in IVCs whose investment theses are consistent with those of the corporation.
- Market understanding and over-the-horizon perspectives: If the understanding markets and geographies where the corporation doesn’t have direct access and/or obtaining over-the-horizon views are important, then instead of creating its own fund, the corporation should consider investing in several top tier IVCs as a regular LP, again paying attention to the compatibility of each IVC’s investment theses and portfolio. This may be a more economical and effective way to proceed. To understand why, consider two notable examples: Kodak Ventures and Intel Capital. Kodak pioneered digital photography and photo sharing, and even though it established a corporate ventures group in 2000, it squandered its lead in these sectors — and we know the rest. Intel made big bets on Wi-Fi, first with the Centrino chip and later with Intel Capital’s investments in WiMax. Yet, despite its lead in the Wi-Fi sector, the corporation has missed the mobility revolution and to date remains a small player.
- Long innovation cycles: Because it is difficult for corporations to accommodate very long time horizons, i.e., for many even 7-10 year time horizons are a stretch, I recommend that corporations operating in industries with longer innovation cycles, such as agriculture, oil and gas, even if they have corporate venture groups to always be actively collaborating with and investing in IVCs.
The five dimensions to employ while setting up a corporate venture group
When considering the creation of a venture group, I use five dimensions of a framework I developed (Figure 1):
- Deal flow
Dimension 1: Strategy
The corporation must establish a long-term strategy for the venture group. This means that the corporation should be thinking of multiple funds over which to execute this strategy, rather than a single fund, as well as the optimal size of each fund. In this way, while starting to invest in fund 1, the corporation and its venture group are already thinking about funds 2, 3, and 4. The components of the strategy include:
- A set of objectives: There must be objectives consistent with this strategy for the venture group to execute. Primary among these objectives is whether the venture group will be a financial-only investor, a strategic investor, or both. Corporations must also consider the amount of the fund that will be allocated for investments in business models already being used by the corporation, new but market-tested models, and completely disruptive models.
- An investment thesis: The thesis should typically be refreshed every 18-24 months. Along with the theses, the CVC group must also specify the sectors and industries in which to invest, such as data security, big data or agriculture. The theses may change 20-30% from period to period.
- The stage of the target investments: The corporation must determine if the venture group will focus on investments of the same stage (early, growth or late stage), or it will have a multi-stage focus, taking into account the corporation’s risk tolerance level and the amount allocated in each fund. For example, until they raise their first institutional round, IT startups use their seed funding to test hypotheses: technology hypotheses, business model hypotheses, market hypotheses and so forth. The startup’s risk level during this phase of its development is extremely high.
- The life of each fund: Most funds have a five-year investing period and a similar-length harvesting period. Corporate funds may need a shorter harvesting period depending on their overall goal (strategic versus financial).
- The amount per investment: Both initially and over the life of the investment, the CVC group needs to develop a line of sight for each investment. They need to have an understanding of what can happen to each portfolio company based on market conditions before actually investing in it. Developing such understanding is particularly necessary when participating in more than one financing round. This is how the good institutional VCs think about their investment candidates.
- The governance of each investment: The corporation must decide whether the CVC group members will be taking board seats in the companies they invest, or just observer seats. Implicit in this decision is also the decision on whether the CVC will be leading rounds, and, if so, under what conditions. For example, when investing in early stage companies, even if the corporate venture group can lead rounds, it should always syndicate with IVCs with whom it has strong relations. This is something we will explore further when we discuss the deal flow dimension.
What’s the right fund size?
Many corporations these days are committing $100M for their inaugural venture fund. The corporation must think why $100M is the right amount for accomplishing the venture group’s objectives. For this reason, it is instructive to look at institutional venture firms and their funds.
Institutional venture funds have a 10-year life. New investments are made during the first five years of the fund, and most typically during the first three. If the fund invests in early stage companies, then an amount equal to 100% of each initial investment is allocated for follow-on investments to these companies, implying that approximately 50-60% of the fund will need to be allocated for follow-on investments to the most promising of the portfolio companies. At least 30% of the allocated follow-on amount is invested to these companies during the first five years of the fund’s life. This is because early stage companies typically raise money more frequently in the beginning of their lifecycle as they build their solution, recruit their initial customers and try to establish themselves in their target market. If the IVC decides to discontinue investing in a particular portfolio company, then the amount reserved becomes available for new investments.
Early stage investments: If we assume that the CVC follows a similar pattern to invest a $100M fund, for example over 3-4 years, then we can expect an investment pace of $25-35M/year since there is no management fee. Most CVC groups, particularly the newly formed ones, typically have 2-3 investing partners. This means that each investing partner is expected to invest on average $8-15M/year between new and follow-on investments. Regardless of whether the CVC leads the round or is part of an investment syndicate, if it invests $1-3M in each early stage company and expects to make follow-on investments to 40% of this portfolio, it is possible to create a portfolio of 25-30 investments over the life of the fund, assuming 8 or so investments per year. Finally, if the group invests in 1-2% of the business plans it considers, and with the above analysis in mind, it is likely that a $100M fund will enable the corporation to use the CVC group only along a specific investment thesis, such as Nokia’s Connected Car Fund, Accel’s Big Data Fund, and DCM’s Android Fund, rather than along multiple markets.
