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Corporate VC: obligatory or oxymoron?

MariWhen I meet with executives from large corporations, they’re often worried.  And they should be; the feeding frenzy in the innovation economy is in some cases because startups are eating the lunch of more established companies.  To quote a friend, if you’re an executive at an established company, your job is to blow on the ice cube to delay its melting as long as possible.

The challenge is how to disrupt yourself, or at least invest/buy the disruptors.  I recently had a chance to interview Mari Joller, an expert on corporate innovation, on this topic.  She had so much insight to share that we broke the interview into two parts, 1) Corporate Venture Capital and more broadly, 2) How the Fortune 500 Can Buy, Invest and Partner with the Innovation Economy (coming soon).   

Mari is now building a new venture in human-machine interaction within the Samsung accelerator, currently in stealth mode.  Previously she was Co-Founder and CEO of SNAZZ, a cloud-based event management platform.  Mari has been a serial intrapreneur for a large part of her career.  Her work included heading Nokia’s location-based services business and app portfolio for emerging markets, which she built from a back-of-a-napkin idea to a 100-person organization with over 10 million users.  At Virgin Mobile USA, Mari led early initiatives in mobile commerce, social networking and advertising.  Mari Holds a B.A. in International Politics & Economics from Middlebury College and an MBA from Harvard Business School.

I worked with Mari over the past few months organizing a two – part series of HBS Club of NY/HBS Alumni Angels panels on these two topics.  Based on Mari’s extensive experience and what we learned from the two panels, she agreed to summarize some of what she learned.

Teten: For a large corporate, what are the advantages and disadvantages of a dedicated fund (possibly with external investors) vs. a 100% on-balance sheet investor?

A lot of venture investing is done on the balance sheet, meaning there is no dedicated fund and investing is done more opportunistically.  By contrast, dedicated funds are becoming more common.

Arguably a balance sheet investor has to be more mindful of her investment choices.  A big investment that turns south or just takes a while to show momentum can set a negative tone for future deals.  A standalone fund can arguably take more risk with a view to its portfolio’s overall performance.

In either case, corporations have to set up their investment vehicles so that the venture capital community sees them as serious players.  This includes a consistent commitment to investing, a dedicated team and compensation like carry to attract top investment talent.

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Teten: How does a corporate VC fit into the overall VC landscape?  What are some of the unique benefits and constraints from the point of view of a founder?  

Corporate VCs participate in rounds with independent VCs and have to abide by the same rules.  Some corporate funds lead rounds and take board seats, others don’t. A corporate investor can provide diversity on the Board as someone who thinks differently from independent VCs.

Corporate venture funds are often referred to as ‘strategic’ investors because of the unique benefits they bring to the table.  Corporate VCs open the door to their parent companies and are well networked in their industries.  Access to the corporate investor’s ecosystem can open up great opportunities from technology validation to customer and partner development.

However, founders shouldn’t take money from corporate VCs because of an exit expectation.  Says Rohit Bodas, Partner at American Express Ventures, “Our investment strategy does not assume that Amex will want to be the acquirer for any of our portfolio companies. We never seek any rights to give Amex preferential treatment at the time of a potential acquisition. There is a possibility that Amex may explore acquisitions within the Amex Ventures portfolio, but those discussions will be on market terms similar to those with other potential acquirers.”

Teten: How is the corporate VC model evolving: in how they interact with portfolio companies or the operating side of their organization?

Entrepreneurs today expect more than just capital from their investors.  Urs Cete, the Head of Bertelsmann Digital Media Investments, notes, “If you think you can provide just money, you will be disintermediated.”

Such expectations have spurred the growth of a new crop of independent venture funds, with notable examples like Andreessen Horowitz and First Round Capital.  These funds provide their portfolio companies with a range of platform services like recruiting support and nurturing founder networks to support one another.

Corporate venture funds compete against their independent peers for the best deals by doubling down on their ‘strategic’ benefits, mainly access to the operating units of their parent companies.  

Corporate venture funds are also investing earlier today.  They used to come in at series B and later.  In the past, CEOs were more concerned with approving the funds’ investments and making sure those companies were going concern.  Now practically everyone is getting involved in Series A.  Some corporate VCs even have seed funds.  It comes as no surprise as technology today enables companies to prove product-market fit much earlier in their lifecycles.

Teten: The new generation of entrepreneurs is asking more from their investors than just money.  What do they offer entrepreneurs that independent VCs cannot, and how does that position them uniquely in the innovation economy?

