Accessing Innovation: So You Think You Want To Set Up A Corporate Venture Fund
Note: This post was previously released as a series of articles in BUILDER Online, Architect Magazine, and MULTIFAMILY EXECUTIVE published August through November 2019.
Part 1: What’s the value in a corporate venture fund?
Setting up a corporate venture capital fund (“CVC”) can be one of the most efficient and effective ways to attract external innovation to a large enterprise. Done wrong, it can also be a colossal waste of money, brains, and time.
Unfortunately, it is typically done wrong.
Returns data for CVCs is notoriously difficult to compile, but according to unpublished data by Correlation Ventures, which includes data from DowJones VentureSource as well as other primary and secondary sources, dollar-weighted (by round size), realized, cash-on-cash multiples for all U.S. venture financings in companies exiting (viz., out-of-business, acquired, or IPO) from 2008 through 2017, were 2.2X for all financings, as compared to 1.8X for all financing with at least one corporate VC participating.
The difference in returns gets less pronounced the later the stage but persists across all stages. In other words, the earlier the round, the worse CVC investments do relative to deals with no CVC.While financial data is hard to get, innovation sourcing efficacy is effectively impossible to measure. That said, anecdotal data points to higher staffing turnover and higher than normal fund closure rates for CVCs as compared to traditional VC, all of which imply that the parent corporation is not satisfied with the CVC as a vehicle for sourcing innovation either.
So while a CVC should, in theory, be a fast, cost effective, way to access cutting edge innovation, all too often they move slowly, make mediocre investments, and miss out on the hottest deals.
The reasons for this fall under two general categories. Let’s break down what goes wrong… and how to do it right.
Failure to function effectively as a VC fund
- Inability to attract high quality venture professionals due to inadequate incentives
- Corporate executives improperly involved in the process
- Investment funds incorrectly allocated
Failure to integrate effectively with the corporate parent
- Target startup investment stage not matched to corporate capabilities
- Allocation strategy suboptimal
- Startup sourcing strategy fails to play to parent corporate’s strength
- Engaging the corporate organization at the wrong time
- Passively assuming that innovation will be received by the corporate parent
Failure to function effectively as a VC fund
- Inability to attract high quality venture professionals due to inadequate incentives
The rap on CVCs is that they are for people on the way up or the way down. The newly hired general partner is either an up-and-coming star looking for a good platform before raising his or her own fund or someone with a failed fund who is looking for a soft landing. While an overgeneralization, there is a kernel of truth: why would anyone who could raise their own fund put up with corporate politics?
So how can a corporate snag a rising star versus a falling one? It can start by replicating traditional venture fund economics so the best talent doesn’t opt out. When JLL set up their $100M CVC fund JLL Spark, they were careful to set it up as an independent fund, giving the general partners the same kind of carried interest they would get if they were running their own fund.
Farsighted corporations think even further ahead: If the first CVC fund does well, the general partners will want to raise a second, likely larger fund, and will naturally be tempted to go out on their own. A savvy corporate will not only expect this but will encourage it by being the lead investor in the second fund while allowing the general partners to bring in outside money to make the fund even bigger. As long as the money doesn’t come from a direct competitor – unlikely in any event – the corporate sponsor should be thrilled: they get more firepower for the same investment on their part.
In addition to structuring Toyota AI Ventures as a standard “2-and-20” VC fund with Toyota Research Institute as the sole LP, Toyota has structured this fund as a template that other Toyota business units can use, either solely or with outside LPs, for their own CVC funds.
Part 2: Corporate executives wade into unfamiliar territory
Because senior management may have a deep understanding of the sector and the specific needs of the corporate sponsor, it seems easy to assume that involving them in the selection process will help the corporate venture capitalist (CVC) pick the right startups to support? However, that’s not the case. I’ll explain.
As part of due diligence, a skilled venture capitalist confirms market demand by talking to a startup’s potential customers. Sector-focused investors can quickly get a feel for what customers in their sector are interested in and what they are leaning into from an investment standpoint. So, at least for a first cut, involving management in the selection process is not necessary.
Not only is it not necessary, it actually can lead to worse decisions. One of the main reasons to set up a CVC is to help its mid- and senior management recognize innovative startups, access them, interface with them, and absorb that outside innovation. So why expect them to be good at it from day one? In practice, inexperienced innovation teams often spend too much time engaging with immature or—to the eyes of a skilled venture capitalist—obviously fatally flawed startups. They waste time, money, and, worst of all, the attention of the business lines, souring them on startups in general.
