Buying innovation: The rise of corporate venture capitalSome organisations are looking beyond their corporate borders to invest in — or outright buy — products or technologies.
Corporations have long striven to compete and grow through innovation — new products, new services, new markets, new business models, and new ways of creating value. The best ones strike a critical balance between maintaining the existing business while venturing into new areas.
Many companies pursue innovation through in-house research and development, strategic alliances, crowdsourcing ideas, and experimentation. But another tack — corporate venture capital (CVC) — is increasingly becoming a means for companies to gain an edge in today's global economic landscape.
CVC deals worth a total of $29.1 billion were funded globally in 2015 — the most in the past four years, according to venture capital database CB Insights. The sum covered at least 1,365 deals, also a four-year high. And 53 new CVC units made their first investment in the first half of 2016, which continues a steady upward trend of new CVC units since 2011. (See Figures 1, 2, and 4, which illustrate the growth and geographic reach of CVC.)
Many notable CVC units are attached to recognisable names. As of 2015, Google Ventures was the world's largest CVC outfit with more than $3 billion under management. Other notable funds include BMW i Ventures, Citi Ventures, GE Ventures, and Intel Capital. "CVC is required for any large successful organisation that wants to last more than a generation," said Patrick Landers, the AARP's director of innovation, who helped develop the organisation's CVC fund.
But an organisation doesn't have to be a global corporate behemoth to pursue CVC strategies.
The CVC concept is fairly straightforward: Investment funds are established within a parent company. The funds target high-growth or high-potential technologies and ventures that could provide value for the parent. The investments are usually strategically aligned to the parent company's mission and values. CVC is most often focused on external investments but could also include investments in internal ventures.
CVC investments provide start-ups with capital, industry knowledge, and access to known markets. In return, start-ups provide the parent company financial returns, market insights, and access to potentially disruptive technologies, promising platforms, and emerging markets. CVC investments complement other corporate innovation initiatives by deepening meaningful relationships with the entrepreneurial, start-up, and venture capital (VC) communities. CVC differs from acquisitions. Whereas acquisitions often fill a gap in capabilities, CVC expands innovation and long-term research and development efforts. (For an option for companies that do not want to invest in a start-up, see the sidebar, "Incubation as an Alternative to CVC".)
CVC is more than money
Corporations that invest in start-ups offer deep industry insights and expertise because of their market positions and proprietary know-how. They become actively engaged in the company in which they have invested, often influencing the strategic direction by taking a board seat or acting as a strategic adviser. This is where CVC differs from conventional VC. Traditional VC organisations are experts in building new businesses and driving financial results by offering both capital and business growth expertise.
Conventional VC firms focus mainly on financial goals and returns. While corporations also seek financial returns, they predominantly focus on actions that benefit the parent company's strategic direction. Start-ups seeking investment capital will weigh the differences between corporate investors and traditional VC investors.
Take Syngenta, an agriculture company with $13 billion in sales in 2015, as an example. The company develops agrichemicals and seeds. That is its core. Yet it actively invests in adjacent market opportunities, such as digital and precision agriculture technologies, that complement its core and address growth opportunities within its business ecosystem.
Not every individual investment will necessarily be a financial or strategic success, but that's not the only measure of CVC. "CVC allows [the parent company] to explore the art of the possible through practical examples," said John Ramsay, the CFO of Syngenta.
Each investment provides an opportunity for market intelligence. Each new venture tests a hypothesis, which furthers the knowledge of the CVC group and parent company. Through CVC, this knowledge can often be gleaned cheaper, faster, and with less risk than innovating exclusively in-house.
Simple recipe for CVC
Potential CVC investments generally fall within one of three stages, each of equal importance. The characteristics of each stage vary. The sweet spot for any particular CVC may depend on the size of available funds, number of investments it wishes to make and can manage at any given time, its appetite for risk, the type of industry, and its patience in seeing returns. (See Figure 3, "The 3 Stages of CVC Investments".)
In setting up and managing CVC activities, consider these simple ingredients:
Find the money. Dedicated funds should be allocated for CVC activity, including cash for investments and the CVC team's overhead. The money can be either recurring annual installments or a one-time allotment. A frequent source of CVC funds is to leverage a percentage of a company's profits, operating revenue, or R&D budget. In starting a CVC unit, it may be easier to secure a one-time allotment of investment funds to prove CVC viability.
Centralise the team. Research strongly suggests that CVC activity should be centralised within one team. The CVC team should actively co-ordinate with applicable business units to ensure strategic alignment. Centralising the CVC team also provides a repository of institutional knowledge, which can persist through time and benefit future CVC teams.
Recruit and retain the right talent. Experience with traditional VC is helpful, but equally important is that CVC staff be excellent brokers of knowledge within their company, have superb strategic thinking skills, be outstanding corporate and political navigators, be willing to spend significant time understanding the strategic objectives and needs of the company, and be credible within their company.
Compensate appropriately. Most CVC staff are well-compensated as flat-rate salaried professionals as opposed to private-equity VC staff who are able to carry interest or establish an equity stake in their investments. The CVC flat-rate compensation model helps to avoid potential risky investments or personal conflicts.
Identify target areas. Be disciplined in choosing the target areas for investment. Consider your company's strategic core, strategic direction, and adjacent market opportunities. Focus investment activity on one or two targeted areas that will support and help grow your company's core. These may include investments that complement your company's core offerings or help grow into adjacencies.
