Corporate VCs Are Moving the Goalposts17 November, 2016 / Articles
Most people are familiar with the traditional approach to venture capital: An investment firm carefully parcels out capital to a portfolio of start-ups, knowing that most will fail—but that with luck, the financial returns from the handful of winners will make the exercise extremely profitable. For more than 40 years, however, another model has also existed: corporate venture capital, in which a very large company invests in start-ups, often in adjacent industries. While traditional VCs are all about financial returns, most corporate VCs are motivated by strategic payoffs. They recognize that big companies often can’t match start-ups’ ability to create breakthrough innovations, so they use their in-house VC operation to gain insight into new products that could affect their competitive position—and perhaps to get a jump on acquiring the start-up if its innovation turns out to be a game changer.
That’s the theory, at least, and it’s proven especially compelling over the past five years. From 2011 to 2015 the number of corporate VC units in the United States rose from 1,068 to 1,501, and from 2012 to 2015 the amount their firms invested quintupled, to more than $75 billion. But as more firms have entered the space, some observers sense a shift in goals. Instead of aiming primarily to enhance their companies’ strategic position, many corporate VCs seem to be focusing mostly on financial returns—just like traditional VCs.
Two researchers at MIT—graduate student Michael Rolfes and professor Alex “Sandy” Pentland—decided to explore this mission drift; they conducted in-depth interviews with the leaders of 16 corporate VC units. Their questions focused on the units’ goals, organizational structure, stakeholders and oversight, incentives and compensation models, and definitions of success. Fourteen of the units claimed that their primary motivation was not financial—but the deeper Rolfes and Pentland probed, the more they found “glaring operational coherency issues.” As they put it, “Many firms were implicitly incentivizing conflicting and inconsistent behavior among their investment team[s].”
Specifically, half the firms said they use financial measures—typically cash-on-cash returns or internal rates of return—to gauge the relative success or failure of investments. More than 40% include financial returns in employee performance or compensation reviews. On the surface, this isn’t completely illogical: Financial metrics are familiar and convenient, and even if strategic goals are supposed to take precedence, corporate VCs do hope to make money. Still, the mismatch between supposed strategic motivations and the prominence given to financial metrics suggests that the units are having trouble walking the talk. “In a lot of our interviews, people conceded that ‘yes, using these measurements doesn’t make a lot of sense,’” Rolfes says.
Other behaviors suggest that corporate VCs aren’t pursuing opportunities that could help them maximize their role as strategic investors. For instance, 25% of them take no board seats on portfolio companies, which means they are missing a chance to gain market intelligence and influence a start-up’s direction. Roughly 70% said they have no interest in acquiring the start-ups they fund. The researchers also found that nearly all the corporate VCs frequently partner with other VCs when making investments—a practice known as deal syndication. This reduces risk and increases potential financial returns, but it can leave a corporate VC with less control and a weaker strategic position.
On the basis of the interviews, the researchers rated each firm on a scale of one to four, with four indicating a firm whose objectives, actions, and key performance indicators were fully aligned with its stated mission, and one indicating a firm with “major coherency issues [and] virtually no consistent approach or objective.” The mean score of the 16 firms was 2.6, indicating moderate conflict between goals and behaviors. When the researchers looked for correlations between firm characteristics and scores, one attribute jumped out: age. Older firms generally deviated further than younger firms from their stated mission, with corporate venture units more than 10 years old scoring 25% lower than units less than five years old. The researchers speculate that this could result from such factors as cultural or political shifts within firms and staff or management turnover. They also found that corporate VC units run by companies operating in regulated industries (such as energy and finance) deviated more from their strategic goals than firms in less regulated spaces, such as software and retail, perhaps because the lower barriers to entry in unregulated industries create more investment opportunities for VCs to choose among.
Having identified an overemphasis on financial goals as a common problem, the researchers are only beginning to think about potential solutions. Rolfes says, “That’s the follow-up: What are the specific recommendations, whether a company is just coming into the space or has gone down the wrong path and wants to correct it?”
In their working paper, the researchers identify active involvement of the CEO as one factor that can make a difference: By voicing continual support for the corporate VC’s role as a strategic investor, he or she can reduce the emphasis on financial returns. The researchers also say that firms need better ways to measure the nonfinancial value derived from investments in start-ups. “That’s the million-dollar question,” Rolfes says. “Companies know that financials aren’t the best metric, but they don’t yet know what to put in its place.”