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A venture too far?

Corporate venturers have come in for some harsh criticism lately for their short-term attitudes – and not without reason in many cases. Yet they can add real value to portfolio companies, enhancing returns for venture capitalists investing alongside. But only if they're in it for the long term.

The world of corporate venturing has been throwing out some mixed messages lately. In Europe, Nestle has recently announced a CHF200m corporate venturing programme to take advantage of food and life sciences developments in smaller companies and Unilever has said that it is considering setting up a venture programme to invest in external companies. Meanwhile, recent figures from the US have shown that corporate venturing activity is in decline. Earlier in the year, Compaq shut its venturing arm and laid off a third of its investment staff. Oracle, too, has scaled back plans to expand its venturing operations into Europe.

As a result of the slowdown, corporate venturers are currently coming in for some heavy flak. Their critics say that they have a tendency to set up venture funds in the good times only to retrench when times get tough.

To an extent, some of this criticism is merited. The sector was far from immune to the euphoria of recent years. In the US, the value of venture funds was estimated to have grown from $392m in 1996 to a staggering $18bn by 1999. How times have changed. A recent Bain & Co study found that nearly half the US executives that set up venture funds last year have now abandoned them. And an EVCA survey out this month showed that corporate venturing in Europe had become an important financing option for smaller companies by 2000. Corporate venturers investing directly in companies committed E1bn last year and raised E2.5bn. The survey makes no reference to what has been happening over the last 11 months, but anecdotal evidence suggests that levels of investment are unlikely to hit E1bn for this year.

The yo-yo effect
It's an interesting trend and one that mirrors the venture capital investment fluctuations of the last few years. But what some private equity fund investors may not realise is that this type of yo-yo investing among corporate venturers can have a detrimental effect on their investments. If a large company invests via a dedicated fund it has set up with commitments from external investors, the risk is limited. Generally, corporations that have done this understand the long-term nature of private equity investing and have the expertise to manage through a downturn. If a corporate investor has committed to a private equity fund, it will be unable to withdraw its funds if it decides to drop venture investing. But it may be less involved in helping underlying companies develop than it had originally promised.

The effect will be felt most seriously by investors whose venture capital funds invest alongside corporate venturers that have now retreated from the market. Again, the company will be unable to renege on the finance it has already committed, but it won't provide follow-on funding and it will no longer provide the type of expert support that can really add value to portfolio companies. This could leave venture capitalists high and dry and their investments in companies less certain. ‘If a corporate venturer retracts from investments in companies that have formulated their business plans on the basis of support and involvement of that corporate, they will be in a difficult situation,' says Dr Gordon Murray of London Business School. ‘They will be suffering a level of uncertainty that is less than helpful in an early-stage company. There may be some question mark about where they will get their next round of funding.

Is it worth it?
Given this effect, some investors in private equity funds may wonder whether it is worth investing alongside corporate venturers. But it's important to distinguish between the more opportunistic corporations who seem to have been looking for a way to make a fast buck and the more experienced ones who were in it for the longer haul.

In the late 1990s and 2000 many large companies saw investing in private technology companies as an easy way to make money. Figures from the US bear this out. In 1995, corporate investment in venture-backed companies stood at £368m, according to figures by PricewaterhouseCoopers and Venture One. By 2000, the figure had ballooned to nearly $6bn. In the first half of this year, investments stood at $353m. ‘There were a lot of people who jumped on the corporate venturing bandwagon,' says Rob Anderson, head of consulting at corporate venturing consultants Edengene. ‘They didn't attract the best venture capitalists or corporate finance workers and they made some poor investments. They entered the market late and paid very high prices. Now that they have been burned, they're stopping their venture programmes. It's also a product of a tough economic climate. Many large corporations are under pressure to save cash - an obvious way to do this is to slash an underperforming part of the business.' Either way, it shows a lack of commitment among these types of corporate venturer.

To be fair to some of the more seasoned players, part of the reason for the slowdown in corporate venturing activity can be explained by a parallel slowdown in new venture capital fund investments. It is no secret that this sector of the private equity industry has been hit particularly hard by falling technology company prices, a lack of exit opportunities as the initial public offering window has slammed shut and a not insignificant number of troubled portfolio companies.

Corporate venturers such as Intel Capital claim that this has had a knock-on effect on its levels of investment. In the first half of 2000, it invested in 98 companies; in the first half of this year, Intel invested in 67 - and it was by far the most active corporate venturer, according to statistics compiled by Alternative Assets' Corporate Venture Funding Report. Cisco came in second with 27 company investments and General Electric third with 24. ‘Financial venture capital investors have really pulled back,' says Johann Weber, sector manager, wireless investments at Intel Capital's European operations. ‘They have been deprived of exit opportunities and are having to provide more follow-on financing to companies than they had planned. We co-invest alongside VCs and we rely on them to bring us new deals. If that doesn't happen, we don't do new deals. It's also a function of the fact that the opportunities aren't as plentiful as they were last year.'

