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Benefits Deriving From Investing In The Portfolio Companies Finance Essay

Literature Review

Introduction to Corporate Venture Capital

“The search for innovation needs to be organizationally separate and outside of the ongoing managerial business” – Peter Drucker.

Knyphausen-Aufseß (2001) defines “Corporate Venture Capital (CVC) as the investment of equity directly in entrepreneurial start-ups by well-established corporations, banks or consulting firms” (Knyphausen-Aufseß, 2001; Dushnitsky and Lenox, 2005).

Motives for the establishment of corporate venture capitals

Large corporations that decide to establish a corporate venture capital will manage a separate unit, which will be responsible for recognizing promising start-ups to invest in. The main object of the investments is to add value to the business of the start-up and the CVC itself will choose how to exit the portfolio-firm and the timing of this decision (Birkinshaw et al., 2002).

In particular, a corporation may engage in corporate venture capital (CVC) investments to foster the business growth and to explore promising areas that are not currently part of the company's portfolio of activities (Markham et al., 2005). Furthermore, these investments might lead to access breakthrough technologies developed by young start-ups, which will be further implemented internally by the corporation (Markham et. al., 2005). In addition, Dushnitsky and Lenox (2005) provide empirical evidence showing that corporations achieve higher innovation rates through CVC investments. This goal is realized also through outsourcing of the R&D activities and exploitation of new competences that do not exist within the company (Munsch, 2004; Dickman et al. 2001).

Scholars found that corporate venture capitalists provide not only financial resources to young start-ups, but also non-pecuniary assets and managerial competences (Block and MacMillan, 1993; Chesbrough, 2000).

The Corporate Investing Objectives

Corporate venture units strive to achieve a wide array of objectives, but the key common element among these goals is that to identify and develop new businesses for their parent firms (Birkinshaw and Hill, 2005). The corporate venture capital has two main orientations that have an impact on its performance: a direct financial return on the investment and an indirect strategic benefit (Dushnitsky and Lenox, 2006).

The previous literature suggests that a corporation looking purely for financial objectives is aiming mainly at attractive returns (Chesbrough, 2002). The experience that a CVC acquires trough previous investments might lead to the realization of economies of scale and scope, which in turn can boost the value of the portfolio-companies (Dushnitsky and Lenox, 2006). The experience stems also from an understanding of both the market and the technology involved in said markets, which enables the CVC to assess the quality of targeted ventures, too (Akerlof, 1970). Despite this, a short-term financial goal might hinder a further strategic development of the CVC and, hence, limit the long-term financial returns (Ernst et al., 2005). In line with the previous assumptions, it appears that the accomplishment of financial returns only might be less valuable for a CVC than for an independent venture capital. So, corporate venture firms usually focus more on the strategic objectives that derive from the target companies.

CVCs that pursue a strategic orientation generally gain access to a valuable window on a specific technology, which might either be complementary to the corporation’s business focus or a threat to a current project (Dushnitsky and Lenox, 2004). Therefore, corporate venturing appears to be a valuable mean that a corporation can adopt to detect and, subsequently, harness cutting edge technologies. Targeting, investing in, and, eventually, acquiring promising ventures can also facilitate the access of a corporation in a new high growth market (Sykes, 1990).

However, a CVC may also pursue an investment in order to increase the demand of current and future products by financing and enhancing the development of start-ups that supply complementary solutions (Brandenburg and Nalebuff, 1996). It follows that the synergies with the start-ups can also trigger an increase in the corporation’s profits (Chesbrough, 2002; Dushnitsky and Lenox, 2006). Moreover, Dushnitsky and Lenox (2006) also argue that the strategic orientation of corporate venturing enables a further transfer of know-how between the corporate-backed firms and the CVC, which is beneficial for both parties.

In conclusion, the literature suggests that a corporate venture unit may be willing to bear lower financial returns in favor of the potential strategic benefits that may arise from innovative ventures and that can lead to the development of new business ideas (Dushnitsky and Lenox, 2006; Sykes, 1990).

