Want to Crank Up Corporate Venture Capital Performance? Consider Matching Independent VC Pay PackagesPublished: November 26, 2008 in Knowledge@Wharton
Big companies start venture capital units to help keep their competitive edge. Perhaps the most notable example is Intel, whose VC unit has invested in such entrepreneurial success stories as Red Hat, the North Carolina software distributor, and WebMD, the online medical-information company. But others have launched corporate venture capital units as well, including Comcast, Johnson & Johnson and UPS.
Corporate VC units aim to help their parent companies find highly profitable new projects, spot promising technologies before competitors do, and collaborate with the best new thinkers in their field. But to score these kinds of wins, companies must organize their VC efforts with an eye to the delicate balance between entrepreneurial finance and organizational reality. Some companies may not be doing that, says Wharton management professor Gary Dushnitsky, who studies entrepreneurship. Specifically, they may be undercutting themselves by ignoring the effects of the compensation schemes awarded to their in-house VCs.
Companies often assign internal VC staff salaries the same way they do other corporate staffers. Instead, these firms should consider compensating their internal VCs like independent VCs, giving them a stake in the future returns of the ventures they invest in, Dushnitsky says. If a corporation wants its internal VCs to pursue investment practices that are similar to those used by their independent counterparts, it should match their pay packages.
In a paper titled, "Entrepreneurial Finance Meets Organizational Reality: Comparing Investment Practices by Corporate and Independent Venture Capitalists," Dushnitsky and co-author Zur Shapira at New York University hypothesize that given the typical compensation arrangement, corporate VCs would shy away from risk. That is, irrespective of their strategic or financial orientation, corporate VCs would invest in more mature companies than independent VCs do and would invest through larger syndicates (groups of VC firms that team up to make an investment).
When Dushnitsky and Shapira examined data from more than 13,000 venture capital rounds during the 1990s, that's exactly what they found. "Corporations invest in mature and potentially less risky ventures" than independent VCs do, they write. On top of that, the two researchers observed that deals involving a corporate VC unit "are associated with a syndicate size that is 49% larger" than those with independent VC participation alone. These patterns persist even after controlling for units' objectives (financial or strategic) and other corporate characteristics.
Dushnitsky and Shapira also separated out deals financed by corporate VCs who received more performance-based pay than average. They discovered that those deals looked a lot more like the ones done by independent VCs. These corporate VCs invested in less mature companies and made their investments through smaller syndicates.
Syndicates containing only independent VCs "are persistently smaller in size (that is, fewer participants are involved) than those where a corporate investor is a syndicate member," the scholars point out. "[But] the syndicate size disparity shrinks substantially if a corporate VC program awards performance-pay." These findings hold for strategically oriented corporate VCs as well as financially oriented ones.
"In the presence of performance-pay, corporate VC personnel engage in practices that differ only slightly from that of their independent VC counterparts," Dushnitsky and Shapira conclude.
Mature Firms, Lower Returns
Investing in more mature firms and syndicating both reduce the likelihood of losses, but they also translate to lower returns when an investment ends up becoming a Google or an eBay.
To understand the shortcomings of this conservative approach, compare it with the way a so-called seed-stage investor operates. Kleiner Perkins Caufield & Byers, perhaps Silicon Valley's most famous independent VC firm, has helped launch such entrepreneurial successes as Genentech, Intuit and AOL.
Independent VCs will often fund startups that amount to little more than a savvy management team and a promising business plan. As a result, they will typically get a lot of stock at a cheap price. But they will also see a lot of failed investments because many of their portfolio companies will never end up selling stock to the public or being bought by another company -- outcomes that allow a VC to cash out.
A later-stage investor, in contrast, puts money into ventures that already have proved the value of their technologies and even have customers. This investor is thus more likely to see the venture sell stock or get acquired. But because a more mature venture has more negotiating power, the investor will get fewer shares of stock for his money (compared with what he could have gotten if he had invested earlier) and a smaller potential return.
Similarly, syndication affects investors' risk-return profile. Investors split the costs -- and consequently gains -- with other syndicate members. Therefore, an investor who takes part in a larger syndicate stands to lose less money if the venture fails. But the investor will also have a smaller potential return if the venture is successfully liquidated.
Do more conservative investment practices impact performance? The two researchers' analysis of investors' ultimate performance suggests so. Corporate venture capitalists (CVCs) experience successful portfolio exits at a higher rate than independent venture capitalists (IVCs), likely due to CVC's ability to leverage parent-firm resources, industry foresight, and customer and supplier networks. However, the performance gap is sensitive to CVCs' compensation scheme: It is large when CVC staffers are privy to performance-pay, and diminishes substantially when they receive little or no incentives.
