12 minute read 4 Jan 2021
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Why now may be the time to start a corporate venture fund

Authors
Peter Ulrich

EY-Parthenon Principal, Digital Strategy and Transactions, Ernst & Young LLP

Digital Innovation in Strategy and Transactions. Knowledge in industrials, automotive, machinery, construction, infrastructure, mobility, and logistics.

Jeff Leach

EY Americas Business Development Leader, Strategy and Transactions

Strategy and M&A advisor, delivering topline growth and bottom-line results. Dad to twins. Yogi, runner, advocate for the ethical treatment of animals.

12 minute read 4 Jan 2021

CVC can be an integral part of the corporate toolbox to fill capability gaps and explore new technologies.

In brief

  • Corporate venturing can be a key way to accelerate digital capabilities and M&A options.
  • A separate fund structure multiyear capital commitment may be the most effective approach.
  • Staff with venturing experience and clear value proposition are keys to CVC fund success.

Large corporations have both been inspired and challenged by technology startups launching new business models, products and services during the past decade. Many of these digital solutions, which were already in demand, have seen dramatically increased speed of user adoption during the COVID-19 pandemic. In order to accelerate their own digital journeys, corporations can employ corporate venturing, choosing from multiple approaches ranging from investing off-balance sheet, to setting up a dedicated internal fund, to creating a separate fund with multiple limited partners (LPs).

Most companies ultimately end up with a separate fund structure and multiyear capital commitment, as this proves most effective for them. In this article we examine corporate venture capital (CVC) funds as a key approach for companies to invest in upstart companies and other cutting-edge technologies.

Companies with CVC funds hedge their risk while exploring opportunities through a portfolio of minority investments in startups. This helps them tap into future growth opportunities, not only during the current period of disruption, but also moving beyond into the post-pandemic world. When executed well, CVCs can become a powerful complement to other tools such as in-house R&D, partnerships, joint ventures and startup M&A to accelerate digital transformation.

In fact, now may be the perfect time for corporate venturing. While multiples have not been as impacted by the pandemic as in previous downturns, the current uncertainty means companies with available cash might be able to find some investments at a discount, especially if startups with longer-term priorities face a short-term cash crunch. Big tech companies increased their startup investments from $7.6b in 2019 to $16.7b in the first eight months of 2020, according to CB Insights.

However, CVCs may need to be selective and proactive in the origination of investments in startups to find the best value deals.

Using CVC to gain insight

CVCs provide a way for established companies to extend their ecosystem in key strategic areas, while getting early access to new technologies and capabilities. This enables them to gather insights and enhance their current business without having to incur the hefty costs of building from scratch or making a complete acquisition.

Hence, CVC deals are becoming more popular: the value of CVC-backed deals more than tripled to $57.1b in 2019 from 2014, according to CB Insights. Yet while the number of corporate venture arms has also grown, more than 80% of S&P 500 companies still do not have a dedicated CVC arm. These companies may be missing an opportunity since CVC funds have the potential to create even higher returns on investment than traditional VCs.

A series of key questions can help an organization determine the best way to set up and operate a CVC fund, tying it to the company’s strategic innovation agenda so it is fully supported by the board and leadership of the company.

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Chapter 1

Why should stakeholders support the creation of the fund?

A CVC fund may never take flight without CEO and board support, tying it to corporate strategy.

Executives who are trying to launch a fund should identify the capabilities, products or markets that are missing in the company’s portfolio and understand how CVC can help fill these gaps.

For example, a global industrial automation and electrical equipment company was interested in a specific technology, but had to decide whether to incubate its own solution from scratch, invest in the startup company or buy the startup outright. After establishing an initial partnership with the startup, the team opted to first make a small investment to signal its support and maintain insights into the technology. Over time, the company became convinced of the technology’s legitimacy and potential value and leveraged its existing position to buy out the equity stake held by a major VC in that particular startup.

Leadership realized that the CVC investment offered more optionality down the line for areas the company was interested in exploring. It could get involved with concepts much earlier in the process and become comfortable with them over time, rather than taking on substantial risk from the onset by buying the startup or using the company’s internal incubation program. Today, this Global 1000 company now has a broader $500m CVC fund based in Silicon Valley. The company has been building a portfolio of startup investments with a focus on energy management, e-mobility, intelligent industrial automation, robotics and cybersecurity, aligning with the parent company’s future growth strategy.

