Breaking New Ground with Modern Corporate Venture Capital Strategies
The Case for Corporate Venture Capital
Back in 1992 Siemens’ top management received a delegation from US-VC Kleiner Perkins seeking to unload a 30% stake in recently publicly listed Cisco Systems then trading at a market cap of well under $400m. Driven by a mixture of hubris and a well cultivated ‘not invented here’-syndrome Siemens’ Munich-based Telecom Division leaders declined contemptuously and instead chose to bet the farm on spending thousands of R+D-man-years on ATM, a hybrid packet/fixed-channel – based technology which at the time was believed to become the new global standard for voice and data communications. Insult came to injury when the same misjudgement was repeated in late 1995 during discussions with US-VC Sevin Rosen bringing into play a sub-$100m-valuation based corporate investment into post-series A portfolio company Ciena. The company, an emerging leader in the DWDM-space (dense wavelength division multiplexing), had developed a powerful bandwidth-booster technology for optical fibre networks forming the core of today’s mind-boggling ‘cloud’-transmission capacity. The rest is history, Ciena went public in 1997 at a whopping $3.4bn valuation, and while ATM went nowhere, Cisco won the battle with their TCP/IP-bet to become today’s $140bn market cap telecom powerhouse. While Siemens, who as a start-up in 1847 invented revolutionary long-distance telegraphy networks, has since been forced to continuously shred their once proud global workforce of 60.000 and eventually divest their entire communications activities in 2013 for a song to Nokia.
Historic Evolution of CVC
The editor of this article remembers the above mentioned and rather nightmarish case-study particularly well since it served me as a major argument in convincing Siemens’ central board in 1997 to start a $100m corporate venture capital (CVC) fund. The internally managed fund (initially the Siemens Mustang Ventures, later renamed into Siemens Venture Capital) was meant to pursue the following major goals still valid in any modern CVC strategy:
- Create a window on disruptive innovation by exposing internal resources (R+D, Product Marketing, Sales) to the challenging strategies of portfolio companies
- Build trusted relationships with major Venture Capital firms to ensure access to early information and ‘open-ears’ for mission-critical M+A deal flow
- Create an environment for ‘hedging bets’ in key business areas, a concept that had been found to be impossible in an internal set-up
- Profitably allocate free-cash flow
Quite naturally, companies in the semiconductor and telecommunications industry were among the first players to draw the CVC-lesson. Given their inherent and direct exposure to the challenges of Moore’s law top-fortune corporates such as Intel (Intel Capital since 1991), Cisco (Cisco Investments since 1995), Siemens (Siemens Venture Capital since 1998), Deutsche Telekom (T-Venture since 1997) and Qualcomm (Qualcomm Ventures since 2000) recognized the danger of being disrupted in their core-business areas by the digital revolution.
These pioneers were quickly followed by other industries equally falling prey to rapid business model innovation. Retail, Media and others initially seemed to be better shielded against digital disruption. However, rapidly emerging e-commerce companies such as eBay, Amazon and Zalando started to attack the classic retail and distribution industry ferociously while travel & hospitality experienced rising pressure from newly emerged OTAs, booking and price comparison sites. Legacy media & entertainment companies saw their business models being outright destroyed by online news distribution, download and streaming services and a striving video-gaming industry cutting deeply into the cake. With recent noises being made by Apple and Google about the autonomous car revolution you can imagine how a rather self-sufficient automotive industry could be next in line for a merciless battle. Needless to mention the global banking industry being under tumescent attacks by a plethora of nimble fin-tech start-ups.
While this is indeed nothing else than good old ‘Schumpeter’ at work, unfortunately this time around things happen at light speed and with global scale. Reason enough for every industry leader to contemplate a bespoke CVC-strategy tailored to the individual company’s size, focus-area and market geography.
And with the principal goals still being the same, the call for action in modern CVC-strategies can nowadays be based on a wider choice of implementation options than in the past. The vast majority of corporates simply do not have the need, scope, size and cash reserves to entertain an internal CVC organization (‘GP model’). Count at least an initial commitment of €100m for that approach and hold your breath for what will rather turn out to be a marathon than a one-shot action plan. This is the reason why over the past few years a couple of specialized independent VC-firms have refined specific CVC implementation models that can be tailored to the individual requirements of corporates seeking for an out-sourced solution.
A Zoom on Modern Outsourced CVC Strategies (‘LP model’)
Today, corporates (in this model acting as Limited Partners, LPs) can choose between the following three ‘externalized’ CVC investment models offered by independent VC-firms (acting as General Partners, GPs):
- I. Leveraged Multi-Corporate Fund: several corporate LPs pursuing complementary strategic interests invest into an externally managed fund, leveraged in size by adding purely financially interested LPs. In that model, GPs will tend to offer ‘exclusive’ slots to corporates coming from different industries in order to prevent conflict of interests between competing strategic investors. The financial leverage helps to reach critical fund size and fosters an investment strategy that does not ignore financial return goals. However, it is of crucial essence that a reasonable balance between strategic and financial investors and an upper limit of the number of corporate investors is maintained. If leverage turns out to be too high and/or too many corporates are subscribing the Leveraged Multi-Corporate-model simply becomes a plain-vanilla Venture Capital fund prone to disappoint strategics in all CVC-related manners.