Corporations have extensive resources that they can summon to support entrepreneurs.  They have hundreds, if not thousands, of engineers, world-class design studios, subject matter experts from supply chain to manufacturing.  Corporate venture groups are making it easier for startups to access this talent by setting up learning and co-working spaces on their premises.  New York Times’ timeSpace is a good example.  A large percentage of corporate venture funds’ portfolio companies end up having a commercial relationship with at least one of the corporation’s operating units.  

Corporate VC networks extend beyond their own parent companies.  Corporate venture investors are well versed and well connected in their respective industries and can facilitate connections for their portfolio companies.

For entrepreneurs, tapping into the corporations’ networks can help on many levels.  It can help develop applications for the startup’s technology in its early days.  Corporate experts can steepen the startup’s learning curve in key areas like manufacturing.  But most commonly these are customer relationships: the operating unit becomes one of the startup’s first or largest customers.  Having said that, there are times when it’s wise for the startup not to work with the parent company…or to hold off until its product is mature enough.

Teten: How do corporate VCs interact with the broader VC community?   

Corporate VCs are at the table with all the other venture funds.  They invest alongside financial VCs.  Some corporate funds now lead rounds.  Others follow independent financial lead investors and most require that independent investors be part of the syndicate.  This sector has come a long way and matured a lot.  

Teten: What makes for a good vs. bad corporate venture investor?

Protecting one’s reputation is incredibly important for any investor, whether independent or corporate.  In the past (and probably still today) there has been bias against corporate venture funds.  Two years ago, Fred Wilson of Union Square Ventures famously stated that he would never again invest alongside corporate VCs.  He later clarified his statements and has done several deals with corporate venture funds since.  Good corporate investors realize that a bias exists and avoid being a source of friction.

Most importantly, good corporate venture investors don’t approach investments with a strategic investment mindset. They act in the interest of their portfolio companies like any investor would.  This can mean protecting the portfolio company from their own parent company and the interests of operating divisions.

The term sheets of good corporate investors reflect the venture capital industry standards and don’t require special treatment like first right of refusal in case of a sale or operating agreements with their parent company’s divisions.  No one wants terms that negatively impact the outcome.

The best corporate investors strive to move fast even in the face of more complex approval and due diligence processes imposed by their parent companies.  Darcy Frisch, VP at Hearst Ventures says, “We are aware of the perception of our slowness.  We have to respect the due diligence requirements of our parent company, but haven’t found it penalizing.”

Teten: How does having a venture fund help the corporation as a whole to innovate?  Our discussion focus is corporate innovation: how do corporate venture funds help corporations innovate better?

Corporate venture funds are one of the most visible, but not the only mechanism to drive innovation at corporations.  Internal R&D, labs, incubators, accelerators, corporate and business development, and M&A all play important roles in helping corporations innovate.

That said, corporate venture funds have a unique vantage point to facilitate knowledge transfer from the external innovation ecosystem to the parent company and its operating divisions.  Corporate investors see a vast number of startups and deals, like any venture investor.  They have deep insights into how technologies and markets are moving.  They often get the first look into coming trends and disruptions.  That sets corporate venture funds up well to transfer knowledge to their parent companies.  There is tremendous value in conversations around what’s the latest in areas that matter to the operating units.  It can provide a valuable external benchmark for internal teams. Exposing operating units to up and coming startups can nudge teams to embrace new technologies faster.

In this area, funds are doing more and more for their parent companies.  It’s not uncommon for the venture group to take corporate executives to trade shows and arrange for them to meet the best and brightest startups.  Venture groups lead internal discussions on trends, field questions about the startup ecosystem, make introductions to relevant startups, identify talent, and help operating units when they buy companies even if it is just lending an opinion.

Of course, bringing startups (whether prospective or existing portfolio companies) closer to operating divisions has business and customer development benefits.  Access to potential buyers and partners is, after all, one of the main attractions why startups seek investment from corporate venture funds.  Corporations in turn benefit from the new technologies, products and services these startups bring to the table.

Teten: What is the proper mission of a corporate VC towards the parent company?  

Usually it’s a two-pronged mission.  The vast majority of corporate venture funds straddle financial and strategic missions towards their parent companies.   

The financial mission is more straightforward.  It translates into maximizing the internal rate of return.  It’s important to distinguish between the return on one specific investment vs. return on the total portfolio or fund over the investment horizon.  It’s the latter that the corporate VC should be focusing on.

