Corporate Venture Capital’s Role in Innovation, Part 4: Completing the Framework

Trident-ES-1234By Evangelos Simoudis

In the previous post I introduced a five-dimensional framework to employ while setting up a corporate venture group and discussed in detail two of its dimensions: strategy and people. The corporation must establish a long-term strategy for its venture group, and as part of this strategy, it must create a set of objectives and formulate an investment thesis. Strategy must also dictate the stage of the target investments, the life of each fund, and the amount per investment. Recognizing that venture investing is a people business, the CVC must pay particular attention to hiring well. A CVC group may have up to six different teams depending on the scope of its activities and overall strategy.

Next I will present the three remaining dimensions: the incentives to offer to the members of the corporate venture group, the approaches for generating the right deal flow to achieve the group’s strategy and satisfy its investment theses, and guidelines for the CVC group’s governance.

Dimension 3: Incentives

Creating the right reward or compensation incentives for the members of the corporate venture group is the most difficult dimension to address in my framework. It requires alignment between the corporate leadership and the CVC leadership on investment strategy, risks — and the appropriate financial rewards for these risks — as well as agreement on the innovation-KPIs. In order to better appreciate the challenges of the topic, it is important to first understand how institutional venture investors incentivize their investment professionals.

Institutional venture compensation incentives consist of salary, performance bonus and carry, (also known as carried interest (and here)). In institutional venture firms, the salary and the performance bonus of every investment professional is paid out of each fund’s management fees. An institutional venture fund typically charges a management fee that averages to 1.5-2.5% per year.

Carry is the portion of the profits generated by the venture fund’s portfolio of investments that go to the fund’s investment professionals. In most institutional venture funds, the profits are calculated after the amount contributed by the fund’s investors, or its limited partners (LPs), is returned in full. The purpose of the carry is to motivate the investment professionals to perform and is typically capped at 20-25% of the fund’s profits. In most cases, institutional venture investors trade salary and annual bonus for carry. Institutional venture investors also contribute to each fund, side by side with their LPs. The contribution ranges from 1-10% of each fund’s size. This means that the IVC’s investment professionals are aligned with their LPs because they participate on both the upside and in the downside.

When designing the right CVC group incentives, the corporate leadership and the CVC group’s leadership must be aligned on the group’s strategy; the risks this strategy carries; the group’s expected contribution to the corporation’s innovation goals; and the required experience and background of the CVC’s members.

For example, a strategic investor investing small amounts (say, up to $3M per investment) in late stage private companies assumes less risk than a financial CVC who leads investments in early stage startups and can invest over $10M per portfolio company. The carry packages for each should reflect the risk they must take in accordance with the group’s investment strategy.

Measuring the contribution to the corporation’s innovation goals is hard because such contribution is difficult to quantify. Measurement requires the establishment of innovation-KPIs, which, as we’ve discussed, corporations find difficult to agree on and set. The way this issue is ultimately handled reflects the corporation’s innovation culture. It is indicative of whether the corporation intends to use the new model for achieving its innovation goals and measuring its impact, or whether it will continue to place R&D as the sole innovation driver. For example, in the case of IBM, the company’s R&D organization is still the company’s innovation driver, whereas its CVC group plays a more constrained role by identifying promising startups for the company to partner with.

The composition and experience of the CVC group’s members, particularly that of its investment team, also impacts the compensation structure. Strategic CVCs tend to be staffed by corporate executives who typically join them from another corporate organization. Such executives tend to expect salary, bonus and option packages that are consistent with their previous experiences and assignments. They prefer the certainty of these incentives instead of the potentially higher — but less certain — financial return based on the ROI of the CVC’s investments. CVCs with a financial mission — or a mission that combines financial with strategic goals — typically include investment professionals with institutional venture experience. Such investment professionals, particularly those with significant IVC experience, will likely expect incentives that are similar to those offered by institutional venture investors, even if their ultimate value is lower than what they were used to with the IVCs. Less experienced IVC investment professionals may be more willing to accept a position in a CVC even without receiving a carry-like incentive. In my experience it is the decision on whether or not to offer an incentive with a significant financial value tied to the monetary form of the ROI (strategic or financial) that makes this a difficult dimension to address. I’ve seen situations where corporate investment professionals are rewarded on the basis of the size of the portfolio, rather than its quality and the ROI it provides the corporation. This approach provides the wrong incentives.

