Unlocking the Power of Corporate Venture Capital
Michelangelo: Hey, listen up! This article is completely different from the rest I’ve written.
Everyone else: Do you mean this one will finally be without cliché quotes, lousy humour, and venture capital jokes?
Michelangelo: Well, I would phrase it a bit differently, but that’s pretty accurate indeed.
Everyone else: Mhm, interesting, but explain us what you mean by different then.
Michelangelo: Not so fast cowboy, let me first tell you a story.
I felt nervous, and the clock was ticking at an incredible pace.
In a few minutes, I will interview one of the leading venture capital firms in the world. In that regard, I had prepared some questions, but besides than, that I had no clue how to act.
It was already late in the evening, and I struggled to keep my mind running at full speed. Stupid mind, why would you bail on me at this moment? Damn, I need to operate at top-notch performance.
Oh, I still have two minutes left, let’s run to the coffee machine to get some fuel.
Yes, now I feel the rush. I am ready.
“Hello? Can you hear me?”
Half an hour minutes later, I was still sitting in my chair glancing over the beautiful skyline view from the office. I could hardly believe what they told me. In short, they loved my research project and wanted me to publish it.
A couple of weeks ago, I finalized the research project. I interviewed seven of the leading corporate venture capital firms, and I am eager to share the main highlights.
Disclosure: the names of the firms and participants have been anonymized for privacy reasons.
Introduction 🔮
In the last decade, digitalisation has changed how the world thinks and does business.
Christensen’s theory of disruptive innovation tells us that an entrepreneurial firm can shake up an industry previously dominated by a few giants. More specifically, a start-up with fewer resources can challenge an established business successfully by targeting overlooked segments, gaining a foothold by delivering more suitable functionality and lower prices (Christensen, Raynor, & McDonald, 2015).
Research conducted by EY explains the decrease in the average lifespan of a company listed on the S&P 500 from 60 years in 1960 to expected 20 years in 2020. In the last decade, there has been a surge in CVC activity and companies are currently using it as a way to get closer to the edge of innovation. At a glance, global CVC activities reached an all-time high in 2018, with $53B invested in this asset class from only $10.6B in 2010. Furthermore, 95% of CVC units reported positive returns in 2017 (Brigl, 2018). Also, the number of CVCs investing for the first time grew from 64 in 2013 to 264 in 2018 caused by a decrease in confidence in the exploitation of R&D activities.
Research question 💭
“How can a CVC firm assist the start-up in its development and growth?”
The sample 🤷🏽♂️
Seven corporate venture capital firms across Europe agreed to participate in the research and the participants ranged from investment associate to partner. All the participants had at least two years of experience in venture capital, entrepreneurship, consulting, investment banking or other relevant industry experience.
The findings 📚
The question asked during the interviews focused on units’ goals, organisational structure, stakeholders, incentives and compensation models and definitions of success.
The three main themes found are:
- The importance of innovation
- The degree of involvement
- The purpose of the cooperation
The importance of innovation ⚡️
The participants described innovation as one of the primary drivers of their investment strategy and reasons for their existence as a fund, and consequently, as the core factor contributing to supporting start-ups. Most of the participants mentioned that it is the prime need for the corporation to look outside of its boundaries and discover new cutting-edge technologies and innovations.
However, investing in innovative companies alone will not help corporations to become more dynamic. This statement is supported by one of the participants who said; “when a corporation creates a venture fund it is important to align two entities in terms of core activities and segment focus because only then they can leverage each other’s competitive advantages”. Therefore, to assist the start-up, the fund must be aligned with it in terms of the industry and segment focus.
Some of the participants stated that reasons for establishing a venture fund include attempts to make the culture of the company more dynamic and forward-thinking. One of the participants said; “the world around us moves much faster than we do. Therefore, we need to change our culture internally to embrace innovation instead of resisting it”. Another participant emphasises the importance of finding the right people inside the corporation and building the trust needed to allow the business unit to understand the power of innovation.
The same participant continued by saying that; “managers in every business unit should understand when the window for innovation is free”. Such statements indicate that the business unit still needs to understand the benefits of innovation fully.
Several participants have mentioned the importance of innovation and how it results in increased market insights. However, one of them provided another perspective by saying; “we are located both in Paris and London, and, therefore, we have a robust entrepreneurial ecosystem that helps the business unit to understand the importance of innovation”.
Location advantage is thus crucial, and particular ecosystems facilitate the innovation process better than others. Therefore, firms should consider expanding into already established entrepreneurial ecosystems. Ultimately, to support start-up’s development and growth, the CVC and the business unit need to understand how to handle innovation and what its implications are.
