A decade after the Nasdaq stock index peaked with the dot.com bubble, the technology sector’s corporate venturing units are still dealing with the consequences of its subsequent fall.
At 2,358 on March 10, the Nasdaq was still less than
half its 5,132 peak 10 years earlier. The stock index came to symbolise the new paradigm of dot.com stocks from internet-related business and its rise and subsequent fall reflected and drove the frenzy of venture investing in this period, primarily in North America but also round the world.
Venture capital investment in US technology companies increased from $1.8bn in 1995 to $16.2bn in 1999 and $37.5bn a year later back to $5.3bn last year, according to the MoneyTree report.
Corporate venturing was even more pro-cyclical as companies rushed to the potential financial return through investing in and then selling internet- related companies.
Ninety-five US companies, almost all in the technology media and telecom sectors, set up a corporate venturing unit in 1999. Of the 28 that disclosed the amounts committed in 1999, the total was $6.3bn, including $1.5bn by computer and management consultants EDS/AT Kearney, according to Asset Alternatives. The total the year before had been $1.7bn (see table, page 20).
Corporate venture investments, having stayed in a cyclical range of $85m to $542m annually from 1980 until 1996, also surged to $8.6bn in 1999 and then to a peak of $16.2bn a year later, according to US trade body the National Venture Capital Association.
Most of the corporate venturing funds by technology companies launched in the 1999 and 2000 were closed, most quietly but a few leading to court battles and sales on the second-hand market, such as Comdisco.
The write-offs were sometimes large, such as software company Microsoft taking a $2.6bn hit and energy group Enron $1.2bn in the second quarter of 2001.
Alexander Loudon, a consultant at CapGemini, estimated companies in total wrote off $9.5bn in those three months from their corporate venturing investments.
But many of these companies had also made large returns by floating companies, such as Microsoft’s $367m and Apple’s $1.3bn in the final three months of 1999.
However, a number of firms, such as chip maker Intel andnetwork equipment company Cisco, invested through the cycle and others, primarily in Asia, such as Legend Capital (see profile), were subsequently launched.
All, however, adjusted their strategies as they realised the asynchrony that shareholders sometimes did not recognise the gains during the good times but would disproportionately punished the stock price if it made losses.
Strategic rather than financial returns, therefore, became the most important reason for having a corporate venturing unit, although avoiding further red ink – indicating a loss on a balance sheet – was high on the agenda, too. But firms have started to invest again.
Subra Narayan, director of external alliances at photographic technology company Kodak, said the company had been very active in corporate venturing in the late 1990s and then dropped back after the millennium. However, it was "now swinging back to being more activeagain", he said.
The main difference now is the ventures unit seeks deals where Kodak business units are going to buy equipment from the startup.
It also has to decide on the quality of the business’s management team, prospective return on investment and whether other deals are possible.
Narayan said: "Most, if not all, tech companies agree they need to know what goes on in private companies and they cannot do it all internally. We have learned the lesson that corporate venturing is not just for strategic insight and if Kodak helps a company be successful why not take some equity and participate in the upside?" John Leckrone, head of Adobe Ventures, the $300m corporate venturing unit of software company
Adobe Systems, said it had used two models – first, between 1993 and 2006, a series of venture funds where Adobe had been the sole investor, or "limited partner"; second, since 2006, to have the corporate venturing invest off the parent company’s balance sheet in partnership with VCs. The shift had also meant a change from leading investment rounds to backing later-stage businesses and so "leverage known or existing relationships", Leckrone said.
He added: "We have a distinguishing platform to make investments: not seeking opportunistic deals but where there is a potential commercial relationship with Adobe.
"Money is not a differentiator but having a set of expertise to build real value for the portfolio company and Adobe. It is not necessary for Adobe to acquire a company as an outcome, this has only happened in one out of nearly 100 deals. It is an issue of strategic relevance.
"This means our portfolio is not built looking for two home runs and 13 poor deals but for all our investments to generate two to four times the money invested and be going concerns. It is early days but the signs are good our [methodology] is paying off.
"Corporate venturing units are in sweet spot now as they have cash on the balance sheet but still value VCs for helping turn a good idea into a large business and their knowledge for when to prune portfolio companies."
