Corporate Vampires and Startup Virgins
On any given day, plane loads of executives and government agency officials from around the globe land at San Francisco International Airport. Their hope is to learn by osmosis and replicate some of that Silicon Valley magic to drive growth of their enterprises and economies. Though it is impossible to replicate the confluence of events that made Silicon Valley the capital of world innovation, its mindset – driven largely by startups – is being institutionalized. Corporate Innovation programs are springing up all over the world as large organizations are fighting to stay relevant in a business world spinning faster every year.
For most startups, attaining a partnership with or an investment from a well-known brand can add a lot of value in the form of market validation, distribution, supply chain access, and sometimes even a path to an exit via acquisition. Of course, the waiting game and endless meetings to accomplish this can drain the will to live.
What’s less obvious to the startup founders, especially ones who haven’t worked at large companies, is that corporates need startups much more than vice versa. Think of the them as old vampires who need to feed on virgin startup blood to stay alive.
Since the birth of Microsoft and Apple 40 years ago, a major source of innovation has been from venture-backed startups. Disruptive companies typically come from commercializing an enabling technology and exploiting the newly found market advantage.
The importance of timing cannot be overemphasized. If you are too early, the market is not yet ready to embrace the products or services. First attempts at VR in the 90s, consumer 3D printing, and nano-anything come to mind. If you are too late, the markets are already owned and controlled by large players nearly impossible to unseat. Remember Diaspora, the open source social network that tried to beat Facebook?
With few exceptions, startups are simply solving the same old, boring problems in new ways with the help of next generation technology. Market-collapsing companies that make something ten times cheaper, faster, or more convenient trigger a generational change in the way of doing something. Amazon changed the way most things are bought. Google organized the world’s information. Facebook changed the way we communicate. AirBnB provided an alternative to hotels. Uber changed the way we get around. This shift is the required ingredient to create that explosive growth, category leading unicorn businesses of the future.
When startups go from idea stage through rapid scale and become a true company; they organize around the rules of their business model at that given moment in time. The length of tenure at the top and a company’s ability to exploit its market dominance can vary wildly. Statistically, we know the average time companies spend at the top of the Fortune list is shrinking by the year. In fact, the average tenure of a company in the S&P 500 went from 75 years to 16 and according to Innosight, 75% of the current list will be replaced by 2027. Naturally companies evolve, but frequent reorganizations are impractical and risk destroying too much shareholder value for any public company CEO to endure.
With the frequency of change increasing at the speed of Moore’s Law, corporates are breaking their habits of “not invented here” thinking and look for innovation in the global startup laboratory.
My entire career I’ve been on the operations side of startups; first in designing software products and then as the CEO for over 15 years. Over the past few years, I’ve been shifting to the investment side of the table and in March I was given the opportunity to help launch and run the corporate venture arm of Silicon Valley’s original startup, HP.
Developing the overall strategy of the fund and its support activities has taught me some interesting things worth sharing about the building blocks of corporate innovation. Whether you are a startup founder looking to partner with a big company or an executive facing secular business decline and the need to find your next source of growth; I think you’ll find these narratives useful.
Ecosystem Participation and Support
Investing marketing dollars to be perceived as a cool company can have a lot of practical benefits; from the ability to attract top talent at lower cost to selling products at a premium to a loyal customer base. Technology has become engrained in our popular culture and tech CEOs are truly the new rock stars.
Large companies are rarely able to create that cool factor on their own, but aligning with the most exciting entrepreneurs of the moment and their iconic brands can rub off some of that glitter. The most consistent way large companies can do this is by supporting the right events and educational programs.
Microsoft has lead in this area since the BizSpark program started providing free or discounted products and services to startups in 2005. They went on to launch an Accelerator, co-working space, and full-fledged venture arm. As a platform company, Microsoft has benefited from this initiative tremendously.
You can almost never predict which bright-eyed and bushy-tailed young wunderkind is going to become the next Zuck, so you should support the entire ecosystem of your chosen industry and/or region. This initiates encounters with entrepreneurs early in their education and development and pays dividends over time as they build and express their positive bias towards your brand. They will always remember their first hackathon or the award they picked up at a conference sponsored by BigCo.