Return to normality
It's worth putting the drop in funding levels and corporate venturing activity into context. The last couple of years should be seen as more of a blip than a normal  pattern. The amounts being invested were extraordinary in 2000. What we're seeing now is a return to more sustainable levels of investment - much the same could be said for financial venture capital activity. ‘We're seeing a return to normality,' says Edward Siegel, manager of corporate venturing at Philips. ‘The numbers are just going back to 1999 levels. The year 2000 was an exception rather than the rule. Corporate venturing has fallen back in line with the rest of the economy.'

And that is precisely the point. Corporate venturers that are committed to this type of investment in the long term and that understand the nature of investing in equity in unquoted companies realise that we are in more normal times. The ones that have cut back couldn't have understood what they were getting into. ‘The persistent investors understand the modus operandi of corporate venturing,' says Murray. ‘They understand that they are managing contradictions, such as getting a huge company to relate to the issues confronted by a ten-person operation. They also understand that to get real value - strategic and financial - from their investments in companies, they have to think long term. Less experienced corporate venturers seemed to be under the impression that it was possible to grow a successful company and exit it in two years. It actually takes between five and ten years, sometimes longer. Microsoft, for example, was nothing for ten years.

‘You can't beat seasoned experience in this arena. It took venture capitalists as a profession three funds to learn their job. Many corporate venturers came in and tried to do it without having learnt any lessons and in the strongest bull market the world economy has ever seen.'

Where's the value?
It's this seasoned experience that can add value to portfolio companies and therefore to returns. Murray and Markku Maula of the Helsinki University of Technology have conducted a series of studies looking at what corporate venturers bring to the table. In one, Complementary Value-Adding Roles Of Corporate Venture Capital And Independent Venture Capital Investors, they examined the relative strengths and weaknesses of VC investors and corporate venturers. They found that while venture capitalists were able to add value to investee companies by helping them manage early growth and build viable organisations and by recruiting key employees; corporates could help companies gain market credibility, attract customers, suppliers and alliance partners. They concluded that the two types of equity investor had ‘different and complementary value-added profiles'.

In theory, this collaborative approach can bring benefits to venture capital fund investors in the form of enhanced returns. It's a view endorsed by many coporates. ‘We are completely collaborative,' says Diane Noble of Reed Elsevier Ventures. ‘We rely heavily on VCs who are very good at developing start-ups and building management teams. We are looking to invest at a later stage. We also work alongside later stage investors. They need us and we need them.'

Strategic vs financial
But in practice, the relationship doesn't always run this smoothly. Some institutional investors are sceptical about how the motives of the two sides can be squared. In the main, corporate venturers invest in companies for strategic benefit, such as keeping up with disruptive technologies in their market. Nestle, for example, is setting up its venturing arm to explore and keep tabs on what is happening in life sciences. ‘This area will have an important impact on Nestle, but it's outside our normal research activities. We want access to interesting developments in the market,' says its head of corporate communications Francios-Xavier Perraud. All venturers will say that financial gain is important, but it will always be second on the list. For venture capitalists, the motive must be purely financial - to provide their investors with maximum returns.

It can make for a difficult relationship and some venture capitalists feel uneasy about investing alongside corporates. Exits are a big issue. The best time to exit for a VC may not be the best time for a corporate. VCs are motivated by producing the best returns in the quickest possible time to boost their internal rates of return. Corporate venturers may wish to hold onto an investment for longer to gain maximum strategic benefit from it. ‘In this type of scenario, the two parties need to ensure that the corporate can provide the VC with an exit value if it wants to remain with the portfolio company,' says Anderson. He adds that another problem is that a VC will often need to act as referee to ensure that a portfolio company is receiving the attention it should from the corporate. ‘It's all very well imagining that a company will be able to use its corporate investor's marketing department to help it. But in reality, it is working alongside an organisation whose overall priorities do not lie with that company.'

New solutions
However, there are innovative ways around this. Some venture capitalists are coming up with ways of marrying the market knowledge of corporates with their own management expertise - and in ways that will lock corporate venturers in for the long term. Granite Capital in the US, for example, manages a fund solely for Adobe and one for Texas Instruments. The idea is that the two companies can make strategic investments through the fund, add their own value and make use of traditional VC skills. Plus, the CV-VC relationship means that these corporates can also help portfolio companies in Granite's other venture capital funds. Advent International is one of a number of funds that actively seeks corporate investors. It has around 40 of some of the world's largest companies investing in its funds. And then there's an interesting move by Amadeus. It has set up a seed fund for corporate investors that will focus on early-stage wireless businesses in and around Cambridge. The interesting part of this is that it will match investment from this fund with money from its Amadeus II fund. Again, the idea is to add value in the traditional VC manner and to supplement this with support and advice from corporates.

Corporate venturing is clearly an evolving market. This evolution has not been without some pain already - mainly suffered by inexperienced hands. There will doubtless be more to come. But it is also a market that can help boost institutional investors' returns as long as its players understand the downside as well as the upside. ‘Those who are not committed will disappear,' says Murray. ‘Those that remain will have already learnt or will have to learn venture capital skills. They will have to ensure they have the right reward structures and be in it for the long haul - if you take one shake at the dice, they will invariable go against you. The majority will get out of the market and you will be left with a core of about 20 to 25 good quality investors.'