My previous post in the corporate venture capital (CVC) series provided a broad historical perspective on the sector. In this post I review important lessons learned by CVCs that have been operating for many years and several economic cycles and best practices being used by newer CVCs. The lessons in this post would be of value to CVCs looking for best practices and corporate leaders whose companies have already established venture organizations or are considering doing so as part of enabling innovation.
In the previous post I introduced a five-dimensional framework to employ while setting up a corporate venture group and discussed in detail two of its dimensions: strategy and people. The corporation must establish a long-term strategy for its venture group. As part of this strategy it must create a set of objectives, formulate an investment thesis, decide on the stage of the target investments, the life of each fund, and the amount per investment. Recognizing that venture investing is a peoples business, the CVC must pay particular attention in hiring well. A CVC group may have up to six different teams depending on the scope of its activities and overall strategy. Next I will present the three additional dimensions: the incentives to offer to the members of the corporate venture group, generating the right deal flow to achieve the group’s strategy and satisfy its investment theses, and guidelines for the CVC group’s governance.
In the first part of the series on corporate venture capital I explored how the disruption of institutional VCs (IVCs) and the imperative for corporations to innovate provide an opportunity to corporate VCs (CVCs) to make their mark in the startup ecosystem and be viewed as viable and valuable financing sources to private companies. In the second part I provided more context on CVCs by presenting a brief history of corporate venture capital, and detailing the characteristics of CVCs during the dot-com period and today. In this blog I discuss when corporations should be establishing venture funds, I introduce a framework for creating venture funds and discuss two of the dimensions in this framework.
I started writing these posts with the hypothesis that in their effort to innovate, corporations must re-invent the traditional R&D model with one that augments the R&D efforts with venture investments, acquisitions, strategic partnerships and startup incubation. Corporate VCs (CVCs) are expected to play a big role in this innovation quest. It is assumed that a CVC can move faster, more flexibly, and more cheaply than traditional R&D to help a corporation respond to changes in technologies and business models. With that in mind corporations are establishing such groups in record numbers, including corporations from industries that have not traditionally worked with venture capital. Corporations have been providing their venture organizations with significant size funds to manage, and expect them to invest in companies of various stages and geographies. Today’s CVC prominence can result in many advantages for entrepreneurs and co-investment partners but also carries risks, many of which are due to the way CVCs are set up and operate within the broader corporate structure. In the last blog I examined how the disruption of institutional VCs (IVCs) can impact corporate VCs. In this blog I start taking an in-depth look of corporate VCs. I will examine the different types of corporate VCs, compare the characteristics of today’s corporate venture groups to the characteristics such groups had in the late ‘90s, and describe the areas where CVCs must focus on in order to succeed. In the next blog I will provide some ideas on how to best set up a CVC organization based on my work with such organizations to date.
A large corporation recently requested my advice on how to set up and structure their venture fund, which they wanted to base in Silicon Valley. This corporation had initially set up a venture fund in the late ‘90s to invest in Internet startups. By 2002 they closed down the fund after determining that its portfolio companies had lost their financial value and had created little intellectual property of interest. But the startup activity of the last four years and the disruptions startups are causing in the company’s industry is leading it to re-establish its fund. This example, and many other similar ones, demonstrates a recurring theme of the past three years: corporations from a variety of industries are establishing, or re-establishing, venture funds in Silicon Valley, and other innovation clusters, and are aggressively participating in startup financing rounds. According to Global Corporate Venturing today 1100 corporations have active venture funds. The number of funds has doubled since 2009 and 475 of which have been established since 2010. VentureSource reported that corporate venture capital firms (CVCs) invested $5 billion during 1H14, a jump of about 45% from a year earlier and the highest level since the dot-com era. The emergence of corporate venture capital as a major source of startup funding has been the result of two factors, the first accidental and the second intentional. First, because institutional venture capital is being disrupted, corporate venture capital is able to fill some of the void that is created and emerge as an important startup-financing source. Second, as was previously discussed, corporations intend to access externally developed disruptive innovations by participating in the financing of startups. This blog examines what CVCs need to understand about the institutional venture capital disruption in order to best capitalize on the opportunities it will create. In the next blog I will explore how to best set up a CVC organization so that it can provide the corporation with impactful, over the horizon visibility to technologies, business models and startups that can help it achieve its innovation goals while becoming a trusted and value-added partner to entrepreneurs.
