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Making Sense of Corporate Venture Capital

Corporate VC funds pulled back dramatically on their funding of independent start-ups in 2001. But was that the right thing to do? Smart players including Microsoft, Intel, Merck, Qualcomm, and Millennium Pharmaceuticals continue to invest heavily for strategic reasons, if not financial. In this Harvard Business Review excerpt, Harvard Business School professor Henry W. Chesbrough looks at making sense of corporate venture capital.

Corporate VC investments in external start-ups dried up in 2001, but many smart companies including Intel, Microsoft, and Merck continue to place strategic bets. In this Harvard Business Review excerpt, Harvard Business School professor Henry Chesbrough provides an overview of corporate VC investment strategies and why they can be critical to driving growth in your company.

Large companies have long sensed the potential value of investing in external start-ups. More often than not, though, they just can't seem to get it right.

Recall the mad dash to invest in new ventures in the late 1990s—and then the hasty retreat as the economy turned. Nearly one-third of the companies actively investing corporate funds in start-ups in September 2000 had stopped making such investments twelve months later, according to the research firm Venture Economics, and during the same period, the amount of corporate money invested in start-ups fell by 80 percent. This decline in investments was part of a historic pattern of advance and retreat, but the swings in recent years were even wider than before: Quarterly corporate venture-capital investments in start-ups rose from $468 million at the end of 1998 to $6.2 billion at the beginning of 2000 and then tumbled to $848 million in the third quarter of 2001. While private VC investments also ebb and flow as the economy changes, the shifts in corporate VC investments have been particularly dramatic.

Henry Chesbrough
Henry Chesbrough

Such inconsistent behavior certainly contributes to the low regard with which many private venture capitalists view in-house corporate VC operations. In their eyes, the wild swings are further evidence that big companies have neither the stomach nor the agility to manage investments in high-risk, fast-paced environments. They also point to some high-profile missteps by individual companies to support this conclusion. Those missteps have, in turn, tended to make some companies hesitant to launch programs to invest in external start-ups, even in good times.

Such inconsistent behavior certainly contributes to the low regard with which many private venture capitalists view in-house corporate VC operations.
— Henry Chesbrough

A number of companies, however, have defied this stereotype of the bumbling corporate behemoth and have continued to make investments in new ventures. Even as substantial numbers of corporate venture capitalists have headed for the exits in the past year and a half, some big companies—including Intel, Microsoft, and Qualcomm-have publicly committed themselves to continued high levels of investment. Others—such as Merck, Lilly, and Millennium Pharmaceuticals—have actually come in the door as others have left. What gives these optimists their confidence? More generally, why have some companies' forays into venture capital been successful, generating significant growth for their own businesses?

To answer these questions, we need an organized way to think about corporate venture capital, a framework that can help a company decide whether it should invest in a particular start-up by first understanding what kind of benefit might be realized from the investment. This article offers such a framework, one that also suggests when—that is, in what kind of economic climates—different types of investment are likely to make sense.

But first, let's briefly define corporate venture capital. We use the term to describe the investment of corporate funds directly in external start-up companies. Our definition excludes investments made through an external fund managed by a third party, even if the investment vehicle is funded by and specifically designed to meet the objectives of a single investing company. It also excludes investments that fall under the more general rubric of "corporate venturing"—for example, the funding of new internal ventures that, while distinct from a company's core business and granted some organizational autonomy, remain legally part of the company. Our definition does include, however, investments made in start-ups that a company has already spun off as independent businesses.

Our framework helps explain why certain types of corporate VC investments proliferate only when financial returns are high, why other types persist in good times and in bad, and why still others make little sense in any phase of the business cycle. It can also help companies evaluate their existing and potential VC investments and determine when and how to use corporate VC as an instrument of strategic growth.

