Why corporate venturing is more like hedging than institutional venturing

Corporate venture arms with strategic mandate should stop trying to be like institutional venture firms.

Photo by Karl Bewick

It is no secret that corporate venture capital, in the grand scheme of things, has not been blessed with success. Even though the lifespan of the typical corporate venture arm has increased from just one year historically to four years more recently, this is still less than half the time institutional venture firms take to close out their funds. Institutional venture firms ask their investors to stick around for ten to twelve years, knowing that the portfolio startups that contribute the most to their funds’ returns will need this much time to exit. Within just four years, it is nearly impossible for a corporate venture arm to create any meaningful impact.

Why do so many corporate venture arms close up shop prematurely? Some might argue it is because corporate venture arms often have less experienced partners compared to institutional venture firms. As a consequence, so the reasoning goes, corporate venture arms have access to fewer opportunities and make suboptimal investment decisions among those opportunities, two compounding effects. Others might doubt the suitability of the members of the typical corporate investment committee. These frequently include executives from the parent corporation with little prior venturing experience, who, in the worst case, could be swayed by fear of cannibalization and corporate politics. Yet others might contend that the average corporate venture arm is not set up to make a large enough number of transactions to diversify sufficiently.

All of these concerns may be justified in some cases and can indeed give institutional venture firms an edge over corporate venture arms. But none of them is an inherent characteristic of corporate venture arms. If a corporation just hires the right partners into their venture arm, finds capable, external advisors for their investment committee, dimensions the fund so as to allow for a sufficient number of deals, and opens up offices around the world to cover the most vibrant innovation hotspots, these limitations disappear.

This said, there is one innate characteristic of corporate venture arms that does hold them back vis-a-vis institutional venture firms, and neither a stellar team nor the perfect setup can fix it: This is the strategic mandate that most corporate venture arms are given, but institutional venture firms never need to worry about.

Most corporate venture arms serve a dual purpose: A strategic mandate to help the corporation learn about emerging technologies, new business models, or the lean and agile ways of working of strong startups. And a financial goal, in some cases pegged to benchmarks for institutional venture firms. The reason the strategic mandate holds corporate venture arms back is because it conflicts with the financial goal. It reduces the expected financial return of the venture arm relative to what it could be without the strategic mandate. (The qualifier “expected” is important here because there are clearly corporate venture arms that perform just as well, or better, than some institutional venture firms.)

The strategic mandate adds an extra filter to the set of opportunities that the corporate venture arm is allowed to consider. This puts pressure on the financial return because it narrows the opportunity set: Some of the opportunities that do not pass through the extra filter may have been great ones financially, but the corporate venture arm just cannot pursue them. An institutional venture firm in general has a broader set of opportunities to choose from.

The opportunity set of an institutional venture firm versus that of a corporate venture arm

The strategic mandate furthermore can cause a corporate venture arm to focus on the wrong thing. It requires the corporate venture arm to pick startups based on the use cases they are addressing, whereas an institutional venture firm can focus on the team of the startup. The use case is a two-sided sword: On one hand, it is the only way for the corporate venture arm to assess strategic relevance. On the other hand, it is generally not a great predictor of the future success of a startup. The best such predictor is the team — its grit, camaraderie, and experience — and this is precisely what institutional venture firms can lean on when they make investment decisions. On top of this, the use case is generally not even stable over time. Almost every startup goes through pivots. And every time a startup pivots, its use case might change. So the portfolio startups of a corporate venture arm may become less interesting to the corporation over time, whereas startups that start out with use cases outside of the corporation’s wheelhouse might eventually become relevant.

Strategic mandate and financial return therefore work against each other. One cannot optimize for both. Independently of how experienced the team and how professional the setup, a strategically motivated corporate venture arm is always at a disadvantage compared to a purely financially motivated institutional venture firm that can invest more broadly.

Strategic mandate and financial return work against each other. One cannot optimize for both.

Of course, not all corporate venture arms have a strategic mandate. So what about those that do not? Prominent examples include GV, previously known as Google Ventures and a purely financially motivated venture arm of Google’s parent company Alphabet, Sapphire Ventures, a venture firm owned by enterprise software maker SAP, and Cisco’s new Decibel subsidiary. These corporate venture arms are investment vehicles, not innovation disciplines. They exist to put the corporation’s cash reserves to good use. Because corporate venture arms without strategic mandate are equivalent to institutional venture firms, which are also purely financially motivated, the remainder of this article will treat them as institutional venture firms. This leaves two categories of venture capital to distinguish: Corporate venture arms with strategic mandate on one hand, and institutional venture firms (including corporate venture arms without strategic mandate) on the other.

