Venture capital: why corporations invest differently from traditional funds
As big corporations aim to reap the benefits of nimble, innovative startups, corporate venture capital funds become more and more common. Corporate giants invest with a different mindset from traditional venture capital funds, which translates into different strategies for startups. A new model sheds light on the impacts and outcomes for startups.
Rise of the corporate venture capitalist
If asked what a venture capitalist looked like, most entrepreneurs would likely give a description involving impeccable dark suits, deep pockets, and a no-nonsense attitude. It would probably be a far cry from “four guys get[ing] out of the car with their corporate tee shirts and singing the company song,” as Bob Ackerman, director of the venture capital firm Allegis Capital disparagingly said of corporate fund managers back in 2011. He may have been trying (not very subtly) to convince corporations (which he incidentally described as “the dinosaurs we're trying to kill”) to partner up with experienced independent venture capital (IVC) funds before jumping into the startup world. He was also somewhat unfair in his assessment of the “image problem” associated with corporate funds. The corporate venture capital (CVC) funds of tech giants such as Intel and Dell have strong track records. For example, Intel's proprietary fund, Intel Capital, set up in 1998, invested in software and hardware makers whose products capitalized on Intel's semiconductor chip. More recently, it injected cash into an ecosystem of wireless players, ultimately benefiting its own wireless products. More companies like Microsoft and Google and even pharmaceuticals are joining in. According to Global Corporate Venturing, more than 475 corporate venture funds have started since 2010, bringing the worldwide total to more than 1,100. But CVC funds differ widely from traditional funds in several ways.
A model to compare investors
Tailor-made suits and corporate tee shirts aside, private equity funds, whether attached to a large corporation or acting independently, hoping to make a successful investment, make decisions about how and how long to get involved in startups. And yet, the two types of funds pursue different objectives and manage their investments differently, which ultimately has an impact on the exit strategies of startups – i.e., how they will cash in on their investment. For a successful startup, the two main exit routes (which, again, are important in that they determine the financial return for investors as well as for the startup) are being listed on the stock exchange through an Initial Public Offering (IPO) or being acquired by an existing firm. Does the source of funding – IVC or CVC – influence the frequency the outcome is an acquisition or an IPO? There was mixed evidence in the literature, so HEC Paris researcher Yun Lou and her two co-researchers, Bing Guo from Madrid's Universidad Carlos III and David Pérez-Castillo from Barcelona's Universitat Autonoma, decided to solve the puzzle. They set up a mathematical model comparing level of investment, duration of investment and the exit strategies of CVC- and IVC-backed startups. They then used data pertaining to more than 4,000 successful startups spanning more than three decades to empirically test their model, and found strong contrasts between the investment relationships of corporate backers and traditional investors with start-ups.
Venture capital “another way to spend on research and development”
Different goals, different ways of investing
What the researchers found was that CVC funds invest higher amounts and over a longer time than traditional venture capitalists. The average investment per venture for exit strategies is around $50 million for CVC-backed startups, but only around $21 million for those backed by IVCs. The mean duration for CVC-backed startups is 1,929 days (that is just over 5 years and 3 months), compared to 1,649 days (roughly 4 years 6 months) for IVC-backed startups. They also found that CVC financing led to more investment rounds and to exits at a later stage, i.e., more exits at later stages. “Very big corporations want to see how the project goes, and they have the cash, the ability, and the incentive to wait,” says Yun Lou. Indeed, the difference in behavior between both types of investors stems mainly from the fact that the natures of their goals differ. “Traditional funds like KKR are looking for quick financial returns; corporate venture capitalists care about financial returns as well, of course, but their objective is also more strategic,” says Yun Lou, adding that this strategic element makes them more “patient” investors. She describes venture capital as “another way to spend on research and development,” pointing out that in-house R&D takes time, resources, and human capital. The idea for large corporations is to find a start-up already working on a product that could become important for future business, as was the case with Intel and wireless technology.
Exiting via IPO versus acquisition
The ultimate impact of the nature of the financial backer on the exit strategy was far from clear. Interestingly, investment on the part of a corporate fund produced two opposite effects. A longer investment time – which implies “more precise information about the company”, says Yun Lou – made an acquisition more likely: a one percent increase in the duration of the venture significantly decreases the likelihood of IPO exit by 0.017%. On the other hand, a higher level of investment – which implies “a higher expected value of the company” – made an IPO more likely, with a one percent increase in the amount invested increasing IPO likelihood by 0.065%. So is there any way to determine which effect will dominate? According to Yun Lou, “You can find lots of theoretical arguments, but in practice, it's very difficult to observe.” For instance, you could expect parent corporations investing in a startup to want to influence its innovative technology and make it unique to the parent corporation's products; and yet, according to recent studies cited by Global Corporate Venturing, only 5% of CVC-financed startups are acquired by the backing parent corporations. At the end of the day, different backers might invest differently, and the duration and fund's characteristics may lead to different exit routes for start-ups. Regardless of which exit route to follow, start-ups backed by different funds can all be successful.
Based on an interview with Yun Lou and her article, co-written with Bing Guo and David Pérez-Castrillo, "Investment, Duration, and Exit Strategies for Corporate and Independent Venture Capital-Backed Start-ups" published in Journal of Economics & Management Strategy (2015)
Applications for managers
If both the IVC and the CVC road are successful, is there an optimal strategy for startups? Yun Lou says it depends on the objectives of the startup's managers. She suggests an entrepreneur at the beginning of his venture, hoping for lots of support, might want to get backing from a CVC fund, since these tend to be “cash rich and willing to wait”. But an entrepreneur who is very much attached to his or her innovation, “who doesn't want their technology to be 'stolen' by a big corporation,” as Yun Lou phrases it, might want to turn to a more independent venture fund.
The researchers built a mathematical model. They then empirically tested their main results using data from 1969 to 2008 on 4,801 successful startups in the US market covering 63 industries. The relevant data was obtained from the VentureXpert database and included investment amount; IPO date; acquisition date; investment rounds; number of investors; IPO price; acquisition deal value; venture capital fund size; and so on.