By focusing on strategy, companies over the past decade have developed a number of alternative strategies depending on their companies’ area of technology and ambitions.
Microsoft, Dell and IBM decided a better way to support their dominant positions in personal computer software, hardware and enterprise hardware, respectively, was to encourage the entrepreneurial ecosystem generally through competitions, free equipment and mentoring (see related content on partnering).
Intel became increasingly international in its venturing through its Intel Capital unit (see profile) and boosted the number of events for portfolio companies to meet technology suppliers. Cisco set up a host of innovation centres and competitions as well as continuing to invest in direct deal-making and committing to independent venture capital funds. Telecoms equipment suppliers often moved later stage, such as Nokia, which spun off BlueRun Ventures and retained Nokia Growth Partners as its corporate venturing unit to invest in more developed businesses able to strike a business partnership using its engineering skills.
John Gardner, a managing partner at Nokia Growth Partners and former founding partner at BlueRun, said: "Return on investment is a key aim, as we report to the chief financial officer, so it is not strategy only. However, Nokia Growth invests exclusively in strategically important companies for Nokia’s family of companies.
"This means those with an edge in the market where we bring expertise, that is slightly later stage, as Nokia is a strong engineering organisation so has a tendency to build everything.
"Our aim is to help extend the ecosystem [including in India and China as well as the US and Europe] and find partnership opportunities for Nokia’s roadmap of products, not to buy companies.
Investing gives optionality for business units but partnerships and being part of the whole ecosystem is increasingly important for cost control, finding creative solutions and being faster to market. Building a development community is a tool for any responsible manager."
Frederic Rombaut, managing director for Qualcomm Ventures Europe, the corporate venture unit of wireless technology company Qualcomm, said its investments strategy had moved from looking exclusively at wireless technology to include service-enabled software, green-tech and med-tech.
He added: "Everything has or is going to have a wireless component. Our goal is to make financial investments in strategic areas which will help to speed up innovation across the whole value chain."
All technology corporate venturing units have also had to deal with the changing dynamics of the technology industry and often interrelated financing environment. The microprocessor and internet have achieved the goals of its 1990s exponents and provided strategic inflexion points for practically every industry and company round the world.
As a result, every corporate venturing unit run by companies in other sectors invest in technology businesses, from car makers Honda and General Motors, through oil major Chevron, to media group WPP.
Kuk Yi, managing partner of Best Buy Capital, the corporate venturing unit of US electrical retailer Best Buy, summed up the reason behind non-tech companies being interested in the sector as potential disruption to their existing business models and new opportunities.
He said at the IBF Corporate Venturing and Innovation conference: "For 10 years we were number one for music sales. Now it is Apple. We did not handle the change well so set up Best Buy Capital two years ago to be a retailer within the technology and entrepreneurial ecosystem to see what technology consumers will adopt and also to encourage OEM [original equipment manufacturers] with their speed of delivery to the consumer."
Google is the greatest example of a business, in this case media directories, using technology and the internet to become monopolistic, a model being copied by USbased social networking platform Facebook, Russia’s Yandex and China’s Baidu. (see case studies)
The pace of change has also quickened. Ken Morse, professor at US-based Massachusetts Institute of Technology (MIT) said it had taken the automobile 56 years to reach a quarter of US households, 45 years for electricity, over 30 years each for the telephone and microwave, more than 20 for television and internet, while mobile phones needed just 14 years.
Capital requirements have adjusted to the relative maturity of technologies. Hardware and semiconductors require substantially more time and money to achieve $100m in sales than in previous decades.
Jim Diller, an investment manager at VentureTech Alliance, which acts as a fund manager for a number of venture funds with companies as the sole limited partners, such as Taiwan Semiconductor Manufacturing Company (TSMC), said: "Semiconductor deals are tough right now in the early stage, as valuations of public chip companies are low and what capital is needed to get the portfolio company to $100m in revenues has increased. It is a big company game in many tech areas."
TSMC last month became the sole investor in a $65m VentureTech-managed fund set-up specifically to invest in US-based clean-tech company Stion. Diller said this was "a unique situation as the venture model remains having 10 to 15 deals per fund". TSMC last year had acted by itself in taking a similar minority stake in MoTech.
