Betting Your Innovation Budget: Why risk it on CVC?

Corporate Venture Capital (‘CVC’) or “Strategic Venturing” is inexplicably on the rise. In 2018, 186 CVC funds made their debut, while the dollar amount invested climbed to a dizzying $31.2 billion globally!

According to CB Insights, active CVC funds more than tripled from 2012 to 2018 – so why the enormous growth? 

That’s not a rhetorical question, and it’s not something I will go on to explain in this article. I couldn’t if I wanted to. Because I just don’t get it. 

I’ve worked as a venture capital investor, raised investments for startups I’ve founded, and advised countless startups as a mentor. Today, when asked by Executive Boards about investing in external startups, my answer is always the same (though the level of awkwardness rises when it’s an activity they’ve already undertaken): 

“Don’t touch it with a bargepole! There are better ways to waste your money, and a hell of a lot better ways to invest it in genuine innovation.” 

When I turn the question around, asking firms why they think they should do CVC or why they do it already? They commonly cite the same two core reasons: 

1. “It’s strategic”. Wanting to invest in startups who augment their current business, thereby unlocking massive ‘strategic synergies’ when connecting their portfolio companies to the mothership. Often believing that investing in the startup is a prerequisite to successfully partnering. And “Because we can invest strategically, we can increase both our probability of success and expected returns to the Group.”  
   
   
2. “There’s huge potential for return on investment while hedging against the future”. Referring to the commonly sited stats of the venture capital industry were, “the top-performing funds have the potential to make 5-20x returns on cash.” 

I can’t help but feel that those who champion the creation of a CVC fund from within an organisation must have a more personal cause at heart. I can’t see how it can be about furthering the company’s real innovation agenda, i.e. creating a repeatable and transferrable organisational capability of continuous long term renewal. 


Here’s why I don’t buy it: 

1. The odds are against you! 75% of all venture capital funds lose everything! Additionally, the top 20 firms (long-established firms out of approximately 1,000 total venture capital firms) generate 95% of the industry’s returns; globally! Looking at the economics of venture capital as an investment asset class, the average annual venture capital return over the past 10 years has only been 8.1% as compared to 5.7% for the S&P 500. That clearly does not compensate any limited partner for taking the increased risk associated with venture capital. Given the statistics, the facts, I honestly don’t understand how CVC funds have succeeded in securing $50-400 million to bet with on that probability. I applaud them for their tenacity, but what I would love to understand is how they justify this risk and sizeable use of funds to their shareholders? For a detailed analysis of venture capital economics, see this excellent article by Wealthfront co-founder Andy Rachleff
    
   
2. Deal flow means more than just quantity of startups – quality is everything! Yes, your company may be inundated with hundreds of startup applications. If not already, it can be all too easy to assume that deal flow won’t be an issue with such a big corporate brand. But even if you have thousands of startups approaching you, do you have the top 1-2%, and will they let you invest? All venture capital funds are only as good as the quality of their deal flow, and for the best startups, you’re competing with funds that have spent years investing in their network and brand for this purpose alone. Can you ever expect to compete with the Andreessen Horowitz, First Round Capital, Union Square Ventures and Sequoia Capital of the world?  
   
   
3. The odds of unlocking the strategic benefits of your investments are often lower than your chance of a profitable IRR. In order to unlock the synergies of any corporate-startup engagement, you need to fight against corporate inertia; wading through risk, legal, IT, and procurement, only to find yourself once again reliant on the relevant business units. Is this startup engagement clearly aligned to that business unit’s strategic objectives? Are senior managers incentivised via their KPIs to engage in startup pilots? If not, getting them to allocate the necessary resource and attention will be a considerable challenge, and worse case, they may see you as a risk and actively block you. Furthermore, an investment thesis that aims to maximise ROI is rarely compatible with a collaborative innovation approach that seeks to realise commercial value from corporate-startup engagements. The best startup investments are seldom the best startups to engage in commercially focused pilots. Finally, one does not need to invest in a startup to run a successful pilot – please can we expel this myth! For a more detailed overview of the challenges of unlocking corporate-startup synergies, framed in an M&A context, see this article by Steve Blank.
   
   
4. You can’t target the middle of the road returns. Corporates often have a strategic investment mindset, thinking if they can achieve an average return of 2-5x, then it will even out across the portfolio, giving them good net returns. But, as the power law of investing proves, every investment you make has to, at least in theory, be able to return the entire fund plus the expected IRR (30%). Venture capitalists don’t just set a min. 10x target for every investment for the bragging rights, they do it because they know if they do succeed in getting a positive return on their fund it will likely be from just 1 or 2 of their portfolio investments. (For more insight on how incredibly skewed actual venture capital returns are and thus the investment mindset that’s required by investors, I encourage you to read Peter Thiel’s essay entitled ‘Venture Capital and You’).
   
   
5. Corporates don’t have the venture capital skill-set in-house. As an incumbent operator within your industry, by definition, you don’t have experienced venture capital investors in-house. Why would you? And if you believe you do, ask yourself, why did they leave the much more lucrative (based on typical remuneration structures) non-corporate venture capital industry (see point 6) in the first place? Furthermore, traditional corporate finance or M&A expertise is an entirely different skill-set than early-stage venture capital. Years of experience in the former does not prepare you for the latter – let’s expel this myth!  
   
   
6. So you try to hire in the talent: but you’ve got the wrong incentive structures in place! You need best-in-class talent to craft a strategically aligned investment thesis, assess the startups, structure investments, and manage the portfolio if you’re going to have any chance in returning cost of capital. Experienced managing partners expect the traditional: 2% management fee and 20-30% carried interest. Typically, corporates do not feel comfortable offering this level of remuneration to the individuals managing their startup investments. CVC funds unable to offer attractive incentive structures are limited in their ability to hire experienced managing partners, often having to resort to individuals with no prior venture capital experience.  
   
   
7. Even if you do succeed against the laws of probability; finding yourself in the top 5% of funds that deliver sufficient return on capital (>3x), the money returned won’t be realised for 5-10 years. By that point, the actual net profits generated are still going to be a rounding error compared to the Group’s total revenues – especially, when considered over that 5-10 year period. And that’s a best-case scenario! If you’re a little less lucky, you’ll quickly find you could have accrued more interest with a low-cost well-diversified index fund, or worst case, you’ve lost it all. 

For me, CVC is a bubble, and the downturn is coming. Yes, a handful of the best CVC funds like Intel Capital and Qualcomm Ventures have and may continue to return positive IRRs – there will always be outliers. However, looking at the industry as a whole, I caution that the current level of corporate euphoria is not only in a league of its own but will be considered woefully misguided in the long run. 

What makes it even more painful for me, is knowing how that money($31.2bn or $50-400m per corporate) could have been invested in initiatives that address the company’s underlying corporate innovation challenges. Instead, focusing on continuous longer-term renewal, navigating disruption, identifying possible directions of growth before they become obvious, and creating structures to be able to do that in parallel with ‘business as usual’.

Drive Growth Faster and With Less Risk