Take a portfolio approach. A diversified approach can reduce risk. The same is true for CVC. Spread your CVC investments across different types of companies at different stages that align with different components of your company's strategic core.
Be clear on decision-making authority. Corporate investment decisions will have to be informed and approved by the right people. Many CVC decisions are made by a small team consisting of the CFO, chief technology officer, head of R&D or equivalent, head of the CVC unit, and the lead of any applicable business units that align with the start-up. Smaller is better for quick and sharp decisions.
Be willing to partner with other investors. Not all investments will require or invite other investors. But be open to the possibility of needing other investors due to the investment size or need for additional expertise in the start-up's activities. If other investors are involved, be sure to conduct due diligence on them, too, to ensure a good fit and the likelihood of a good working relationship.
Measure success. Choosing the right success metrics depends on your company's priorities, strategic direction, culture, and maturity of the CVC fund. CVC funds often have a combination of metrics including deal flow and investment activity, value added to its own business units, and financial return. Details and weighting of each are highly variable. Some CVC groups even look for a simple financial return that pays for the CVC group's existence plus some percentage in excess. Most importantly, the CVC group should provide value for the parent company.
CVC process in 5 steps
CVC generally has five discrete steps:
1. Deal sourcing. The quality and quantity of potential investments depends on the quality of a CVC team's relationship network. An effective deal-sourcing network includes getting out of the office, connecting with entrepreneurial communities of practice, and connecting with other CVC or VC groups. Entrepreneurial communities include individual start-up companies and convening venues (such as co-working spaces that cater to early-stage companies). By sharing your CVC group's investment interests and targets with other CVC or VC groups, you increase visibility into other potential investments and make yourself known to other investors who may benefit from your expertise. As your CVC group matures and becomes better known, expect entrepreneurs and other investors to start coming to you.
2. Due diligence. Potential investments should be well-vetted and researched. Among the things to look for:
- Commercial viability.
- Alignment with the parent company's strategic plans.
- Strength of the start-up company's founders and staff.
- Sustained competitive or technological advantage.
- A well-defined market — and a well-defined problem this solves for the market.
- Strength of intellectual property.
- Difficulty for a competitor to replicate.
- Assessment of the positioning and strength of other potential investors.
Additionally, a valuation of the start-up should be calculated to ensure that the size of the potential investment is appropriate for the amount of equity being purchased.
3. Deal closing. A term sheet detailing, among other things, the company's valuation and equity being purchased should be agreed upon by the start-up company and the CVC group. There may be co-investors. Some investors may get squeezed out of a deal because they provide no additional expertise or value to the start-up or other investors beyond their money. Therefore, even small investors may be highly valued because of their special knowledge, market access, or specific market influence.
4. Monitoring. This step is the longest. It includes coaching, mentoring, advising, and otherwise influencing the future of the company in which the CVC invested. Depending on the size of the investment and the amount of equity owned, this step may include a seat on the board of directors. For smaller investments, it may instead include an observer role on the board or simply an advisory role with the leadership team. In either case, this step is all about influencing the company to benefit its growth and the parent company. The parent company should expect to lend subject-matter expertise and market access in the interest of growing the investment and ensuring strategic alignment.
5. Exit. Exiting may include writing off the investment due to company failure, selling the equity as part of a merger or acquisition, cashing out due to an initial public offering of stock, or purchasing all of the start-up as part of the parent company's own growth.
Overcoming the boom-and-bust cycle
Five years is about the time needed to see a measurable return on the typical CVC group's investments. Due to CVC's ambiguous nature and potential riskiness, CVC groups tend to have roughly a five-year boom-and-bust cycle, especially during lean economic times.
There are three simple things a CVC group should do to arrest the cycle:
- Make your board and CEO proud of the CVC function. Let them tout and own its successes.
- Ensure that your CVC function furthers your company's strategic objectives. All investments should align with your strategy.
- Ensure that your CVC activities and all the expertise your company brings to an investment actually add value to the start-up company beyond the money.
Mark S. Brooks is the senior manager of innovation at the American Institute of CPAs, where he is focused on strategic innovation, thought leadership, growth of the profession, and member value.
Incubation as an alternative to CVC
Directly investing in start-up companies may not be tenable for all organisations. One viable alternative is to operate a corporate incubator. The intent of a corporate incubator is to find promising new ideas and technologies and work closely with them to further develop in a protected space.
Corporate incubators often provide non-financial resources to entrepreneurs and start-up companies. Resources may include office space and access to corporate talent, expertise, and information technology systems. In return, the start-up may be required to integrate some of its activities into the incubator's parent company. This benefits the start-up by giving it industry credibility, rapid knowledge gain, and the potential for sales. The incubator benefits by having influence over the start-up and the ability to leverage it in generating revenue with extremely low risk and overhead. While equity ownership does not normally change hands in corporate incubators, a financial arrangement may be involved, such as the incubator paying the start-up to tailor its offerings for the parent. If the incubation is successful, the start-up may be bought or established as a vendor.
Incubators can also be internally facing. They can rely on internal ideas and staff to develop new ventures. Internal incubators often operate outside their corporation's regular structure. This protected environment helps ensure that promising ideas are not killed by the demands of the core business.
Both models focus on developing opportunities of strategic importance and can be low-cost alternatives or even precursors to CVC.