The dual dimensions of corporate VC
A corporate VC investment is defined by two characteristics: its objective and the degree to which the operations of the investing company and the start-up are linked. Although companies typically have a range of objectives for their VC investments, this type of funding usually advances one of two fundamental goals. Some investments are strategic: They are made primarily to increase the sales and profits of the corporation's own businesses. A company making a strategic investment seeks to identify and exploit synergies between itself and a new venture. For example, Lucent Venture Partners, which invests the telecommunications equipment maker's funds in external companies, makes investments in start-ups that are focused on infrastructure or services for voice or data networks. Many of these companies have formal alliances with Lucent to help sell Lucent's equipment alongside their own offerings. While Lucent would clearly like to make money on its investments in these start-ups, it is willing to accept low returns if its own businesses perform better as a result of the investments.

The other investment objective is financial, wherein a company is mainly looking for attractive returns. Here, a corporation seeks to do as well as or better than private VC investors, due to what it sees as its superior knowledge of markets and technologies, its strong balance sheet, and its ability to be a patient investor. In addition, a company's brand may signal the quality of the start-up to other investors and potential customers, ultimately returning rewards to the original investor. For example, Dell Ventures, Dell Computer's in-house VC operation, has made numerous Internet investments that it has expected to earn attractive returns. While the company hopes that the investments will help its own business grow, the main rationale for the investments has been the possibility of high financial returns.

The second defining characteristic of corporate VC investments is the degree to which companies in the investment portfolio are linked to the investing company's current operational capabilities—that is, its resources and processes. For example, a start-up with strong links to the investing company might make use of that company's manufacturing plants, distribution channels, technology, or brand. It might adopt the investing company's business practices to build, sell, or service its products.

Sometimes, of course, a company's own resources and processes can become liabilities rather than capabilities, particularly when it faces new markets or disruptive technologies.1 An external venture may offer the investing company an opportunity to build new and different capabilities—ones that could threaten the viability of current corporate capabilities. Housing these capabilities in a separate legal entity can insulate them from internal efforts to undermine them. If the venture and its processes fare well, the corporation can then evaluate whether and how to adapt its own processes to be more like those of the start-up. In rare cases, the company may even decide to acquire the venture.

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Excerpted with permission from "Making Sense of Corporate Venture Capital," Harvard Business Review, March, 2002, Vol. 80, No. 3.

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Henry Chesbrough is an assistant professor of business administration, and the Class of 1961 Fellow for Harvard Business School.

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Four Ways to Invest

The author identifies four types of corporate venture capital investments, a framework to help companies think about their investment strategies. In brief, they are:

Driving Investments. This type of investment is characterized by a strategic rationale and tight links between a start-up and the operations of the investing company.

Enabling Investments. In this mode of VC investing, a company still makes investments primarily for strategic reasons but does not couple the venture tightly with its own operations. The theory is that a successful investment will enable a company's own businesses to benefit but that a strong operational link between the start-up and the company isn't necessary to realize that benefit.

Emergent Investments. A company makes these kinds of investments in start-ups that have tight links to its operating capabilities but that offer little to enhance its current strategy. Nevertheless, if the business environment shifts or if a company's strategy changes, such a new venture might suddenly become strategically valuable. This gives it an optionlike strategic upside beyond whatever financial returns it generates.

Passive Investments. In this mode of VC investment, the ventures are not connected to the corporation's own strategy and are only loosely linked to the corporation's operational capabilities. Consequently, the corporation lacks the means to actively advance its own business through these investments. And despite the perception of some companies that they enjoy technology or market knowledge that gives them advantages over other investors, the recent flight of corporate VC suggests otherwise.

Excerpted with permission from "Making Sense of Corporate Venture Capital," Harvard Business Review, March, 2002, Vol. 80, No. 3.

1. See Dorothy Leonard-Barton, "Core Capabilities and Core Rigidities: A Paradox in Managing New Product Development," Strategic Management Journal, summer 1992, for a discussion of how companies' capabilities can become liabilities. For an introduction to disruptive technologies, see Clayton M. Christensen, The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail (Harvard Business School Press, 1997).