Strategies for achieving a successful corporate venture fund

A corporation that decides to establish a corporate venture capital has to be able to manage it carefully if it wants to achieve successful results. Scholars argue that there are some critical aspects that determine the success of a corporate venture unit. Firstly, the CVC should be managed by a very good team with venture capital expertise professionals that need to be motivated through rewards conditional on the performances (Hardymon et al., 1983; Siegel et al., 1988). In order to achieve this result, the corporation should be able to attract high skilled managers to its corporate fund through a fair compensation scheme. This approach can also represent a solution for overcoming the lack of incentives that generally characterizes CVCs (Siegel et al., 1998; Block and Ornati, 1987).

Sykes (1990) also suggests that establishing a relationship of mutual assistance between the corporation and its CVC is pivotal for the success of the latter. The parent company should assist the venture unit in its own area of expertise, i.e. industries and markets related information, and specific know-how, in return for strategic insights about new technologies. Furthermore, the author remarks that the corporation and its venture unit should establish a long-term relationship. The two parties are also supposed to be aware of the respective specific needs that have to be met. It is evident that the corporate fund should focus on fulfilling the corporation's requirements. This goal, however, might not be achieved because the corporation does not grant the CVC enough autonomy when it comes to taking financial decisions. This lack of independence may, in turn, jeopardize the result of the investments (Hardymon et al., 1983).

Besides this, the relationship between the CVC and the entrepreneur of the start-up has a pivotal role for the outcome of the investment. It is important that the parties involved in the transactions establish a mutual trust. This is an essential element that has to be taken into consideration if the CVC wants to overcome the skepticism of the entrepreneurs concerning the sharing of information with a large corporation and, thus, to obtain a window on a new technology (Dushnitsky, 2004; Hardymon et al., 1983). It is only after acquiring management expertise and valuable network connections that the entrepreneur will be more likely to trust the investors and to share information concerning a new technology (Hardymon et al., 1983).

Potential Issues of CVC

CVCs are themselves start-ups, hence, they face challenges similar to those of the young ventures they invest in. They also encounter problems concerning the unskilled management and the access to funds (Birkinshaw, 2005).

According to Dushnitsky and Lenox (2006), corporate venture capital investors can be subjected to information asymmetries. This problem could stem from the concern that high quality start-ups have when dealing with a CVC. They might hesitate to share information regarding their technology because of the fear that the corporate could appropriate or copy their innovations. Therefore, the venture possesses inside information that is not recognizable by the investors (Gans and Stern, 2003). Hence, investors may be led to adverse selection and choose to invest in low-quality companies that present themselves as good ventures (Dushnitsky and Lenox 2006).

Another problem related to the corporate fund is the lack of manager’s incentives, which might prompt internal conflicts. Block and Ornati (1987) suggest that the incentive problem is mainly due to the CVCs’ compensation scheme, which means that CVC managers receive a larger share of the compensation in fixed salary than the venture capital managers. The authors report that usually a corporation does not differentiate between the compensation of the company managers and the compensation of the managers in the CVC. The absence of a reward scheme within the CVC may result in the loss of high skilled professionals that would be leave to work for an independent venture capital.

History of Corporate Venture Capital

The development of CVC has experienced three booms and bust cycles (Gompers and Lerner, 1998). Corporations decided to gain access to the corporate venture market after assessing the success of independent venture capitals without carefully estimating their capacity (Block and Ornati, 1987; Gompers, 2002). The specific choice of this strategy has inevitably led to a shrinking of their commitment.

