Venture Capital and Private Equity: Module IV
The final module reviews many of the key ideas developed in the course. Rather than considering traditional private equity organizations, however, the two cases examine organizations with very different goals from the ones we have considered previously. Large corporations, government agencies, and non-profit organizations are increasingly emulating private equity funds. Their goals, however, are quite different: e.g., to more effectively commercialize internal research projects or to revitalize distressed areas. These cases will allow us not only to understand these exciting and challenging initiatives, but to review the elements that are crucial to the success of traditional venture organizations.
Since corporate and public venture capital initiatives are so different from traditional private equity funds, one may wonder why these cases are included in the course. There are three main reasons. First, this arena is the focus of intensive activity of late. These funds today are important investors. Second, it is difficult to examine the issues faced in adapting the private equity model without thinking about the rationales for the key features of traditional private equity funds. Thus, this section of the course allows us to review and revisit many of the issues we have considered in the previous three modules. Finally, corporate venture capital programs, in particular, provide an interesting alternative way to break into the private equity field that few students consider.
Interest in adopting the private equity model has exploded in recent years. In an era when many large firms are questioning the productivity of their investments in traditional R&D laboratories, venture organizations represent an intriguing alternative for corporate America. Much of the interest has been stimulated by the recent success of the independent venture sector. While total annual disbursements from the venture industry over the past two decades have never exceeded the R&D spending of either IBM or General Motors, the economic successes of venture-backed firms—such as Intel, Microsoft, Genentech, Thermo Electron, and Cisco Systems—have been profound. The Private Equity Analyst estimates that at least two dozen such programs were launched in 1996 alone. [Asset Alternatives, "Corporate Venturing Bounces Back, With Internet Acting as Springboard," Private Equity Analyst, 6 (August 1996) pages 1 and 18-19.] Meanwhile, several leading private equity organizations—including Kleiner, Perkins, Caufield & Byers and Advent International—have begun or expanded funds dedicated to making strategic investments alongside corporations.
The growth of venture funds organized by public and non-profit bodies has been even more striking. Recent estimates suggest that close to 40% of venture or venture-like disbursements in the United States—and more than half of early-stage investments—came in 1995 from "social" sources: those whose primary goal was not a high economic return. Nor has this activity been confined to the United States. Governments in dozens of countries have established significant public venture programs. In recent years, non-profit organizations have also become increasingly active in encouraging and overseeing venture funds. Some of America’s largest and most prestigious foundations, such as the Ford and McArthur Foundations, have been particularly active backers of community development venture funds. An interesting new trend has been the involvement of successful private equity investors, most notably Henry Kravis, as investors in and advisors to community development funds.
A second reason for the inclusion of this module is that it allows us to review and think about the key features of independent private equity firms. In particular, in adopting the private equity model, features of independent funds have been adjusted or altered. In some cases, these changes have been benign; but in others, the consequences have been disastrous. By reviewing successful and failed modifications of the private equity model to serve the goals of corporate, public, and non-profit organizations, we will gain a deeper understanding of how traditional funds work. During discussions, we will return repeatedly to the frameworks developed in the earlier modules of the course.
Finally, corporate venture capital programs represent an interesting avenue for entry into the private equity field that relatively few students consider. The intense competition for jobs in traditional private equity organizations allows many funds to demand that new hires already have a demonstrated investment track record. Yet it is difficult to develop such a track record without a job in the industry. Corporations are often much more willing to hire candidates directly out of school. If one can successfully make one’s way into a corporate venture group, it can provide valuable experience and serve as a stepping-stone to a position at an independent private equity firm.
The first corporate venture funds were engendered by the successes of the early venture capital funds, which backed such firms as Digital Equipment, Memorex, Raychem, and Scientific Data Systems. Excited by this success, large companies began establishing venture divisions. During the late 1960s and early 1970s, more than 25% of the Fortune 500 firms attempted corporate venture programs.
These generally took two forms, external and internal. At one end of the spectrum, large corporations financed new firms alongside other venture capitalists. In many cases, the corporations simply provided funds for a venture capitalist to invest. Other firms invested directly in start-ups, which gave them a greater ability to tailor their portfolios to their particular needs. At the other extreme, large corporations attempted to tap the entrepreneurial spirit within their organizations. These programs sought to establish a conducive environment for creativity and innovation within the corporate workplace. In an ideal world, internal venture programs allowed entrepreneurs to focus their attention on developing their innovations, while relying on the corporation for financial, legal, and marketing support.
In 1973, the market for new public offerings—the primary avenue through which venture capitalists exit successful investments—abruptly declined. Independent venture partnerships began experiencing much less attractive returns and encountered severe difficulties in raising new funds. At the same time, corporations began scaling back their own initiatives. The typical corporate venture program begun in the late 1960s was dissolved after only four years.
Fueled by eased restrictions on pension investing and a robust market for public offerings, fundraising by independent venture partnerships recovered in the early 1980s. Corporations were once again attracted to the promise of venture investing. These efforts peaked in 1986, when corporate funds managed two billion dollars, or nearly 12% of the total pool of venture capital. After the stock market crash of 1987, however, the market for new public offerings again went into a prolonged decline. Returns of and fundraising by independent partnerships declined sharply. Corporations scaled back their commitment to venture investing even more dramatically. By 1992, the number of corporate venture programs had fallen by one-third and their capital under management represented only 5% of the venture pool.
