Corporate VC makes a comeback

Even burger chain McDonald’s launched a venture capital fund in the heady days of the Internet bubble. But when boom turned to bust, corporate VCs beat a hasty retreat. Prominent shops such as Flatiron Capital, the venture arm of investment bank JP Morgan, shuttered their doors, and the VC units of major tech companies, from Applied Materials to Sun Microsystems, followed suit. It has taken a few years, but corporate investors have finally made a comeback, with 2006 poised to be their biggest year since 2002.

Corporate VCs invested $1.04 billion in the first half of this year, putting them on track to invest 30% more than the $1.5 billion they invested in all of 2005, according to the National Venture Capital Association (NVCA). At the current pace, 372 corporate venture capital firms will invest in 730 companies this year, outpacing the 348 corporate VCs that invested in 581 companies last year. The last time the totals were that high was in 2001.

The lure of a quick buck drew many corporations into the venture arena during the bubble, says John Taylor, VP of research at the NVCA. “Corporations were flooding in because they thought it was easy money and it paid even better than their core business,” he says. “Most of that money did not do well at all.”

Today, corporate investors are demonstrating more discipline and restraint, he says. Indeed, corporate VC dollars accounted for 16.1% of all venture dollars invested in 2000—among the worst years to put money to work. But today, corporate money accounts for a more reasonable 8.2% of all venture dollars invested, according to an analysis by the NVCA. “These are not the same tourist VCs we saw during the bubble,” says Taylor. “A lot of these corporations have been making venture investments for quite some time and know what they are doing.”

These are not the same tourist VCs we saw during the bubble.”

John Taylor, VP of Research, NVCA

While corporate venture capital is often painted with a broad brush, the approaches of corporate VC firms can be as varied as the strategies of their parent corporations. Traditional VCs hoping to benefit from big name backing would do well to keep this in mind.

Tourist season

When it comes to a popular sector like clean technology, traditional VCs are the ones that look like tourists. A number of corporations have a long history of working in the sector. Gerald Brady, managing director of Siemens Venture Capital, points out that his company has been focusing on clean technology for decades, while many traditional VCs have only started investing in the sector in the past few years. Siemens boasts impressive achievements in the field. Two out of three ethanol plants in the United States use technology built by Siemens, which is the world’s second largest maker of coal gasification technology and is one of the world’s largest producers of wind power, Brady notes.

Other corporations, including Chevron, DuPont, and Cargill, also have deep expertise and long histories in areas related to clean technologies. Much like the health care and biotech sectors, where corporations have long worked closely with venture capitalists, the clean technology industry offers a natural venue for partnership, says Brady. Clean technologies tend to be complicated and expensive. The huge resources and deep pockets that corporations bring to the table can be a big boost for traditional VCs.

Along with technical expertise in some sectors, corporate VCs also provide startups with a global reach, which is increasingly important but often missing for traditional venture funds. Finally, the big name backing that comes with a corporate venture investment can put a stamp of legitimacy on an otherwise tenuous startup. “An investment by a big name can provide a halo effect and overcome a lot of the nervousness customers may have in dealing with an early stage company,” Brady says.

Having an investment in one company in a space shuts down our chances with other companies in the space.”

Claudia Fan Munce, Managing Director, IBM Venture Capital Group

Deceleration

Still, Siemens has not been without its missteps and backtracks when it comes to investing in startups. In December 2005, the company shut down its Accelerations in Communications group, which invested in seed stage communications companies, and sold its 24-company portfolio on the secondary market. Mr. Brady says the decision was driven by Siemens’ desire to invest in more mature startups that had already developed a product. “Where we can really help in a meaningful way is when there is a [communications] product that can be taken to a customer,” he says.

Siemens’ investment strategy continues to be determined on a sector-by-sector basis, Brady adds. The company looks for Series B deals in the dynamic communications sector, where having a product in hand is crucial when customers are looking to buy. It also continues to target seed and early stage deals in sectors like energy and health care, where sales cycles are long, the needs for capital are large, but paydays—when they finally arrive—can be immense. “You can be selling to the same customer for five years,” Grady says, “but when the order does come, it will be huge.”