In addition to determining whether to offer an incentive tied to the generated ROI, the corporation must also decide whether to offer it to every CVC member or just to members of the investment team, and what monetary value it will represent. Many corporate CEOs and boards balk at the possibility this monetary value could be higher than the total compensation received by the corporation’s top executives, including its CEO. Today the members of many CVC groups expect their corporation to offer them an incentive tied to the ROI provided by their organization. By not offering it, the corporation runs the risk of “training” the members of its venture group and then seeing them leave at the first opportunity to join an institutional venture investor or a corporate investor that offers better incentives, thus losing the investment knowledge and experience, as well as relations to the startup ecosystem. Strong performance has to be rewarded even if it does not fit the corporation’s average compensation norm.

The corporation has two ways to structure an incentive tied to the monetary ROI created by the CVC’s investments. First, it can offer specially configured option packages. These packages should be of significant value commensurate to the packages top corporate executives would receive rather than mid-level executives, and have vesting schedules that are tied to the investment timelines. For example, the vesting schedule for investors working with early stage startups can be 7-8 years instead of the typical 3-4 year vesting schedule of corporate option grants. The option packages for high-performing investment professionals should also be periodically refreshed in the same way venture-backed startups refresh the option packages of their high-performing executives.

Alternatively, a corporation can pre-allocate a portion of the profits it receives from its venture investments for distribution among the members of the CVC group, after it recovers all of its original investments. This will require the corporation to create funds rather than allocate funding on an investment-by-investment basis off its balance sheet. The distribution of this pre-allocation among the investment professionals should be based on each investment professional’s historic performance, the overall portfolio company performance in the current “fund,” and the seniority of each investment professional.

Dimension 4: Deal Flow

Every venture investor, and thus every CVC, wants to invest only in the high-caliber companies that fit the stated investment thesis. This requires the CVC to have a deal flow of sufficient volume and quality. Volume is important because only a small percentage, typically 1-2%, of the considered opportunities ultimately become investments. Quality is important for obvious reasons. CVCs are always asking how to build their deal flow to sufficient volume and quality; how and who to partner with in building deal flow with these characteristics; and how to select the right investment opportunities to focus on.

It takes a new VC about one year to build deal flow that targets specific sectors within IT while satisfying particular investment criteria and providing an investor with options to consider. It takes longer in fields such as biotech. In creating deal flow, the CVC’s investment team will need to determine how to balance its inbound sourcing efforts, or the investment opportunities that come to group from its network, with its outbound efforts, the investment opportunities that are due to the CVC’s proactive outreach efforts.

The key to a successful inbound sourcing effort is the CVC’s relationship network. The bigger the network with the right level of relationships, the richer the deal flow can be. CVCs have the opportunity to create broader relationship networks than IVCs by taking full advantage of their corporate position, while also developing strong and meaningful relationships with the startup ecosystem.

A CVC should leverage the relationships its members can create within the corporation. The relationships with the corporation’s business units are significant because at any point in time, each business unit may be partnering with several private companies — all of which represent a potential inbound investment opportunity for the CVC. Partnering closely with the business units will also expose the CVC group to the problems these units are trying or want to address. Each such problem offers the CVC the opportunity to conduct deep sector analyses in order to identify startups that can potentially address it. Once these startups are identified, the CVC’s team can reach out to them to generate outbound investment opportunities. During this process, the CVC will not only be able to strengthen its relationships with the business units, but it will also be able to demonstrate to each prospective portfolio company the unique business value it can provide compared to most IVCs.

The CVC should also collaborate closely with the business development and corporate development organizations. These organizations constantly work with many private companies, which in turn can present additional inbound investment opportunities for the CVC group. If the corporation already has a business relationship with a startup, the CVC group may have an easier time convincing the startup to take an investment, and its pre-investment due diligence work will be greatly facilitated.

If the corporation has also established an incubator or an accelerator, the “graduating” teams can provide proprietary investment opportunities to the CVC group while enabling the corporation to protect and enhance its incubator investments.

In addition to internal relationships, every CVC must develop a rich network of external relationships that should include institutional VCs; angels; superangels; executives; startup founders (particularly if the CVC focuses on early stage investments and is in the position to lead new investments rather than just be part of an investment syndicate); incubators and accelerators; and even other corporate venture investors who may have a similar investment strategy and theses. It is also reasonable for the CVC investing in early stage companies to utilize platforms like AngelList, Kickstarter and Indiegogo.