Once the CVC has winnowed out 9 out of 10 (or 19 out of 20) potential investments, there’s definitely a place for the line management to vet the solution in greater depth… stay tuned for another in depth look at this topic in another part of this series.
How is fiscal oversight managed? When a corporation allocates $50 million or more than $100 million to a project, it is only natural that they want oversight. In this case, it often means that senior management wants to sit on the investment committee and approve investments. But these senior managers often run multi-hundred-million dollar divisions where their “day jobs” always come first. Asking them to find mutually convenient time to meet to review a $1M deal is a recipe for delay. Plus, when a fund has a reputation for moving slowly, the hot deals pass them by.
A smarter balance between speed, flexibility and oversight is to allow the CVC to make routine investments, subjecting only especially large follow-on investments for approval by senior management.
In theory, investing off the balance sheet from budgeted funds should be as effective as committed capital within a formal venture capital fund structure. In practice, it rarely is. Budgets get cut, routine approvals become bargaining chips for corporate horse trading, investment committee members push for pet projects, in addition to potential acqui-hires (hires through acquisition). Creating an arm’s-length contract that obligates them to meet capital calls and also creating governing documents that clearly establish the fund’s mandate and general partners’ sole authority to make investments, up to a certain threshold, insulate the CVC from these pressures, empower it to operate on par with traditional venture capital funds, and enable it to attract top talent.
Another more subtle reason for an arm’s-length fund commitment is to avoid failing by success. When a venture team has a large exit that makes the partners some of the most highly compensated people in the company, there can be a lot of pressure from line management to renegotiate that deal. Since salary is easier to cut than carry, top venture capital talent often shy away from CVCs.
But structuring a CVC to be able to function as effectively as a traditional venture capital fund is only half the battle. The best startups have their pick of investors. How does a CVC make it so that it is a hot startup’s top pick?
Part 3: Making good with the corporate parent
Structuring a corporate venture capital (CVC) to function effectively as a venture capital firm (VC) is only half the battle. Even phenomenal VC returns often amount to a mere rounding error on a Fortune 500 company’s financial statements. So if the CVC doesn’t meet the strategic objective of injecting innovation into the mothership, it is a failure regardless of returns.
At the same time, there is a lot of venture money out there chasing great startups. So how does a CVC mobilize the corporate sponsor as a unique competitive advantage over other VCs?
Fortunately, the same plan solves both problems.
In most cases, a CVC should be investing at the seed or series A round stages. If they approach investment at an earlier point, the startups are still basically cocktail napkins and science projects; any later, they aren’t at the cutting edge of innovation. If an organization is good at working with the earliest stage startups and patient with founders who are still figuring out how to work with large corporations, engaging at the seed stage yields the most exposure to innovation for the buck. Unfortunately, very few corporations meet this description.
Most corporations have little or no structural process for introducing startups to the business lines and provide little or no training to line management on how to work with entrepreneurs. In these situations, working with entrepreneurs who have some experience making corporate pilots work significantly increases the odds of success.
Now let’s take a look at how to optimize the allocation strategy. A typical Series A round in New York City is currently somewhere between $4 million and $8 million. So funds in that stage are looking to make initial investments of more than $2 million, if they want to lead the round, down to as little as $500,000, if they are following a lead. Most VC funds want a mix of deals to lead and follow. After all, if they don’t lead some deals, why would other VC funds syndicate their deals to them? So, it is safe to assume an initial average $1 million check. Assuming also that a fund would like to make at least 10 investments a year over the three-year initial investment, that would add up to $30 million for initial checks. Furthermore, most funds like to reserve about half their fund for follow-on investment. This implies that $60 million is the ante for a traditional series A VC fund, which would also yield 30 portfolio companies.
A CVC is tasked with maximizing its exposure to innovation, so what are some ways it can get more shots on goal for the same or less committed capital? For one thing, it might not need capital for follow-on investments. While the general partners of the fund would want the dry powder to make these investments in order to maximize their ROI, follow-on investments don’t increase the corporation’s net exposure to innovation. So a CVC could have zero reserve for follow-on investments and opt to invest off the balance sheet on an opportunistic, case-by-case basis. This means that a CVC could get exposure to the same 30 portfolio companies with just a $30 million fund.
