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On a global scale, venture capital investments of young companies in technology and innovation are on the rise - startups are seen as innovation drivers that make companies appear outdated.
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Corporates are well aware of this and have indicated a greater interest and willingness to invest in startups that challenge or complement their core business.
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At the same time, there are a number of reasons for startups to give preference to venture capitalists over strategic investors - corporates miss the opportunity to invest.
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For this reason, the creation of a subsidiary that can act as an independent corporate venture capital (CVC) arm at a distance from the core business as an investor has yielded promising results in the field.
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The figures confirm this trend: Since 2013, CVC volume has increased fivefold worldwide, and the concept has arrived in Germany as well.
Venture capital is the driving force behind the rapid growth and scaling in startups
The fact that venture capital is the basis for many growth and success stories for startups is nothing new: capital investments make it possible for young companies to focus on growth. Typically, such companies enjoy a high degree of entrepreneurial freedom and tolerance during the implementation phase - they experiment, adapt, and optimize at a rapid pace. In many cases, the key measure of success is sales growth. The objective is to achieve a long-term, competitive position in established industries as quickly as possible with new, innovative concepts and/or approaches.
For decades, investors have been contributing enormous sums to the future success of young companies with innovative ideas and business models - and the trend continues to be on the rise. In 2018, over $US 250 billion VC was invested; the most recent focal points were AI, Mobility, Health, and Fintech. By way of comparison, the investment volume in 2013 averaged around $US 80 billion (source: KMPG Venture Pulse Q4 2018).
Regarding the investment strategy of venture capital investors, success across the entire startup portfolio is more important than the obligatory financial success of the individual venture: what is essential here is that the ROI of a few startups provides profitable co-financing for all other "wagers." This sets VCs apart from investors who want to achieve strategic advantages through participation - for example, companies that not only hope for financial advantages from working with startups, but also seek access to recent technologies, innovations, and highly motivated young talent.
Corporates are also increasingly aiming to take part in startups
In the course of ongoing digitalization, it has become apparent across all industries that global players are complying with the need to adapt their often obsolete and, in some cases, still extensively manual processes to the digital age. While some companies still lack a complete digital strategy, the ever-faster innovation and development cycles continue to exert competitive pressure on those who have already adapted to new market and customer needs. Startups are regarded as the driving forces behind innovation, which dynamically promote the reassessment of products, processes, and services.
In its 15 years of consulting experience, LSP Digital has had the opportunity to fully experience the daunting challenges of redeveloping entrenched structures within large-scale companies. For years, corporates have been providing more capital to finance not only the transformation of their core business but also the development of new digital business models. From "make" to "buy," a broad range of options is available.
In spite of being financially superior to startups, corporates are often unable to independently develop or scale competitive new products. Experience has shown that innovations are often able to evolve particularly well outside the organization or separate from existing structures - for example, in independent startups.
Thus, for companies, the option to buy or invest is becoming increasingly important as a means to ensure long-term competitiveness. There are four reasons to directly invest in a share of independent startups (with the long-term goal of acquiring a majority stake):
- Technical development takes place in greenfield startups; this is simpler and more efficient than developing within existing structures.
- Market maturity is reached more quickly, since investments usually focus on operationally active companies that are able to demonstrate functioning technology, ongoing processes, and, in some cases, established customers (no start from zero).
- The need for time and financial resources for an (initial) investment is often lower when compared to the need to establish inter-company departments.
- There is a higher degree of motivation and willingness on the part of founders who hold shares and, in the event of success, receive a significantly higher incentive as compared to a traditional employee relationship.
Many startups categorically reject money from strategic investors
Yet the mere willingness of corporates to invest in startups will not suffice. Experience has shown that startups shy away from involvement with strategic investors seeking business concepts, innovative ideas, or technical solutions, at least in the growth phase.
