Over the past year several corporations have asked me for advice on the venture groups they plan to form. These days corporate venturing funds are announced on a weekly basis. Before providing my advice I ask three questions.
First is whether the CEO is ready to lead the corporation’s innovation goals, and see the venture group as one of the means for achieving these objectives rather than as a panacea. I have previously discussed the CEO’s role in establishing the company’s innovation culture. The CEO’s tenure, 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 at the beginning of renewed contract, typically approaches the creation of a venture group very differently from an existing CEO at the end of an employment contract.
Several partners of new corporate venturing units have admitted that CEO tenure is one of their major concerns regarding the long-term prospects for their venture groups, their investment efforts and the commitments they make to their portfolio companies.
The CEO’s staying power with the corporation is also 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. Hewlett-Packard, on the other hand, has had six CEOs over the past 15 years, something that has not helped it recapture its innovation roots.
The CEO must be able to continue supporting the innovation initiatives regardless of the pressure he or she may be receiving from the markets and shareholders for short-term financial performance. This is also why, in a previous article, I spoke about timelines and how institutional venture capital (VC) firms investing in early-stage companies think in terms of seven to 10-year horizons for a startup to reach maturity. Innovative companies are led by CEOs with long tenure and staying power.
Second, I ask why the corporation wants to start a venture group and what will be the mission of the group. Typically, corporations create venture groups because they believe they provide the best way to invest in the startup ecosystem instead of providing them with financial returns. I have found that corporations invest in the startup ecosystem for thefollowing reasons.
1 To create an acquisition pipeline, including identifying opportunities for the acquisition of talent.
2 To support existing or prospective partners.
3 To understand a sector and the associated market with its dynamics.
4 To provide over-the-horizon views 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 prioritises the four investment reasons above, conflicting behaviours that diffuse the effectiveness of the corporate venturing group could arise. For example, business units within the same corporation may not share the same over-the-horizon perspective about a particular technology. Moreover, central research and development (R&D) organisations always believe they have the best and most updated perspective on a technology.Therefore, before creating a corporate venturing group, the list of reasons provided above not only has to be created but it has to be prioritised.
Third, I ask whether the corporation has considered other options instead of forming a venture group. Corporations have four investment options. They can invest:
1 Off the corporate balance sheet, for example, Intel’s $740m investment in Cloudera.
2 Directly from a business unit, for example, Cisco’s investment in Mavenir Systems, and Cisco’s and VMWare’s investment in Hytrust.
3 In an institutional venture firm, for example, 10 corporations invested in the Java fund that was managed by Kleiner Perkins Caufield & Byers, and many other corporations have invested in institutional venture funds.
4 Through their corporate venturing arm, for example, Intel Capital’s big data investments, such as Guavus and MongoDB.
I have the following recommendations for when to create a corporate venturing unit.
1 If creating an acquisition pipeline, or supporting partners are of high priority, then the corporation needs to establish a venture group. Moreover, if the creation of an acquisition pipeline is a particularly high priority, then the corporation should consider establishing a venture fund and investing in institutional VC firms whose focus is consistent with the corporation’s acquisition interests.
2 If understanding sectors in breadth is very important, then the corporation needs to establish a venture unit and invest as a limited partner (LP) in institutional VC firms whose investment theses are consistent with those of the corporation.
3 If understanding markets and geographies where the corporation has no direct access, and providing over-the-horizon views are a high priority, then instead of creating its own fund, the corporation should consider investing in several top-tier institutional VC firms as a regular LP, again paying attention to the compatibility of each VC firm’s investment theses and portolio. 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 photosharing, and even though it established a corporate venturing group in 2000, squandered its lead in these sectors and we know the rest. Intel made big bets on wifi first with the Centrino chip, later with Intel Capital’s investments in WiMax. Yet despite its lead in the wifi sector, the corporation has missed the mobility revolution and to date remains a small player.
4 Finally, I recommend that the corporate venturing units in industries with long innovation cycles – such as agriculture, and oil and gas – should always be collaborating actively with institutional VC firms.
When considering the creation of a venture group Iuse five dimensions of a framework I have developed – strategy, people, incentives, dealflow and governance, as depicted on the right.
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 fund 1, the corporation and its venture group are already thinking about funds 2, 3 and 4. The components of the strategy include the following.
A set of objectives, consistent with this strategy, for the venture group to execute. Primary among these objectives is whether the venture group will be a financial investor, strategic investor or both, defining 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 that is typically refreshed every 18 to 24 months. Along with the theses, the corporate venturing group must also specify the sectors and industries in which to invest, such as data security, big data, agriculture and soon. The theses may change 20% to 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 – 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 on. 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 investors in the corporate venturing unit need to develop a line of sight for each investment – 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 VC firms think about their investment candidates.
The governance of each investment, in other words whether the corporate venturing 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 corporate venturing unit will be leading rounds, and, if so, under what conditions. For example, if investing in early-stage companies, then even if the corporate venture group can lead rounds, it should always syndicate with institutional VC firms with which it has strong relations. This is something I will explore further when I discuss the dealflow dimension.