Remember, though, that attracting top investment talent to the CVC is critical. So to align incentives with the general partners, if the corporate sponsor does invest, the general partners get their usual carry on that investment; if it does not, the pro rate investment rights revert to the general partners to syndicate in any way they see fit.
But what if the CVC found a way only to follow on rounds that other funds lead? In that case, the initial check size drops to $500,000 and that same $30 million fund now gets 60 shots on goal. So how do we pull that trick off?
Part 4: Target startups to leverage your corporate strengths
All too often, a corporate venture capital (CVC) will over-negotiate from a position of strength and demand nonstandard terms. For example, a CVC may demand a right of first refusal on sale. From the corporation’s perspective, this is a reasonable way for them to protect their innovation advantage. From the startup’s perspective, this deters other buyers from bidding on their startup, the startup is limited to extend resources if the corporation can exercise a right of first refusal. Senior management may also seek to block the startup from selling to competitors, limiting the startup’s ability to grow. At best, these demands slow the process down; at worst, they kill the deal… or the startup.
Instead of over-negotiating from a position of strength, a CVC needs to take the startup’s prospective and structure a strategy that plays to the corporate parent’s strengths.
What do all startups need more than anything else? Customers! A CVC has unique and unfair advantage over traditional VC funds in this respect. Done properly, they can introduce a portfolio company into the organization, generating not only significant revenue but also meaningful proof points that will make the startup itself more investable overall. A smart startup makes room for strategic investors like this.
This means that a “follow-only” strategy may be a viable option for a CVC. Consider this value proposition to a startup, which you can get in writing with either a carefully constructed, but not over-lawyered, Investor Rights Agreement or warrant coverage:
“We will get you a pilot within the organization. If the pilot goes well, we will hard-commit to invest $500,000 in your next round*, as long as it is led by an institutional VC fund. If we cannot get you a pilot or if the pilot does not go well, we will not invest.”
It’s clear, it’s concise, and it’s compelling. Climb a hill, plant your flag, and start yelling it from the mountaintop. Startups will come to you.
No capital allocated to follow on investment lets the CVC halve the required fund size from $60 million to $30 million. A pilot-to-invest strategy that only a CVC can deliver on, enables it to double the number of startups it can invest in out of that same half-sized fund.
How do you engage at the right time? The above strategy only works, however, if the CVC gets the timing right. If the CVC engages too late and the startup raises its series A round before the pilot is complete, the effort is lost.
Pilots within a large organization can take six months (or more) to connect, structure, execute, and evaluate. CVCs need to understand what a reasonable timeline is for their organization and then target startups at the appropriate time. Engaging with startups three to six months after their seed round gives them time to complete the pilot nine to 12 months post-seed, which generally coincides with when the startups are beginning to raise their series A.
Part 5: Manage the innovation process
Through this series, we have focused on maximizing the quantity of innovation that a corporate venture capital fund can deliver to the corporate parent. But, where otherwise effective CVCs often fall down is in assuming that bringing an innovative startup to the organization will automatically result in pilots and innovation transfer. Line management is busy running their own business units. After the initial flurry of focus, engaging with startups is typically nowhere near the top of their priority list.
There are two basic strategies for aligning focus so as to maximize a large organization’s exposure to innovation and to accelerate the CVC portfolio’s growth:
Informal – Someone affiliated with the CVC works hard to develop personal relationships with key decision-makers throughout the organization. This person gets to know who is serious about and amenable to working with startups to find innovative solutions to problems and who is merely paying lip service to the creed. He or she uses a bit of salesmanship, some moral persuasion, and the knowledge of the possible to make pilots happen. This approach requires minimal change to the corporate parent and can be implemented the fastest. The disadvantages are that it takes a very skilled person to pull this off and that, in many cases, the fund will have to pass on startups that really could make a difference to the parent organization simply because they are not able to convince anyone within the corporation to conduct a pilot.
Formal – This involves creating a series of structures designed to involve mid- to senior-management in the innovation ecosystem. This includes but goes far beyond simply scheduling pitch events throughout the regions where the corporate parent operates. To be truly effective, management’s job requirements and compensation structure have to change. While the possibilities are endless, here are a few examples:
- Incorporating into six month and annual reviews metrics quantifying how many pilots a business unit attempted. Avoid over-emphasizing pilot success – that ends up deterring experimentation. After all, several quick-and-cheap failed pilots are also valuable.
