There is much talk about the conflict between strategic and financial objectives in corporate venturing. These apparently opposing objectives are portrayed as an unavoidable feature, resulting in an insoluble problem that can at best be managed but never fully overcome. At its worst, the venturing unit can develop an acute form of corporate schizophrenia and become destined for a short and unhealthy life.
With restorative therapy, however, corporate venturers can regain clarity of vision and a chance for longevity. They have the opportunity to use their unique advantages to demonstrate that investing in early-stage companies can be highly profitable.
The initial step in the treatment is recognising that the supposed conflict between strategic and financial objectives is largely illusory and results from two misconceptions. The first is the belief that there is strategic value that cannot or does not need to be translated into financial return. Related to this is the mistake of using the parent company’s cost of capital as the basis for stipulating a targeted rate of return. This can be termed the “fallacy of misplaced cost of capital”.
This thesis rests on a bold statement – the success of any strategic decision can and should be judged by the return it generates. A corporate venturing unit may be established with a set of strategic objectives ranging from gaining access to novel technology, tapping into adjacent markets, developing alternative business models or making minority investments as a prelude to a takeover by a business unit of the parent. These are all valid strategic objectives. The challenge is how to determine whether they are successful.
Broad strategic options are difficult if not impossible to value. How does one value gaining access to a new, unproven technology? How does one quantify the benefit of entering a new market or developing a new business model? Valuing strategic objectives can be attempted only if they are broken down and expressed as specific investment propositions. They can then be analysed and assessed employing the same process used to make any discrete investment decision.
Financial return is the one clear, objective standard that can be used to judge the success of any business strategy over any length of time. Without setting return targets, the corporate venturing unit is more susceptible to shifts in the parent company’s strategy, often precipitated by a change in senior management. Short-term changes in strategy are not conducive to the health of a corporate venturing unit, which requires a persistent clarity of purpose and a long-term operating plan.
Corporate venturing is sometimes viewed as a form of outsourced research and development, the success of which can be judged by the quality and quantity of new ideas it produces rather than the financial return that might flow from the creative output. This way of thinking is akin to the erroneous notion that intellectual property has intrinsic value apart from any cashflow that might be generated from its deployment.
New ideas can be exciting and it may be easy to be persuaded that a brilliant idea could be worth billions.
The ultimate reality, however, is that no technology has long-term value unless it can produce a sustainable cashflow.
All forms of intellectual property, including brands, trademarks, copyrights and know-how, only have enduring value if they become part of a profitable business.
Similarly, however successful the corporate venturer may be in discovering or creating new technology, products, markets or business models, his or her efforts will fail if they do not lead to profitable businesses. Strategic initiatives have scant relevance if they do not produce profits.
Like any venture capitalist, the corporate venturer needs to balance nurturing early-stage businesses with applying hard-nosed judgment. When an investee company no longer looks capable of delivering an adequate return, it should be killed. The corporate venturer should have the authority to terminate unsuccessful investments without second-guessing whether the investee company should be kept alive because it is “strategic”. The corporate venturer’s authority, of course, can be maintained only if it records some successes.
The corporate venturer’s mission is to make money by making good investments. By using its parent’s assets to add value to its investments and by helping create successful companies that are relevant to its parent, the corporate venturer can demonstrate corporate venturing at its best.
So what returns should the corporate venturer target? The simple answer is that the targeted return should be the expected market return commensurate with the risks undertaken. If an independent venture capitalist would target a 10-times return on an investment, then so should the corporate venturer. A corporate venturer may talk himself into targeting a lower return because the investment meets a strategic objective, but if an investment does not stack up, determining it to be “strategic” does not make it any better. It only raises the question of whether it is a good investment.
The corporate venturer may believe a lower return is justified because the investment can be derisked through access to the parent’s assets or network. A similar issue arises in corporate mergers and acquisitions. An acquirer may be tempted to offer more for a target company because it believes it is able to enhance the value of the target after it has been acquired. While it is often stated that a company should not pay for value it brings, it is generally accepted that as long as the expected return exceeds thecompany’s cost of capital, the acquisition is justified. If the corporate venturer is investing in start-ups or early-stage businesses where the risks are high, the required rate of return should reflect this. The fallacy of misplaced cost of capital is the assumption that the corporate venturer needs only to achieve a rate of return that the corporation targets on acquisitions or investments in established businesses.
By targeting high returns, the corporate venturer will have the best chance of achieving success over time, as the occasional exceptional return will more than offset the more frequent losses.
The irony is that venture capital returns have generally been abysmal.
Only a handful of independent venture capitalists have achieved returns commensurate with the considerable risks of investing in this asset class. It is no surprise that the overall venture capital market has contracted sharply during the past five years.
Corporate venturers have a huge advantage over independent venture capitalists, which enables them to take a different approach to negotiating investments. Because of the added value it can bring to the table, the corporate venturer can argue that it should get a better deal – that is, pay less for the investment. Rather than targeting a lower return because of its ability to derisk an investment, the corporate venturer can turn this logic on its head. Higher returns should be achievable precisely because of the value it can add.
As independent venture capitalists bow out of the market, corporate venturers are stepping into centre stage.
Corporate venturers can create a new venture capital paradigm if they can avoid the delusion of conflicting objectives and vigorously pursue the one clear goal of venture capital investing.