The terms “incubator” and “accelerator” are often used interchangeably. This is a mistake. Incubation is the process of growing the seed of an idea into a sapling and then a strong oak of a business within the protective greenhouse of a bigger organization. If successful, the incubated business either becomes a discrete unit inside the parent or spins out into a new company.
The objective is to use the operational efficiency, brand recognition, and established distribution to quickly (and cheaply) enter a new category or realign the company overall for a generational technology paradigm shift. Incubation is the way to go in a world where possibly cannibalizing your exiting business is the preferred choice to letting an unaffiliated startup eat your market from the bottom-up.
Executing on this strategy often proves to be much more difficult in practice than in PowerPoint. Though the large company has all the advantages that come with the territory, the disadvantages are usually only enumerated in the post-mortem once the program has failed. Paradoxically, the entrepreneurial talent, constrained resources that force creativity, and properly aligned financial incentives can – almost by definition – only exist outside of the corporate structure and environment. For this reason, successful incubation programs must exist as skunkworks operations outside the regular business units whose antibodies reject anything that doesn’t fit their pre-determined way of doing things.
Corporate Accelerators and Co-working Space
The brutal truth, however, is that maybe only the top-10 accelerator programs in the world are successful as profitable investment vehicles. The mortality rate of pre-seed and seed stage startups that go through (all the) accelerators is so infinitely small that there isn’t enough demo day confetti in the world to hide the fact that most of the programs fail by year two.
So, what chance do corporate accelerator programs have in this context? Even with the brand recognition to attract high-potential applicants and the can’t-fail program structures of the likes of TechStars (who’s launched programs for Barclays, Disney, R/GA, and others) the financial returns have proven not to be worth it.
The goal must then be to build positive brand recognition within the startup community and earn the opportunity to hire outstanding talent from the failed startup experiments and acquire strategic technologies that survive, early. Essentially outsourced R&D, a rent-to-own hiring plan, and some temporary PR benefits.
With the unrealistic financial returns incentive out of the picture, offering a co-working space may even provide most of the same benefits to the company without committing to the difficult task of staffing and running an accelerator program. A good example would be Johnson & Johnson’s JLabs.
If you are a startup founder, knowing this and given the choice, you’d certainly select a top tier independent program that will provide unencumbered mentors with the right experience, access to a wide pool of investors, and long-term support. So then, in turn, corporate accelerators are simply not capable of attracting top-tier entrepreneurs and their startups. You do the math.
Corporate Venture Capital
The subtle difference in the name between corporate and institutional venture capital doesn’t go far enough to describe the rather unsubtle difference in their intentions and operational structures. Institutional venture capital (more commonly known as just “venture capital”) seeks to fund the best entrepreneurs working to create billion-dollar companies in fast-growing markets for a great financial return. Corporate funds add a thick layer of strategic goals to all of this.
To put it in perspective, you can look at a company like HP that generates well over $1B of revenue each calendar week of the year. Even the biggest corporate venture funds that invest upwards of $350M per year, a 600% return on investment in 10 years (which would put you into the top quartile of all venture funds) would not move the needle substantially for the parent company.
The bigger motivation for corporate venture capital (CVC) is strategic. From this perspective, the investment activities become a highly-effective defense tool. A shield from the relevance decay every business falls into without the healthy obsession with the future and relentless effort to keep reinventing itself.
More specifically, the right reasons companies should put the effort and budget into building investment operations are to hedge their product roadmaps, gain deep learnings and influence in neighboring businesses, gain visibility into future categories, and develop relationships for acquisitions.
According to Arnaud Bonzom’s report on corporate innovation, CVC is the number one choice by the Forbes Global 500 to engage with startups. When companies decide to create a direct investment operation, they often do it with an insider team of business development and M&A experts. This internal SWAT squad may make perfect sense from the corporate perspective but to the startup ecosystem, they are still outsiders. The tight-knit startup community relies on relationships to a large degree where the trust factor is crucial and the value you provide (on all sides) must be constantly reinforced. It is difficult to gain respect without putting in the time and effort.
