Corporate Finance

Nothing Ventured, Nothing Gained

Corporate America is pouring money into the venture capital sweepstakes.
Stephen BarrOctober 1, 1998

Corporate venture capital funds are all the rage. Lucent Technologies Inc. recently set aside $100 million to sprinkle around; so did Texas Instruments Inc. In February, America Online created a new business unit called AOL Investments and put former CFO Lennert Leader in charge of a $200 million portfolio. Others, like IDG Ventures ($80 million), E.W. Scripps ($50 million), and Cambridge Technology Partners ($25 million), have smaller venture funds, while Comdisco, according to its Web site, has invested more than $750 million in more than 450 venture-backed companies.

According to VentureOne, a San Francisco research firm that tracks venture activity, corporate investments more than doubled between 1995 and 1997, growing from $1 billion to $2.4 billion. More significant, corporations have accounted for a greater percentage of all venture capital invested. In 1995, their share of the venture capital market was 15.4 percent; in the first quarter of 1998, it stood at 29.5 percent.

Harvard Business School professor Josh Lerner calls the current surge in corporate venture investing the “third wave.” Each wave, he argues, has come at a time when overall venture activity and the stock market were strong. The first was in the late 1960s and early ’70s, when more than 25 percent of the Fortune 500 started venture divisions. The second wave came in the mid-1980s, when corporate investments accounted for 12 percent of the venture pool.

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Despite the recent downturn in the stock market and apparent pressure on corporate earnings, Lerner doesn’t expect this third wave to recede anytime soon. “Some say we’re going to see déjà vu all over again,” he observes. “But the sophistication in the people involved leads you to believe that [this wave] will have more staying power than previously.”

Yields are important to corporate investors, of course, but even more important are strategic concerns. That could mean anything from nurturing an acquisition candidate to fostering strategic alliances to simply gaining insight into next-generation technology. “We wanted a mechanism that allowed us to look over the [technology] horizon,” says Ray Bingham, CFO of Cadence Design Systems Inc., in San Jose, California, which started a $30 million venture capital fund in 1995 and now has a portfolio of 11 technology start-ups. “Our second motivation was to get a higher yield on all the cash we generate.”

Perhaps the biggest strategic driver of current corporate venture activity is the Internet. “[Corporate] venture investing has existed for decades,” observes J. Neil Weintraut, partner with 21st Century Internet Venture Partners, a San Francisco­based VC firm, “but the Internet has ratcheted it up a whole other level– because it’s such a different world in terms of business philosophy and the underlying technology. This is less about capital returns than about getting a toehold on the future.”

The Players

Not surprisingly, high-tech giants are also among the giants in corporate venturing. Looking to drive demand for its chips, Intel Corp. has more than $750 million in some 125 technology firms that it hopes will expand computer use. Senior vice president Les Vadasz says he has 40 people on the prowl for more deals. Microsoft Corp. tends to make a smaller number of investments, says director of business development and investment Greg Stanger, as it seeks to “cement relationships” with companies that are already working with its business units.

A third big player is Cisco Systems Inc. According to CFO Larry Carter, Cisco has about 25 minority investments that will build markets for its networking products and offer an early look at acquisition targets.

But other types of companies are getting into the venture game, too. Humana Inc. has invested in companies that help the HMO better manage information among its network of providers. United Parcel Service of America Inc. created a $30 million fund last year and is backing, among others, a shipping-software developer and a company that digitizes documents for electronic transfer.

Visa International and its member banks are increasingly active in electronic commerce, while Knight-Ridder Inc. is a major investor in Zip2 Corp., which makes mapping and directory applications for the Internet. According to Knight-Ridder vice president and treasurer Alan Silverglat, these programs are an integral part of the Web sites of the media company’s 31 newspapers.

For most corporate venture programs, it’s too soon to gauge the financial returns on their investments. Many report that they have seen paper gains as they have participated in successive rounds of investing with some start- ups, and their portfolios, they say, contain at least a handful of companies that will soon enter the IPO chute.

Despite no cash returns, Ray Bingham says that subsequent financing rounds on 5 of 11 investments has doubled the notional value of Cadence’s fund, and 4 are primed to go public or be sold in the next nine months. In May, the maker of software tools for semiconductor design created a second $30 million fund.

