Since 2012 the success of the traditional venture capital model has been questioned, with headlines such as “Is venture capital broken?” and “We have met the enemy … and he is us” setting the tone, while the number of corporate venturing groups has dramatically increased.
With 210 new funds and units launched since 2010, tak- ing the total to more than 1,000, according to Global Corpo- rate Venturing, corporate venturing is a strong component in the start-up and innovation ecosystem. In 2012, corpo- rate venturing units accounted for 8.2% of total venture capital invested and participated in 15.2% of all financing rounds, according to US trade body the National Venture Capital Association (NVCA). Participation is particularly high in certain sectors – corporate venturers participated in 20.5% of investments in the industrial and energy sectors, for example.
Corporate venturers are in a good position, equipped with technical and market expertise, as well as customer access through their respective corporations. With the venture community undergoing substantial changes and many institutional investors having difficulty raising new funds, the role of corporate venturing will only increase in importance.
Having been immersed in the technology innovation ecosystem of California’s Silicon Valley for the past seven years, and the last four of those in corporate venturing, I set out to understand whether and how different corporate venturing groups are capitalising on this trend. Interviews with 20 US-based corporate venturing groups showed that overall the corporate venturers seem to be working on becoming viable partners of entrepreneurs and tradition venture capitalists (VCs), but work remains to be done on aligning the respective goals and incentives.
In this article, I present the results of this research and argue that setting up strict financial goals and incentivis- ing the corporate venturing management accordingly is the best practice. Such policies are, in the long term, beneficial to the corporate venturing group and result in a more sustainable programme. Unfortunately, only a few groups interviewed have established such metrics and the respective corporations, in many cases, lack the necessary understanding of the impact.
Sustainable corporate venturing
Based on my data, I identified three requirements for sustainable corporate venturing – strategic goals, continuity and financial sustainability. Corporate venturers are usually already strong in the first, and the second can be addressed relatively easily, so I argue that the third requirement is the most critical.
Strategic goals: Unlike the sole focus on financial returns common to traditional VCs, most corporate venturers also have to deliver on strategic goals set by the corporation.
This notion was casually framed by one interviewee as follows: “Over a 10-year horizon, if we only break even on the money, but prevent our corporation from paying billions for an acquisition because of a missed technology trend, the strategic value is ridiculous[ly high].”
A survey by the NVCA published in 2012 shows that a strategic focus is core to 95% of the surveyed corporate venturing groups. Furthermore, about 75% of surveyed corporate venturing groups value delivering on the stra- tegic interest as high as or higher than delivering financial returns. This finding aligns with the results of my interviews with 20 US-based corporate venturing groups, pri- marily focused in the technology sector – only four valued financial returns higher than strategic value. Nevertheless, delivering on financial goals does not exclude delivering strategic value. As one participant concluded: “Only in a subset of cases can you argue that a company which went bust three years after you invested added a lot of strategic value.”
Continuity: Venture capital is a rather small industry where much depends on a good reputation and personal referrals from trusted sources.
Any investor, institutional or corporate venturer should strive to become a reliable and sustainable partner to entre-
preneurs, start-ups and other investors. Consequently, a prerequisite for establishing a successful corporate venturing programme is continuity with regard to strategy, investment focus, and the core team. Even though this topic was not specifically addressed in my interviews, this neces- sity seems to be recognised in the corporate venturing community.
Groups are often set up with the combination of a core team that does not go through the corporate three to five- year job rotation, and people who gain experience at the unit for a limited amount of time as part of their career development. The core team is essential to assure conti- nuity for the external team – entrepreneurs, portfolio com- panies, VCs and other corporate venturers – as well as for the internal network of the corporate venturing group. Financial sustainability: Corporate venturers, especially those investing in early-stage technologies, must be in the game for at least as long as the life of the companies they invest in – an average of more than eight years. Long-term sustainability in a corporate setting can be achieved only if the unit is not losing money over a longer period of time, as corporations are often quick to cut loss-making programmes during times of crisis. As one participant said: “Things do not stay strategic for very long if they do not give you the financial performance.”
On the other hand, corporate venturing investments without strategic goals – that is, only for financial goals – are not sustainable either, as the corporate venturing group usually contributes only marginally to the bottom line and the risk-reward profile of such investments and limited liquidity of the assets does not fare well with most corporate mindsets. Hence, corporate venturing programmes that lack strategic goals are also close to the axe in times of financial stress.