Others remain skeptical about the degree to which corporations have a role in venture investing. Ari Ginsberg, a professor of entrepreneurship at the Stern School of Business at New York University, lists several major reasons that corporations are ill equipped to play the role of venture investor. First, corporations have difficulty finding the right VC talent, since corporate life rarely provides the sort of experience that makes for strong venture capital investors. Building a business from the ground up and generating deal flow are not best cultivated inside secure, large companies.

We will take some risks that maybe others won’t.”

Scott Darling, Vice President, Intel Capital

Strategy vs. profits

Most corporate VCs also tend to invest for strategic rather than financial reasons. The primary purpose of corporate venture investment is usually to boost the parent corporation’s main line of business and provide it with a window on the innovation taking place at startups. While lofty strategic goals are hard to pinpoint and measure, the money lost due to failed investments is painfully evident when things turns sour.

“When the economy gets tough, you no longer have the resources, your shareholders get skittish, and financial losses are seen right away,” says Ginsberg. One upshot of Siemen’s decision to sell its Acceleration in Communications portfolio was to gain quick liquidity. Investing in later stage deals, meanwhile, can have an immediate impact on Siemens’ business through partnerships—often in the same fiscal year—which further underscores how short-term earnings considerations can impact investment strategy.

Finally, the strategic orientation of corporate venture investors can actually be at odds with the financial motivations of traditional venture capitalists, says Ginsberg. Business decisions that may be of interest to the corporate parent in the long run may be at odds with those that increase the prospects of the venture in the near term. One corporation addressed that problem by taking money out of the equation. After an initial foray into venture investing, IBM decided in 2002 to partner with startups rather than to invest in them. That means traditional VCs don’t see IBM as a competitor and IBM does not dilute a startup’s equity base. It also allows VCs to be more comfortable with bringing their most promising startups to IBM for potential partnerships.

My primary driver is a financial return.”

Elizabeth Reeves, Senior Vice President, SAP Ventures,

The setup is critical to IBM’s overall strategy, which shifted from actually making application software itself to playing the role of technology integrator instead. By maintaining a relationship with about 1,200 startups, almost 175 of which have a revenue generating partnerships with IBM, the company is able to furnish customers across many industries with innovative technologies. Startups, on the other hand, are given a chance to access customers that would otherwise be hesitant to buy from a fledgling company.

Claudia Fan Munce, managing director of the Venture Capital Group at IBM, says investing in startups would limit the scope of IBM’s relationships and hamper its larger strategy of providing flexible solutions to its customers on a case-by-case basis. Just as importantly, she adds: “Having an investment in one company in a space shuts down our chances with other companies in the space.”

SAP Ventures, the venture unit of software giant SAP, veers to the other end of the spectrum when it comes to prioritizing financial and strategic objectives. It places financial objectives squarely ahead of any strategic goals. “My primary driver is a financial return,” says Elizabeth Reeves, senior vice president of SAP Ventures, who reports directly to SAP’s chief financial officer. While most corporate VCs require that a business unit within the parent corporation back investment decisions, SAP Ventures is free to make investments on its own. This allows SAP Ventures to move quickly when it sees a promising opportunity. As examples of companies that are removed from SAP’s business but are appealing as standalone investments, Reeves points to Social Text, a maker of online collaboration tools, and Black Duck, which makes compliance management software.

A little of both

Some corporate VCs maintain that there is no way to draw a line in the sand between strategic and financial considerations. Scott Darling, vice president of Intel Capital, the most active corporate venture investor in the market, says for an investment to have a strategic impact, it has to be financially successful to begin with. Intel Capital’s strategy consists of making investments in startups that help fuel the demand for its parent company’s microprocessors. But without the financial legs to make a major impact on one of the many industries that count on Intel chips, an investment made for strategic reasons alone does not live up to this mandate. Still, Darling says that mission of growing Intel’s core business can sometimes outweigh the purely financial merits of a deal. “We will take some risks that maybe others won’t,” he says.

In fact, a large part of Intel Capital’s role is to provide Intel with often unforeseen insights into markets where it is a big player, which leads to a very broad investment mandate. Says Darling: “I joke that for 20% or 30% of our investments I want GMs at Intel to say, ‘I don’t know why you made that investment.’ Then, five to seven years down the line, I want them to say, ‘That company you invested in that we are working with is very relevant, and we are glad you had the foresight.’”