In past posts in this series I addressed briefly some of the most critical issues corporates should think about when starting an external innovation effort that will focus on startups. In this last post, I address the issue of value creation, which is perhaps the least understood and least defined aspect of most corporate venturing projects at their outset.
Earlier, I described four basic external innovation agendas, and it’s worth revisiting that list before starting the discussion on value. The four agendas are:
- Venture: These companies have strong in-house venture or capital group that is active in seeking and growing innovative ideas and startups
- Connected: These companies cast a wide net so that any idea — relevant or not at first glance — is at least seen and considered
- Gap: These companies are usually looking to fill specific, well-define innovation gaps in their own product development plans
- Sync: These companies are synchronizing their innovation cycles to external innovation cycles so they do not miss out on a critical technology, material, etc., in the future
I came up with these four general categories after many discussions with VCs, startup CEOs, and corporate venture leaders; the more I use them, the more the validity of the set is reinforced in my mind. The questions for this post, then, is: how is value created and measured in each of these models? Is value the same as the agenda in each of these models? Or should we think of value independently of these four agendas?
I posed the last question above to a group of corporate and VC leaders I met with in NYC this past week, and after listening to their responses I think that external innovation efforts create value in ways analogous to two other corporate functions:
- Functional/indirect value, i.e., value equivalent to that of corporate research and development departments
- Investment/direct value, i.e., value equivalent to that of corporate treasury departments
Each of these two value models has different goals, methods and metrics, so let’s examine each in turn.
In the first value model, the goal of the corporate venture capital (CVC) team is to accelerate and/or substitute for corporate R&D investments. In other words, the principal aim of the CVC outreach is to find specific technologies that can enhance or complete technology developments within a company. Examples of these efforts include finding new materials or components, as well as service capabilities, that either are not being developed in house or are being developed too slowly. In this value model, the team is not necessarily looking to meet or exceed a specific financial return (say, the typical 10X threshold of long-term funds or an annual IRR metric); rather, the team is driven by technical (and sometimes cost) metrics, such as “percentage of products launched from external innovations.” In this value model, funding is better considered as R&D investment. One such R&D measure is Return On Research Capital (RORC), which is the ratio of current year Gross Profit to previous year R&D expenditures. A modified version of this metric might be Return On Ventured Capital (ROVC), which would try to measure the impact that past CVC investments have on current profit. As with RORC, ROVC would be used not to look at the inherent performance of CVC investments but on their functional (e.g., indirect) impact on a critical corporate financial metric. Indeed, in an extreme example of this approach, I know of one company that “writes off” all CVC investments when they are made, treating them as sunk R&D costs and not as sources of future investment value.
The investment value model is, of course, quite different. In this model, it is the inherent (direct) financial value of the CVC investment portfolio itself that is the principal metric. In this case, a CVC team would be measured, when all is said and done, using the same metrics that any Limited Partner would use when evaluating the performance of a VC fund, i.e., total return or performance against external indices. Whatever the metric, what is important is that the CVC management team understands that above and beyond and interesting startups or technologies that may be incorporated into the corporate parent, the team must generate specific financial returns through their investments. Simply finding “innovations” is not enough, in this value model, to justify the existence of the CVC team in the long term.
Returning to our four innovation agendas, we can see that the Venture agenda maps directly to the Investment value model. We can also see that the Gap agenda is naturally aligned with the Functional value model. Though not as immediately apparent, Sync can actually go either way. A company such as Accenture that depends on syncing with external technology partners, say, can easily create an Investment value model for its external innovation investments. On the other hand, a company such as BMW that depends on the technology cycles at Bosch might prefer a Functional value model. As for the Connect agenda, here, again, I can see (and have seen) both the Functional and Investment models at work.
Before closing the value discussion, it’s worth noting that if a CVC team is working under an Investment value measurement model, then it stands to reason that the team should be compensated in much the same way. Interestingly, this is often not the case. I often come across new CVC teams that are measured by Investment metrics yet are compensated as if they were in a Functional value model. Typically, this is not sustainable, and the best CVC leaders eventually leave such settings for VC firms where they can reap rewards commensurate with the performance risk they are asked to manage. Contrariwise, asking a team whose focus should be on Functional value to deliver Investment value first and foremost often leads to conflict within CVC teams and between the team and the corporation.
There are other related topics in the CVC value model discussion that should also be considered, of course. Risk threshold and measurement is a critical one, as is value creation from the point of view of the startup/external partner. My advice to any new CVC team is to spend a lot of quality time with their CEO and corporate senior management defining the right value model prior to starting a large-scale startup outreach. No CVC team should be looking at startups without having a clear sense of how value creation is defined and will be measured by their corporate leadership. Investing in this this discussion up front is a critical strategy for avoiding lost time, lost money, or even abandoned CVC efforts down the road. Investing in all of the four innovation dimensions I have outlined in this series is a solid foundation for any CVC effort that aims not just to be exposed to innovators at a given moment in time but to deliver high performance over the long run.