The NASDAQ’s downward spiral has inspired apocalyptic visions among some market watchers, especially those in the venture-capital realm. A longer view contradicts those dismal prognosticators: Professionally managed venture funds command more money than ever before, angel investment is reaching unparalleled levels, and most of the real suffering over the NASDAQ index is limited to those who invested at its dizzying heights. Where we once may have suffered from irrational exuberance, we may now be in the throes of irrational anxiety.
This year has witnessed a shift in the markets, but rather than talking about war, famine, death, and pestilence — the traditional four horsemen of the apocalypse — we should look to the four horsemen of the new economy: AT&T, Xerox, Polaroid, and Kodak. These blue chips are living testaments to one of the new economy’s fundamental theses: Companies must innovate or die. At one time, AT&T, Xerox, Polaroid, and Kodak embodied innovation; even more, they represented corporate venturing — a kind of innovation that is currently in fashion again after a lapse of twenty-odd years. All four companies now stand as examples of highly innovative companies that have lost their technological edge.
Starting in the 1960s, a number of companies began to move their money out of internal R&D into free-standing venture funds or into funds they established on their own. The theory was that innovation would increase if put in the hands of talented, energetic, and independently minded entrepreneurs.
In the late 1980s, AT&T, Xerox, and other major players cooled on corporate venturing, particularly after Black Monday — the October 1987 market crash that crushed the financial returns from venture investments. The troubles these corporate giants are facing today may be traced to years of relative idleness in the venture arena. The management teams at companies from Intel to Deutsche Telekom, from Cisco to SoftBank, apparently agree with this conclusion, for they have dramatically increased their interest and activity in corporate venturing.
But the corporate-venture model has its own pitfalls, and it pays to consider them closely.
Any large company looking to stay on the cutting edge in technology has three alternatives to consider: direct investing in early-stage tech firms, investing as a limited partner in a free-standing venture fund controlled by others, and creating its own fund in which it is the only or the dominant investor.
Investing in external R&D is a win-win proposition. A company as an investor can strategically tap into new technologies. Additionally, it can farm out technology it doesn’t want to develop in-house to a venture fund that will create a company around that technology. This win-win solution, however, is riddled with problems — chief among them is the fundamental tension between the interests and culture of a large multinational corporation and the manager of a venture portfolio.
The most serious problem of the corporate-venture model has to do with the economics of venture capital. Take the case of the third option, a wholly owned corporate venture fund. A senior vice president earning $350,000 a year plus benefits in a corporation could do significantly better as a general partner in its $300 million venture-capital fund. If the $300 million is invested successfully and the fund’s partners take the typical 20% of profits distributed, that vice president may wind up significantly richer than the chief executive of the multinational company. And that same manager-turned-successful-VC could now shop the fund’s track record around and raise her own fund of, say, $500 million. Imagine the morale problems, not to mention the potential talent drain: The other senior VPs see their colleague become a multimillionaire due to a simple transfer to the venture fund, while they’ve been working for wages — generous wages maybe, but wages nonetheless.
There is no solution for this quandary. The conventional — and only — wisdom is that talented money managers will not perform up to their capacities unless they are compensated with a “piece of the action” competitive with other venture funds.
Secondly, in today’s environment there is a lot of money out chasing good deals. An investor needs to move quickly, before another party snaps up a promising prospect. Big corporations generally don’t have a problem with the kind of speed and independence necessary to execute such deals, but they may be uncomfortable having the fund linked with their brand. The relationship between the firm and the fund are usually widely known; thus, if a portfolio manager makes some bizarre mistake, the corporation feels its brand has been degraded. This conflict often results in a turf war between the independently minded fund manager and the board and senior management of the investing firm. The remedies vary widely and include firing individual managers, replacing the fund’s entire management and continuing business, calling off the game and liquidating the fund, and curtailing new investments. None of the options is particularly appealing.
The third major issue is conflicts of interest. Say an investing corporation comes across a promising piece of technology. Is there an obligation to share or concede that investment opportunity to the fund, or may the corporation conclude that the deal is too good to pass up and buy the company? What about when it comes time to put a funded company on the block: Is there any obligation to favor the corporation in the bidding process? Then again, take the case of a fund with multiple limited partners. May the fund managers favor the dominant investor with preferential coinvestment rights? There is no perfect answer to these thorny issues, and a solution usually requires elegant wordsmithing to pacify all sides. Often, a contract will state, in effect, that the dominant partner will use its “best efforts” to act “fairly and equitably,” but if that partner does see something particularly appropriate for its own portfolio, it can snatch the investment opportunity away from the fund.
There’s one last side to this issue. Most investors buy into a fund dominated by a big, multinational corporation because they think the corporation will bring in a lot of deals through individuals stationed in its remote offices. Senior management can urge people on the front lines to forward promising deals to the fund, but these days, trying to motivate simply through inspirational language just doesn’t cut it. Corporations often set up “side-by-side funds,” which invest in lockstep with the main partnership as a way of rewarding key executives for finding promising deals.
The above is only an overview of a highly complex landscape. For further details, contact Joseph Bartlett at JBartlett@MoFo.com and stay tuned for materials to be published on www.vcexperts.com.