For companies that have seen cash flow into the corporate coffers, the returns are impressive. Adobe Systems Inc. has two $40 million funds that contribute an average of 10 to 15 percent per year to earnings. Adobe was an early investor in Netscape Communications, Siebel Systems, and Peerless Systems, all of which had successful IPOs. “We’re getting VC- like returns, and they’re showing up below the line,” boasts Fred Mitchell, vice president of venture development.

Strategic Wagers

While traditional venture capitalists would be quite content with such hefty financial gains, corporate investors insist they’re looking for something more.

“VCs are in this business for ROI,” says Ken Andersen, assistant managing editor of VentureFinance, a newsletter. “Corporations don’t want to lose money, but they also want to invest in companies that create a broader market for their own products or get them information about a new technology.”

The problem is, strategic is as strategic does. “Once you justify something as ‘strategic,’ you can justify just about everything,” warns Harvard professor Lerner. “A successful corporate venture program should have some linkage between what the parent does and what the fund invests in, but a direct pairing of every deal to some strategic purpose is likely to be counterproductive.”

“The financial return is the easy part,” notes Intel’s Les Vadasz. “The strategic return has more ambiguity.” For Intel, though, there’s probably less ambiguity than for most. The chipmaker wants to help companies with products that will require more processing power, and that’s reflected in investments that cover digital imaging, enterprise computing, broadband delivery, and Internet content.

Start-up executives are encouraged to call on Intel managers for assistance with technical and marketing issues. All Intel is looking for in return is viability. “If they become real companies,” Vadasz says, “they help our long- term strategy.”

The strategic relationship is murkier for other corporate investors. Cambridge Technology Partners, a systems integrator in Cambridge, Massachusetts, has invested in six software developers since starting its fund in December 1997. “We’re not interested in what these portfolio companies can do for Cambridge; we’re interested in what we can do for these companies,” says Barry Rosenbaum, the fund’s managing director. What Cambridge typically does is present applications developed by these start-ups to its clients. “We help them rise above the noise,” Rosenbaum says.

He dismisses, however, the conflict of interest that could arise if a client is looking at software from multiple vendors and a Cambridge-backed company is one of the prospects. “We have to be up-front with the client that the software provider is a portfolio company,” says Rosenbaum. “We are very aware of that potential conflict, but we’re known for vendor neutrality.”

Adobe is more direct about the strategic alignment between many of its portfolio companies and its own software. One start-up, Extensis Corp., offers a productivity add-on that Adobe sells to its installed base of customers, while Electronic Submission Publishing Systems Inc. offers a product suite for the pharmaceutical market that includes Adobe’s Acrobat application. These companies “fill market needs that we might be able to get to and enhance Adobe’s position in the marketplace,” Mitchell says.

Still others look beyond licensing, distribution, and co-branding deals, and see venture investing as a strategy for building a farm team of potential acquisitions. Cisco takes positions in companies with technology that is “not ready for prime time,” says Larry Carter, to get a foot in the door and right of first refusal. Some, like Netsys, which makes software for network management, are acquired after they develop a product that Cisco wants in its product portfolio. Others, like Cascade, were divested after Cisco bought another company that had a competing technology.

“Netsys developed super software that we wanted to integrate,” Carter says. “That was a gamble that paid off. Cascade was one that didn’t work out.” Or perhaps it did: Cisco put $3 million in Cascade, and cashed out for $225 million after an IPO.

Tolerating Risk

Many venture capitalists predict that as soon as the VC industry takes a downturn, corporations will abandon their venture programs as they have in the past. Already they point to Informix Corp., which cut back on its venture activity after it announced an unexpected $140 million loss in 1997. “They missed their numbers, and abandoned venture investing to get things right with the company,” says VentureFinance’s Andersen.

Besides becoming a possible distraction, venture investing requires a different mind- set from typical corporate investments. VCs are used to operating in a world where you have your share of winners and your share of losers. But how many write-offs will corporations be able to tolerate? “Some say 1 in 10 is good for VCs,” observes Texas Instruments’s vice president of worldwide strategic marketing, Doug Rasor. “We hope we can do better than that.”

