Cover Story — Corporate VCs: Ill-Equipped to Weather The Storm –

For most of the 1990s, AT&T Ventures was a financial star in the venture capital world, earning returns estimated in the triple digits. An investing partner from the corporate VC group joked that it was AT&T’s best investment besides the monopoly.

Despite the fund’s strong financial performance, a change in the guard at AT&T led to a joint decision between the venture unit and its parent not to raise another fund. While the partnership-now called Venture Management Services-still supports its portfolio companies with follow-on financing, new investments have ceased.

At first glance, AT&T’s shift away from the external venture partnership isn’t surprising. Indeed, faced with lower earnings, a depressed portfolio and a difficult exit environment, scores of corporations have abandoned VC over the last 12 months,

However when one considers that AT&T made that decision back in 1999-during one of the most profitable periods in the VC market’s history-the already uncertain future of corporate venturing looks even more dubious.

From a financial perspective alone, it’s easy to see why corporations are heading for the exit doors: Collectively, they wrote down $9 billion worth of venture investments in the first quarter of 2001, and another bloodbath is expected in the first quarter of 2002. Companies like Comdisco, Wells Fargo and Lucent have already written off considerable investments or closed shop.

But corporations have long argued they aren’t in it just for the investment returns. Instead, the party line has been that the primary goal of corporate VC is to gain strategic benefits, like leveraging new technology to advance the core business. Making big bucks off the IPO was considered the icing on the cake-not the main course.

Regardless of if they were in it for the money, many are now getting out of it for the money. With earnings down and shareholders applying intense scrutiny, corporations are being forced to focus their energies on their core business, and in many cases they’re shifting VC to the bottom of the priority list.

During this painful reevaluation period, many corporations are realizing they simply weren’t prepared-or properly staffed-for managing a sizable venture portfolio. Worse yet, some concede that VC simply hasn’t provided the strategic benefits they were hoping for. Their current predicament raises the question: Is corporate VC, as it’s been defined thus far, a fundamentally flawed concept?

“Corporations almost always fall short,” argues Harry Edelson, general partner of Edelson Technology Partners and a longtime thorn in the side of corporate VCs. “They make a few investments that have strategic benefits, and the rest are just problems.”

“I’m not sure if corporations ever get involved in venture capital for any of the right reasons,” says a 25-year veteran corporate finance attorney specializing in technology transactions.

Surely, not all corporate VCs have taken a step back from VC. Longtime corporate investor Intel Capital, for example, made new investments just last month.

But there’s no question this faction is retrenching. According to VentureXpert, 20% of deals in the 2001 third quarter had corporate participation, down from 27% in the year-ago period.

While economic pressure is one of the culprits pushing corporate VCs to the sidelines, an economic rebound may not necessarily bring them back to the playing field. Market pros say that unless the formula for corporate VC changes, the effort is nothing more than a losing battle.

“Corporations don’t have the stick-to-it-ness that venture investing requires,” says the corporate finance attorney. “They don’t have the time and resources to shepherd these companies.”

In Pursuit of Strategic Gain

Corporations enter the venture game hoping to find new technologies, to create new sales opportunities for the current products or to become more efficient.

Hearst, for example, lost considerable revenue from the classified advertising business in the newspaper divisions to new online job boards. The venture group invested in and tied the start-up to their current classified advertising to save the classified revenues.

Other efforts are too fresh to judge. Motorola Ventures invested in Sportvision, a company making applications for an upcoming Motorola interactive cable box. The investment looks promising, but it may be difficult to tie that investment back to revenue from sales of the cable box.

Indeed, corporate VCs generally have a tough time producing clear evidence of investments providing strategic benefits.

“Trying to measure the strategic value is exceedingly difficult,” says Elliot Swan, managing director at Intel Capital. “Can I go back and count how many more servers I’ve sold?”

A consultant to corporate VCs adds, “Almost all of them fail because they confuse their mission. They get started for a strategic reason, but they find there’s no good way to measure that. Then, they start measuring them based on financial returns.”

That worked nicely in 1999 and 2000, when small dotcom and telecom investments quickly turned into lucrative IPOs. It was easy to stretch their definition of “strategic” when the financial benefits were rolling in.