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 VC firms and their funds.
Institutional VC 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% to 60% of the fund will need to be allocated for follow-on investments to the most promising of the portfolio companies. At least 30% ofthe allocated follow-on amount is invested during the first five years of the fund’s life to these companies. 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 VC firm decides not to continue investing in a particular portfolio company then the amount reserved becomes available for new investments.
If we assume that the corporate venturing unit follows a similar pattern to invest a $100m fund – three to four years –then we can expect an investment pace of $25m to $35m a year, since there is no management fee. Most corporate venturing units, particularly new ones, typically have two to three investing partners. This means each partner is expected to invest on the average $8m to $15m a year between new and follow-on investments. Assuming the corporate venturing unit invests $1m to $3m in each early-stage company, regardless of whether the corporate venturing unit leads the round or is just part of an investment syndicate, and expects to make follow-on investments to 40% of this portfolio, then creating a portfolio of 25 to 30 investments over the life of the fund is possible, implying eight or so investments per year.
Finally, assuming the group invests in 1% to 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 corporate venturing 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.
If the corporation wants to focus its venture fund on late-stage investments, then $100m allocation implies a small number of meaningful investments (eight to 12) with $8m to $10m per investment. This is the main reason the amount has to be large enough as a percentage of the total amount invested in the company, so that the corporation can have information rights as a result of the investment that 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 would make sense to expect returns within three to four years of the initial investment being made. For investments targeting new but market-validated models, expect returns within four to six years. Finally, for investments targeting disruptive technologies and business models, expect returns within seven to 10 years.
My recommendations regarding strategy include:
1. Focus in the same areas where the parent is working. Successful corporate venturing units – for example, Johnson and Johnson Development Corporation and Comcast Ventures – tend to do exactly that.
2. Funds of $100m should be pursuing a single-stage investment strategy. Larger funds – $300m to $500m – may consider pursuing a multi-stage strategy.
3. For funds pursuing a single-stage strategy around early-stage investments, a potential fund allocation could be 30% of the investments to 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.
People
Venture capital is a people’s business. Therefore, as is the case with startups, the quality of the people associated with the corporate venturing group is a good indication of its success prospects. In my framework I call for six teams that need to be associated with the corporate venturing group.
Leadership team: Unlike institutional VC firms that have partnerships and an operating committee staffed by a subset of the firm’s senior partners, corporate venturing 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 also includes a chief financial officer (CFO). I prefer flatter organisations, where the partnership is also the leadership team, because such organisations create a better culture of ownership.
Investment team: This group consists of both partners who can lead investments and other investment professionals, such as vice-presidents and associates, who support them. 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 to consist of more than investing partners.The partners themselves should be experienced enough for the entrepreneur to want to collaborate and to filter out inappropriate investment opportunities but pick the right opportunities. As a VC I have always learned that it is easy to reject an investment opportunity. Picking the right opportunity to invest and generate financial returns is much harder.
Investment committee: This is responsible for deciding whether a particular investment will be made under the terms recommended by the investing partner and based on the results of the investment team’s due diligence effort. The committee’s members come from the venture group, typically the group’s CEO and its most senior investment partners, as well as the rest of the corporation, typically the corporate CFO and the head of corporate development. I have also seen cases where heads of business units are members of this committee.
Advisory board: Every good institutional VC firm uses advisory boards and some have more than one. The members of these boards come from the sectors in which the firm is interested in investing and provide a valuable outside perspective that is used to formulate new investment theses and identify particular sectors and companies for investing. For example, they inform the investment professionals of important problems they are facing, significant trends in their industry, solutions being considered, particularly by incumbent vendors. Even though corporations have first-hand understanding of high priority problems to address, it is highly recommended for every corporate venturing unit to use an externally staffed advisory board to receive additional feedback that can lead to a new investment idea, or lead to abandoning a particular investment thesis.
Knowledge transfer team: Many corporate venturing senior investment professionals told me that much of the knowledge that is gained by the corporate venturing group through interactions with the startup ecosystem as well as with particular portfolio companies is lost because typically there is no dedicated team whose mission 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 corporate venturing investment professionals joining institutional VC teams, but mostly either to join another corporate venturing unit or take another position in the corporation. For these reasons, it is important for every corporate venturing unit 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 Groupand In-Q-Tel have been pioneers in establishing such teams.
Portfolio services team: As I have mentioned in the past, entrepreneurs expect more than money and periodic advice from their venture investors. Once the corporate venturing group determines the type of services it wants to offer to its portfolio companies, it should establish a team that can provide these services. Example services can include access to business and process knowledge, as well knowledge of specific geographies that can be invaluable as the startup considers international expansion, and sales, marketing and recruiting mentoring and execution from corporate executives. I recommend that the members of this team come from the corporation’s business units.
This article originally appeared on Simoudis’ blog.