Three essentials of successful corporate venture capital

| Podcast

Corporate venture capital can accelerate internal innovation efforts, but it entails many risks. In this episode of the Inside the Strategy Room podcast, the authors of the recent article “How to make investments in start-ups pay off” discuss why companies should consider corporate venture capital (CVC) as a way to boost innovation, how they should approach it, and what they can expect from it. Matt Banholzer leads McKinsey’s global innovation practice. Sid Ramtri is a core member of our private equity and venture capital practices. This is an edited transcript of their conversation. For more discussions on the strategy issues that matter, follow the series on your preferred podcast platform.

Sean Brown: First, how does corporate venture capital differ from other innovation pathways such as joint ventures or in-house accelerators?

Matt Banholzer: With CVC, you invest corporate capital directly into other companies, usually as a strategic investor with a minority stake. In internal innovation vehicles such as venture studios or accelerators, you’re looking to accelerate the development of promising innovations. An accelerator’s constituent ventures might partner with other companies, but that’s not CVC. Corporate venture capital is controversial, insomuch as you can have controversy around innovation. Some claim they have gotten a lot of value out of it. Others are skeptical, saying, “We set up these units. They didn’t deliver.”

Sean Brown: What is the current pace of CVC investments?

Sid Ramtri: Still, corporate participation in venture capital has consistently increased year over year. In the past two decades, a significant proportion of Fortune 100 companies have built corporate venture capital units and new CVC funds are being launched across many sectors (Exhibit 1). Corporate participation in deals is also growing. Meanwhile, start-ups are increasingly recognizing the value in working with corporates.

Venture investing by corporations has become commonplace.

Sean Brown: What’s driving this interest in corporate venture capital?

Matt Banholzer: First, your competitor landscape is broader than before. It’s not just the same two or three established players but numerous start-ups that are reaching scale because they amassed a lot of dry powder in the past ten years. Many executives also believe their business models are at risk. We’ve all heard about the Internet of Things, autonomous vehicles, blockchain—technologies that put many traditional business models under threat. And the time from an innovation’s inception to the point where it reaches a million or a billion users is compressing every decade. A company under attack can’t just throw more money at its R&D department or internal incubators and accelerators. External innovation becomes very important.

Sean Brown: What are companies primarily looking to gain from these venture investments?

Sid Ramtri: Financial returns matter—no corporation wants to see its capital diluted or destroyed—but we consistently see that a connection to your long-term strategy matters a great deal. CVCs can give companies better market insights and visibility on disruptions while helping them build a name in the broader innovation ecosystem.

Sean Brown: How do companies track whether their investments are delivering what they want out of them?

Sid Ramtri: First, you need a clear bifurcation between financial and strategic metrics. You can measure financial performance based on the internal rate of return (IRR) relative to a hurdle rate or cash-on-cash multiples. On the strategic side, corporate sponsors want to assess the performance of the venture fund leader. We see metrics such as the number of deals prospected or the number of introductions the CVC fund makes between corporate business units and start-ups. Initially, you typically track the quality and depth of learning, but over time you try to measure tangible results, such as the extent to which the fund has driven product development, partnerships, or joint ventures.

Matt Banholzer: You can also quantify the market insights you get. What technologies could we access that our competitors also want? Can we have an early look at them and maybe even exclusivity? This can be about capability development as well. Have we gotten a view into different talent pools? Some of my clients ask, “How many recruiting goals have we met for new profiles?” Talent sees CVC investments as a sign of seriousness, which is particularly important for companies trying to move into markets where they don’t have a reputation or brand.

Sean Brown: What are the primary reasons that start-ups might embrace corporate venture capital?

Sid Ramtri: CVC funds have built a clear value proposition relative to pure-play VCs—they bring operational and strategic orchestration know-how. For instance, the corporation can provide access to expertise, sales channels, even be a customer. It can provide advice on and at times directly facilitate access to a new market. On my home continent of Latin America, some CVC funds say, “We’re a window into a large and significant market that is often overlooked. We can provide enabling capabilities and assets to our portfolio companies to help them drive Latin American expansion.” Oftentimes, reputation also matters: having a brand-name company with an operating legacy in the sector behind you can be massively important.

Sean Brown: Do you see start-ups getting tangible benefits from these partnerships?

Sid Ramtri: We analyzed what happens to start-ups that receive corporate participation in their first, second, and third funding rounds and saw that companies that have this participation are consistently better at realizing successful exits (Exhibit 2). Their odds of failure are also lower. When we dug into that, we discovered that start-ups that draw on corporates’ advice and tap into their market access have more stable growth paths to profitability.

Start-ups with corporate participation are more likely to grow and less likely to fail.

Sean Brown: At what point in a typical start-up’s life cycle does a CVC fund usually invest—seed stage, series A, B, or C?