Of course, when those returns dropped-as they did for all venture investors this year-the corporate venturing units were hard pressed to justify maintaining their VC activity, and those who couldn’t point to strategic benefits had no leg to stand on. At the same time, corporations decided to get back to their core businesses, with many losing interest in VC.

Internal Squabbles

Most corporations go into VC expecting positive results for the company. On paper, the plan sounds wonderful: What company wouldn’t want to develop a startup that returns incredible profits by helping other divisions improve their technology, increase sales or reduce costs?

Unfortunately, getting the rest of the corporation to buy into this strategy doesn’t always work. Some of the divisions intended to benefit from VC aren’t always cooperative, and division managers often maintain a short-term outlook.

“When the R&D director comes in, the [operating managers] say, What can [the start-up] do in the next 12 to 18 months to help me? If it’s four years out, I don’t care,'” says Don Laurie, chief executive of Boston-based management consultant Oyster International. “They’re focused on incremental changes, not disruptive technologies.”

In addition, some corporate cultures require operating managers to be so faithful to their core division that they cannot participate in productive joint technology partnerships with outside companies.

Chris Varley, new market development vice president at AT&T Labs, said at a conference that some managers in his company worried about what ideas the start-ups were going to steal, and start-ups commonly have the same fear of all their corporate partners.

Furthermore, if successful, the venture group may discover start-ups that threaten the corporation’s core business. According to Laurie, one large corporation was developing their latest version of a $500,000 X-Ray machine when the venture group found a company developing a similar machine for $1,500much to the dismay of the team expecting revenues at the $500,000 mark.

“You need an attitude in the leadership that we’ll eat our own. If you try to hold [the start-ups’] heads underwater, they’ll pop up somewhere else. It won’t work,” says Laurie, who targeted corporate executives with his recent book, Venture Catalyst: The Five Strategies for Explosive Corporate Growth.

Also complicating matters is the fact that, as customers or vendors of the portfolio companies, corporations often find themselves with stakes on both sides of the negotiations over licenses.

For example, Intel Capital established the Intel 64 Fund to invest in software companies that will port software to the new Itanium Chip. Like most corporate VCs, Intel invested in companies and signed development agreements with them.

Negotiations over the terms in the agreements put Intel on both sides of the table. For the software companies to redesign their applications was not an insignificant operation. The business units wanted provisions in the agreement requiring the companies to commit to the process, but the VCs probably wouldn’t have wanted those terms had the VC been acting strictly in the interests of the start-up.

Moreover, unlike a standard VC fund, which is run by VCs, corporate VC programs are controlled by executives with no sentimental feelings toward venture capital. The CEO, who gets inputs from operating managers and other sources, has to argue for the program before the board.

Regardless of whether or not the operating managers support the program, the corporate finance people often find fault with VC, in large part because, like all equity investments, private equity valuations fluctuate. Furthermore, assigning a value to private companies is no easy, or standardized, task.

“Top management wants predictability of earnings,” Edelson says. “It’s not going to be there with a venture capital unit.” Adds former Intel Capital managing director Harry Laswell: “When the scale of your program grows, its ability to affect your earnings can become an additional challenge.”

Corporations establish venture groups as internal business divisions, as separate partnerships with multiple LPs and as everything in between. With committed capital, separate partnerships are intended to insulate themselves better from corporate whims.

However, separation failed to protect Primedia Ventures. Primedia invested as a sole LP in two funds, but it missed a capital call on the second fund due to pressure on other areas of the operation. Even though Primedia Ventures, as a separate entity, had complete general partners’ discretion, the parent LP in reality caused the end of the venture as surely as it would have had the venture been an internal business unit.

“Being reliant on a single LP is suboptimal because of the customer risk,” says Larry Phillips, founder and former managing director of Primedia Ventures. “I think Primedia, too, would have been better situated had we taken outside limited partners.”

Staying Lean

Max Schroeck, managing director of Agilent Ventures, says keeping groups on the small side is a key to their success. “You get the same amount of benefit with substantially less risk,” he said. “We are not a bank.” Smaller fluctuations generally attract less scrutiny.

Indeed, staying small has been a common strategy for a number of corporations. Two years ago, IBM launched an ambitious hybrid business development/ traditional VC practice with relatively little capital. IBM established relationships with 80 venture firms globally and fronted $350 million among 40 of them where the relationships required capital. IBM then sent business development liaisons to work with those venture firms, looking for potential synergies in their portfolio.

