The strategic value of indirect investments as part of a corporate venturing or innovation strategy is hazy at best. Or at worst, a capital destroying misuse of shareholder funds.
When established companies look for ways to stay ahead, they often look to corporate ventures — being involved in building new businesses, technology, and business models. One of the methods for pursuing this is to make investments into third party venture funds with no brand association that then invest in the ventures themselves, thus the name indirect investments.
The argument for indirect investment usually rests on one or more of the following points:
- We don’t have the capability to build ventures ourselves but we want to be involved.
- We don’t have the capability to assess startup ventures.
- We don’t have the reach to source the best ventures out there.
- We don’t want to lose money, we could make more money through a fund.
Overall, the view taken by companies looking to invest in one or more funds is that it removes the risk of the company losing money, which means they are more likely to make huge gains, and that they will also be able to absorb the innovation of the startups backed by the venture funds.
It sounds compelling. However, if you consider the nature of an indirect investment, the four methods for corporates to gain strategic value from venturing is to look at the alternatives and consider shareholders. Then the indirect investment approach to corporate venturing starts to make much less sense.
Here is some context around how venture funds work that needs to be taken into consideration in corporate venturing:
- Focus: you will need to invest in focused venture funds that fit your company’s strategy. If you invest in a general fund, you’ll be exposed to new ideas but mostly outside your strategic focus.
- Access & Insights: as a limited partner (investor in the fund) it’s the fund’s partners that work directly with the ventures and their managers. They will be assessing new ventures and building relationships. While you will gain some access and some insights. Generally speaking, you are one step removed from the insights and access you are really looking for.
- Influence: unless you are a cornerstone or major investor in the fund then you will likely be just one of the fund’s many investors. This is particularly true if it is a good fund; the better the fund the less influence you are likely to have. You’d almost want to be wary of a fund that you can heavily influence.
- Timeline: venture funds are usually working on a different timeline to your organisation’s strategy. Venture funds will have a 5–10 year time horizon.
- Managers: you need the ability to assess fund managers. You’re likely better at assessing ventures in your industry because you know your industry. Rather than your ability at assessing fund managers.
- Financial: venture fund returns are highly skewed towards the top funds. The rest struggle.
Source: Correlation Ventures
Consider a $100m fund and the size of the investment you would need to make to play a key role. Now, consider that you’d likely want to spread that across multiple funds and consider that each of these funds would need to be focused on your area of interest (do that many exist?). It starts to become more attractive to create your own fund so you can get what you actually need strategically, especially given the likelihood you don’t significantly grow your capital either way.
Going indirectly also downplays the value you have as an established company to offer new ventures. They want to work with you, you don’t need to invest in them for this to happen.
There are four ways corporate ventures can provide strategic value to an organisation:
- Learn faster: venturing as a way to learn more about key parts of your core strategy or how you’ll be disrupted.
- Better leverage: venturing as a way to get more leverage out of your core strategy.
- Future acquisitions: venturing to ensure you can acquire the businesses and assets required to fulfil your core strategy.
- Encourage the ecosystem: venturing to encourage the ecosystem around your core strategy.
In each of these ways, the indirect investments struggle to provide strategic value.
- Limited learning: An indirect investment provides limited learning opportunities. You don’t see the dealflow, you just see the winners. Part of learning about the market is seeing what people are trying and what isn’t working. Also, your organisation — the people on the front lines where innovation really happens — aren’t exposed and learning because it’s only a handful of people that get the venture fund’s updates and invites to the cocktail party.
- Fewer opportunities: An indirect investment provides fewer opportunities for leverage. You aren’t the key influence, the venture fund is. You don’t have a seat on the board, you don’t have voting rights. You also aren’t seeing what the venture fund is disqualifying that might give you leverage but isn’t a great pure financial investment.
- Impacts future acquisitions: An indirect investment doesn’t set you up well for future acquisitions. You may not have rights. You’ll likely have a conflict of incentives in that you want the lowest possible price while the fund you’ve invested in and its other investors want a higher price. There’s also a chance that the better companies have moved beyond your capacity to pay but this isn’t unique to indirect investment.
- Restricts the ecosystem: An indirect investment doesn’t encourage your ecosystem. A venture fund won’t be focused on your specific ecosystem because, due to their financial motivations, a fund will want their ventures to be playing in your competitors’ ecosystems as well.
If you consider the quantum of investment you would need to make in order to pursue indirect investments in a way that drives strategic value then you are looking at investing in the tens of millions. At that scale of investment you have to ask, what else could we do with that money?
Why is it tens of millions? A few $250,000 (minimum buy-in for smaller, less established funds) would represent less than 2% of a small fund’s (~$20m) assets under management. But, a less established fund is a high-risk investment to make for a corporation that likely doesn’t have the capability to assess venture fund managers. Meaning, you will want to go with established funds that are going to be larger ($100m+) and require a larger investment to just participate let alone be influential.
For millions or tens of millions, you can follow many alternatives over which you have direct control and gain immediate value such as making direct investments or creating the capability to work with earlier stage companies.
For a lighthearted alternative, consider how much pizza you could buy tens of thousands of dollars for all the relevant startup meetups. You’d gain as much if not more insights than indirect investments.
Finally, shareholders have invested in your organisation because of the focus it has. If a shareholder wanted exposure to the venture asset class then they would invest there directly.
Investing in financial instruments (a venture fund) where the strategic benefit is low, especially when compared to alternatives (as I’ve outlined above), is likely a misuse of shareholder capital.
After all, your shareholders want you to create strategic value in the business that you have.