Ray Bingham says Cadence has had one write-off so far, of a company looking to develop an online employment recruiting service. “The investment was right up our alley,” he says, “but it was one of those that just didn’t work out.” Intel’s Vadasz says he still has a black T-shirt and cap from an Internet investment that went belly up. “They cost me several hundred thousand dollars,” he jokes. “I wear them on weekends to remind me we’re not infallible.”

But venturing might be even riskier if companies started butting heads with the independent venture funds. Right now, there’s a high level of cooperation that Harvard’s Lerner says was not around during the previous waves of corporate venturing. Adobe, for instance, hired an outside venture firm, Hambrecht & Quist Group, to manage the deal flow and negotiate term sheets. Others prefer to manage the process internally, but have done outreach campaigns to encourage venture capitalists to invite them in on deals. Many insist on VC involvement to even consider making an investment.

A number of new venture funds feature corporate limited partners. In April, Accel Partners announced that Microsoft, Compaq, Lucent, and Northern Telecom contributed $35 million to its new $310 million Internet Technology Fund, while Kleiner Perkins Caufield & Byers lined up 10 corporate heavyweights in 1997 for its Java Fund.

Also mitigating risk is that corporate investors tend not to get involved in seeding start-ups. They want a piece of the action in subsequent rounds, after the heavy-duty R&D work has been done and the business plan has been tested. “We’re not in the business of helping people get their products to work, but we can help them take their products to market,” says Rosenbaum of Cambridge Technology Partners. “We pay a higher price, but we take a lower risk.”

Indeed, valuations may be an area of conflict ahead. Because companies are interested in the strategic value of an investment, there are instances where they are willing to throw in more money to participate, and that has contributed to lofty prices on some deals. “Lately there have been conflicts over valuations be-cause some have been galloping to unreasonable levels,” says Intel’s Vadasz.

A Certain Cachet

Still, it may turn out that corporations ride this third wave of venture investing longer than skeptics predict, because they have a surprising advantage over their VC counterparts. Many entre-preneurs say they prefer working with corporate investors, which have deeper pockets and broader operational resources. “I chose deliberately not to raise venture capital,” says Katrina Garnett, CEO of CrossWorlds Software Inc., a software developer, “because I wanted my investors to add value to my strategy.”

Garnett has raised more than $46 million from companies like Compaq, SAP, Ernst & Young, and Intel. Compaq has helped her make business contacts in Japan and Ireland, while Ernst & Young has helped her with the systems integration part of her business. But more than anything, she believes the corporate investors lend a certain cachet to the young firm. There’s an implicit endorsement that the start-up is doing something important when a major corporation puts its money in.

“There are plenty of places to get cash,” she explains. “But when I make sales calls, people want to know who we are–and we’re only as good as our investors.”

———————————————– ——————————— Sharing The Wealth
Harvard Business School professors Josh Lerner and Paul Gom- pers have identified three pitfalls that they believe undermine corporate venture programs: overly broad objectives; an unstable organization that can be swept aside if top management changes or quarterly earnings decline; and inadequate compensation plans, in which the venture managers do not share in the investment returns the way a venture capitalist does.

Compensation disputes, in particular, are at the heart of many corporate VC difficulties. Xerox Corp., for instance, ran what many see as one of the most successful corporate venture programs ever before dropping it in 1996, just as the market heated up again. According to Lerner’s conservative estimates, the company realized a 56 percent internal rate of return over the previous 10 years. The problem, says a former member of Xerox Technology Ventures, was largely that people kept leaving, because they were paid a salary and bonus, but not a “carried interest,” which is a share of the profits.

“The question of whether to give a carried interest is a difficult one,” says the former Xerox member, who spoke on condition of anonymity. “If you do, the VC people sometimes make more than many high-level executives, and if you don’t, you lose the good ones.”

Lerner and Gompers say that a large number of corporate programs are now structured around a number of key best practices. Many are setting up independent investment subsidiaries that have a dedicated pool of funds. They’ve hired partners who work directly for the venture group and are compensated like traditional venture capitalists. Some have even been allowed to take a pure financial orientation, in which the fund managers are not required to make investments that directly generate business for their corporate parent.

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