Other technology investments, such as internet-based services or platforms, such as Google, Facebook and Skype, can achieve critical mass in just a few years and relatively limited initial investment rounds.
Peter Thiel, president of hedge fund and venture capital investor Clarium Capital and co-founder of angel fund Founders Fund as well as a previous co-founder and chief executive of online payments company PayPal, said the key to technology investing was to "look for the last great technology company in an area, not the first, as it becomes a monopoly business".
He said Xanadu was effectively the first internet browser in 1969 but Netscape reaped the rewards after 1992 and the same had happened with Internet Money and PayPal, while Facebook, in which he had been an early investor, was proving the same in social media.
Facebook was a lesson in valuations, Thiel added. "How you measure the progress of portfolio companies is if valuations go up. I came into Facebook at its second round in August 2004 at a $5.5m valuation, by April 2005 it was $85m post-money so a 12-times valuation in 8 months. My heuristic mistake was to think the world has not changed that much rather than to say it is actually worth 20 or 30 times its previous value. If a year later the company’s valuation had been the same then the company is very bad."
One industrial corporate venturing expert said Apple and Google were the conglomerates of the 21st century in the way industrial manufacturers Siemens and General Electric had been in the 20th.
Both trends, along with poor returns from the 1999 and 2000-vintage funds affecting subsequent fundraising, have meant most independent venture capital firms have become more risk averse even where they remain in earlier-stage investing and individuals’ "angel" investment groups become more important in some areas.
Gerald Brady, a managing director within Silicon Valley Bank’s venture capital group, was hired in November from Germany-based industrial conglomerate Siemens to lead the venture debt provider’s work with corporate venture and corporate development groups. He said at the IBF conference: "VCs are being funnelled to software and internet-based companies because of time and cash requirements. Hardware, communications equipment, semiconductors, clean technology and enterprise software are being left to corporations to back. This is because it is hard to make money in these area or the time and capital intensivity mean VCs are increasingly partnering with corporations, which are looking at these areas because they have the cash and are looking for new growth areas.
"We are seeing innovation being valued in this part of the economic and stock market cycles. Stock markets shifted this year to looking for where growth will come from, not on a company’s balance sheet strength."
David Denny, director of UK-based VC Oxford Technology Management, said it was looking for global applications that were pivotal, or disruptive technology that was unproven, but which did not have a large cashflow to get to break-even, "or we like companies with strong intellectual property and patents and about to get commercial traction".
Last year, US VCs raised $15.2bn in 120 funds, the lowest number of vehicles raised since 1993, according to US trade body the National Venture Capital Association. In Europe, fundraising fell 63% to €2.8bn ($3.5bn) across 41 funds.
The aggregate amount raised for US VCs was the worst only since 2003, however, as investors concentrated their commitments to fewer, larger funds by top-tier managers, such as New Enterprise Associates which closed its latest fund at $2.5bn and was third in the ranking of most active technology VCs by data provider VentureXpert (see table on VCs in related content).
In the final three months of last year there were six flotations of venture-backed companies in both the US and Europe, althoug there were 35 in Asia, primarily China. The primary exit route for companies inthe past decade has increasingly been bankruptcy or sale to a corporate.
As Peter Hébert, a co-founder and managing partner of Lux Capital, in an editorial for news provider PEHub. com said: "VC is an unlevered, unhedged, portfolios of equity investments in private companies. And when equities are in the tank, there is nowhere to hide.
"The VC industry won’t thrive without healthy public equities markets. And by healthy, I mean flush with cash, future-oriented and dense with demand and [buying stakes in private companies]."
There are few signs of change in western markets. The Nasdaq is on a price to earnings before interest and tax (P/Ebit) of 13 and this multiple could fall to 10 this year and 8.5 next year as company earnings increase in the US, according to Chris Williams, a partner at UK-based corporate finance boutique Cobalt. In Europe, London’s FTSE P/Ebit multiples were 22 in 2007 but less than 12 last year.
James Montgomery, chief executive of the eponymous US-based investment bank, said at February’s IBF conference he expected 600 deals in the next 12 months against 450 two years ago and 200 last year. This was because VCs’ structure meant they needed to find liquidity for funds raised in 1999 and 2000 "and corporations were providing 95% of exits", he added. He said later-stage private equity and growth capital funds had replaced initial public offerings as liquidity for growing companies. Last month, UK-based buyout firm Apax Partners closed its deal to buy a majority stake in software company Sophos from growth capital provider TA Associates for an enterprise value of $830m.
