The series continues with why CVCs fail to properly integrate with the parent corporation and how to fix that so the CVC becomes the investor of choice for the hottest startups and, ultimately, delivers on the innovation goals that the corporate parent set for it. Get caught up and read part 1 and part 2 here.
Structuring a corporate venture capital (CVC) to function effectively as a venture capital firm (VC) is only half the battle. Even phenomenal VC returns often amount to a mere rounding error on a Fortune 500 company's financial statements. So if the CVC doesn't meet the strategic objective of injecting innovation into the mothership, it is a failure regardless of returns.
At the same time, there is a lot of venture money out there chasing great startups. So how does a CVC mobilize the corporate sponsor as a unique competitive advantage over other VCs?
Fortunately, the same plan solves both problems.
In most cases, a CVC should be investing at the seed or series A round stages. If they approach investment at an earlier point, the startups are still basically cocktail napkins and science projects; any later, they aren't at the cutting edge of innovation. If an organization is good at working with the earliest stage startups and patient with founders who are still figuring out how to work with large corporations, engaging at the seed stage yields the most exposure to innovation for the buck. Unfortunately, very few corporations meet this description.
Most corporations have little or no structural process for introducing startups to the business lines and provide little or no training to line management on how to work with entrepreneurs. In these situations, working with entrepreneurs who have some experience making corporate pilots work significantly increases the odds of success.
Now let’s take a look at how to optimize the allocation strategy. A typical Series A round in New York City is currently somewhere between $4 million and $8 million. So funds in that stage are looking to make initial investments of more than $2 million, if they want to lead the round, down to as little as $500,000, if they are following a lead. Most VC funds want a mix of deals to lead and follow. After all, if they don't lead some deals, why would other VC funds syndicate their deals to them? So, it is safe to assume an initial average $1 million check. Assuming also that a fund would like to make at least 10 investments a year over the three-year initial investment, that would add up to $30 million for initial checks. Furthermore, most funds like to reserve about half their fund for follow-on investment. This implies that $60 million is the ante for a traditional series A VC fund, which would also yield 30 portfolio companies.
A CVC is tasked with maximizing its exposure to innovation, so what are some ways it can get more shots on goal for the same or less committed capital? For one thing, it might not need capital for follow-on investments. While the general partners of the fund would want the dry powder to make these investments in order to maximize their ROI, follow-on investments don't increase the corporation’s net exposure to innovation. So a CVC could have zero reserve for follow-on investments and opt to invest off the balance sheet on an opportunistic, case-by-case basis. This means that a CVC could get exposure to the same 30 portfolio companies with just a $30 million fund.
Remember, though, that attracting top investment talent to the CVC is critical. So to align incentives with the general partners, if the corporate sponsor does invest, the general partners get their usual carry on that investment; if it does not, the pro rate investment rights revert to the general partners to syndicate in any way they see fit.
But what if the CVC found a way only to follow on rounds that other funds lead? In that case, the initial check size drops to $500,000 and that same $30 million fund now gets 60 shots on goal. So how do we pull that trick off? Join me at HIVE to find out, during my presentation on Launching Innovation or keep tracking this article series.
This article appears as it was originally published on our sister site, www.hiveforhousing.com.
Acknowledgments: I’d like to thank David Coats (Correlation Ventures), David Gerster (JLL Spark), Blake Luse (Ferguson Ventures), David Teten (ask him about his new fund), Linda Isaacson (FPL Global), Jill Ford (Toyota AI Ventures), Stacey Wallin (Numinus, formerly at BD Tech), Ameet Amin (Proto Homes, formerly at Colliers) and everyone else who contributed their thoughts to this article.