The first wave began in the late 1960s and early 1970s, when more than 25 percent of the Fortune 500 companies funded CVC units (Rind, 1981). Corporations’ strategies included the financing of start-up that had already obtained funds by independent VCs, the passive investment in VC or the internal development of new firms for the development of innovative ideas. The early 1970s saw a significant drop in the IPO market, which represents the most common exit strategy of independent VC. The financial returns of venture capitals decreased and it became difficult to raise additional funds. For this reason, corporations also decided to reduce their operations, terminating the CVC programs after only four years (Gompers, 2002).

The second wave began between the late 1970s and early 1980s, when managers decided to invest in the traditional venture capitals to capitalize on new opportunities arising from the market, which was characterized by technological breakthroughs, such as computer hardware and software. CVC units were restored subsequently and, by 1986, they were accounting for the 12 percent of the VC pool. However, in 1987 the stock market collapsed followed by the IPO one as a consequence, determining the end of this second cycle (Gompers, 2002).

In the late 1990s, the telecommunications and Internet-related firms fostered a new increase of the capital industry determining the beginning of the third wave. Corporations discovered once again an interest in CVC, expanding their strategies to joint ventures, acquisitions and other collaborations. During this phase, independent VC started to look strategically at corporate venture units and carried out partnership where both parties where bringing unique capabilities to each other concerning know-how and expertise (Gompers, 2002).

CVCs and External Innovation

The previous literature review reports that investing in young start-ups may be beneficial for the corporation because they allow the access to innovations or new technology through licensing or acquisition (Dushnitsky and Lenox, 2006). Corporate-backed firms bestow a window on technologies, opportunities deriving from a new market e innovative business models. Hence, CVCs investments represent a source of technological innovativeness (Markham et al., 2005). Portfolio-ventures are also more flexible in adapting to changing situations and are not concerned by the fact the development of a new product might cannibalize the sales of a previous one (Henley, 2007). As a result, it can be also seen as a promising way to gain access to external innovations.

With regard to the development of external innovations, Ernst, Witt and Brachtendorf (2005) individuate five main strategic motivations that can lead a CVC to invest in a start-up. Firstly, the venture wants to “monitor technological development” that can have an important impact on the expected growth potential for the corporation. A corporation’s R&D department cannot undertake all possible technological developments that might represent attractive options for further businesses. In particular, the creation of a window on technology may result in the realization of radical innovations (Stringer, 2000). The “access to highly qualified technology experts” represents a second possible goal. The previous literature shows that CVCs are a valuable channel for a corporation to attract highly skilled specialists (Hardymon et al., 1983). Thirdly, the authors identify the “creation of growth opportunities for the mother firm’s core business”. The CVC can achieve this goal triggering the demand for the corporation’s products, which will be sold to the start-ups (Chesbrough and Scolof, 2000; Chesbrough, 2002).

“Encouraging an entrepreneurial culture in the mother [corporation] and fostering the commitment of entrepreneurial employees” represents another possible objective. The previous statement implies that a corporation should try to promote eventual spin-offs allowing employees to develop their own business ideas, that might not by completely in line with the corporation business focus. These additional returns can be regarded as a growth option on new technologies that could otherwise represent a threat (Winters and Murfin, 1998; Schween, 1996; Bower and Christensen, 1995). Last but not least, the authors suggest the “increase of the internal efficiency of R&D”. Start-ups are characterized by a higher organizational flexibility, hence, CVCs provide a possibility for the increase of the corporations’ R&D efficiency, which is obtained outsourcing the research activities to the start-ups (Bower and Christensen, 1995; Gompers and Lerner, 1998; Simon et al. 1999).

Comparison Between Corporate Venture Capital and Venture Capital

Definition of Venture Capital

While the process of corporate venture capital has been explained in detail so far, the traditional venture capital (VC) investments imply a different procedure. Kortum and Lerner (2000) define this type of financing organization as “equity or equity-linked investments in young, privately held companies, where the investor is a financial intermediary who is typically actively involved as a director, an advisor or even a manager of the firm”.

