Corporate Venture Capital (and its inevitable conclusions)

The good news is, there’s a ton of capital in the venture arena these days. That’s probably a confluence of two major tends: 1) an extended economic expansion where firms have excess liquidity and need to find clever ways to invest it and 2) the realization that technology is taking over every industry sooner or later (i.e. hedging).

The bad news is, there’s a ton of capital in the venture arena.

The basics of supply and demand dictate that some silly things start happening when too much capital chases too few quality deals. But that’s a topic for another day.

For now, let’s talk about a subset of that influx of capital — Corporate Venture Capital. Specifically, why they start and then where they inevitably end up.

For a good primer, I highly recommend reading the CB Insights History of CVC. (You should also subscribe to their newsletter, if only for Anand’s next-level snark.)

I’ll admit that the majority of my direct exposure to CVC has been in the real estate and private equity space, but since they are high-quality representatives of both the financial industry at large and generic large corporations I think the patterns extend beyond the niche.

Let’s start with a definition for the uninitiated. My favorite is from Kauffman:

Corporate venture capital (CVC) is an equity investment by an established corporation in an entrepreneurial venture. In contrast to individual venture capitalists, who are purely focused on financial returns, most corporations seek strategic benefits in addition to financial returns.

Now, let’s make the world a little more manageable by bifurcating CVC by their primary motivation. (I say primary because there are always multiple reasons to invest in technology like recruiting, competition, M&A deal flow, etc.) CB Insights does another good job of skewering corporates on their innovation strategies here.

As I said above, many of the CVCs I know are actual investment firms. Realizing they can invest in a new asset class stokes their ego and they start to think they can get extraordinary returns by investing in startups. ( “Exposure” “Diversified Risk Profile” “Synergistic with Current Holdings” blah blah blah.) They form their own funds and try to “figure out” technology diligence themselves.

So, Group A (for Alpha [Fe]Male) is the group of CVCs who want to make money by investing. Group B is the corporates who want to see new technology coming (hedge against disruption to their business model), pilot new technologies (increased efficiency and hopefully cash flow), or potentially recruit/acquire tech talent to their otherwise old-school business model.

Group A is the “make money” group. Group B is the “save money” group. (Anecdotally, Group B is about 40x bigger than Group A, but Group A controls about 40x the capital. So it evens out.)

Let’s start with A —

For Group A, you need to solve two problems that every investment firm in history has had. 1) How to we attract the highest quality deal flow and 2) how do we attract and RETAIN the best talent to manage it?

Turns out, the answer to both questions is essentially the same.

High-quality deals (including tech startups) go to investors first.

Let me say that again: People who actively, repeatedly put money into startups will see the best startups.

Duh.

If that is surprising to you, stop reading now. You and I don’t understand Free Market Capitalism the same way and the rest of this post will just upset you.

Neat. So, you have to invest in startups to see the best technology. Great, how do you structure it? (That will answer the second question.)

Some firms think they can just form an internal fund or invest off the balance sheet, but they soon learn that both are problematic. Even if you are, say, Blackstone, and you form a $100M fund to invest in startups. You are going to run into a branding problem.

Most tech founders with any sort of experience have dealt with corporate VCs or strategic investors and they know how slowwwww, disorganized, and bureaucratic they are.

I can already hear you scoffing and saying “Yeah but we are _________ (insert large, prestigious firm). Our brand equity is amazing. Best in market, even. Just having our name on a startup’s cap table will be transformative.”

Lots of people thought that. Outside of Google and maybe Intel and Microsoft, it has almost never been true. (I wouldn’t bet against the Alexa Fund, but it’s too early to tell.)

No, being big is actually a negative in early stage startups. Fair or unfair, “big” and “slow” are synonyms in early-stage world. Your size and prestige is a negative to the experienced founder.

Don’t believe me? Do an experiment. Survey all the Google, Facebook, and Amazon employees you know. Ask them to tell you who Blackstone is. See what they say.

After you pick your jaw up off the floor, ask yourself what type of person is most likely to be a founder at the next breakaway startup that will change your business forever.

Get the point?

If you are going to have a vehicle to invest in startups, it has to be external and separately branded. That means you can either create your own fund or invest in an existing one. Either one is probably fine if you structure your own fund like an actual, stand alone venture with LPs and a PPM and everything. Single LP funds are “iffy” at best. If you don’t structure it correctly, you are going to run into that second problem I mentioned: talent.

This concept is an issue that has faced Pension Funds, Endowments, and other institutional LPs for decades. They recruit, train, and nurture bright deal-pickers to select their investments and craft a thoughtful portfolio. Then these talented young women and men start seeing the General Partners at the firms they select building extraordinary wealth and start to ask “Could I do that?”

Essentially, it’s a math problem. (And not a very difficult one.)

It’s pretty well established that you will get paid less at a CVC than a stand alone venture firm. And you know what most CVCs don’t offer? Carry. So here’s your pitch:

“Hey, Becky Brilliant, come join us at Corporate Ventures. You’ll get paid less than at a VC firm and get no carry on the winners you pick! Sound good?”