"You cannot disconnect corporate VCs from independent VCs," Dushnitsky states. "They invest in the same kinds of ventures and often do so together. They are dependent on each other for deal flow. Corporations need to be aware of the implications of what they are doing. They may be hindering their corporate VC units from fulfilling their full potential."
Ferraris vs. Camrys
Independent VCs take big risks and, when they bet right, they reap big rewards. Google, eBay and Amazon all started with venture backing. Independent VCs also receive a big piece of the profits that they generate for their investors.
A typical independent venture capital firm raises money from pension funds, universities and wealthy individuals, and then invests the funds on behalf of those investors. For that, it gets a management fee -- an annual percentage of the total assets under management -- plus part of the return. (VCs call their share of the profits "carried interest" or sometimes simply "carry.") A common setup is the "2 and 20" arrangement in which the VC receives a 2% management fee and 20% of profits.
Corporate VCs, in contrast, invest their parent company's money and often receive just a salary and maybe an annual bonus. In a famous example cited by Dushnitsky and Shapira, SAP, the German software maker, paid straight salary to the head of its Silicon Valley VC unit even though he racked up a 6,000% return on the company's money.
Corporations cite all sorts of reasons for why they pay their internal VCs the way they do. Some say that they don't want to face the bookkeeping hassles of compensating one small group of employees differently, Dushnitsky and Shapira point out. Those administrative headaches get compounded as staffers transfer into and out of a VC unit.
Other companies say that they want to "maintain pay-equality to avoid resentment by employees in other business units," the two researchers write. In 1999, a leading corporate VC unit tried to persuade its parent company to change its pay structure after a consultant recommended that it offer carried interest to its staff, Dushnitsky says. The company's board of directors rejected the request on equality grounds. It didn't want "someone driving a Ferrari and parking it next to all the beat-up Camrys," he notes.
Some businesspeople might dismiss this concern, arguing that the Camry drivers had nothing to complain about. According to this line of thinking, corporate staffers should get paid for their contribution to the bottom line, period. But Dushnitsky argues that organizational considerations do have a role in compensation decisions. "To gain the strategic benefits of corporate VC, you need your [internal] VCs to be in close touch with other people within your firm, especially the R&D personnel and business unit people. If the [internal] VCs flaunt their high pay, it might be more difficult to facilitate the right kind of communication. You need to incentivize them, but you also want to avoid resentment."
Yet too great an emphasis on pay equality can lead companies to overlook the less obvious, but potentially bigger, costs of failing to compensate internal VCs appropriately, Dushnitsky and Shapira say. Simply put, people who aren't compensated to take risk won't take it, and, on average, less risk translates to lower investment returns for the parent company. Thus, structuring a compensation scheme for CVC staffers raises an organizational dilemma.
As noted above, corporate VCs can reduce their risk by either investing in more mature companies or by making their investments alongside other VCs in syndicates. "The theory of syndicates predicts that in the face of uncertain payoffs, investors choose to diversify their holdings," the two researchers state. "When an investor cannot adequately diversify by investing in multiple ventures, she may opt to syndicate her investment."
A possibility that Dushnitsky didn't test but doesn't rule out is that big companies pay salaries to their staff VCs because they don't want them to take too much risk. "In big corporations, the tolerance for failure is sometimes lower," he says. "An independent VC firm will tolerate failures as long as there are also big successes. In a corporate setting, failures are highly visible." In an organizational setting where corporate venture capitalists are not awarded 'carry' in successes -- yet their failures are salient -- they will likely opt to invest conservatively, Dushnitsky states.
Google Joins the Crowd
Corporate venturing faces many challenges and opportunities. As a member of the advisory board for the 2008 global corporate venture capital survey published this month by Ernst & Young, Dushnitsky notes that more than 80% of the responding CVC units were in operation for five years or longer. He quotes a comment from Gil Forer, global director, Cleantech, IPO and Venture Capital Initiatives at Ernst & Young: "Many large corporations recognize that they cannot compete effectively in today's global markets by relying on in-house research and development alone. In response, we are seeing a significant uptake in corporate venture capital and it has become a vital component in the innovation strategies of many leading corporations." In line with the academic study, the survey indicates that gaining parent company support of corporate venturing is the most significant challenge facing today's corporate VC professionals, according to Dushnitsky.
In another sign of the growing significance of corporate VC, Google a few months ago announced it was launching an internal VC group. Google, of course, has racked up success after success since being launched as a venture-backed startup. Managing the sensitive relationships with other entrepreneurial ventures may pose less of a challenge to Google's CVC unit, notes Dushnitsky. But in the short term at least, it may find the compensation issues just as vexing as other big companies have. "Not every firm can, or should, mimic the incentives that are prevalent in the world of entrepreneurial finance," Dushnitsky comments. "The success of Google's venturing efforts will hinge, to a large extent, on finding the right balance between entrepreneurial finance and organizational realities."