The right IVC partners are important not only because they can provide the CVC with vetted investment opportunities, but they can also help the CVC’s investment team analyze deals it receives from other sources (if they represent co-investment opportunities), as well as provide access to high caliber management teams. The network of trusted IVC partners should include the firms with which the CVC has co-invested (or would like to co-invest), as well as the IVCs where the corporation is an LP. The CVC must also understand which IVCs will be competitors. In the process of identifying candidate IVC partners, the CVC will also be forced to articulate the value it will be providing to the IVC. In other words, the CVC must justify why the IVC should share with it the higher quality investment opportunities. For this reason it is important for the CVC’s investment team to demonstrate depth of knowledge in particular fields; provide access to relevant business unit personnel; and make certain this personnel are ready to collaborate with the IVCs.

I have seen situations where corporations bring senior business unit executives to visit with Silicon Valley startups and investors and realize after the fact that these executives have no intention to ever collaborate with the Valley’s ecosystem. It doesn’t take long for IVCs to stop paying attention to these corporations and their venture units.

Because of the industry affiliation, it is easier for a CVC to create or access a network of executives than it is for an IVC. Each business unit’s executives can be helpful on this task, as well as the job of nurturing the corporation’s alumni network. For example, many employees from companies like IBM, SAP, Oracle and GE — but also Google, Facebook, Amazon and others — find their way to startups, either as founders or as members of the management team. By keeping track of its alumni network, a corporation can jump-start the creation of its CVC relationship network.

Participating in and sponsoring startup-networking events, conferences, and open houses are highly effective ways to build a broad relationship network that can provide inbound deal flow. Intel Capital, Silicon Valley Bank, Qualcomm Ventures and AMEX Ventures are particularly strong in this type of relationship building.

If the CVC would like to expand its outbound sourcing efforts beyond its internal relationship network, then I recommend they set up a dedicated deal sourcing team within the investment team, whose objective would be to reach out to companies of interest.

Such outbound sourcing efforts require:

  • Creating databases of startups; keeping track of detailed data about each company and its team; and accessing pertinent information from third-party databases, such as Crunchbase, Mattermark, Kite Solutions, Startup Genome, and CB Insights.
  • Periodically calling the companies of interest to identify investment opportunities. This often requires the CVC’s investment team to create an investment opportunity where one didn’t exist before. In the process, the CVC must convince the startup of the overall value the corporation can provide the startup beyond the investment.
  • Being ready to quickly issue term sheets and make an investment. The outbound sourcing effort depends on the number of new investments a CVC can complete on an annual basis; the investment theses being pursued and the available opportunities that satisfy these theses; and the overall investment environment.

Dimension 5: Governance

Governance in a venture organization is a challenging but extremely important issue for CVCs to address. Unless the corporation has a small venture organization — maybe a single investment professional investing occasionally and managing a fund less than $50M — the CVC needs to establish a set of policies, processes and procedures that define its governance. Strategy, people and incentives necessitate governance. The need for governance is not unique to CVCs.

Each IVC firm has:

  • An operating committee responsible for establishing and administering the firm’s policies, processes and procedures. This may include setting and managing the firm’s annual budget as well as hiring, reviewing, promoting and letting go of investment professionals — and more.
  • An investment committee comprising the firm’s senior partners and responsible for determining whether the firm will invest in a company (either for the first time or in a follow-on opportunity); the terms under which an investment will be made; and the amount that will ultimately be invested.
  • An advisory committee made up of the CVC’s biggest LPs and responsible for reviewing the firm’s financial performance, though the committee should not be thought of as playing the role a board of directors does for a corporation.

As I mentioned in the section describing the People dimension of the framework, every CVC must have an investment committee and must consider establishing at least an external advisory group.

Governance in a CVC group must address the reporting structure in relation to the rest of the corporation; establish who will make the group’s operating decisions; and manage the processes and procedures associated with investment decisions. CVCs that manage funds from several corporations, such as Iris Capital or WiL, must also address LP relations by potentially creating an advisory committee.