Here’s the math:

Let’s say you worked at Car-maker Ventures and saw Uber as a canny early bet and invested $1M in the startup. If Uber goes public this year and you get a 150x, here is your compensation in 2019:

CVC = $200,000 Base + $150,000 Bonus = $350,000

VC = $225,000 Base + $50,000 Bonus + $10,000,000 Carry = $10,275,000 (This assumes a $50M fund, with two GPs, and an 80/20 split with LPs)

Which would you choose? Need some time to think about it?

It’s simple — The most talented people in the market don’t settle for simple salary and bonus. They want to enjoy the full upside of their work.

Given that simple truth, how are you going to attract top-tier talent to your CVC if it’s just a salary and bonus position funded off the balance sheet? (Hint: You won’t.)

So, again I say, if you want to actually make money by investing in startups as a corporate, create a fully-separate, uniquely-branded fund or invest in one of the dozen specialized external funds. (If you want recommendations, email me.)

And that’s where the A guys inevitably end up: creating their own stand-alone fund or investing in an existing fund.

On to group B.

Remember, these are the firms who mainly want to avoid being Blockbuster to the next Netflix. They want to use “evolutionary” technology and know about “revolutionary” technology before it’s too late.

It’s not a bad strategy, but it’s a little tricky.

Essentially, you are trying to have two separate roles within the Diffusion of Innovation curve. To see the earliest, most-disruptive tech, we’ve already established you need to be an investor. The problem with that desire is that you need to be an “Innovator” in the DoI paradigm and you just told me that your preferences are more pragmatic. That’s more likely an “Early Majority” strategy. This is why it’s tricky. You are trying to play two different roles in the Diffusion of Innovation curve with the same team.

The only way that I have seen it work is by outsourcing one and focusing on the other.

More likely than not, you need to outsource the Innovator part and focus on the Early Majority stuff.

That means you need to invest in at least one fund that sees the early-stage tech you want to see and then focus your internal resources on running pilots and creating healthy environments for tech to grow. I know that sounds ethereal, but I’ll make it practical in a second.

If you pushed back on my “invest in a fund” comment, I’m going to hit you with some math. Most funds I know have a five-year capital call. That means you only need to commit 20% of your investment per year. Several of those funds have investment minimums of $500k or $250k. That means you need to set aside $100k per year or even as little as $50k per year to be in that fund. If you are telling me you can’t afford that, then I would ask you to please stay away from startups because you are not taking this seriously or do not have the disposition to deal with companies at that stage.

If you do take it seriously and have the capital, I’d recommend investing in more than one fund so that you cover the geography (non-US, for example) and stage (Pre-seed, Seed, Bridge, A, Late stage) of startups you want to know.

For the internal adoption strategies, the best tool I have seen work is compensation. I know I’m waving my Capitalist flag pretty hard in this post but think about this not-so-hypothetical scenario . . .

Company X has the executive committee and board tell all employees and shareholders that they will be using, implementing, and creating new technologies to streamlines their business. All employees should support, embrace, and learn new technologies as often as possible.

Company Y says the exact same thing and then adds that all bonuses will now have a 20% component that measures how effectively each employee tested and implemented new technologies.

Which do you think will run better pilots for startups and be more technologically advanced at the end of the year?

Me too.

Tie it to comp and people will pay attention. Say pretty words about innovation and disruption and you’ll hear people talk about it for a few months and then get back to business as usual (after all, that’s what got them to their current position).

So these are the inevitable scenarios for our B companies. Either invest in a fund and tie compensation to tech adoption or stay the hell away from technology until all of the other companies in the industry make them a standard. Either is fine and you need to know your firm well enough to know where you fit.

One note on the Innovator part of your strategy here. I think it’s very fair to ask the fund(s) you invest in to give you updates on the technologies and companies they think are interesting that they did NOT invest it. All of them will beat their chest on their portfolio and brag about how great their companies are doing. You should push them for information on companies they missed, haven’t invested in yet, or are exploring at the moment. That should help you cover that Netflix-level threat you need to see coming before it’s too late.

So this is where CVCs all end up eventually. The investors (A) form or invest in independent funds. The general companies (B) invest in a fund and then create a well-incentivized internal adoption culture.

The savvy reader will probably see that there are two distinct classes of technology here and each needs a thoughtful strategy. Internal Tech is software or hardware you will use in your primary business every day. This is sometimes called “evolutionary” technology because it’s the logical evolution of old technology into newer, faster, leaner, or cheaper technology. In a previous post, I referred to it as Iterative disruption. Think about moving from the iPhone 7 to the iPhone 8. It’s better, but not wildly or radically different.

The second type of technology is the external or “revolutionary” technology. This is the type of software and hardware that will radically change a business or industry. Think about going from a flip phone to an iPhone. It’s a totally different game.

Both types of technology will be covered by the strategies above, but if you are inside of a corporation trying to create a plan for this, you’ll need to delineate between the two and discuss how the above strategies address both. Just a friendly heads up!

Finally, I am aware that I am advocating for all CVCs to invest in funds. That may seem self-serving, but I didn’t say my fund. Invest in any fund. There are plenty. Find one you like and pull the trigger. And if you want recommendations, you know where to find me.

Agree? Think I’m an idiot? Drop me a note and tell me your thoughts and war stories — MKnight@blkhwk.com