The purpose of the cooperation 🤛
Out of the seven CVCs interviewed, four considered themselves to be strategic while the other three emphasized financial objectives. One of the strategic CVCs defined their strategic objectives by saying: “our goal is to bring novel technologies to our business, for us that is where the greatest value, and the reasons for our existence”.
On the other hand, one of the financial CVCs defined their financial objectives by saying: “our objective is to grow our fund size by making intelligent financial investments, that will bring the highest returns”. This distinction is crucial as it determines the identity of the fund.
Most participants ranked strategic partnership as their first or second priority in their investment strategy, and all of them mentioned collaboration as a crucial part of their daily activities in relationships with the business unit, the start-up company and with other investors.
However, there is a clear distinction between how the strategic and financial CVCs cooperate with all the external stakeholders. One of the participants made a clear distinction between the two roles of a CVC firm by saying: “in my opinion, it is elementary that, by the end of the day, we need to measure the success of the investment by the amount of technology the corporation has implemented. The start-ups care about getting money, but, most importantly, they care about value. Therefore, we want to be strategic investors who provide the little extra”.
One of the strategic CVCs explained the importance of a strategic collaboration by saying: “I think strategic value outweighs financial return by miles. Even when our fund made a 3–4x financial return on our investments, we did not receive any flowers from the CFO. Of course, you don’t want to lose money but what most people want to hear is that the investment led to strategic cooperation that added value inside the organisation”.
A different strategic CVC elaborates by saying: “we measure successful cooperation based on the technological advancement the start-up brings to the corporation. The start-ups care about getting money from us, but, most importantly, they care about the value we provide. Therefore, we help start-ups as their channel and design partner”. To conclude, it seems clear that strategic CVCs provide value-adding activities that involve the knowledge base of the corporate, and those synergies are the key objective of the cooperation.
Financial CVCs explained the importance of financial returns by saying: “it is hard to say if cooperation has been successful and we like to measure success based on an internal rate of return. In my opinion, the financial outcome is the measure of successful cooperation”. The financial CVCs emphasised that they invest with the same aims as traditional venture capital funds but with the advantages of a CVC.
Further analysis with the other financially-oriented CVCs revealed that: “it is hard to achieve both a financial and strategic fit. However, we still look for a combination. In some cases, a strategic fit will help the cooperation, and in some other cases, financial return makes more sense”. Two participants mentioned they provide value-adding activities such as credibility, market insights and geographical coverage.
To conclude, financial CVCs tend to focus on returns from an internal rate of return (IRR) perspective and pay less attention to synergies achieved. Furthermore, they tend to be more focused on exiting their portfolio companies and hence to analyse the potential fit based on the exit-potential of the start-up.
The degree of involvement 🤲
The CVCs are pursuing opportunities that could help them to maximise both financial and strategic value. For instance, all of the respondents have either a board seat or board observer seat in the startup they invest.
The separation between more and less involved funds was made apparent by two keywords mentioned — “hands-on” and “hands-off”. These two terms refer to how engaged the CVCs are in daily operations of their portfolio companies, with “hands-on” referring to highly involved and “hands-off” to those committed to a smaller extent.
The degree of involvement was explained by one of the financial CVC in the following way: “We like to be involved in the company and, therefore, we prefer to have a board seat. Once we enter the company, we have an operating partner that help and support the company. Most of the members are actively promoting the company from strategy, fundraising, recruiting and sales”.
Another financial CVC elaborates on the importance of having a board seat by saying: “it is essential to have a board seat and, in some cases, we are also majority shareholder, but we usually want to hold at least 10% equity. A higher stake in the company enables us to have a more hands-on approach”.
Strategic CVCs tend to reference their relationship with the business unit as their main point of differentiation. This statement is further emphasised by one of the strategic CVCs by saying: “we make sure that start-ups, scale-ups and later-stage companies speak to the right people. In some cases, we help them to scale their distribution channel, support with their regulatory issues and compliance. We are not hands-on; we are a middleman, meaning we help the start-up to be in an optimal position to move on their own”.
Strategic CVCs identified themselves as mediators mostly guiding start-ups. However, they want to provide value and keep a certain degree of control but preferably through cooperation with their business unit.
Findings from the study suggest that financial CVCs are more involved in the portfolio companies compared to their strategic counterparts and utilise their hands-on approach to differentiate themselves from other CVCs. Regardless of that, both parties actively provide value to the start-ups and want to be active in the company. The hands-on approach of the financial CVC can also be linked to higher equity stakes as they can be naturally translated to increased ownership. Meanwhile, the strategic CVCs generally have less equity and, therefore, prefer to act as a middleman and to provide their portfolio companies with increased freedom.