Neil Foster, partner at law firm Field Fisher Waterhouse, said mergers and acquisitions strategies would be more sophisticated in the next cycle and often follow tactics used in life sciences of initially seeking licences and taking some equity.
George Petracek, managing director at US-based corporate venture fund manager Atrium Capital, summed up the changes as: "Corporations in general are much more aware and want to know about the potentially disruptive (attractive and/or dangerous) technology innovations that come from universities, spin-outs and VC-backed startups.
"This is in contrast to 10 or more years ago, when a large number of corporations, [maybe even the] majority, were mostly reliant on internal research and development, acquisitions of late stage/developed companies and perhaps some sponsored research.
"VCs [meanwhile] are much more aware of the value, or need, of early strategic engagement [to provide] guidance for the start-ups toward relevant markets, products and large partners. Again, this is in contrast to [VCs’] historical preference of bringing in corporations only at a late stage [and] at high valuations, mostly as financial investors and/ or public relations value. The focus now is on fundamental, or real, collaboration."
These broader trends have meant technology-sponsored corporate venturing units have had to adjust their tactics.
First, the fall in the number of venture capital firms earning performance fees – called carried interest – has shrunk to an estimated 30 to 40, industry experts said. This has meant corporate venturing units have been able to hold on to staff more easily, with Intel Capital’s managing directors often having served more than a decade, and recruit from VCs. Leckrone at Adobe Ventures said its remuneration model of earning similar salaries and bonuses to other Adobe employees had not changed.
This meant there was a difference, or "delta", from traditional model of VCs’ earning the so-called 2&20 (2% annual management fee on funds under management and 20% performance fees, called "carry").
Leckrone said: "Over the past eight to 10 years few VCs have earned carry so our overall compensation stacks up. This has led to a switch of younger associates or principals from VC to corporate venturing units, also as the overall number of VC jobs has shrunk."
However, in more buoyant venture markets, such as China and Asia more broadly, retaining staff has proved difficult – Adobe Ventures lost several of its team of five to China-based Legend Capital while others, such as Best Buy Capital, are deciding how to build a team in the region.
Second, to cope with risk aversion and the move to later-stage investing by a significant number of VCs, corporate venturing units have found pulling together a syndicate has proved harder in the past 18 months.
Reese Schroeder, managing director at Motorola Ventures, the corporate venturing unit of mobile phone maker Motorola, said at the IBF conference that its strategy had not changed in 13 years due to the unit’s "very strong support from the very top".
He added: "In the past 18 months, however, half the deals we have gained approval for have not happened because no syndicate could be formed and there is no temptation for us to go alone."
Some, such as Intel Capital, have increasingly led rounds or become sole investors to deal with this, while others have encouraged entrepreneurs to seek grants and venture debt, such as from Silicon Valley Bank, or form consortia with government-financed vehicles.
The European Investment Fund, Europe’s largest fund of venture capital funds, said more than 30% of money committed to local VCs last year came from public sources.
Last month, two large state pension funds, OMERS and ABP launched a 15-year programme, INKEF Capital, to deploy €200m in Canada and the Netherlands over the first five years in start-ups with innovative ideas and technologies.
However, a number of independent groups are trying to tap into early-stage investing and provide partnerships with corporates interested in the emerging ideas and talent.
David Lambert, operations manager at US-based VC Right Side Capital, said at the IBF that his firm was launching a seed, or angel, fund able to invest $75,000 to $1m and do 100 deals a year.
This would provide diversification to offset the risks of very early-stage investing but also take advantage of the increasing capital efficiency in the technology sector.
This meant Right Side could deliver a 20-times return on money invested by realising $10m on a $500,000 investment whereas most VCs "need to invest $10m for a $200m return", he said.
To encourage corporate venturing units to be limited partners in his fund, he said Right Side would invest only in the first round and would ascribe follow-on rights for future rounds to corporations that did invest.
Editor’s note: See related content for the boxes and tables that accompany this piece or read in the PDF magazine above the search box on the home page.