Pros: broader sector coverage supporting a solid investment rhythm and sufficient deal flow to allow for high quality investments; from a corporate LP’s perspective, coverage can easily be expanded by spreading several tickets among different GPs (multiple investment strategies in terms of geography, portfolio maturity, themes); ‘vintage’ investment model with commitments that can be adapted to yearly budget constraints; ample networking opportunities thanks to a potentially larger number of GPs; critical size to justify and motivate highly skilled GP resources; if the fund is well balanced, sufficient proximity between corporate LPs and GP can be entertained; lower financial risk and volatility (‘averaging’-effect)
Cons: depending on the number of corporate GPs investing into the same fund it can become challenging to develop deep ties with individual GPs; direct co-investments by corporate LPs into strategically important portfolio companies can be more difficult to execute;
- II. Cross-Leveraged Co-Invest Fund: the term co-investment here stands for a mechanism where a dedicated CVC investment-vehicle will co-invest on a pro-rata base with one or several ‘mother-fund(s)’ managed by that same GP. Financially interested LPs will invest into the ‘mother fund’, hence provide indirect ‘cross-leverage’. The investing corporate(s) will oftentimes be granted veto-rights on individual investments to ensure that the CVC-vehicle respects a narrower investment strategy than the mother-fund, usually targeting specific investment themes. The mother-fund will in that model invest within a broader scope, covering more themes than just the target investment spectrum of the dedicated co-invest vehicle.
Pros: sufficient proximity between LP and GP; good precision of sector focus; corporate GP benefitting from dedicated resources at the GP-level; direct corporate shareholding in portfolio companies via the fund.
Cons: Co-investment vehicle tracking mother-fund which can lead to a slower investment pace (some mother-fund investments will not fall into the defined sector focus), potential for diverse conflicts of interest between LP and GP when veto-right comes into play too often;
- III. Non-Leveraged Dedicated/Captive Fund: In that scheme an independent GP will jointly define a tailored investment strategy with one or several corporate LPs to create a dedicated investment vehicle. This fund will typically be fuelled by less than 3 strategically aligned corporates, while mono-LP funds are quite common and only few exceptions with a larger number of smaller corporates can be found. It is obvious that this model requires a significantly higher financial commitment from LPs to justify the provision of fully dedicated resources.
Pros: very close ties between LP and GP, investment strategy jointly defined between LP and GP; dedicated resources at the GP-level; ‘direct’ corporate shareholding in portfolio companies via the fund.
Cons: a narrow investment strategy can put financial returns and investment speed at risk and hence threaten to demotivate the GP (who does not equally benefit from the other strategic values); cyclical nature of narrow investment strategies (‘flavour of the month-syndrome’); risk of fund being unattractive to targeted portfolio companies given the degree of potential conflicts of interest; GP independence at stake, hence risk to end-up with second class investor-teams;
Historically, corporates pursuing a tailored CVC-strategy have found the latter two models (II. and III.) to generally bear much higher implementation risks. Due to the numerous challenges we have seen various initiatives for captive and cross-leveraged CVC funds fail in the past. Moreover, successful examples delivering the right mixture between strategic and financial pay-back are specifically rare in Europe.
We would therefore recommend a well-structured and carefully balanced Leveraged Multi-Corporate Fund (option I.) specifically to new entrants into the CVC-space. Corporates adopting the ‘LP-model’ for their CVC-activities should carefully select the best GP for their particular requirements.
Choosing the Right Partner in Outsourced CVC Strategies
It is initially important to spend enough time and effort on a careful specification of the individual goals for a particular CVC-program. A mix of strategic considerations and requirements will form the foundation for a thorough GP-qualification process. Clarifications will be needed in areas such as:
- geographical reach being sought
- nature and type of the expected disruptions in a particular industry sector, caused by
o deep technology innovation
o application innovation
o business model innovation
o or a mix of the above cited
- investment stage and maturity of prospective portfolio companies
o early/seed-stage companies to be put on a corporate’s mid- to long term radar system
o series A/B participations to experiment with early business-collaboration and pre-M+A target identification
o late stage/pre-IPO investment strategy with the goal to spot concrete M+A-targets or significant and immediate partnership opportunities
- dedicated resources being offered by the GP; process and intensity of the information flow to be installed between LP and GP
The detailed blue-print for a bespoke CVC-strategy will be followed by a thorough selection process in order to identify a well suited GP which can fill the role of a trusted outsourcing partner for the long run. Criteria being applied during that selection will obviously encompass classical check-boxes used by experienced financial investors. Questions regarding the GP’s team stability, historic fund performance (absolute returns, IRRs, DPIs, volatility, etc.) will obviously play a role.
A corporate LP, whoever, will need to look behind a pure set of financial performance parameters. Depending on the individual CVC-program’s goals corporate LPs will have to diligently examine the fit of specific GPs in terms of their sector expertise, investment cycle focus, level of portfolio involvement, relevant industry network/reputation. Last but certainly not least the GP’s core investment strategy will be examined: a historic portfolio review will reveal the GP’s nature and mix of bets as well as the related appetite for deep technology disruption, business model innovation, momentum opportunities, transactional deal-making and so forth. The individual GP’s ability in spotting proprietary opportunities rather than concentrating on ‘flavour-of-the-month themes’ or the next best ‘copy-cat’-opportunity will certainly play an important role in finding the right partner.
It will need an open-minded, fairly experienced and well connected GP to help corporates of all kind to avoid life-threatening miss-outs on potential business-disruptors merciless driving forward the digital revolution.
General Partner Ventech