Conclusion ⭐️
After taking a closer look at the data, it can be concluded that this distinction is evident and that both investors provide a unique set of value-added activities. Strategic CVCs prefer investing in start-ups with a “commercial” side letter, and with this written collaboration, they can offer their distribution channel to introduce the start-up to new markets. Additionally, strategic CVCs provide value-adding activities that involve the knowledge base of the corporate.
Financial CVCs focus on returns from an IRR perspective and evaluate investments from their exit-potential. Financial CVCs are more involved in the entrepreneur daily operations helping with recruiting, follow-on investment, minimum viable product and managerial issues. Both structures acknowledge the importance of technological advancement and innovation, but the value-adding activities vary with the involvement of the fund.
Additionally, when the portfolio firm and the corporate business unit are complementary in their line of business (similar business segments), both strategic and financial fit are more likely to happen, creating the ideal scenario for both types of investors.
CVC is a valuable way to explore innovation, to obtain both financial and strategic results and to provide a vast range of value-adding activities to start-ups. The different fund structures need to be analysed to answer the research question on how CVC firms assist start-ups with their development and growth. Hence, the answer is that it depends on the type of fund and needs of the entrepreneur.
In some cases, a strategic CVCs would provide the most suitable value-adding activities that mostly create synergies. At the same time, in other situations, the financial CVCs could be the most beneficial partner if financial returns are the main objective. For example, a serial entrepreneur would, in some cases prefer strategic CVCs because of the reduced involvement, therefore letting the entrepreneur run their business more freely. On the contrast, for a first-time entrepreneur who usually needs more guidance, the participation of financial CVCs would add the most value. In other words, it likely depends on the needs of the entrepreneurs.
Finally, as a concluding remark, entrepreneurs should not base their funding decisions solely on their capital need but rather identify investors who believe in their vision and can provide value-adding activates in the specific life-cycle stage.
Recommendations 💡
Based on the research findings, a strategy is developed to achieve a successful CVC initiative and to support start-ups in their development and growth phases. The plan is based on three pillars that need to be followed subsequently. The recommendation is universal and could be applied to any CVC firm in any industry.
1) A successful CVC investment requires alignment between the corporation and the fund as well as a team that can learn and adapt to the uncertainties that come with corporate venturing.
Due to differences in cultures between corporation and start-ups, the corporate venturing initiative needs to resonate with the culture of a specific start-up. Therefore, establishing an entrepreneurial culture within the firm is crucial, and the awareness of the change need is vital.
Hence, as a first step, the focus should be on aligning the interest of the business unit with this of the fund, both in terms of industry and structure. Most importantly, however, the initiative needs support from the parent company’s board of directors as this body is authorised to approve potential investments. In this case, a throughout analysis should be conducted where the board members and the management of the fund align their interests and try to find common ground. Additionally, the investment strategy and the decision as to whether the fund objective is mainly to create financial or strategic value should be elaborated on with the board.
As a second step, it is crucial to identify key people in the committee that understand risks associated with corporate venturing and the entrepreneurial aspect of it. For instance, the managing director’s task is to facilitate the flow of information and to ensure knowledge sharing between the fund and board members.
To conclude, once the two agendas are aligned, and the board has a thorough understanding of the reason for the fund’s existence, the corporate venturing project can commence.
2) The business unit should be included in critical decision-making and portfolio management activities.
The business unit has a crucial responsibility for the success of the portfolio company. But, in most cases, its role is not entirely defined. The lack of a prevailing direction and goal alignment lead to many middle-managers to not commit fully or social loafing once the project has begun. Here the role of the CVC is to involve the business unit in the decision-making process with respect to potential investments and to gather market intelligence that would have been beyond the unit’s capabilities.
As a first step, portfolio management should become a defined role in the job descriptions of the business unit. Afterwards, each business unit should elect one contact person to be in charge of managing the expectations and of communicating back to the CVC. On the other hand, the CVC managers’ role is to maintain a good relationship with all elected contact persons. Additionally, the team-member of the fund should continuously exchange business opportunities and information bilaterally with the business unit.
3) KPIs should be established to measure and monitor the impact of the investment.
Peter Drucker famously said: “If you can’t measure it, you can’t manage it.” (Drucker, n.d.). In a similar tone, the impact of portfolio companies on the corporate, and of the corporate on portfolio companies is of utmost importance for both parties. Different firms will have different KPIs based on their financial and strategic objectives. Therefore, the solution is not universally applicable. However, in any case, these indicators should be developed based on the unique characteristics of the CVC.
The goal-setting theory suggests that people who set goals do perform better (Locke & Latham, 1991). Therefore, the CVC should establish KPIs as guidelines that can stretch the ambition of the company. Examples of KPIs could be related to the satisfaction of the business unit in terms of the collaboration, to revenue increase resulting from investments, to the number of reseller agreements or the number of involved technology partners for each portfolio company.
The last few words
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