Late stage investments: If the corporation wants to focus its venture fund on late stage investments, then a $100M allocation implies a small number of meaningful investments (8-12) with $8-10M per investment. The main reason the amount has to be large enough as a percentage of the total amount invested in the company is so the corporation can have information rights as a result of the investment, which will enable it to learn through its association with the private company.
Adopting a particular strategy has implications on investment timelines. For example, for investments that support existing business lines and models, it makes sense to expect returns within 3-4 years after the initial investment is made. For investments targeting new but market-validated models, expect returns within 4-6 years after the initial investment is made. Finally, for investments targeting disruptive technologies and business models, expect returns within 7-10 years after the initial investment is made.
My recommendations regarding strategy include:
- Focus in the same and in adjacent areas where the parent is working. Successful CVCs such as Johnson and Johnson Development Corporation and Comcast Ventures tend to do exactly that.
- Funds of $100M should be pursuing a single-stage investment strategy. Larger funds, say $300-500M, may consider pursuing a multi-stage strategy.
- For funds pursuing a single-stage strategy around early stage investments, 30% of the funds could be allocated to investments that support existing business models, 50% towards new but market-tested models, and 20% towards disruptive models — thinking that 20% disruption may lead to 80% value for the corporation.
Dimension 2: People
Venture capital is a people business. Therefore, very much like is the case with startups, the quality of the people associated with the corporate venture capital group is a good indication of its prospect for success. In my framework, I call for six teams that need to be associated with the corporate venture group.
- Leadership team: Contrary to IVCs that have partnerships and an operating committee staffed by a subset of the firm’s senior partners, corporate venture groups usually have a CEO. The CEO tends to be a senior corporate executive. Depending on the size of the venture group, the leadership team may also include a CFO. I prefer flatter organizations, where the partnership is also the leadership team, because such organizations create a better culture of ownership.
- Investment team: This group consists of both partners who can lead investments and other investment professionals who support them, such as vice presidents or associates. Partners are expected to identify potential investment opportunities; lead the pre-investment due diligence effort; invest in companies; and manage each investment.
The size and composition of the investment team are particularly important. The team needs to be large enough to deploy each fund and should consist of more than just investing partners. The partners themselves should be experienced enough investors for the entrepreneur to want to collaborate with them. They must also quickly filter out inappropriate investment opportunities but pick the right opportunities. As a VC, I have learned it is easy to reject an investment opportunity — selecting the right opportunity to invest and generate financial returns is much harder, as the fund performance shown in Figure 2 demonstrates.
As Figure 2 shows, few institutional venture funds achieve even a 1.5-2x ROI (at that ROI a corporation may double its investment on the venture fund). But some rejections prove to be very expensive, as do many selections (see the list of funds with low ROI).
- Investment committee: After taking into consideration the results of the investment team’s due diligence effort, the investment committee is responsible for ultimately deciding whether a particular investment will be made under the terms recommended by the investing partner. This committee should include the CVC group’s investing partners, the group’s CEO, and the corporate (or business unit) CFO, especially if the corporation is investing off its balance sheet. The investment committee could also include representatives of the company’s strategy, corporate and business development organizations, particularly if the CVC is part of the corporate structure rather than a standalone entity.
- Advisory board(s): Every good institutional venture firm uses advisory boards, and some even have more than one. The members of these boards come from sectors the firm is interested in investing in. They provide a valuable outside perspective for formulating new investment theses and identifying particular sectors and companies to consider for investments. For example, they inform the investment professionals of important problems they are facing; significant trends in their industry; and solutions being considered, particularly by incumbent vendors. Even though corporations have firsthand understanding on high priority problems to address, it is highly recommended for every CVC to use an externally staffed advisory board to receive additional feedback that can lead to a new investment idea — or result in abandoning a particular investment thesis. The corporation may also consider forming an internally staffed advisory boardthat includes representatives from the R&D, strategy, corporate development and business development organizations.
- Knowledge transfer team: Many CVC senior investment professionals have told me that much of the knowledge gained by the corporate venture group through interactions with the startup ecosystem and portfolio companies is lost because typically there is no dedicated team whose mission it is to transfer this knowledge back to the corporation. The knowledge is lost either because it has a short shelf life or because the investment team frequently changes (sometimes with CVC investment professionals joining IVC teams, but mostly either to join another CVC or take another position in the corporation). For these reasons, it is important for every CVC to have a team whose mission is to transfer the knowledge gained from investments, prospective investments and market analyses back into the corporation. IBM’s Venture Group and In-Q-Tel have been pioneers in establishing such teams.
- Portfolio services team: As I have mentioned in the past, entrepreneurs expect more than just money and periodic advice from their venture investors. Once the corporate venture group determines the type of services it wants to offer to portfolio companies, it should establish a team that can provide these services. Example services include access to business and process knowledge as well as knowledge of specific geographies, which can be invaluable as the startup considers international expansion. Services can also include sales, marketing and recruiting mentorship and execution from corporate executives. I recommend that the members of this team come from the corporation’s business units.
In the next post, I will continue presenting this framework by discussing performance incentives, deal flow generation and governance issues.
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/.