Capital Markets

Bright Lights, Big Paycheck

If you want to play, you've got to pay.
Stephen BarrMarch 1, 2000

Maybe Jack Welch was wrong. Last year, General Electric Co. lost nearly two dozen executives from its internal venture-capital groups, and GE’s legendary chairman and CEO didn’t shed a tear. He let them go to join fledgling companies or traditional venture-capital firms rather than give them a cut of the profits of the start-ups they funded. He confirmed as much in several public statements, arguing that incentive compensation should be tied to no other form of equity than the parent company’s stock. “We can’t have people in separate rowboats,” he told the Financial Times in November.

But as more corporations are swept up in a flood of venture investing, they are destined to face the same pay issue that confronted Welch: maintain salaries and bonuses commensurate with corporate pay scales, or try to match compensation in the venture capital arena. It’s a tough call, and others might flinch.

An average partner in a venture capital firm collects upward of $1 million in salary and enjoys an equity upside in excess of $5 million after a very short waiting period, according to one insider. Companies want to retain their internal venture investors in order to remain competitive. But if keeping them happy and productive means boosting their compensation way beyond corporate norms, is it worth the cost? Equity stakes alone, a share of the payoff known in the venture capital trade as “carried interest,” can cause havoc back at the home office.

“The question of whether to give a carried interest is a difficult one,” says a former member of Xerox Technology Ventures, who spoke to CFO 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.” Xerox Corp. discontinued its successful corporate venture program in 1996 over this issue.

In December, largely to avoid a similar fate at Times Mirror Co., Thomas Unterman relinquished the CFO post at the Los Angeles­based media company to become managing partner of TMCT Ventures, a newly formed venture unit that plans to invest about $500 million in new firms.

Back in 1995, then-CFO Unterman had set aside $120 million for taking stakes in emerging companies. But as the investment returns mounted–an estimated 1,300 percent on Netscape Communications alone, as well as smart bets on Hollywood Online and WebTV–it became harder for the finance chief and his three top associates to watch, as all the proceeds went back into the corporate coffers.

“Retention became a big issue,” Unterman says. “It was getting to the point [where people were going to leave the company] when we effected the deal” to set up the separate venture firm. And no surprise here: Unterman and the three who joined him as partners will be compensated in a manner befitting venture capitalists, with a portion of the investment returns.

Dramatic Shift

The debate over compensation for internal venture capitalists highlights a dramatic shift in corporate venturing from a pure strategic play to a financial one.

In recent years, billions of corporate dollars have been pouring into high-tech and Internet start-ups in search of insight into next-generation technology or an edge in fostering strategic alliances. But as these venture portfolios have swelled and some astounding returns have rolled in, companies have developed an appetite for the whopping boosts to the bottom line when risky ventures succeed. “Strategic” describes those investments that fail; all others are financial.

“The situation now,” says Kirk Walden, national director of venture capital research at PricewaterhouseCoopers LLP, “is that not doing venture capital investing is seen as leaving opportunities on the table–not just from a pure research-and-development standpoint, but also from a financial standpoint.”

According to the Pricewaterhouse-Coopers Money Tree Venture Capital Survey, in 1999 a record $30 billion (estimated) was invested in start-ups–the total for the previous three years combined. The vast majority of those dollars, about 88 percent, are going into new technology companies, and more is on the way.

“There are plenty of dollars available,” says Walden.

Corporate venture capital accounts for a greater percentage of all venture capital invested than ever before, according to the National Venture Capital Association. In 1999, their share of the market was 15 percent, up from 2 percent in 1994 and 7 percent in 1998. The 2000 edition of the Corporate Venturing Directory and Yearbook lists 163 companies with venture programs, triple the number in 1996. In mid-December, within days of each other , EDS Corp. ($1.5 billion), Andersen Consulting ($1 billion), and Time Warner Inc. ($500 million) announced the formation of three of the largest corporate venture programs yet.

Third Wave

Harvard Business School professor Josh Lerner calls the current surge the “third wave” in corporate venture capital activity, and suggests this one may have more staying power than those in the late 1960s and the mid-1980s. “Corporate venturing today has become an important tool for managing the innovation process,” says Lerner, co-author of a 1999 book entitled The Venture Capital Cycle.