The strategic mission is more vague and usually broadly defined.  Generally it implies that the corporate venture fund invests in areas that have strategic importance to its parent company.  However, corporate venture funds also require venture-sized returns.  So it makes sense to invest only in those strategic areas where such returns can be achieved.

The strategic mission is also about early access to startups that may discretely impact the corporation’s markets.  The savviest corporate investors pay close attention to adjacent, upstream and downstream markets in addition to the corporation’s core business.  Gleaning valuable insights about ways in which relevant technology is moving is high on the corporate venture groups’ strategic agenda.

Teten: How should a corporate VC define and measure success?

Financial return has to be one of the top measures.  For the fund, it is critical to demonstrate impact to secure its place in the corporation’s long-term priorities.  This is especially true if the fund is a balance sheet investor without a dedicated fund.  Financial success is also critical to attracting and retaining investment talent.

The strategic benefits are harder to define because it is less clear how you put a value on it. One of the more common measures of strategic success is collaboration between portfolio companies and operating units.  After all, the strategic ecosystem that a corporate venture fund brings to the table manifests in business and customer development opportunities for the startups in its portfolio, and arguably helps said startups get ahead because of it.

Teten: How should funds interact with their operating businesses: e.g., idea generation, investment validation, creating opportunities for portfolio companies, other?

It is all of the above and more.  Successful corporate venture funds have well-tested and well-oiled interactions with the operating side of their parent companies.  When it comes to investment validation, funds invite operators join conversations with entrepreneurs and use their colleagues as sounding boards.  Having colleagues from the operating side interact with a potential investment can answer important questions.  Can the founders communicate well?  Are they good sales people?  Could they excel at customer development with enterprises?

We talked about knowledge transfer above, but just to reiterate that it is an important interaction between funds and their operating units.   A fund can bring a group of startups that aren’t even part of its portfolio to speak to employees in the relevant business units.

Well-defined distance between the fund and operating divisions is equally important. While operational units play a key role in due diligence, they don’t get directly involved in the deal approval process.  To compete for the best investments, corporate VCs are pushed to move at the pace of the market.  Complex approval processes involving multiple individuals in various operating divisions would not only slow down the funds but also muddle accountability over investment decisions.

That said, key operational people could champion deals, in a way giving their stamp of approval to the investment and vouching that the deal would be strategic and important to the corporation.  Involving operational people in this process exposes them to innovation, relevant startups and injects fresh ideas into how they run their businesses.

Teten: What are the pitfalls in corporate VC and how to avoid those?

There has to be a Chinese wall between the venture group and the operating side.  The corporation has to accept that the venture group will do what’s best for the startup.  That can lead to conflict, for example if the operating side is looking to buy a startup that the venture group has invested in.  The operating unit cannot ask for special treatment or information that can undermine the startup’s ability to negotiate the best deal it can get.

To deal with such conflict, the venture group cannot be buried in the corporate structure.  It has to have backing from the top to negotiate against colleagues from the operating side who may run multi-million dollar units with hundreds, if not thousands, of employees.  Likewise, conflict can arise from a customer relationship going south between the portfolio company and an operating unit as its customer.  If things don’t work out, the fund, because of its fiduciary duty has to mediate while representing the portfolio company.

When it comes to governance, putting operating heads on portfolio company boards hasn’t worked.  The role of the board member is first and foremost fiduciary duty to the company.  That doesn’t really fit with the goals and concerns like budget pressures of executives on the operating side.  The advice is to put venture people on those boards.

Another pitfall is short-term vision.  Corporate venture funds have the same investment horizon as independent VCs. That can mean 4-7 years before the first meaningful exit and 10 years before portfolio-level success.  Historically the median tenure of corporate venture funds has hovered around a year.  When markets trend downward or the first few investments haven’t (yet) generated expected returns, executives get nervous.

To avoid the common pitfalls in corporate VC, it is important to clear the path upfront. Says Frisch, “When a corporate gets into corporate venturing, everyone has to hold hands before they jump off.”  In other words, accept that there will be conflict, understand required time and financial commitments upfront, and to talk about it on the executive level.

Teten: What is your view on where we are today in corporate venturing and what the outlook may be in the years to come?

