Corporate Venture Capital: Moving to the Head of the Class –

In a marketplace glutted with money to be put to work, it seems as if everyone – including the kid next door – has launched a venture fund. Meanwhile, established venture capital firms are working harder than ever to differentiate themselves from their competitors.

While traditional VC firms scramble to provide all the services the next can’t-miss company is looking for, corporate venture groups have emerged as an unexpected winner in the fight to prove who has the more valuable dollar.

That’s right: corporate VC groups, yesterday’s purveyors of the gladly accepted and much derided, dumb money – a phrase which described corporate VCs’ habit of showing up late for the party and then over-paying for deals, now provide a growing percentage of the must-have capital for many of today’s developing companies.

According to Venture Economics data, disbursements by corporate VCs have jumped to $12.27 billion through the first three quarters of this year, accounting for 17.9% of all VC disbursement, compared with $10.26 billion for all of 1999 and a relatively paltry $392 million in 1995.

“Corporate VC is a growing presence within the VC community. . . you can’t ignore that today nearly $1 out of every $5 is corporate,” says Bryant Tong, president and chief executive officer of Pacific Venture Capital LLC. Pacific, a backer of energy, energy-related and telecommunications companies, is the VC arm of PG&E Corp., an energy-based holding company.

How has corporate VC made the transition from dumb money to smart money? Corporate VCs point in particular to the services they can offer to their portfolio companies, as well as the value-added skills they bring to a funding syndicate. In addition to this, many corporate VCs say a growing focus on financial return and not simply the strategic fit a portfolio company might have with the VC’s parent company has been crucial to their sucess.

Part of the explanation behind corporate VC’s recent rise in prominence is due to the fact that these groups have a value proposition that is critical to developing companies rushing to market in so-called Internet time. Corporate VCs say this proposition is not matched by traditional VC firms.

“We provide valuable sets of experiences and services not found in traditional firms,” adds Jeffrey Nolan, an investment professional with SAP Ventures, the VC arm of SAP AG, the German inter-enterprise software company. SAP Ventures backs enterprise software, mobile computing and Internet companies. “We bring a brand name and resources such as access to markets, pricing models and global experience,” he adds.

“Entrepreneurs need to be global quickly, to grow quickly and they can only do that with corporate help. They have to learn to dance with the elephant,” says Thomas Dollhopf, investment manager at Siemens Venture Capital GmbH, the VC arm of German electrical engineering and electronics giant Siemens AG. “Corporate VC is in the best possible position to provide added value,” he adds. “Siemens has a presence across the world, research and development labs, a worldwide network of bankers and consultants, and established distribution channels,” he says, noting “we can even bring our portfolio companies to Europe.”

Jim Shraith, president and managing partner of Quantum Technology Ventures (QTV), the VC arm of information storage technology company Quantum Corp., concedes QTV probably will not help its portfolio companies fill out its management team like a traditional VC might. However, QTV can add value to a company by arranging for its parent to provide its portfolio companies with engineering help, manufacturing help and possibly entering into supply agreements. Moreover, Shraith points out an investment in a young enterprise by a well-known company can be seen by the larger marketplace as a potentially much needed validation of a particular start-up’s technology.

“I do think corporate VC will become a more important part of the overall industry, because to receive an investment from a VC group representing a particular industry would be a big deal,” Shraith says. “If you are in the network space and bring Cisco Systems into a deal, that’s a big thing for a young company. Or, if you are in storage and bring QTV into your deal that’s big, too”

“I think it is a stamp of approval; it certainly can’t hurt,” says Randy Fardal, vice-president of marketing at Nishan Systems Inc., a developer of storage over IP technology, which in early September closed a $50 million Series C round in which QTV participated. “We could have had a lot of money, but we wanted smart money in this round,” Fardal said, turning the table on the usual distinction between corporate VCs and traditional VC firms. “By using corporate groups, we can work closely with these guys and maybe this might lead to some distribution agreements,” he says. To date, Nishan has raised $90 million in financing in three rounds of venture funding and its strategic investors included Sun Microsystems Inc., Dell Ventures and Siemens Venture Capital and a number of traditional VC Firms.