“We’re not looking for return on investment,” says Richard Birney, IBM’s vice president of venture investing. “We’re just looking to put in a minimal amount of money in order to solidify the relationship.”

For IBM, establishing relationships with VCs this way means the company doesn’t have to compete on the same playing field or operate like a standard VC would. “For me, to attract the best venture capitalists around the world and attract the best deal flow around the world where people there are already significantly entrenched seemed like a fool’s game,” Birney says.

The ongoing expense for IBM, which spends about $5 billion annually on R&D, should decrease due to the longevity of the partnerships. Last year, an idea from the venture group led the company to add a life sciences division. However, they have also protected their balance sheet better than some programs with large direct investments.

For its part, Intel Capital stresses that it’s more of a passive investor than a standard VC, and generally doesn’t take board seats on its portfolio companies. However, considering that Intel currently manages 500 investments, it’s hard for passive investing not to consume considerable resources. (By comparison, Advent International manages 175 investments.)

What Will the Future Bring?

There’s no question that corporate VC has changed dramatically. Longtime VC Ken Rind says he gave his first speech on how to set up a corporate VC fund in 1999, and this year he’s given several speeches on how to shut them down without repercussions.

The ramifications of this change haven’t been lost on the rest of the VC market. Secondary VC investors have increased, including those specifically targeting corporate portfolios, and several other VCs have positioned themselves to benefit from the shift in corporate sentiment away from in-house venture groups.

Advent, for example, offers corporations dedicated funds, where a corporate investor influences the fund’s investment charter, participates in the due diligence and scours the deal flow for partnering opportunities. Usually, the corporation puts someone in-house.

Steve Kahn, managing director at Advent, compares the strategic benefit for the corporation investing in a dedicated fund to fishing with a net. He says in-house corporate VCs are like going fishing with a rod and pulling in each fish individually.

However, economic factors and the whim of corporate executives have continued to prevent corporate VCs from realizing their intended strategic benefits. New strategies aside, most market pros remain skeptical that corporate venturing achieves its objectives better than lower-risk, traditional business methods.

“Given your objective, have you executed successfully?” asks Dan Singer, a partner in McKinsey & Co.’s PE practive. “The question is: Did it work? If your goal was to create new marketing opportunities, did it grow sales more than investing the money in your marketing program?”

Beyond that, corporations may not have the stomach to forego quarterly results in order to commit to the longevity these programs often require to bear a full harvest of strategic or financial gains. “The reality of the venture model is that 20% to 30% of these investments are successful,” says Chris Aidun, partner and head of the VC practice at Weil, Gotshal & Manges LLP. “As a corporation, can I tolerate that kind of success rate?”

To be sure, the corporate market follows cycles. During the last significant economic downturn, corporate investments in startups dropped to $87 million in 1991 from a peak of $458.7 million in 1985, according to Venture Economics. By 1996 annual corporate investments went up to $532 million and reached a peak of $17.6 billion in 2000.

And even if naysayers like Edelson correctly predict the demise of coporate VC, it’s important to note that many groups will still be bottom-line successful. According to Intel, even if Intel Capital and its portfolio of 500 companies completely disappeared, the company would have returned more capital than it invested. End result: Net positive, at least financially.

That doesn’t account for all the human capital its operating managers diverted to the VC program, but it also ignores any additional sales, improved technologies and new markets the venture group discovered.

However, regardless of those benefits, it’s hard not to classify corporate venturing, as a whole, as a flawed concept if it can’t weather the cycles of the markets and, more importantly, can’t even quantify its strategic benefits.

“My prediction is that every one of them will go out of business except the financial ones like the Sprout Group and GE Capital,” Edelson says. “Well, maybe not 100%, but 98% of them will.”

To date, only a few corporate venture programs have achieved the longevity to prove their commitment to the concept, and even proponents of corporate venturing agree that conflicts exist among the goals and realities of the program. However, significant strategic potential awaits the corporations that successfully crack the code.

“There are good or not so good corporate venture capitalists,” says Joseph Bartlett, partner at Morrison Foerster LLP. “It is a function of how well the company thinks through what they want to do in the beginning.”