Digital incubation toolbox

Characteristics of successful CVCs

Although their structuring can vary, successful CVCs tend to share similar characteristics. They are typically staffed with dedicated investor talent, based out of Silicon Valley or other startup hubs. They have dedicated funds to invest over a period of multiple years, and they establish clear goals for their capital, with both strategic and financial metrics that will be used for measuring success. Showing clarity and gaining early alignment on these goals and metrics can help win CEO and board support that will last, long term, even through management changes and strategy shifts.

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Chapter 2

What are the differentiators for my fund?

Entrepreneurs with quality ideas have no shortage of capital available to them.

Many corporate investors often struggle to penetrate deal syndicates and in some cases are viewed as “dumb money” by traditional VCs.

Therefore, CVCs should try to find ways to differentiate themselves in the venture market. First and foremost, they should try to distinguish themselves from the “tourist CVCs” — corporate venture funds that are “playing VC.” There are many defining characteristics of tourist CVCs that need to be avoided:

One financial services CVC became well-regarded in the CVC community when it helped two-thirds of its portfolio companies establish commercial relationships. The CVC accomplished this by establishing parent-startup collaboration platforms internally to engage executives and founders and create incentives for both sides to enhance the value of their partnership. Those platforms produced several new offerings, including a B2B payment automation service.

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Chapter 3

How will investments be sourced and executed?

A fund should try to build a diverse portfolio of startup investments, aligned to its strategic mandate.

CVC funds can proactively screen, filter, engage in due diligence, close the deal and capture value from the startup investment until it exits the investment.

Companies can leverage a variety of techniques to identify investments, but one effective method involves proactive outreach to entrepreneurs and other VCs that are active in areas where the fund is focused. This is an area where CVC advisors can help by leveraging their networks to provide access to those VCs and entrepreneurs that companies may not otherwise be able to reach.

This active search for investments can even pay off in indirect or adjacent areas that the company did not originally consider to be a priority. In one instance a multinational corporation with a core capability in sensor technology was introduced to a startup in the robotic delivery space, which was adjacent to one of the company’s core lines of business. Through the diligence process, the company learned that the startup was already using its sensors in an autonomous vehicle, which led to not only an investment, but also to a strategic partnership between the two firms to develop sensors and related technologies for a future delivery robot.

Successful CVC funds generally have some autonomy or internal processes to help enable fast decision-making, meaning that a startup investment can be approved within days, not weeks. This is critical, because if a CVC is seen as dragging its feet on one deal, it may not be able to get into the next one.

Successful CVC funds generally have some autonomy or internal processes to help enable fast decision-making, meaning that a startup investment can be approved within days, not weeks.

C-suite executives are often part of the board to provide strategic guidance and general oversight. Other executives from R&D, M&A, corporate development or business unit leadership might be part of the advisory board to establish links between the individual startups and the parent company. Regardless of the investment committee composition, it is critical that all players involved be committed, responsive and accommodating with their time, particularly when a high-value investment is on the line.

The management of the deal flow and transaction cycle from screening to close to exit should be closely aligned with the financial and strategic goals of the CVC fund. The connection between investments and these goals should be able to be clearly articulated. For example, a large automotive OEM (original equipment manufacturer) CVC focused on investments in mid-growth-stage startups related to on-demand mobility in order to bring valuable insights and partnership opportunities for the company’s carsharing service platform. Communication with stakeholders and partnerships with VCs, startup incubators and other experts in the startup ecosystem is essential to identify the best startup opportunities and expand return on investment.

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Chapter 4

How will the core business and the fund interact?

CVC funds must balance financial and strategic goals to reap value and synergies from investments.

Some CVC funds take a more hands-off, purely financial approach, while others actively build networks among portfolio companies to spark inspiration, skill building and collaboration. Some engage their own R&D organization on specifically defined collaboration projects with startups to drive business.