We have identified six key reasons why startups prefer financial investors to corporates:
- Cultural Differences: Considerable cultural differences exist between companies and startups. In many cases, the corporate structure, which is still very much hierarchical, involves a high number of contacts, long coordination cycles, and thus an elevated level of communicative and operational effort. These have a detrimental effect on a startup's agility. Moreover, two worlds collide, to put it in bold terms: the 9-to-5 world meets hackathons, design sprints, and flexible working hours. The willingness "to go the extra mile" is often higher in startups.
- Reduced Pace: Committees, decisions made by the board of directors, and processes for approval and reporting require time and increase complexity. Startups are thwarted in the development phase and lose their vital competitive edge as a result. After all, speed and agility are important driving forces for a startup's success. Financial investors are equipped to respond to the need for rapid reaction and have modified their coordination processes accordingly.
- Lack of Commitment: The executive board and/or the management of strategists is measured and incentivized by comparatively short-term goals. As a rule, the expectation that a young, fast-growing company will be profitable and generate revenue within a few years is not a normal occurrence. Consequently, management assigns disproportionate weight to financial risks, minimizes investments, and therefore impedes start-up growth. At the same time, internal accounting mechanisms and cost center structures add greater complexity, which, from the startups' point of view, impedes success and motivation.
- Lack of Investment Culture: Financial investors have created a VC environment in which risks and high investments are commonplace. Founders are keen to sell as few shares as possible at the start of their business in the hope that these will quickly increase in value. At the same time, VCs do not demand excessively high shares in order to keep their founders motivated. This quickly leads to high valuations of young and often not yet profitable companies. Corporates are often unable to justify these investments, so that investment readiness is too low to attract founders.
- Limited independence: Strategists invest because the investment aims to gain a foothold in the core business or develop a new strategic impetus. This influence hinders the founders from acting in the optimal interest of their startup. They are thus prematurely stripped of their entrepreneurial freedom: following the strategist's investment, the path is often already predetermined.
- There is no going back: Building on the previous point, an investment by a strategist in most cases marks the exclusion of other corporates from (further) investment rounds. Especially in the case of competing corporations, there are strategic differences of interest that minimize the probability of a co-investment. For the startup, this early focus on an incumbent means a further, strong limitation of exit options - for the latter pursues the long-term goal of a majority takeover and not a sale.
Potential solution: setting up an investment vehicle of one’s own that is as self-sufficient as possible
In the event that a direct investment does not prove successful, there is the possibility of providing capital by setting up one's own corporate venture fund or a CVC corporation. Although these companies belong to a group, they act at a distance from the operating business, even when the investment focus is typically strategically linked to the core business. From the startups' point of view, the complexity of collaboration is thus reduced, and the range of freedom increases. This is because, at least in the short-to-medium term, startups are assessed against CVC company objectives rather than (operational) corporate objectives.
Corporates face many challenges in establishing a (successful) CVC company. For example, a CVC is only attractive for a startup if it offers the same conditions as an independent VC. For this to exist, qualified and experienced teams are needed to design and negotiate these conditions. In addition, governance structures appropriate to the start-up world must be put in place in order to foster an attractive investment culture.
Corporate venture capital as an investment model is gaining popularity
It has become evident that corporate venture capital is gaining popularity as an investment model. According to CB Insights, the number of deals concluded by CVC worldwide since 2013 has nearly tripled, and the investment volume has even increased fivefold. This corresponds to approximately 20% of all VC investments in 2018.
This trend has also been observed in Germany. Among the largest CVCs are Tengelmann Ventures (investments of up to €40 million per venture), Bertelsmann Investments (over €1 billion invested out of four funds into more than 200 investments since 2006), and Robert Bosch Venture Capital (investments of up to €15 million and currently over 30 investments).
For companies that are not (yet) up to the challenges or would like to learn on the basis of initial experience, there is also the option of investing in an existing high-tech fund or setting up a "Managed CVC Fund" (managed by an independent financial intermediary), possibly with specialization in their own industry. Of course, a number of factors play a role when selecting the best investment vehicle. A so-called "right" or "wrong" is determined by the unique circumstances of the company. If you are in search of information or an exchange in this regard, we look forward to hearing from you!
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Felix Blütener
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E-Mail: felix.bluetener@lsp.de