Sid Ramtri: It depends on the industry and the number of start-ups in it. For instance, a retail bank trying to move into new payment solutions can choose from a wide variety of start-ups. Much is also dependent on your objectives for the CVC program. Some companies look at targets around series B because they see the product–market fit as having been established and the start-up is beginning to find a path to profitability. For example, if you think about hydrogen in the climate tech space, that entire start-up ecosystem is very early stage, so if you want access to a new hydrolyzer manufacturing technology, for instance, you will have no choice but to assume the technological risk, because you will have to invest at an early stage.

Things have also changed over time. Back in the late 1990s and early 2000s, CVC funds tended to invest at a late stage. Some of those same funds, as they have gained experience and sharpened their strategy, are now going early-stage. What you see much less frequently are CVCs dipping into seed-stage territory.

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Sean Brown: We’re hearing a lot about the ecosystem economy. Are companies looking to build such ecosystems more inclined to take the CVC route?

Sid Ramtri: Absolutely. Technology is disrupting so many markets that companies are trying to go beyond one link in the value chain or to collaborate with competitors. As barriers between industries break down, CVC is also a way for companies to get into new sectors. For retail companies, for example, making minority investments in start-ups allows them to bring those companies into their ecosystems, expanding their reach while giving the start-ups access to customers who otherwise would be very expensive to access. For young companies in the climate tech space, one important validator is evidence of demand. Being able to work with an end customer and say, “They’re an investor in my company, and with that comes an advance purchase commitment,” is a clear signal of demand. And for corporates, these types of arrangements not only provide access to new products but help burnish their credentials with talent and other start-ups.

Sean Brown: What is the typical success rate of CVC partnerships?

Matt Banholzer: When clients ask me, “Should I open a CVC?” my tongue-in-cheek answer is, “Are you willing to endure an 80 percent failure rate on your investments?” That usually creates a moment of dead air before we unpack what that means. CVC can be a path to success, but can you weather that up-and-down trajectory? How do you make a CVC fund successful in the context of a multiyear, even multidecade definition of success? In corporate venture capital, you are looking at a minimum of five years for these investments to mature.

Sid Ramtri: Execution matters more than anything else. There is great potential value to be created, but there are many execution pitfalls as well.

Sean Brown: What does it take, then, to do CVC well?

Matt Banholzer: We’ve distilled it into three big areas. First, you need the right vision and strategic objective. Is it access to capabilities, a new market, insights? It is important to understand from the outset what success means because that will shape your deal flow. It will also help short-circuit the inevitable difficult conversation that happens 24 months in, when the honeymoon period is over and people are wondering what you got from your investments. It’s too early for them to have paid off, but you can point to metrics and leading indicators to say, for instance, “We agreed that our goal was to drive capability building, and through our presence in this segment, we have been able to recruit five or 15 new profiles of colleagues we would not have gotten otherwise.”

Talent sees CVC investments as a sign of seriousness, which is particularly important for companies trying to move into markets where they don’t have a reputation or brand.

Matt Banholzer

Second, you need to align on the type of ventures you want to invest in. Companies often lack coherent investment theses or search areas. Sometimes you hear, “Well, our competitor was looking at this start-up, so we wanted to get in there to disrupt them.” That is not a recipe for success. Instead, you need a core theme such as entering a new product type, or geography or business model, and building a portfolio of similar companies in that space.

Defining how you will source opportunities is another aspect of deciding the venture type. Companies initially often want to place lots of bets. Equally important is knowing how you will double down on the bets that are paying out and exit those that don’t. You eventually want to develop a few powerful investments that turn into value creators for the company. You want to get out of that pilot purgatory, so to speak.

That’s where the third dimension comes in, which is formalizing the operating model. The CVC fund needs a dedicated team with specified roles, not just one person doing it part-time. You also need well-defined governance. There will be a budget. There will be agile investment decisions. You’re not investing along the annual corporate budget cycle but based on the approach a pure VC firm would use. What is the deal thesis? What do we hope to learn? How do we revisit the investment once it has met milestones? You also want those lessons to link to the business units. A big failure mode in CVC is treating it as something on the side, when it should be an engine for business units’ growth.

Sean Brown: Given the need for those close linkages to the business, do companies ever outsource the management of their CVCs to seasoned venture investors?

Matt Banholzer: Typically not. You definitely don’t want to just outsource it to a VC fund and say, “You guys manage this for us,” and hand it off, because you then can’t internalize the insights. You also lose all those advantages that corporations have around expertise, access to assets, your brand, your markets—you essentially become another limited partner to the VC, and one that’s harder to work with than a family office, for instance. However, a corporate venture fund run in-house can benefit from making connections with VCs. Clients of mine co-invest in rounds with VCs or use a VC for deal sourcing, market intelligence, or introductions: “This seed company is interesting. You’re not going to invest for another few years, but I want you to have it on your radar.”