We have seen this huge swell in the past few years. Corporate venture funds have become many corporations’ answer to participating in the entrepreneurial ecosystem.  Today, more than 1,100 corporations have corporate venture funds.  475 of those have been formed in the last 5 years, according to Global Corporate Venturing.  Last year, corporate venture groups deployed $5.4 billion to the startup ecosystem. To put this in perspective, that’s more than the levels achieved in the heights of the dot-com boom of late ‘90s.  Given the statistics, it’s natural to ask if we are in another bubble.

I don’t think we are.  Corporate venturing has matured a lot.  Models have been worked out in more detail, there is a higher level of understanding from the top management and operating side that certain parameters like dedicated teams, arms-length distance and long term commitment are required to be successful.  

The cycles of innovation continue to shorten.  This means the risk of a disruptive startup emerging from the proverbial garage is greater than ever.  Corporations don’t frankly have a choice but to find effective and sustainable ways to keep an ear to the ground as to trends, changes and innovations, and a foot in the door to the startups representing them.  Corporate venturing is one of the most effective ways to achieve that.  It comes as no surprise that more and more corporations are setting up funds as the primary means to participate in innovation.  Conventional R&D can only address so many areas and it’s not exactly lean or fast.  The risk of missing out on a startup that will upend your market is high.

Corporate venture funds today are doing good deals.  They are making substantial exits and are not just cost centers.  That is the best measure for future.  There may be some shakeout if the market downturns, but those that have laid the right rails have staying power.

Teten: When it comes to corporate innovation, how should executives think about setting up a corporate VC fund as a way of driving innovation?  

Understand what you are trying to achieve and whether a venture fund is the right means to get there.  There are various vehicles to access innovation, corporate venture fund is just one way to get there.

To participate in deals, build a portfolio and generate returns, the corporation has to commit to meaningful and sustainable payments over a long period of time.  The alternative model is to set up a dedicated venture fund and even supplement it with outside limited partners.  This requires a greater commitment upfront but makes the corporate fund less sensitive to any down periods in the parent company’s financial performance.

The long-term view cannot be emphasized enough.  As a corporation, you have to realize you are committing to 4-7 years before the first good exits come along that provide the corporation with a return.  Corporate venturing is venture capital, not corporate financial asset management.  The investment horizon should reflect that.  There will be periods when it will feel like you are just paying money out, especially out of the gate.  That will make people nervous.  Having patience is key.  Cete remarks, “You could say that if the fund is not incurring some amount of losses the investors are not taking enough risks.  Because if they are, the investors are bound to invest in some companies that will fail.  Nobody has a 100% hit rate.”

Executive support is critical, especially from the parent company CEO and CFO.  That goes towards the investment horizon, decision-making and separating the fund’s goals from those of operating units.

Invest in a dedicated investment team and give that team authority over investment decisions.  You can put in place investment committees with the likes of Strategy or M&A heads to approve bigger deals, but keep operational units out of investment decisions.  Structure compensation like carry for your investment professionals so that they are competitive with the external market and you can hire the best talent.

Finally, make sure you are comfortable with conflicts that may arise between the fund and operating units, whether related to an acquisition of a portfolio company or a customer relationship.

Teten: What has to be true of the corporation itself for the fund to succeed?  Culture of innovation, a strong balance sheet, other?

Strong balance sheet is a must – the fund needs to invest in order to stay in the game.  So is strong support from the parent company’s leadership.  As for culture, a degree of openness to new things has to exist within the operating units to achieve any strategic goals, most notably deals between the fund’s portfolio companies and the corporation’s operating units.  For collaboration to happen, the investment team also needs to understand the parent company’s DNA and adapt the strategy accordingly.  Bodas notes, “Some corporations are very technology and engineering centric so the technology risk that may come with investing in an earlier stage startup is more broadly understood within the corporation. If technology is not part of the corporate DNA, investing at a later stage where the technology risk has already been addressed may make more sense.”

Teten: How should founders approach corporate VCs?

It’s the same as approaching any VC.  A warm introduction goes so much farther than a cold call.  Do your homework about the fund: what they look for, do they have strategic objectives (if at all), what stage they invest in are all important to understand if the fund is a fit and to craft a meaningful approach.

So how do you get a warm intro? Leverage your LinkedIn network, talk to the fund’s portfolio company CEOs, ask co-investors from the fund’s previous deals to introduce you.

Depending on the fund, you can sometimes leverage the fund as a conduit to the operating side: to get introductions to operating units that are relevant to your business.  Understand whom you can approach with what type of a request before you do, and always use warm channels to reach out.

I posted a summary of this at PeHub.

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