Due to their strategic mandate and its adverse effect on expected financial return, corporate venture arms are more risky and financially less lucrative compared to institutional venture firms. Consequently, from a financial perspective, corporate venturing has an opportunity cost and should be done only for its impact as an innovation discipline. Corporations should be aware of this and use corporate venturing only where other innovation disciplines are less effective.

As a previous blog article has shown, startup partnerships are preferable over corporate venturing for all innovation that is compatible with the way the corporation does business. In other words, if the corporation can apply an innovation without materially altering their structures and processes, then they can partner with the startup and learn just as much as they would if they were to invest in the startup and take a board seat.

The sweet spot of corporate venturing is innovation that is incompatible with the way the corporation does business. Startup partnerships are infeasible in this case because the startup’s value-add is not a fit for the corporation’s structures and processes. For example, the startup may be targeting a customer segment that the corporation’s go-to-market motion leaves deliberately unaddressed; it may use a subscription-based business model while the corporation sells by the unit; or it may distribute its products online only, while the corporations uses brick-and-mortar outlets. Whatever the reason, if the ways in which corporation and startup do business are incompatible with each other, a venture investment and a board seat is the only way for the corporation to learn from the startup.

The sweet spot of corporate venturing is innovation that is incompatible with the way the corporation does business.

Corporate venture arms should therefore focus on innovation incompatible with the way their parent corporations do business, and refrain from investing in anything compatible. This way, they can ensure they operate at their sweet spot and leave other areas to innovation disciplines that are a better fit. Of course, absent a clear directive to do so, it is easy to see why corporate venture arms will be inclined to invest in both compatible and incompatible innovation: Narrowing the aperture to incompatible innovation will again contract their opportunity set, compounding the effect of the strategic mandate and further reducing their expected financial return. But the narrow aperture is crucial because investing in compatible innovation is neither financially nor strategically justifiable. Not financially, because the opportunity cost of corporate venturing, as shown above, implies that corporate venturing should never be done for financial reasons. Not strategically, because a startup partnership offers the same learnings for less in the case of compatible innovation. Rewarding the partners of a corporate venture arm based on financial return is therefore an adverse incentive that might undermine the strategic mandate of the venture arm and erode its focus on incompatible innovation.

One might wonder if a corporate venture arm is still worth having as one reduces the scope of it to the intersection of the strategic mandate and incompatible innovation. Is the learning opportunity still significant enough? Is the opportunity set, and hence the expected financial return, not too modest at this point? Make no mistake: Corporate venturing is indeed an indispensable innovation discipline. Because the intersection of a strategic mandate and incompatible innovation is precisely where some of the most impactful innovation can come from. And if ignored, this can also be the innovation most detrimental for a corporation.

Oftentimes the kind of innovation most impactful is new technology that allows an industry’s value proposition to be delivered in a better way. This kind of innovation is always incompatible with the way incumbents do business because it alters to a significant extent how value is delivered. And it is dangerous because, even though it may appeal strongly to customers, the corporation will struggle to take advantage of it due to its mismatch with the way business is being done at present.

Fortunately, a corporate venture arm can step in on behalf of the corporation when this happens. It can make an investment, take a board seat, and keep a close eye on the innovation. Later — or even directly, in lieu of the initial investment, depending on urgency and the maturity of available startups — it can get the corporation ready for an acquisition. This will defend the corporation against incompatible innovation, and potentially enable it to come out stronger if competitors fail to act correspondingly.

All things considered, the role of a corporate venture arm is more similar to that of a hedge than it is to that of an institutional venture firm. It allows the corporation to protect itself against incompatible innovation that could render the corporation’s business model obsolete. Also, like a hedge, corporate venturing is not free: The opportunity cost implied by the narrower opportunity set of a corporate venture arm compared to that of an institutional venture firm means that the corporation could be making higher gains on its funds by investing elsewhere. But, as with any hedge, this cost may pay off handsomely at some point, like when the next incompatible innovation comes about.