Sunday, July 1, 2012

Firms Chasing Profits, and Then Running Away from Them: Corporate Venture Capital

Venture capital firms provide early funding to startup firms, and for that they get an ownership portion and a say in their strategy. Many startup firms value both the funding and the strategic advice, because they often lack the managerial experience that venture capital firms have.  A quick look through news sources on venture capital is enough to give the impression that venture capital firms are backing some startup companies that are earning very high returns, and are likely to earn more. A recent (June 29) entry on the Wall Street Journal blog "Venture Capital Dispatch" showed a $50 million deal for advertisement optimizing company Rocket Fuel.  The same entry reported an $81 million deal for cancer-drug company Tesaro.  Tesaro sells hope for investors and (potentially) relief from side effects of chemotherapy for patients. Its most advanced drug helps against common and noxious side effects, but is not yet approved for use.

What these reports don’t show is that for every venture that succeeds there are many that fail. Most fail before they even get the kind of capital injections that are reported above, some fail afterwards. For example, discovery of any dangerous side effects of Tesaro's chemotherapy drug would be a major setback because they are only investigating one other drug at the time.  So venture capital firms are in a risky business. That is well known.

What is less well known is that many established firms in other industries have also been looking at venture capital returns and wondering if they can get them too. They also have funding that they can turn over to startup firms; they also have managerial expertise. As a result, Corporate Venture Capital departments have popped up in various firms from well-known ones like General Electric and BMW to firms that are less famous but still large enough to put substantial funding into startup firms. For the startup firms, this is promising because any kind of funding may be what they need to turn an innovation into a venture. For the established firms, this is a way to possibly increase growth and returns.

But then there is the risk. Relative to the size of these firms, a Corporate Venture Capital department is not a big risk on an absolute scale, but it is easily among the riskiest activities they can take on relative to the money invested. Established firms worry about risks, which means that they react in ways that are quite different from what venture capital firms do. As Vibha Gaba and Shantanu Bhattacharya have shown in a recent paper, they start imitating other firms: when other firms start corporate venture capital, they do too. When other firms close their corporate venture capital department, they do too. Somehow a risk that is acceptable when others take it isn’t when others are not.

Firms also look at their own research performance, and they seem to let the confidence decide what happens to corporate venture capital. If they do really poorly, then they are unlikely to start and very likely to stop doing venture capital. Such firms seem to lack confidence that they can do anything right. If they do really well, then they are unlikely to start and very likely to stop doing venture capital. Such firms seem to lack confidence that they can do anything right. Such firms act as if they don’t need venture capital to do well. It is the firms with in-between performance that are most likely to start and continue corporate venture capital. So an activity that is a haven for the really high risk-taking independent financiers is, ironically, also a favorite for the firms that are just OK in their research.