If the goal of the CVC fund is to fill strategic needs and capture synergies between the parent and the startup, it will be important to involve executives from the core business, whether to suggest gaps where CVC investment may be needed or to work closely with founders to build new offerings.

Successful CVC funds invest in startups that fall into clearly defined focus areas for the company — ones where there is an operating model and infrastructure to capture synergies and value between the startup and the parent company. The value creation logic should be a part of the screening, due diligence and exit strategy.

In another case, a global financial services company established a CVC fund to participate in disruptive technology plays in the sector to grow the business and hedge risk early on. Given the strategic focus of the CVC, it was important to establish links and accountabilities between the company and the startups in the fund. Business executives from the company were involved in “venture days” to screen potential investment candidates and take accountability for potential learning or partnership opportunities. While the focus of the investment is in financial services, the fund invested in direct-to-consumer companies early on to learn how customers buy in digital ecosystems and ultimately applied these learnings to the company’s financial services offerings.

In order to foster cooperation between the core business and the fund, CVCs may also deploy an internal communications plan to share the benefits that corporate venture investing has for the business.

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Chapter 5

How do you measure success?

Historically, 80%–90% of startup investments fail.

Boards need to become comfortable with a portfolio approach that hedges risks and expands returns, and they should reflect this comfort in communications with stakeholders. Working with seasoned advisors who have deep knowledge of venture capital can help improve the hit rate of the CVC and increase the overall success of the fund.

While traditional VCs typically care solely about financial outcomes, CVCs have additional strategic returns to track. In other words, successful CVCs can speak to their return on innovation, not just their return on investment.

Strategic success for CVCs may be measured in several different ways, including:

  • The number of deals in strategic focus areas sourced or evaluated
  • Financial impact (i.e., EBITDA or revenue growth) as the result of investing in a startup
  • The number of business units engaged in pilots or commercial relationships with portfolio companies
  • Knowledge transferred from the startup investment to the CVC fund (and, subsequently, to the parent)

Financial metrics for CVCs can include:

  • Multiple of invested capital
  • Individual portfolio company return on investment
  • Portfolio internal rate of return (IRR) vs corporate ROIC (return on invested capital)
  • Portfolio IRR vs. median VC fund returns
  • Pull-through revenue (i.e., incremental revenue in core business driven by startup and vice versa)
Leading practices to set up a CVC fund

Five key takeaways

  1. Be clear about your financial and strategic goals and design the CVC accordingly.
  2. Aim for early wins that accelerate your rate of learning.
  3. Silicon Valley needs more than your money: while dedicated capital is important, being able to tangibly add value to startups is crucial to get into top deals.
  4. Measure the return on innovation (the strategic value) and not just the ROI.
  5. Integrate your corporate venture activities into a wider corporate innovation and digital transformation strategy.

This article was created in cooperation with Mach49, the growth incubator for global business.

  • About Mach49

    Mach49 offers a unique approach to helping global companies start, run and improve venture investing. Mach49 deploys a new concept called “General Partner in Residence” where it supplies an experienced GP from a top-tier venture fund to help start a new venture firm inside large companies.

    In addition, Mach49 helps source new deal flow, conduct due diligence and manage portfolio fund execution. Learn more at mach49.com.

Summary

CVC can be a good tool for staying current on emerging trends and technologies, identifying growth areas, de-risking M&A, and moving faster than traditional R&D. Companies might consider CVC investing to reap future benefits from new products, technologies and geographies. At the same time, companies may be able to generate a higher ROI based on lower prices potentially available during times of market disruption. It is essential to not just focus on financial returns but on a “return on innovation,” by aligning the CVC strategy with the core company goals. This may require patience but will help boost long-term value.

About this article

Authors
Peter Ulrich

EY-Parthenon Principal, Digital Strategy and Transactions, Ernst & Young LLP

Digital Innovation in Strategy and Transactions. Knowledge in industrials, automotive, machinery, construction, infrastructure, mobility, and logistics.

Jeff Leach

EY Americas Business Development Leader, Strategy and Transactions

Strategy and M&A advisor, delivering topline growth and bottom-line results. Dad to twins. Yogi, runner, advocate for the ethical treatment of animals.