Corporate Venture Capital vs. Independent Venture Capital

The main focus of venture capitals is the investing in promising market, since VCs are not strategically involved in the development of innovative technologies. The decision-making process is rather quick and usually takes three months from the evaluation of the investment to the actual exercise (Markham et. al., 2005). Beside the financial contribution, independent venture funds also assist the young ventures with the recruitment of employees and professionals in the early stages of operation and provide help to arrange additional funds (Maula and Murray, 2001; Maula et al., 2005). In fact, VCs have recently established partnership with headhunters and recruiting agencies as an addition to the broad network of people that already co-operate with them to be able to identify key executive that can increase the growth of the backed-company. Furthermore, independent venture funds are also involved in the strategic nurturing of the firms, which might become future market leader (Maula and Murray, 2001). On the other hand, the support given by CVCs is concentrated on the establishment of commercial credibility in order to overcome the “liability of alienness” that usually characterizes new ventures (Burgel et al., 2001). The problem with start-ups is that they struggle attracting customers because no one knows the quality of their products and, therefore, nobody wants to be the first one purchase them. However, corporate units possess the necessary resources, i.e. sales and marketing channels, to enhance the image of the portfolio-company (Maula and Murray, 2001). In addition, CVCs attract customers and suppliers, and make technical support available (Maula et al., 2005). Table 1 provides a general overview of the main differences between CVC and VC.

--------------- Insert Table 1 about here ---------------

Characteristics of the Investments

Both CVC and VC investments are conducted in stages (Gompers, 1995), which are contingent to the achievement of milestones by the backed-venture. However, prior analysis confirms that the investment procedures of CVC and VC are dissimilar (Dushnitsky and Shapira, 2009).

VCs usually invest in the early stages of the firms’ development (seed, start-up and early growth finance) and they usually assist the strategic development of the idea of the entrepreneurs, who can be talented but might lack of experience. Hence, VC’s critical expertise may be pivotal for the success and survival of the start-up (Gorman and Sahlman, 1989; Macmillan et al., 1989; Sapienza, 1992; Sapienza et al., 1994, 1996; Hellmann and Puri, 2002). On the other hand, the previous literature suggests that CVC invests in later stages. Gompers (2002) claims that CVC investments are focused on the development stages of the backed-company. In line with this, also Dushnitsky and Shapira (2009) found that CVC undertake investments at later stages of the venture’s growth. In addition, Gompers observed that CVC also provides larger amounts of funds in comparison with other financing organization. This might be explained because later stages are correlated with decreasing levels of risk and uncertainty that characterize young start-ups (Gompers, 2002; Yang et al., 2009).

Maula and Murray (2001) suggest that CVC investors usually have less experience concerning the accomplishment of a financial transaction. Therefore, many CVC units choose to syndicate the investments with other VCs, which will act as so-called lead investor. Lerner (1994) defined syndication as the process of co-investment undertaken by two or more investors. Partners engaging in a syndicated investment share their competences, which might result in a better ability concerning the choice and modality of investing in a venture (Lerner, 1994). CVC units can learn from independent VCs the criteria that are important when deciding to invest in a company and they can gain access to VCs’ networks. All these factors may also lead to an increase of the corporate investors’ experience (Yang et al., 2009). Beside the learning process that derives from this investment technique, syndication can also contribute to a better control of the risk involved in the transactions with the portfolio-companies. Thus, Wilson (1968) perceived syndicated investments as a practice of risk-sharing, which also allows corporate and independent venture capitals to vary their financial operations (Dushnitsky and Shapira, 2009).

To conclude, Maula, Autio and Murray (2005) argue that even if resources that are brought to the start-up by both VC and CVC are different, they are complementary and this has an important effect on the value they add to the portfolio ventures. While the former enables backed-companies to set up viable firms, which also helps them secure new funding rounds and recruiting skilled employees, the latter enhances the credibility. They also attract new customers and suppliers, and provide the technological support that companies necessitate (Maula and Murray, 2001).


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