Strategic Fit vs. Financial Return

A common marketplace criticism of corporate VC is that it is overly concerned with a portfolio company’s strategic fit with its parent company. Corporate VCs may not be concerned enough with generating a superior financial return on their investment to work on building their portfolio companies, because, ultimately, they just want access to a new technology or see the portfolio company as a possible acquisition target. “A $5 million investment by a corporate VC might not generate a great return, but it could cement a relationship or get a distributorship,” notes one private placement agent with a major investment bank. However, many of today’s corporate VCs say that while they do think about strategic fit when doing a deal, the potential financial return a deal could produce is just as important – if not more important – a consideration to them.

“Our primary interest is financial and the secondary interest is to form an environment that creates alliances,” says Dennis Merens, director of corporate venture capital at Dow Chemical Co. “You go wrong if your VC program just has a strategic goal. If you’re going to invest in a start-up the best thing to do is to work to build a company and have a goal of creating a successful start-up.” The reasons for this approach are pragmatic, he notes. “If you get the reputation of trying to skim technology, you will become a less attractive corporate investor to both funds and start-ups in the industry. Also, strategic returns are in many cases meager, relative to the expectations. Corporate VC is not a particularly rich environment for mergers and acquisitions activity,” he adds.

“Financial return is our No. 1 objective,” says Sam Schwartz, managing director of Comcast Interactive Capital (CIC), the venture fund launched by the broadband cable company Comcast Corp. in January 1999. While part of his fund’s purpose is to familiarize Comcast with the ways in which the Internet is affecting the companies’ business lines and its future call this the traditional corporate VC approach the immediate goal is to try to leverage Comcast’s assets to help build top-notch companies and generate good returns for Comcast’s shareholders. SAP Ventures’ primary objective is also generating a superior financial return with a portfolio company’s possible strategic relationship to SAP given due consideration, Nolan says. Successful corporations have developed great experience in building companies and can transfer this knowledge for a high return on its investment, while also potentially getting access to new ideas, technology and partnerships. “There is a benefit here for both the portfolio company and SAP,” he adds.

While not every corporate VC has made financial returns their primary goal, strategic corporate VCs are not investing according to the traditional stereotype and making investments regardless of the return they may generate. “We manage investments for strategic return, but that does not mean we take a bath on the investments we make; of course we care about the financial return,” says Stephen Nacthsheim, vice-president and director of Intel Capital, Intel Corp.’s strategic investment program. Warren Holtsberg, vice president and director of venture investing for Motorola Inc.’s VC arm, One Motorola Ventures, says that an investment made for strategic reasons does not guarantee poor returns. “If the strategic fit is strong enough, the investment will make money,” he adds, noting he refers to the strategic investments his fund makes as “equity plus” investments. “We win on successful companies by accelerating them to market and benefiting from their energy,” he says.

Corporate VCs, whether investing for strategic reasons, a financial goal or some combination of the two, all say they do not make investments thinking of their portfolio candidates as potential acquisition targets. “Out of 450 investments in our portfolio, we only acquired two companies,” says Intel’s Nachtsheim. SAP’s Nolan also notes most corporate VCs are taking very small stakes in their portfolio companies, making an acquisition a large leap. “It’s a pretty long step from a minority ownership stake to an M&A deal,” he notes.

Working Together

One result of corporate VC firms being viewed as dumb money was that some traditional venture firms wanted to avoid working with their supposedly slower moving, less adept corporate cousins, says one private placement agent. While this still might be true in some circles, as the VC business has begun focusing more and more on technology-heavy companies, traditional VC firms are turning with greater regularity to corporate VCs because of their connections to technology savvy engineers, who bring serious know-how to the due diligence process. “People need us, we bring a lot to a syndicate and have strong relationships with a number of [traditional VC] firms,” says One Motorola Venture’s Holtsberg.