The CVC’s reporting structure to the rest of the corporation depends on whether the group will be set up as a separate entity or a department within the corporation. Regardless of how it is set up, the CVC is connected to the corporate leadership, the business unit leadership and other corporate organizations as shown in Figure 1.

fig 5

Figure 1: The organizational connections of a CVC

If the CVC group is created as a department, the corporation will need to determine the reporting relation of the CVC’s CEO to the corporate organizational structure. I have seen two alternatives. The CVC’s CEO may either report to the corporate leadership (CEO, CFO or other), or to the head of a business unit. I suggest that the CVC group does not report to the head of corporate R&D because of the potential conflict over how each organization will drive the corporate innovation mission. However, the group’s relationship to the corporate R&D organization regarding innovation must be clarified. If the CVC unit is set up as a separate entity, then it is important for its CEO to report to the corporation’s CEO or CFO.

Due diligence: In creating the process for deciding on investments, the CVC must establish due diligence process for new investments and follow-on investments, as well as the approval process to be followed by the CVC’s investment committee. This of course will be dependent on whether the CVC leads investments or not; the stage it is investing in (early, growth or late); and the target investment sectors.

The due diligence process must detail the ways by which the collected information will be documented and potentially shared with the corporate parent. The insight gained during the due diligence process allows the CVC to provide value to its corporate parent. It is also important to decide how to handle the information gained from diligence conducted by other investors in a syndicate in which the CVC is participating. For example, if the CVC is co-investing with one of its partner IVCs, then its investment team may be willing to accept all the diligence conducted by the IVC, or it may choose to conduct only high-level confirmatory diligence.

Term sheets: The investment committee of the CVC that leads investments must also determine at what point in the diligence process a term sheet will be issued. For example, many VCs issue a term sheet after conducting light diligence and then complete the bulk of their diligence once the term sheet is signed by the company but before deciding whether to invest. Others, particularly those investing in later stage opportunities, may first complete 70% of their diligence before issuing a term sheet. Based on the information gathered and the investment team’s analyses, the CVC must decide whether to invest and under what terms while the diligence is still being conducted. The investment committee or the investment team makes this decision. Certain CVCs, like Intel Capital, require that the head of a business unit always signs off on a future investment before a term sheet is issued.

Board positions and conflicts of interest: Another element of the investment decision process must address whether the CVC will take a seat on the board of a portfolio company or just an observer seat. Board seats can be a tricky issue. The CVC, and by extension the corporation, must decide whether the board member representing the CVC will vote for the interests of the corporation, even if these run counter to the interests of the portfolio company and its other shareholders. For example, what if a portfolio company receives an acquisition offer from the parent corporation’s competitor? Or what if a portfolio company, in order to continue operating, needs to accept an investment that will represent a down round from the valuation the CVC used when it invested in the company? The CVC board member may come under pressure to determine if the corporation will view such a valuation decrease negatively because it will impact the portfolio’s value. Should the CVC refuse to participate in the down round and even walk away from the investment? If it does so, how will such a decision impact the startup’s management team and the other investors in the syndicate? In other words, what may be good for the startup may not be good for the CVC and its corporate parent.

Addressing these issues around the investment decision process also has a direct implication on the incentives the corporation will use for the members of the CVC group, and the overall innovation culture it establishes.

LP relations: There are few CVCs that invest on behalf of several corporations. As a result, there are no established practices on how to address governance in these situations. My recommendation is for such CVCs to adopt something similar to the IVCs’ advisory committee. In doing so, the CVCs must ensure the members of such a group, who will be corporate executives, are able to discuss freely and provide true governance without competitive issues limiting the scope and type of conversations. For this reason, selecting the LPs for such a CVC is particularly important to the organization’s longevity and success.

Setting up a CVC group is a complex process involving a multitude of decisions that are necessary to help the corporation achieve its innovation goals. The five-dimensional framework aims to guide corporations in this process by structuring the type and range of decisions they need to make to create strong CVC groups. The corporation must establish a long-term strategy for its venture group, which necessitates hiring the right people and providing them with proper incentives, taking into account the investment strategy and its risks and rewards. Of course, successful venture investing also relies on high quality deal flow, obtained by capitalizing on internal and external relationship networks. Finally, governance decisions must address the CVC’s reporting structure to the rest of the corporation; establish who will be making the group’s operating decisions, and detail the processes and procedures associated with investment decisions. While creating a CVC group is complex, it can be a major step in the right direction for corporations that want to innovate.

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/.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s