003 - Corporate Venture Capital

An untapped weapon

 
Over recent years, every chief executive and business leader has been hammered with exultations to operate at Internet speed and get digital or get dead. Large corporations have tried to become entrepreneurial, to become innovation factories, and to ideate, in this quest to become lean and mean. While corporate venture capital programs have achieved some success in boosting innovation within large companies, most corporate venture capital programs would be more effective if companies thought creatively about where and how to use them.

Corporate venture capital is the practice of making investments in start-up companies, especially those that are a strategic fit with the large company's business. Too often, corporate venture programs have become separated from corporations' core businesses and have focused on returns. While the public market rewarded this behaviour, the party now appears to be over and a hang over will set in for many. The knee-jerk reaction may be to cut off or slow the programs.

This is exactly the wrong thing to do. Instead, companies should re-examine their venture programs to ensure they are getting the most out of them. Venture investing, done correctly, is an important way for companies to increase their leadership role in their respective industries. Further, as technological change continues to accelerate, corporations will need to use technology to unlock the considerable assets they already possess. In this article, we'll explore best practices in corporate venture programs, and we'll explore how and why companies can expand their focus to valuable internal projects.

 
Best Practices In Traditional Corporate Venture Capital

We believe that being New Economy has less to do with what you do — whether you make potato chips or computer chips, or whether you express output in megawatts or megabits — and more to do with how you do it. The most common characteristic of companies that are defining the new economy — many of which were already thriving when the first Web browser was downloaded — is their primal need to be at the centre of innovation in their industry.

To satisfy this need, a company must become a hub for innovation, and that requires the appropriate spokes to reach outside the company. Corporate venture capital is one of the most important spokes available. Through connecting the resources of a big company with innovative start-ups, a great corporate venture unit can foster industry trends and help create significant new products.

To reach these levels of performance, we recommend benchmarking the best. Some important practices we've observed include the following:

1. Create a Balanced Scorecard. A corporate venture unit should be evaluated on a balanced set of objectives that cover financial returns, discovery of innovative technologies, creation of relationships with entrepreneurs and expansion of markets for existing products. Such a dashboard encourages the leaders of a corporate venture fund to engage in the right long-term behaviours and diminishes the impact of market swings.
    
2. Role Model Involvement. Through direct and visible involvement, senior corporate executives can turbo charge their companies' impact on venture investments. Specifically, senior executives should identify the appropriate business teams within their companies that should be working with start-ups. Then they should facilitate cooperation between the teams and the start-ups. This does not mean that senior executives mandate that their companies become customers of specific start-ups. The value is in ensuring the start-ups have the opportunity to win business on their own merit.
    
3. Integrate the Venture Team. The corporate venture group must have frequent access to and credibility with the CEO and CFO of the company. Most importantly, the venture unit must be able to communicate areas of interest to outside venture firms and to start-ups, and it must have the ability to make decisions quickly.
    
4. Focus on Being a Great Partner. Corporate investors learn the most, and start-ups gain the most, when a corporate investor is active in the development of the company. Importantly, corporate investors can start by ensuring that they have a streamlined process for making business arrangements with their portfolio companies. The longer it takes to negotiate a distribution or licensing deal or the more onerous the terms (such as unreasonable exclusivity), the more the value of a corporate investor diminishes.

 
Finding Good Investments Where You Don't Expect Them

The vast majority of corporate venture activity is aimed at young start-ups outside a company. This is important, and best practices like those above are worthy of study and emulation. But, it's amazing to us that so many companies focus exclusively on external start-ups for their venture activity and ignore some of the most compelling opportunities to create new businesses. These businesses lie in the considerable assets — brand, scale, people, technology and patents, and financial strength — that would greatly benefit any start-up. Further, within a company sit the very people and ideas that can reinvent the way the company does business.

For the most visionary companies, corporate venture programs have expanded to creative investments that start inside their companies. Specifically, we are talking about technology and internet-related carve-outs. By a carve-out we mean more than a tracking stock. A carve-out is an independent company, created and capitalised by a parent corporation and outside investors. Unlike a spinout, the parent company remains the most significant investor and maintains tight operational links with the carve-out.

Carve-outs are not for everyone, particularly those who wish to rush through key issues or attempt a quick flip. In fact, the public markets have shown a disdain for technology assets that are spun out carelessly.

A carve-out is a serious investment that requires significant work up-front and a great deal more to make it successful. By constructing a carve-out, a company is effectively exposing its assets (human, financial, technological) to the marketplace in which all venture-backed companies operate. Here, the carve-out will have to find investors, win customers and recruit talent. It will do so with a transparent P and L and a requisite focus on cash flow.

For those willing to subject their ideas to these mortal tests, carve-outs can offer the best opportunity for a company to capture value. The following example shows the advantages of this approach.

McDonald's has assembled some of the world's most impressive skills in purchasing and logistics. In the early part of 2000, the management of McDonald's saw the opportunity to apply those skills to reshape the company's operations using the Internet. It also felt that its clout and market power could dramatically impact any business-to-business (B2B) exchange in the food service industry.

The company faced a range of choices from simply buying Internet-based software for supply chain management, to investing in start-ups in the field, to going it alone. In the end, McDonald's chose to carve out its Internet operations and several staff members into a company capitalised by itself and a partner. The new company, eMac Digital, quickly made its mark on the industry. Together with Cargill, Sysco and Tyson Foods, it created the Electronic Foodservice Network (eFS) to reshape the supply chain in its industry. With the McDonald's volume flowing through the eFS, the eFS is guaranteed to bypass the illiquidity that has plagued many such exchanges.

The creation of eMac Digital enabled the speedy creation of the eFS. McDonald's felt that in order to use its expertise and its size, it had to find a way to work with other restaurant companies and service providers on a neutral platform. The presence of outside investors and the intent to keep eMac independent and potentially eventually take it public convinced Sysco, Cargill and Tyson they were working with a company (eMac) intently focused on the success of the eFS. EMac Digital is going to be the technology and operations leader for eFS and for other initiatives in the food service industry. So, McDonald's needed a way to attract people (both from inside and outside McDonald's) who could run a technology company. The creation of eMac Digital gave the company a currency to do so, and partnering with a suitable partner gave the company access to rich networks of executives.

Because a carve-out requires the same nurturing and coaching as any start-up, experienced and relevant outside investors are critical. While the fit is clear, the agreements must be considered carefully and great trust is required. The financial investor generally allows the parent company to maintain more control than founders generally enjoy in a venture deal. Likewise, the parent company generally gives the financial investor more operational control than their ownership stake would normally indicate.

The parent company and financial investors must anticipate and address important issues before the company is created. What access will the carve-out have to brand names and intellectual property? How far will the carve-out go in working with the parent company's competitors? How active will the parent company be in financing the carve-out? How will this effect employees at all levels that stay at the parent?

 
Partners in Transformation: Venture Firms and Corporations

Those who pick up the challenge to lead the new era of corporate venture investing will reap incredible rewards to accompany significant work. As capital has become a commodity, being a hub for innovation in your industry and starting your own carve-outs will be clear differentiators.

The forward thinking members of the venture capital community realise that there is a great deal of power in cooperating. Venture capital companies are facing many challenges — scaling a heretofore cottage industry, mixing specialisation with flexibility, and globalising — that were met by world-class companies over the last decade. Venture firms and corporations can learn a great deal about critical topics from one another.