Dow’s Merens agrees with Holtsberg about the value a corporate VC investor brings to a consortium of traditional VC firms. “From a fund’s perspective, Dow is a good partner, because it has a significant breadth of embedded skills in areas valueable to VC, in addition to our due diligence capabilities across a host of science and technology segments,” Merens says. Shraith says QTV has had a similar experience. “Now that we have been out in the market eight months, we get invited in on most storage deals, because we have access to a hundred engineers to help with due diligence and that is something a traditional VC firm cannot do,” he adds.

Meanwhile corporate VCs have rounded out the rest of their relationship with traditional VCs firms by establishing themselves as good partners. Corporate VCs still tend to rely on traditional VCs firms to lead deals and set the terms and conditions of financing rounds. “We don’t want to set the price or terms and conditions,” says SAP’s Nolan. “We find that traditional venture firms have better skill sets to establish the terms and conditions. Plus, this keeps our relationship strong and non-competitive.”

Another way corporate VC’s have ingratiated themselves to the wider VC community is by acting as limited partners in other firm’s funds. Some two-thirds of Dow’s VC capital goes to investments in traditional VC funds, Merens notes, although over the next year he is planning to scale this back to around half of Dow’s VC money. Since its inception in 1999, Siemens Venture Capital has made 20 investments for approximately $80 million in other VC funds. “We invested money here to learn the business and build relationships,” Dollhopf explains. “This gets us deal flow, a return on our investment and indirect access to other firm’s portfolio companies from their reports,” he adds.

“We always viewed strategic investors as important from the very beginning of our time in the business. You do need technology validation with a lot of companies or you need someone to focus a company’s applications,” says Bob Nelson, a managing director at ARCH Venture Partners, a backer of early-stage Internet, e-commerce, life sciences and physical sciences companies. Arch counts Dow Chemical among its LPs. Nelson says his firm prefers to work with venture arms who are trying to move a project forward or validate a technology, rather than those who are simply trying to keep a technology platform standard or pad their pipeline.

The Road Ahead

As corporate VCs continue to become more of a marketplace fixture, many say the most important hurdle they face is the issue of compensation. Historically, corporate VCs have been paid a standard salary and bonus by their employers, but do not participate in the carried interest generated by their funds. This stands in sharp contrast to general partners at traditional firms, who do participate in a fund’s carried interest and in an era of mind-boggling returns have seen their bank accounts swell as a result. For companies’ with successful corporate VC groups the danger in not letting their investment professionals participate in the carry is that they may lose them to traditional VC firms and their deeper pockets. “This is absolutely a problem you either need to fix it or good guys will leave,” Siemens’ Dollhopf says, noting his parent company had already moved to address this issue.

“The problem you run into is a political one of people in other companies generating a profit, but not getting the same kind of compensation as the VC guys,” says Comcast’s Schwartz. “Corporations have to ask the question about what kind of people they want to run their VC group,” he notes. In addition, Comcast has sructured CIC so its investment professionals participate in the fund’s carry. “I would not have taken this job if it had a compensation scheme different from a traditional firm,” he says.

One Motorola’s Holtsberg says while he thinks something should be done to make the compensation disparity between corporate VCs and traditional VCs more equal, he does not think corporations should pay the same as VC firms. “We have some different and better benefits, plus the risk profile here is different,” he adds. Intel’s Nachtsheim says he thinks the issue is corporate VCs are currently measuring their compensation against the returns generated in the last three years. “But their have been a lot of years in the last 20, where returns were not so good,” he says, adding “when the market softens, this will be less of a problem.”

While the issue of compensation may remain undecided, corporate VC itself remains poised to become an even more important part of the VC word. “Corporate VC investing will continue to have a significant impact on growth in several industries,” says Pacific’s Tong.