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Making Sense of Corporate Venture Capital

Is this the time for corporate VC funds to run dry? Hardly, says Harvard
Business School professor Henry W. Chesbrough. You just need to
understand the big picture, as do Microsoft, Intel, and Merck.

by Henry Chesbrough HBSWK Pub. Date: Mar 25, 2002

Corporate VC investments in external
start-ups dried up in 2001, but many
smart companies including Intel,
Microsoft, and Merck continue to
place strategic bets. In this Harvard
Business Review excerpt, Harvard
Business School professor Henry
Chesbrough provides an overview of
corporate VC investment strategies
and why they can be critical to driving
growth in your company.

Large companies have long sensed
the potential value of investing in external start-ups. More
often than not, though, they just can’t seem to get it right.

Recall the mad dash to invest in new ventures in the late
1990s—and then the hasty retreat as the economy turned.
Nearly one-third of the companies actively investing corporate
funds in start-ups in September 2000 had stopped making
such investments twelve months later, according to the
research firm Venture Economics, and during the same
period, the amount of corporate money invested in start-ups
fell by 80 percent. This decline in investments was part of a
historic pattern of advance and retreat, but the swings in
recent years were even wider than before: Quarterly corporate
venture-capital investments in start-ups rose from $468 million
at the end of 1998 to $6.2 billion at the beginning of 2000 and
then tumbled to $848 million in the third quarter of 2001.
While private VC investments also ebb and flow as the economy changes, the shifts in corporate VC
investments have been particularly dramatic.

Such inconsistent behavior certainly contributes to the low regard with
which many private venture capitalists view in-house corporate VC
operations. In their eyes, the wild swings are further evidence that big
companies have neither the stomach nor the agility to manage investments
in high-risk, fast-paced environments. They also point to some high-profile
missteps by individual companies to support this conclusion. Those
missteps have, in turn, tended to make some companies hesitant to
launch programs to invest in external start-ups, even in good times.

A number of companies,
however, have defied this
stereotype of the bumbling
corporate behemoth and have
continued to make investments
in new ventures. Even as
substantial numbers of
corporate venture capitalists
have headed for the exits in the
past year and a half, some big
companies—including Intel, Microsoft, and Qualcomm-have publicly committed themselves to
continued high levels of investment. Others—such as Merck, Lilly, and Millennium
Pharmaceuticals—have actually come in the door as others have left. What gives these optimists
their confidence? More generally, why have some companies’ forays into venture capital been
successful, generating significant growth for their own businesses?

To answer these questions, we need an organized way to think about corporate venture capital, a
framework that can help a company decide whether it should invest in a particular start-up by first
understanding what kind of benefit might be realized from the investment. This article offers such a
framework, one that also suggests when—that is, in what kind of economic climates—different types
of investment are likely to make sense.

But first, let’s briefly define corporate venture capital. We use the term to describe the investment of
corporate funds directly in external start-up companies. Our definition excludes investments made
through an external fund managed by a third party, even if the investment vehicle is funded by and
specifically designed to meet the objectives of a single investing company. It also excludes
investments that fall under the more general rubric of "corporate venturing"—for example, the funding
of new internal ventures that, while distinct from a company’s core business and granted some
organizational autonomy, remain legally part of the company. Our definition does include, however,
investments made in start-ups that a company has already spun off as independent businesses.

Our framework helps explain why certain types of corporate VC investments proliferate only when
financial returns are high, why other types persist in good times and in bad, and why still others make
little sense in any phase of the business cycle. It can also help companies evaluate their existing and
potential VC investments and determine when and how to use corporate VC as an instrument of
strategic growth.

The dual dimensions of corporate VC
A corporate VC investment is defined by two characteristics: its objective and the degree to which the
operations of the investing company and the start-up are linked. Although companies typically have a
range of objectives for their VC investments, this type of funding usually advances one of two
fundamental goals. Some investments are strategic: They are made primarily to increase the sales
and profits of the corporation’s own businesses. A company making a strategic investment seeks to
identify and exploit synergies between itself and a new venture. For example, Lucent Venture
Partners, which invests the telecommunications equipment maker’s funds in external companies,
makes investments in start-ups that are focused on infrastructure or services for voice or data
networks. Many of these companies have formal alliances with Lucent to help sell Lucent’s equipment
alongside their own offerings. While Lucent would clearly like to make money on its investments in
these start-ups, it is willing to accept low returns if its own businesses perform better as a result of
the investments.

The other investment objective is financial, wherein a company is mainly looking for attractive returns.
Here, a corporation seeks to do as well as or better than private VC investors, due to what it sees as
its superior knowledge of markets and technologies, its strong balance sheet, and its ability to be a
patient investor. In addition, a company’s brand may signal the quality of the start-up to other
investors and potential customers, ultimately returning rewards to the original investor. For example,
Dell Ventures, Dell Computer’s in-house VC operation, has made numerous Internet investments that
it has expected to earn attractive returns. While the company hopes that the investments will help its
own business grow, the main rationale for the investments has been the possibility of high financial
returns.

The second defining characteristic of corporate VC investments is the degree to which companies in
the investment portfolio are linked to the investing company’s current operational capabilities—that is,
its resources and processes. For example, a start-up with strong links to the investing company
might make use of that company’s manufacturing plants, distribution channels, technology, or brand.
It might adopt the investing company’s business practices to build, sell, or service its products.

Sometimes, of course, a company’s own resources and processes can become liabilities rather than
capabilities, particularly when it faces new markets or disruptive technologies.1 An external venture
may offer the investing company an opportunity to build new and different capabilities—ones that
could threaten the viability of current corporate capabilities. Housing these capabilities in a separate
legal entity can insulate them from internal efforts to undermine them. If the venture and its processes
fare well, the corporation can then evaluate whether and how to adapt its own processes to be more
like those of the start-up. In rare cases, the company may even decide to acquire the venture.

· · · ·

Excerpted with permission from "Making Sense of Corporate Venture Capital," Harvard Business Review, March, 2002, Vol.
80, No. 3.

http://hbsworkingknowledge.hbs.edu/pubitem.jhtml?id=2854&sid=0&pid=0&t=entrepreneurship

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