The key requirement
Today’s corporate venturing units need an operational model in which financial sustainability is achieved in order to avoid the fate of previous incarnations and to enable them to survive cycles. When taking into account a man- agement-fee-like structure and some overhead for corpo- rate controlling, the necessary target approaches a net IRR (internal rate of return – a measure of performance) of 10%-15%. When looking at the performance of the VC asset class in the first half of the past decade, however, such performance would put corporate venturers into or close to the top quartile – a fairly high bar.
Currently, financial goals are not always a priority. Only 70% – 14 out of 20 – of corporate venturing groups had estab- lished measurable financial goals (see table). “Do not lose money” was not considered a viable financial performance goal in the ecosystem. It should be noted that in some cases the corporate venturing unit had to drive the process of establishing such goals or self-impose them due to the lack of corporate understanding of the VC process.
Unfortunately, confidentiality agreements prevent me from illustrating these points with more specific examples. Significantly, most of those groups with established financial goals were close to or higher than the above- mentioned bracket of sustainability. However, achieving such performance is challenging and setting goals that are too high and unrealistic results mostly in failure of the corporate venturing programme.
One alternative to setting fixed financial goals is comparison with a peer group, such as VCs in general or other, more sophisticated benchmarks derived from VC or corporate venturing performance in certain industry sectors. However, four of the 20 respondents mentioned that the financial performance of their programme was com- pared with VC peers. The Cambridge Associates bench- mark – US Venture Capital Index and selected benchmark statistics – for example, is useful for corporate venturing units investing across a broad range of industry sectors. All corporate venturers using peer benchmarking have
been around for more than a decade, indicating that this approach can lead to a programme with continuous sup- port from the corporation, and to experience resulting in best practice.
Where financial goals are in place, establishing financial incentives for the corporate venturing management can sharpen the focus of the team and help achieve financial sustainability – make good deals. It would also help to attract talent from the broader VC ecosystem. One participant said: “We cannot build a world-class team with- out compensating them similarly to their peers around the board table.”
Nevertheless, only a small fraction (10%) of the interviewed groups had a carried interest or similar incentive structure. In most other cases, the established incentive was similar or equal to a corporate bonus structure, with limited to no connection to the performance of the corpo- rate venturing portfolio.
Educating corporations
Very few units interviewed mentioned that their respec- tive corporation understood venture capital – only six of 20. In fact, most said the corporate management needs to be educated – sometimes on a continuous basis – about venture capital. This is a quite sobering finding, and could in some cases prevent a corporate venturing group from exploiting its full potential.
The problem is that VC and start-up innovation focuses on break-out success rather than incremental innovation, but measuring a start-up in a corporate fashion against quarterly performance indices usually provides little value at an early stage. With this lack of understanding at the corporate level, the corporate venturers might be driven toward investing in incremental innovation.
In the long term, corporate venturing units need to find an operational model that ensures sustainability based on financial returns, without neglecting the strategic goals of the corporation. Despite the value of financial goals and incentives, it must be recognised that a large value-add for outside partners of a corporate venturer is the corporation standing behind it. Therefore, the successful corporate venturing group must bring strategic value to both the corporation and the start-ups.
Best practices
At least one corporate venturing unit participating in my research has chosen a financial goal derived from the risk- adjusted cost of capital, and uses a carried interest structure to incentivise the corporate venturing management. As the group is only a few years old, time will tell whether this financial goal will be achieved. But from the interview I learned that despite this focus on financial returns, the group had established a good reputation within the cor- poration with regard to bringing strategic value and was highly regarded.
I hope this data and analysis will lead corporate ventur- ing groups and corporations to consider an educated and balanced approach of including both strategic and finan- cial goals in corporate venturing. In the current ecosystem, corporate venturers – including new entrants – have the chance to establish themselves as viable and long-term partners.
May many of these new entrants seize this opportunity, enabling a vital and thriving innovation ecosystem of start- ups and corporations.
This is a special advance copy of an article appearing in the Kauffman Fellows Report, vol 5, which will be pub- lished in February 2014. Contact press@kfp.org for the full report.