- Setting up a standing committee of senior management that meets once every few months under the guidance of the CVC to identify one or two key areas of innovation (e.g., smart apartment technology for a REIT holding multifamily rental properties) that they want to be the CVC’s primary focus at that time. This has the added benefit of effectively pre-committing the business line to piloting with the startup (or startups) that the CVC finds.
- Requiring all middle management to evaluate prospective startup investments using a simplified scoring rubric designed by the CVC. Innovation is infectious; expose someone to 20, 30, 40+ groundbreaking startups and they will catch the fever. (If they don’t that tells you something about that manager….) Plus, when one of the startups they reviewed favorably is selected, they will be that much more open to more innovation.
The more formal the approach will, of course, yield better results. It requires touching the most sensitive place: compensation. It also means that a lot of people who are not very well-versed in the startup world (e.g., HR) have to construct an incentive structure that encourages engaging with the startup world. But it is doable, and, when it works, it’s pretty awesome.
Capturing Talent: What’s needed for corporate venture fund leaders
A corporate venture capital fund (CVC) is similar, but different from, a traditional venture capital fund. As such, the skill set a managing partner needs to run it effectively is akin but not identical.
Let’s break down the critical and the optional skills that a successful candidate will display.
Critical skills of a CVC managing principal:
- Marketing – As we discussed in parts three and four of the series, “pilot first with a hard-commit follow-on if it works” is essentially a “pull strategy”. Instead of a “push strategy” of beating the bushes hunting for startups, here you need to climb a hill, unfurl a large flag, and yell at the top of your lungs while waiting for startups to come to corporate. Since this relies on getting the word out far and wide, the marketing moxie to pull this off is essential.
- Political savvy – Ensuring that line management ultimately does engage with startups requires a mix of politics and process so that the managing partner must create informal relationships to smooth the path to pilot. Not all managers are equally excited about innovation, so finding someone to gently cajole and smooth ruffled feathers is key.
- Process passion – The managing partner also has to work out a series of touch points and events with corporate. Also, since you get what you measure, he or she will have to help modify the evaluation processes and compensation structures to make sure that working with innovative startups is something that gets his or her partners in management their bonuses and promoted. So, you need someone with some serious operational expertise to sweat these details.
- Domain expertise – Ideally, you want both venture and industry experience, but that’s a pretty hard combo to find. Fortunately, believe it or not, domain expertise may not actually be all that important. A good generalist investor can get up to speed on a new industry quickly, especially given the deep bench strength of industry knowledge the corporate sponsor brings to the table. So, in a pinch, finding someone for the CVC with experience in the field is less critical than it would be for a standalone fund.
- Industry relationships – By the same token, the CVC can lean on the cumulative relationship base of the corporate parent. Furthermore, since the primary set of relationships that the CVC needs to forge are internal, between startups and the business lines, not external, extensive industry relationships are also “nice to have” only.
- Sourcing – With this pilot-to-invest strategy that attracts the startups to the CVC, traditional VC sourcing techniques are less important.
- Valuation – The lead investor in the startup’s round sets the valuation. Since the CVC is following, the managing partner just needs to accept the valuation set by the lead investor or simply pass on the round. Also, since strategic imperatives often outweigh pure ROI for the corporate parents, it is not the end of the world if a CVC occasionally overpays a little.
- Deal structuring – Deal structuring also is determined by the lead investor. As long as the CVC gets the same protections as the lead, there is not much to do here.
- Due diligence – The CVC can free ride on the lead investor’s diligence if it wants, especially since it has already piloted with the startup and has had an extended inside look under the hood.
Where to find this kind of investor? Large corporations interested in starting a CVC are 99.99% likely to use a recruiter to fill this role. But for hyper-specialized roles where clients themselves don’t know what they actually need, a recruiter is only as good as the guidance they get.
For a traditional VC, a good recruiter might look for someone on the rise at another venture fund who also has startup experience in the industry. For a CVC role, finding a VC rising star still makes sense, but rather than looking for additional experience at a very small company, operational experience at a large company and/or top consulting firm is more likely to check the critical skills boxes above.
Acknowledgments: I’d like to thank David Coats, David Gerster, Blake Luse, David Teten, Linda Isaacson, Jill Ford, Stacey Wallin, Ameet Amin, and everyone else who contributed their thoughts to this article.