Venture investing is a very specialized sport whose top athletes get basic training first-hand as entrepreneurs. It is also one of the last apprentice industries where the truffle nose required to recognize patterns inherent in future industry leaders is trained by looking over the shoulders of more experienced investors.
The most effective CVC teams are therefore recruited from the entrepreneurial ranks and other venture investment operations outside of the large company environment. As with most highly specialized professions, to attract the best practitioners from the institutional venture side to the corporate, financial incentives must be competitive and focused on performance. The hurdle is high as there are zero CVCs on the Midas List of top investors and top talent always flows towards the institutional side, not vice versa.
According to PitchBook and CB Insights data, three quarters of CVCs invest from the company balance sheet and the average program only lasts 2-3 years. When investing in this way, the CVC teams spend as much time defending their right to exist as the politicians who start campaigning as soon as they get elected.
Company priorities change often and with them their budget allocations. Yet, the average (successful) startup takes 8 years to get to exit. To align with the reality of this timeline and avoid being setup to fail, CVC funds are most often spun out into separate subsidiaries reporting to the CEO or CFO of the parent. With few exception like Intel Capital, virtually all active, effective and long-lasting corporate venture programs are setup this way. It takes conviction from the executive sponsors and earned trust in the investment team to graduate to this autonomous structure. Regular information sharing with business units – to understand their strategy and make the new portfolio companies available for commercial partnerships – is the most efficient way to extract value out of the whole exercise.
Fund of Funds
Investing in institutional venture funds diversifies the budget and extends the reach beyond the bounds of the corporates’ own team capabilities. The odds of success in early stage startups are low so volume is the way to win the numbers game. The ability to cast the net wide while remaining resource efficient, helps increase both the financial and strategic opportunities for corporates tremendously.
Each deal takes a substantial amount of time and effort to get through the gauntlet. In the case of corporates, this process is almost certainly a more complex and lengthy maze. There is only so much time in a day and the size of the fund (or budget in the case of balance sheet CVCs) determines the typical investment size and therefore the investment stage.
In the case of most corporate funds, the amount of money that must be “put to work” usually pushes the average investment size well out of range of seed rounds. The best deals at Series A and beyond, tend to get subscribed fast and require established relationships to be in the game. Great feeder funds invest a round or two before the corporate would usually enter the conversation. Investing in them puts relevant, high-potential companies on the radar earlier. Some special arrangements, like the right to invest alongside the seed fund earlier than typically or being able to take the seed fund’s pro-rata (investment right in a future round) can also be quite opportunistic.
Corporates also benefit greatly from the specialized knowledge and network of the feeder fund teams. Investors with a strong enough track record to motivate large companies to become limited partners in their funds, are also engrained, subject matter and/or regional experts. Their insights and constant finger on the pulse can be very informative to corporates not only in the context of later investment but to inform market and technology strategy for the business units.
From the perspective of venture capital, M&A seems to be the strategy of last resort to catch up. Companies exist to develop and sell products and services. They invest a lot of resources into R&D to gain a technological advantage, research and strategy to get a jump on the market, and their brand to gain mind share with their customers. This process is far from perfect and fails often enough to create the need for corporate development teams to go out and fill the gaps with acquisitions.
The conversation often turns to “buy or build” and the company has an analysis to go through on each occasion. Sometimes there is visibility to where the pothole in the product roadmap may be. Often the trends and market movements they don’t know they don’t know, can be costlier. Together, you have a crucial area that needs thoughtful and attentive coverage.
It is a thin line for corporate venture teams between investing, partnering, and acquiring. The rule of law is: invest if the company looks like a big potential financial win in a strategic area and/or partner if there is a complementary value proposition, or acquire if the technology fills an immediate strategic gap and the price is right.
Corporates are a key player in the cluster of innovation framework alongside entrepreneurs, institutional investors, academia, and governments. For them, extracting the value out of the innovation exercise requires a thoughtful approach to structuring and staffing the program.
Startups have a lot to be thankful for in their circle of life from idea to exit. Corporates are the biggest investors in enabling technology R&D and comprise the entirety of the M&A market, which eclipses IPOs. If the startup founders are lucky enough to make it all the way to the IPO, they will soon decay and become yet another vampire hunting for that delicious, innovative startup blood.