How to Pick a Corporate VC Model that is Best for Your Organisation

Incubator & accelerator programs

An incubator program is typically a structured, facilitated program for taking a possible solution to a problem statement and attempting to productize and commercialize that idea. An accelerator program, on the other hand, is typically a structured, facilitated program for taking a minimum viable product offering with initial traction and guiding it through a series of iterative market tests to make sufficient progress towards achieving product-market fit for professional investors or a corporate to commit Seed capital to the startup at the end of the accelerator program. They’re both very early-stage startup programs.

Advantages

• Startup selection is based on solving the problem most attractive to the corporate
• Relatively low cost compared to more formal corporate VC programs

Disadvantages

• Very high failure rates between ideas and achieving product-market fit at Series A (90%+).
• A long time to value, so it’s very difficult to determine if the program is working without it running through a complete investment-disinvestment cycle >10 years.
• Program graduates are still operationally immature and incapable of realistically serving the corporate’s requirements at scale.
• Startups require lots of time and specific attention that requires dedicated program resources.
• Getting experienced, relevant external mentors to participate in the program is tough as they usually don’t have enough of an incentive to do so without the program sharing equity with them.
• Often difficult to get startups together in a single location for long periods, which is the most efficient way to share program costs across the cohort of startups.

Single or multiple direct investments

The most basic form of corporate VC is when a corporate invests in a single startup. These opportunities could originate from any number of sources such as a referral, accelerator or incubator program, or even a startup founder pitching an executive at the corporate directly.

Advantages

• Quick to start.
• Enables a corporate to dip their toes into corporate VC.
• Enables corporates to make multiple ad hoc investments from their balance sheet without committing large amounts of capital to a fund upfront.

Disadvantages

• Difficult to resource with experienced startup investors as employees to manage the program or the individual investments because long-term resourcing and capital available to deploy are unclear.
• Usually not assessed by an experienced startup investor capable of identifying, assessing, and managing specific risks or declining to invest because of specific risk.
• Usually not assessed in terms of a comprehensive thesis about how the market being addressed will evolve over more extended periods, the basis of competition, competitive environment, and exit potential to assess market risk.
• A typical, but relatively high failure rate based on the stage of the startup at the time the investment is made (Pre-Seed, Seed, Series A, Series B, etc.) can lead to an appetite for further corporate VC diminishing. Startup failures happen early, and successes take a long time to realize.
• No professional portfolio construction to compensate for high startup failure rates. The startups in the portfolio will often be all over the place in terms of their alignment with the corporate strategy.
• If the startup doesn’t outperform often unrealistic corporate expectations over a short time, the corporate will usually lose interest, and synergies or value chain integration will become harder to explore later.
• Employees hardly ever have strong economic incentives to maximize the value of the investment, such as a share in carried interest earned by professional VC investors.
• Corporates can treat this as a perceived cheap M&A activity and overpay on investments that are very far from being ready to deliver strategic value to the organization.
• Corporates will tend to invest in startups developing incremental innovations that solve immediate problems for them rather than disruptive innovations that create new capabilities and long-term competitive advantage but have less immediate strategic relevance.

Investment in an external VC fund

Corporates can also choose to simply become an investor in an externally managed VC fund where they are one of many investors (or LPs), usually because they have an affinity to the fund thesis or fund manager.

Advantages

• Capital commitment as an LP is clear and called up by the VC fund manager over the first few years of the fund.
• New startup investments are assessed by a professional VC investor capable of identifying, assessing, and managing specific risks or declining to invest because of specific risk.
• New startup investments are assessed by a professional VC investor in terms of a comprehensive thesis about how the market being addressed will evolve over more extended periods, the basis of competition, competitive environment and exit potential to assess market risk.
• Professional portfolio construction to compensate for high startup failure rates. The startups in the portfolio will usually be strongly aligned with the fund investment thesis.
• The professional VC manager will only encourage startups in the portfolio to explore corporate value chain integration once they’ve been in the portfolio for several years and are more operationally mature. Successful corporate value chain integration has a higher probability of success in this case.
• Professional VC manager has strong economic incentives (carried interest) to maximize the investment value for the corporate LP.
• Corporates can treat this as one of many potential M&A channels and are less likely to overpay on investments that are much more likely to be ready to deliver strategic value to the corporate.

Disadvantages

• Limited ability to influence the investment thesis of the fund manager to increase the strategic relevance of the portfolio startups to the corporate.
• Professional VC fund manager creates a layer of abstraction that reduces information flow and knowledge transfer back to the corporate to manage the conflict of interest between the corporate LP and the fund startups.
• Long-term capital commitment, typically 10-12 years before the investments are fully realized and cash invested is returned to the corporate VC.

Internal corporate VC fund

Corporates can also choose to create and resource a dedicated VC fund, with committed capital, an investment committee comprising internal and external advisor resources and their own employees as fund managers.

Advantages

• Complete control over all aspects of the VC fund.
• Long-term capital commitment is clear, but there is more influence over the rate at which the fund management team calls up the capital when necessary from a budgetary perspective.
• New startup investments are usually assessed by experienced VC investors (now corporate employees) capable of identifying, assessing, and managing specific risks or declining to invest because of specific risks.
• Professional VC investors (now corporate employees) will usually assess new startup investments in terms of a comprehensive thesis about how the market being addressed will evolve over more extended periods, the basis of competition, and the competitive environment to assess market risk.
• Professional portfolio construction to compensate for high startup failure rates. The startups in the portfolio will more likely be strongly aligned with the fund investment thesis and the corporate strategy.