“Technology is changing so fast that we’re always trying to get a sense of what’s on the horizon,” says John Morse, CFO of The Washington Post Co., which made about a dozen VC investments in 1999. “We need to understand that to run our businesses well and stay ahead of the game.”

At Redwood Shores, California- based Oracle Corp., which started a $100 million fund in January 1999, venture investing has been integrated as part of a new corporate-development function. “This is one more activity designed to grow the company,” says Matt Mosman, senior vice president of corporate development at Oracle.

But the more compelling reason why Lerner believes that venture investing is more than the quirky fad it once was is the financial returns. Consider that Intel Corp.’s modest equity investments in Red Hat Inc. and VA Linux Systems Inc., competing Linux-based software companies that both went public in the second half of 1999, had a combined value of nearly $1.5 billion at the end of the year. Or that on December 8, the first day of trading for, Omnicom Group Inc., the world’s largest advertising group, saw its 47 percent stake in the corporate Web-site builder, which it had bought for $11.7 million in 1995, become worth about $1.2 billion.

And the returns from these investments are starting to boost reported earnings as well. In the January earnings season, Intel, Microsoft Corp., and ETrade Group reported gains from their venture portfolios. ETrade beat analyst expectations in the quarter by some 19 cents a share, thanks in part to $19.9 million in such sales, while Intel reported $508 million in interest and other income, nearly double what the company had told analysts it would generate. As of December 25, the value of Intel’s venture portfolio was $8.03 billion, with $7.12 billion in publicly traded securities.

Microsoft’s equity portfolio is even larger, at $19.8 billion, and in its fiscal second quarter, the increase in investment income contributed to two- thirds of the increase in income before taxes. Without it, the software giant would have missed analyst expectations.

“Most companies pay lip service to the argument that this is being done for strategic reasons,” Lerner says, “but the reality is mixed. If people say they are using this for some strategic benefit, they are less open about what they’re doing.”

Right People, Right Deals

In the rush to get in on the best deals, corporate venture capitalists tend to see their advantage in the advice, credibility, market contacts, and broader operational resources they can lend over the funds they contribute–things they argue emerging companies can never get enough of.

“To walk in and say, ‘We have money, too,’ is not very compelling, and implies we’re competing with the traditional VCs,” observes Oracle’s Mosman. “What we can bring to the table that VCs can’t is our worldwide market presence and access to software developers.”

“The best returns come from the best deals, and the best deals come from having the best people in the right place to attract the best deal flow,” says Steve Johnson, president of Seattle- based Tredegar Investments Inc., the venture arm of Tredegar Corp., a Richmond, Virginia- based plastics and metals manufacturer.

Back in 1991, Johnson was general counsel, vice president, and secretary of Tredegar Corp., when the company set up its venture firm to invest in other venture capital firms, as well as small, tech-oriented firms. The sole objective was to maximize returns. By 1997, Tredegar Investments was successful enough that Johnson was able to commit to working full-time as president. From that point on, Johnson and his team earned a carried interest.

“If you want to be a top player in the VC business, you’d better step to the plate on the compensation side,” says Johnson, who oversees a portfolio of 47 investments and 20 venture firms that have generated venture capital­like returns. Even on-the-job training commands big bucks. Seasoned or not, says Johnson, managers will seek opportunities elsewhere unless they are paid like venture capitalists.

To be sure, Jack Welch is not the only executive who disagrees with Johnson’s assessment. William Rhodes, general manager of BD Ventures LLC, a new $40 million fund for investing in medical-
device and biotechnology start- ups, is satisfied with his pay package, which includes salary and bonus, as well as stock in the fund’s parent, Becton Dickinson & Co.

“I can make a good return by doing good things for BD,” says Rhodes, who made four investments in 1999 and expects to make more this year. “I like the chances these companies have, and I’ll be rewarded if they enhance the overall stock performance of BD.” In deference to Welch, he might call this reward “The Golden Rowboat.”

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