In 2001 Apple introduced iTunes based on the IP of a company it had acquired in 2000. By 2003, after the introduction of the iPod and of the iTunes Store, iTunes had become the de facto disruptive innovator of digital music. More recently Apple itself started being disrupted by Pandora and Spotify. Streaming music companies have been growing and taking market share away from iTunes because of their business model and technological innovations. For example, the data they collect about subscriber music libraries and listening habits can provide unique customer insights that can lead to better monetization of the service, as well as improved personalization of the service’s user experience. Apple’s internal efforts to develop a streaming music offering have been unsuccessful. In May, Apple paid $3B to acquire Beats, for its streaming music service this time in order to defend its turf and not be disrupted. Apple’s 2000 acquisition shows that disruptive innovation can be acquired in addition to being created. Even companies with strong innovation DNA, such as Apple, Google, Facebook, and 3M, frequently acquire innovation for a variety of reasons, as we will see later on. To access disruptive innovation corporations may acquire early stage startups as Apple did in 1999, or later stage private companies, as Google did more recently with the acquisition of Nest. In this post I try to make three points:
- Innovation can be acquired, as much as it can be created within a corporation.
- Lack of growth in large corporations, combined with the accelerating innovation pace, are causing corporations to increase their innovation-driven acquisitions, particularly of earlier stage companies.
- Corporations must first identify the goal driving each innovation-driven acquisition and utilize five important dimensions with their associated actions during the acquisition and subsequent integration process.
I have been trying to reconcile two trends I’m seeing. First, large companies are acquiring venture-backed startups to accelerate their innovation efforts. Even as the R&D budgets and associated efforts of large corporations are increasing, they have not been keeping up with the accelerating pace of technology and business model innovation. These acquisitions fall in two categories. First, acquisitions as a means of jump-starting corporate innovation efforts and getting corporations into the “innovation flow.” Good examples of such venture-backed company acquisitions include Avis’ acquisition of Zipcar, Walmart’s acquisition of Kosmix and of Small Society, Wellpoint’s acquisition of Resolution Health, and Home Depot’s recent acquisition of Black Locus. These acquisitions are less about the technology being acquired and more about the innovations the startup employees will be able to create once they are part of the acquiring company. Second, acquisitions as a means of staying in the forefront of innovation. Companies in this category are acquire frequently in order to enter a new sector or grow a sector they are already working on. Good examples include VMWare’s acquisition of Nicira, and Facebook’s acquisition of Instagram. Finally, a growing number of corporations from American Express to P&G, from BMW to GE, and Walmart to Best Buy establishing operations in innovation centers, such as the Silicon Valley, in order to tap into the startup and innovation flow.
Second, while the number of seed-stage companies is increasing dramatically because their founders see opportunities for a quick exit based on the first observation, the number of companies that can receive expansion rounds and make viable acquisition candidates remains small. This is because
- Many of the seed-stage startups that number in the thousands and are funded primarily by non-institutional investors, i.e., entrepreneurs themselves, angels, super-angels, friends and families, are not innovating, don’t have no product roadmap, hypotheses of viable business models, or even ideas of how to acquire and retain customers.
- The number of management teams that can be backed by institutional VCs for scale, give the “escape velocity” and make it a viable candidate for an exit that provides high returns to a venture investor has remained small. As shown below, the number of companies that receive additional rounds of funding by institutional investors has remained largely unchanged in the past 2-3 years.
- The number of institutional VCs who can fund and materially help these early stage companies is getting smaller. Fewer of these institutional venture firms are able to raise new pools of capital particularly capital that can be used for earlier stage investments. The Limited Partners (LPs) that provide the capital to the venture firms want to take on less risk with the capital they provide and they want returns faster. The thinking is that investing in later stage companies shortens the time to liquidity while reducing the risk of the investment. Because of the overall venture industry’s returns have been low over the past 10-12 years, the allocations LPs are making to venture funds have decreased and are now about 25% of their peak in 2000. LPs want to invest in only a few venture funds that they consider as having the right deal flow of early stage companies that have higher probability for meaningful exits. So we are moving from an industry with a broad investor base to an industry of specialists (SaaS specialists, biotech specialists, consumer internet specialists, etc.).
Therefore, because the number of the desirable startup acquisition candidates will remain small, large corporations will need to find ways to foster innovation from within. Corporations must also become better at selecting which companies to acquire. In this way will be able to identify companies that can provide the desired innovation in the short term but also have the teams that will stay with the acquiring company thus providing long-term benefits. The capacity of institutional VCs to invest in seed-stage startups will not increase. In fact, it may continue to decrease further. Rather than creating as many seed-stage startups with weak teams, dubious innovations and no long-term prospects, entrepreneurs must seek to form strong teams that can innovate and build large and enduring companies.