Sean Brown: Who typically oversees a CVC fund?

Matt Banholzer: The head of corporate development or the head of innovation is quite common. What’s more important than the title or position is the trust that person has in the company. What you want to avoid is a P&L owner who says, “That product is five years out. It’s not going to help me to make the quarter, so I’m not interested in hearing about your series A opportunity.” That said, if the CVC leader has been in a P&L role before and can bridge the long-term vision to the short-term imperative, that carries a lot of weight in relationship orchestration.

Sid Ramtri: You should consider bringing in someone with CVC experience. A seasoned corporate venture capital investor knows how to find deal ambassadors within the corporation so when they want to get an investment made, they can get support within the corporation.

Sean Brown: How do you establish a shared vision for the partnership when the start-up and the CVC might want different things from the collaboration?

Matt Banholzer: They do sometimes want fundamentally different things. A start-up wants to grow as fast as possible and to have a flexible operating model so it can adjust its strategy quickly. A corporate investor wants access to new solutions. I’ve seen a corporate investor give a portfolio company access to its customers, then realize that the start-up is potentially cannibalistic to the investor’s own product. That should be addressed with up-front diligence.

You want a positive contagion where the strategic insights coming from the CVC program drive new ways of thinking and ideally new business building.

Sid Ramtri

Understanding those differences early is very important. The start-up will work with a large company to get access to its customers or brand, but otherwise it would prefer, as many founders have told me, to work with a VC. That’s because a VC will say, “Grow as fast as you want. Let me know how I can help,” whereas the corporation puts more guardrails on the assets and capabilities it provides.

Sean Brown: What’s the best approach to sourcing potential investments?

Matt Banholzer: There are three paths: the ecosystem, the inbound context, or the outbound outreach. You need to do all three. There’s a caveat, though: think about the speed and how you interact collaboratively. It took one corporate investor a week to sign the NDA with a start-up and it almost lost that partnership because of that delay.

Sid Ramtri: The process should have a speed that matches the start-up’s expectations. The investment committee should be a small intimate group. A regular meeting cadence helps, so you don’t find yourself postponing the discussion and then, lo and behold, the deal itself disappears because the start-up has gone in another direction. Regular meetings also help drive pattern recognition and learning on the part of investment committee members. Finally, if a deal is of a certain size, the investment committee should have liberty to approve it without having to go to the board.

Sean Brown: How should CVC investments be handled so they inspire in-house innovation rather than cause friction?

Sid Ramtri: You want a positive contagion where the strategic insights coming from the CVC program drive new ways of thinking and ideally new business building. That is where the concept of an innovation garage becomes important: you can build an internal structure that is complementary to the CVC fund and focuses on building new businesses. Think of it as start-up building that’s inspired by your start-up investing. In one client situation, the company acquired a start-up in an area identified as promising by its CVC fund. The target is now a 100 percent owned subsidiary, and the corporation is accelerating its scale-up in an innovation garage. When your corporate venture capital is the linchpin of your external innovation efforts, it can drive a lot of value within your internal ecosystem and inspire new kinds of growth.

Sean Brown: What impact do the macroeconomic environment and capital markets have on CVC?

Matt Banholzer: People are focusing on valuation compression for existing start-ups, and if you’re a pure financial-return VC, that can be worrisome. For a corporate venture capital arm, however, it’s an interesting moment, because on average, valuations for later-stage start-ups have gone down more than the equity has for corporate investors. Some partnerships or deals you considered before are now looking more attractive from a financial lens.

But this is not just about financial returns. It’s about creating options, exposure to markets, exposure to technologies and capabilities. That becomes even more important in this era of macroeconomic uncertainty and volatility. You need to find new value pools, and corporate venture capital is a longer-term way to access those. But executives need a what-can-go-wrong mindset strongly embedded. “Are we okay losing money if this company folds in three or four years because it can’t refinance the next round with easy money? Will we still feel like that investment was worth the price if it gets written off but we have new capabilities or tech?”

Sid Ramtri: I’d add that a slowdown in venture capital does not mean that innovation has slowed. The rate of activity for pre-seed and seed-stage companies has ticked up, in fact, because a new breed of entrepreneurs has emerged from the pool of people who had been made redundant in later-stage companies and those founders are now inspired to do more on the early-stage spectrum.

Additionally, the value proposition of corporate venture capital has gone up in some respects because what are VCs most focused on? Disciplined growth, a path to profitability, and operating fundamentals. Who are the actors in the innovation ecosystem who know how to operate with discipline; have the supply chains, industrialization capabilities, and access to the channels; and know how to enter markets based on established guidebooks? It is corporations. The CVCs that can demonstrate the strategic value they add can come out of this period with higher-quality portfolios.

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