Disadvantages

• Difficult to resource with experienced startup investors who may not want to become corporate employees and often have to forego or have limited ability to maximize their carried interest in an internal VC fund.
• Very difficult to manage the internal stakeholder expectations on what the fund can realistically invest in and get wide stakeholder alignment on the fund investment thesis, which will tend to widen rather than narrow the fund investment focus and spread the fund “bets” too widely for robust portfolio construction.
• A typical, but relatively high failure rate based on the stage of the startup at the time the investment is made (Pre-Seed, Seed, Series A, Series B, etc.) can lead to an appetite for further corporate VC diminishing before the fund can construct a portfolio of investments. Startup failures happen early, and successes take a long time to realize.
• Less robust portfolio construction to compensate for high startup failure rates. The startups in the portfolio can be a little less well aligned with the corporate strategy because of executive sponsorship of pet projects and participation on the fund investment committee to get them funded.
• If the invested startup doesn’t outperform often unrealistic corporate expectations over a short time, the corporate will usually lose interest, and synergies or value chain integration will become harder to explore later.
• Corporates can treat this as a perceived cheap M&A activity and overpay on investments that may appear to be very strategically aligned with the corporate but are very far from being ready to deliver strategic value to the corporate. This will likely affect overall fund performance, diminishing the appetite for further corporate VC after a few typically early startup failures.
• Corporates will tend to invest in startups developing incremental innovations that solve immediate problems for them rather than disruptive innovations that create new capabilities and long-term competitive advantage, but have less immediate strategic relevance.

Dedicated fund managed by an external VC team

The final corporate VC form is also the one that is least understood and, in our opinion, the most impactful because it directly addresses many of the disadvantages of the other programs in return for a stronger corporate commitment to the program.

In this program type, the corporate will appoint an external professional VC fund manager to create a dedicated VC fund, with committed capital from a single LP (the corporate) and an investment committee comprising corporate and fund manager resources.

Advantages

• Capital commitment as an LP is clear and called up by the VC fund manager over the first few years of the fund.
• Resourced with experienced, professional startup investors who are strongly aligned with the investor’s interests because of a combination of GP interest (the external fund manager will often also invest in the fund) and the GP’s carried interest, which is only earned if the fund manager creates highly valuable portfolio companies.
• A professional VC fund manager is more likely to manage the internal stakeholder expectations on what the fund can realistically invest in and get wide stakeholder alignment on the fund investment thesis and is strongly incentivized to prevent a widening of the fund investment focus because it will affect the fund manager’s ability to construct a robust portfolio and eventually earn carried interest.
• New startup investments are assessed by experienced VC investors capable of identifying, assessing, and managing specific risks or declining to invest because of specific risks.
• Professional VC investors assess new startup investments in terms of a comprehensive thesis about how the market being addressed will evolve over more extended periods, the basis of competition, and the competitive environment to assess market risk.
• Professional portfolio construction to compensate for high startup failure rates. The startups in the portfolio will more likely be strongly aligned with the fund investment thesis and the corporate strategy.
• Expectation management around a typical, but relatively high failure rate based on the stage of the startup at the time the investment is made (Pre-Seed, Seed, Series A, Series B, etc.) can be more effectively performed by a professional, experienced VC investor. These early failures are then less likely to dampen the corporate appetite for further investment before the fund manager can construct a robust portfolio of investments because the fund management agreement will usually make it hard for a corporate to change its mind once it committed the capital to this program.
• The professional VC manager will only encourage startups in the portfolio to explore corporate value chain integration once they’ve been in the portfolio for several years and are more operationally mature. Successful corporate value chain integration has a higher probability of success in this case.
• Corporates can treat this as one of many potential M&A channels and are less likely to overpay on investments that are much more likely to eventually be ready to deliver strategic value to the corporate.

Disadvantages

• Some, but not complete control over the VC fund, including how it is managed by the external VC fund manager, the investment thesis, how the investment committee makes decisions and how it is comprised.
• Less influence over the rate at which the external fund manager calls up the committed capital when this may be desirable to the corporate from a budgetary perspective.
• It can feel like a very big financial and executive time commitment for a corporate to have to take with no obvious near-term revenue impact on the core business when the investments are predominantly in early-stage disruptive innovation startups. The fund management agreement will usually make it hard for a corporate to back out of a corporate VC program later once it committed the capital to this program over the required lengthy 7-10 year timeframe.
• Professional VC fund managers will tend to invest in disruptive innovation startups that seek to create new capabilities and long-term competitive advantage for the corporate, but for some corporate stakeholders, it may feel like these startups are not solving immediate problems for them and have less immediate strategic or financial relevance.

There’s enough evidence now that truly disruptive innovation, including future capabilities that change the basis of competition in favor of the innovator, hardly ever originates inside large organizations that are more likely to be optimized for efficiency as their addressable market matures and they compete on value (instead of performance). The primary question for corporates accepting this new reality is not whether they must invest in innovation programs that work with startups, but rather which program type is most appropriate to them based on their objectives and their willingness to accept the advantages and disadvantages of each program type.

Written by: 

Newtown Partners will host the panel ‘How Venture Capital is empowering corporate innovation – Are SA corporates ready to embrace disruptive innovation?’ at the 2022 SA Innovation Summit under the Start-up to Unicorn stream.

This stream will tackle how ecosystems can support the impact of great new ideas, share the secrets on how to make unicorns in Africa and take a look at how corporates and start-ups develop the economy. Heads of business will share their insights into how to deal with technology and innovation from the outside-in, working with innovative start-ups, incubation and acceleration programmes and creating venture capital funds. Building portfolios with meaningful impact.

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