09 Sep 2016
The options for returns in the current environment are not great. Meanwhile, industrial disruption, typically driven by the digital revolution, is a growing threat across a raft of industries. That threat is often embedded in start-ups.
"Corporates are aware they have more to offer start-ups than just money."
Andrew Cornell, BlueNotes managing editor
Historically those start-ups have been funded by the venture capital industry. Over the last three or four years however those more traditional sources of funding, from angel investors to funds have been joined by another source: major corporations. Indeed, those same corporations are seen by many of start-ups as dinosaurs needing to be hastened to extinction.
For the corporates then, it’s a case of if you can’t beat ‘em, join ‘em. And maybe buy ‘em.
Major companies to have set up their own corporate venture capital funds (CVCs) include industrial and technological giants like General Electric, Samsung, Cisco, Intel and Softbank.
Deal numbers are never precise but some estimates are that CVCs have accounted for nearly a quarter of all VC activity in the United States this year, investing between $US10 billion and $US15 billion a quarter.
In Australia, several major corporates are following suit, notably Telstra and Westpac Banking Corp (this bank, ANZ, also has a fund).
Conventional VC funds are focussed on one thing: financial returns via a successful exit. The business model is to invest early, take a start-up through funding rounds, often investing more along the way, before a liquidity event such as an initial public offering or trade sale crystalises the return.
CVCs though have a slightly different focus. While a financial return is desirable, a major corporate is also interested in taking options in innovation and technology, hedging bets on disruption, taking out potential competitors and – increasingly – infecting the parent organisation with a more entrepreneurial culture.
In a paper entitled Corporate venture capital can pay, but only if you get the structure right published on The Conversation, S. Ramakrishna Velamuri, Professor of Entrepreneurship, China Europe International Business School, Haemin Dennis Park, Assistant Professor of Management, Drexel University and Paul Asel, Managing Director of Nokia Growth Partners, argued CVCs can be very valuable in developing “ecosystems” – the current favoured term for innovative cultures which draw their power from communication and cooperation across disciplines, companies and departments.
“When used together with other tools (such as in-house research and development, mergers and acquisitions and strategic alliances), corporate venture capital programs can be excellent for developing an ecosystem,” they argue.
“This enables the creation of proprietary partner networks or value chains, without the burden of integrating partners into the existing operations of the corporate sponsor. The sponsor can then retain influence through minority equity ownership. For example, Google, Motorola and Apple have used venture capital programs to help establish an ecosystem around their wireless and web activities.”
The authors note corporations have long had “internal” VC, effectively where the group allocates funding to units in the company. They argue such internal models have evolved over decades and there is not enough empirical data to show which is the better model.
The answer will turn out to be no model is superior. The history of venture capital and CVC in previous waves is it can both succeed and fail and that depends on very idiosyncratic and intangible factors such as cultural clashes, deal structures, expectations and shifting markets.
One case study often used is the Blockbuster video store chain and Netflix. Blockbuster, with its slow-to-adapt bricks and mortar model couldn’t compete with streaming video. But Blockbuster once had the opportunity to buy into Netflix at an early stage in what would have been a CVC deal.
In Australia, a similar value shift took place with the Fairfax media company whose revenues were once comprised of classified advertisements for jobs, real estate and cars.
Those profit pools remain substantial but are now dominated by online ventures such as Seek, Realestate.com and Carsales whose market value dwarfs Fairfax. Like Blockbuster, Fairfax missed the opportunity to buy into the attackers at an early stage. Facebook meanwhile has bought Instagram and WhatsApp.
CVCs undoubtedly make sense – in theory. The challenge is VC investing is a specialist skill. Investing in a portfolio of start-ups with a view to profitable exits over time is one thing.
Investing when the return is expected to be cultural or technological or transformational is more complex. The market too may not see a CVC as a core business of say a bank or a telco and so punish the corporate when write-downs ensure if a deal doesn’t work out – which is only to be expected in start-up world.
Universal banks have long struggled with integrating the different cultures of investment banking or markets trading into retail businesses. Integrating VC personnel and remuneration structures is a challenge of a similar order.
Moreover, for the start-up, the perception is often a CVC funding proposition may come with too many strings attached.
In a recent blog post, Jason Lemkin made the case for caution on the start-up side while acknowledging CVCs were becoming easier to deal with.
“Corporations with active VC programs invest in a lot of start-ups and really don’t have that much time to give them,” he wrote.
“Even if the investors do have time for you, getting a $500,000 investment from a $50 billion company doesn’t guarantee you any face time with the business line VPs you really want to work with, let alone the CEO.
“But it does help. You get to attend their insider events. It helps with access, at least at the margin. It helps with partnering, at least on the margin. It helps with visibility.”
The corporate might also make the same point: access to the inside world of start-ups, early warning of disruptive technologies and access to deal flow, a reputation for being “innovative” if for no other reason than spending a lot of time with innovators.
Lemkin said CVCs tend to have longer term views and aren’t beholden to the same structures as VCs with fund members who look at absolute returns in specific time frames.
“Perhaps most importantly, a corporate partner can add a ton of value,” he argued. “The parent company brings significant domain expertise, connections, talent, etc. to the table and can provide channel access, product integration, and other benefits to help accelerate product development and market penetration.”
It’s hardly a massive shock to conclude the success or failure of CVCs has less to do with a corporate-start-up structure than it does the detail of the individual deal, the degree of common interest and understanding between the two parties and the day-to-day function of the partnership.
But this is a market which is likely to continue to expand. Major corporates realise ‘ecosystems’ make sense, too much innovation and disruption is going on to match it all internally. And they have cash.
Corporates though are aware they have much to offer start-ups other than just money. They have data, customer bases, expertise in scale, regulatory licences and understanding. The challenge will be to grant start-ups sufficient freedom to deliver results while maintaining corporate discipline and market understanding.
Andrew Cornell is managing editor at BlueNotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
09 Sep 2016
08 Sep 2016
06 Sep 2016