<img src=”/vcj/images/BartSchachter.jpg” align=”right” border=”0″>Conventional wisdom says that VCs fund startups to develop innovative new ideas into profitable businesses. Many startups target large businesses-selling them components, software, services or systems.
Often, the clever startup sprints past a large-company competitor; in some cases, the lumbering giant wakes up and buys the startup at a huge premium, generating vast returns for the clever entrepreneurs and their ingenious VC backers.
But some corporate execs have figured out how to turn the tables on this model. They’re doing the leveraging, using the startups and their VC wallets as extensions of their own laboratories and development teams, outsourcing some R&D without having to pay for it. What follows is our primer for those R&D managers, showing them how they can profit at the VCs’ expense.
Easy As Food Stamps
Signing up for the VC charity program is easier than getting Food Stamps-and the richer you are, the more you can get. While numerous corporations have been tapping this resource for years, we’re documenting the process in the interest of fairness, so that everybody can get a crack at it. If you follow our advice, you can run with the big dogs.
It’s easiest to explain the process with an example. Suppose you manage an R&D section for a network equipment company. You’ve been introduced to a professor from the local engineering school who has just founded NewCo to develop a new kind of processor chip that can do wire-speed deep packet inspection running legacy code. You’re not sure what that means, but two of your underlings sit in on the meeting, and they say while it would be great if it were real, they don’t think NewCo can meet its own performance targets, and believe NewCo will miss its schedule by a year. At the same time, if it ever does work, it would be interesting. In fact, your own team would like to investigate a related idea, but you all agree that there are far higher priorities for your own R&D budget.
Your first thought is to tell the professor at NewCo thanks, but no thanks. But that’s completely wrong. Here’s your chance to get some futuristic research done without spending a dime of company money. Explain to the professor that you’re intrigued by the idea and you’d like to hear more when they get their initial computer simulations done. The professor will be excited and will ask you if you might be willing to be a reference for his company as he is about to embark on his fund-raising efforts. You must respond, reluctantly, that you would be willing to take one or two calls from only top-tier venture capitalists.
In not too much time, you get a call from Bigbux Capital, in which an associate explains that he’s doing research on NewCo and understands that you recently met with the company. When he asks for your thoughts, you explain that the NewCo technology could revolutionize the industry, and that if the product existed today, you would most certainly buy it. The Bigbux associate will report back to his partners that “the market opportunity has been validated,” and the firm will plow millions into NewCo based on your endorsement.
What You Get
Because you’ve been so helpful, NewCo will provide you with regular briefings on their progress. If things go well, you’ll have early access to the technology, perhaps pointing it in a particular direction, getting certain features built in and demanding discounted (“most favored nation”) pricing in exchange for additional funding endorsements. If things don’t go well, you’ve learned a thing or two, and saved yourself from wasting your own company’s time and money pursuing the idea (or something similar). All for free!
Order now, and we’ll throw in a desk clock Lucite tombstone. But wait, there’s more!
A few weeks later, you get a call from a partner at Endless Funds Ventures. This fellow is calling about legacy-code based deep-packet inspection CPUs; he’s looking at an Eastern European team that has some unique technology in this area. Do you tell him that you’re already working with NewCo and think they’re probably further along? Absolutely not. You tell him that you’ve become quite interested in that domain and your engineers are meeting on the topic regularly, but that you still haven’t found a supplier that you are convinced is up to the task. The Endless Funds partner will thank you profusely, and then, having validated not only the market opportunity but also the chance to take the hill while others stumble, will wire millions to Estonia. He’ll also direct his newly funded company to meet with you immediately, because you are a “qualified” customer with a commitment to the technology. You then set up the same deal with this group that you have with NewCo.
Dial It In
Now, in just two easy phone calls, you’ve already doubled your leverage. You might think that’s as good as it gets, but you’d be wrong. There are now two well-funded startups in this arena, so the VC community will automatically launch several more, having identified it as a “hot space.” And that’s not all. Because there are now so many players, they will compete even more fiercely for your business, giving you bigger discounts and, in all likelihood, some free stuff. If this technology really does pan out, and you feel your company needs to own it, you’ll have a choice. You can buy the “best of the bunch” (whichever startup that turns out to be) for what it might have cost you to develop the technology on your own, or you can buy one of the other players at a huge discount, thanks to “over-funding” of the sector. It’ll be your choice, and it’s all risk free!
You aren’t an equipment manufacturer, but still want to play? Not a problem. Let’s say you’re the CIO of a Fortune 1000 retailing company. A startup CEO has been calling to pitch you his idea for new supply-chain software that allows your vendors to electronically tie into your internal systems without compromising security. That’s nice, but you’ve got bigger problems-your internal systems don’t even tie to each other, let alone tie with those of your suppliers.
So do you send the CEO packing? Of course not. You invite him in, and, after giving him 45 minutes for his pitch, you tell him this is revolutionary and will change the landscape of retailing. You want to sign up right away, but you have numerous internal systems that will have to be part of the project. Does his product have interfaces to all of those, and can it facilitate transfer of data between them? No? Well, you can’t consider his product until you’ve gotten all your internal systems up to snuff, and given your limited staff, that will probably take a year or two.
Believe it or not, the CEO says he’ll do the work for you! Just agree to license his product, and he’ll dispatch a dozen engineers in India to spend the next six months on your integration project. Being the clever fellow you are, you sign up for the license but demand an 80% discount; that’s only appropriate as a “charter” customer. Reluctantly, you agree to be a reference for investors. The money you spend on the license will be a fraction of what it costs to do the “integration” project.
How did that happen? The CEO knows that with a flagship customer like you, he’ll have no trouble attracting venture capital to fund his company. The VCs will be thrilled to find a software business already “in revenue.” He’ll explain to them that there are some “product features” that are still being developed. In reality, they are subsidizing a consulting business that may never be profitable, but that shouldn’t stop you from taking advantage of their ignorance.
The VCs are willing to subsidize almost anybody-and the bigger the better. You’re the No. 2 wireless phone carrier? Let one of their startups pay to roll out an innovative new service for you, targeting the lucrative youth market, perhaps (or the senior market-we don’t care). You’re a giant transportation company? The VCs will pay to trial their new combination RFID/GPS tracking technology in your fleet. You just need to know how to play the game.
Of course, this offer can’t last forever. Some VCs are owning up to the fact that in many cases, even “successful” startups are being acquired for less money than they raised. As part of their diligence efforts, certain investors are scrutinizing early customer deals much more closely, and are having more substantive conversations with the Blue Chip references provided by the startup. They’re making more careful consideration of the competitive landscape, and adding a dose of healthy skepticism to wild market forecasts. These venture investors understand that there are still great opportunities to build great companies that generate significant returns. But don’t look to them (or their LPs) to contribute to the big-business subsidy program.
Bart Schachter and David Frankel are managing directors with Blueprint Ventures. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software and communications semiconductors. He may be reached at