As has been often pointed out in this course, the entire venture capital industry is cyclical. So too has been corporate venturing. At the same time, it appears that the decline of the earlier corporate venture programs was also due to three structural failings. First, these programs suffered from a lack of well-defined missions. Typically, they sought to accomplish a wide array of not necessarily compatible objectives: from providing a window on emerging technologies to generating attractive financial returns. This confusion over program objectives often led to dissatisfaction. For instance, when outside venture capitalists were hired to run a corporate fund under a contract that linked compensation to financial performance, management frequently became frustrated about their failure to invest in the technologies that most interested the firm.
A second cause of failure was insufficient corporate commitment to the venturing initiative. Even if top management embraced the concept, middle management often resisted. R&D personnel preferred that the funds be devoted to internal programs; corporate lawyers disliked the novelty and complexity of these hybrid organizations. New senior management teams in many cases terminated programs, seeing them as expendable "pet projects" of their predecessors. Even if they did not object to the idea of the program, managers often were concerned about its impact on the firm’s accounting earnings. During periods of financial pressure, money-losing subsidiaries were frequently terminated in an effort to increase reported operating earnings.
A final cause of failure was inadequate compensation schemes. Corporations have frequently been reluctant to compensate their venture managers through profit-sharing ("carried interest") provisions, fearing that they might need to make huge payments if their investments were successful. Typically, successful risk-taking was inadequately rewarded and failure excessively punished. As a result, corporations were frequently unable to attract top people (i.e., those who combined industry experience with connections to other venture capitalists) to run their venture funds. All too often, corporate venture managers adopted a conservative approach to investing. Nowhere was this behavior more clearly manifested than in the treatment of lagging ventures. Independent venture capitalists ruthlessly terminate funding to failing firms because they want to devote their limited energy to firms with the greatest promise. Corporate venture capitalists have frequently been unwilling to write off unsuccessful ventures, lest they incur the reputational repercussions that a failure would entail.
An illustration of these difficulties is Analog Devices' venture subsidiary, Analog Devices Enterprises (ADE). [This account is drawn from David H. Knights, "Analog Devices Enterprises/Bipolar Integrated Technology," Harvard Business School Case No. 9-286-117, 1985; Rosabeth Moss Kanter, Jeffery North, Ann Piaget Bernstein, and Alistair Williamson, "Engines of Progress: Designing and Running Entrepreneurial Vehicles in Established Companies," Journal of Business Venturing, 5 (1990) pages 415-30; Bruce G. Posner, "Mutual Benefits," Inc., 5 (June 1984) pages 83-92; and various press accounts and securities filings.] Analog Devices decided to establish a corporate venture program in 1980. Through these investments, it hoped to gain both attractive financial returns and strategic benefits in the form of licensing agreements and acquisitions. Funds for these investments were provided by Amoco. By 1985, ADE had invested $26 million in eleven firms.
The ADE program was suspended in that year, after Amoco ceased contributing capital. Around the time the investment program was terminated, Analog Devices took a $7 million charge against earnings; in 1990, when most of the portfolio was liquidated, it took another $12 million charge. Of the eleven firms in ADE's portfolio, most were terminated, acquired by other companies at unattractive valuations, or joined the "living dead" (ongoing companies whose prospects are so marginal that they cannot be taken public or otherwise harvested). Only one of the firms ultimately went public. In this case, ADE's stake was so diluted by a merger that it was only worth about $2 million at the time of the offering.
The failure of the ADE program can be attributed to several of the concerns outlined above. The program managers were hampered by the lack of a clear objective: they were urged to invest in firms pursuing technologies relevant to the ongoing businesses of Analog and Amoco, to obtain options to acquire firms that interested Analog's management, and to generate high financial returns. Analog Devices' researchers, who saw scarce resources being devoted to ADE, resented the program. Amoco only committed to fund the program for five years, much less time than was needed to grow the early-stage companies. Finally, the incentives of the various parties appear to have been improperly aligned. Not only did the management of ADE believe that they were insufficiently rewarded, but Amoco did not share in the profits generated.
Consequently, concerns linger about attempts to replicate the success of venture capital firms in the corporate setting. The previous two surges in corporate venture capital, like today’s activity, were stimulated by well-publicized successes of independent venture investors. When their initial venture investments faltered in the past, corporations rapidly abandoned their programs. Avoiding the mistakes of the past is a major challenge for corporate venture capital programs today. In this module, we will explore how one corporate venture fund is seeking to address these challenges.
It is interesting to note that the primary motivation in 1946 for the founders of the world’s first private equity fund, American Research and Development, was largely not the creation of profits. Rather it was the encouragement of economic growth in the United States and New England. As founder (and former Harvard Business School professor) General Georges Doriot responded, when confronted by some investors who complained about the slow progress of many of his investments:
You sophisticated stockholders make five points and sell out. But we have our hearts in our companies: we are really doctors of childhood diseases here. When bankers or brokers tell me I should sell an ailing company, I ask them, "Would you sell a child running a temperature of 104?" [ Patrick Liles, Sustaining the Venture Capital Firm, Cambridge, Management Analysis Center, 1977, page 70.]
While American Research and Development sought to combine social goals with profits, the Small Business Investment Company (SBIC) program is generally regarded as the first explicit "social venture capital" endeavor. This program was launched by the U.S. government in 1958 in the aftermath of the Soviet Union’s launch of the world’s first satellite, Sputnik. The level of social venture activity remained relatively modest until the late 1970s. During the past fifteen years, over one hundred state and federal initiatives have been launched. European and Asian nations have also undertaken many similar initiatives. While these programs’ precise structures have differed, the efforts have been predicated on two shared assumptions: (i) that the private sector provides insufficient capital to new firms, at least in certain regions or industries, and (ii) that the government can identify firms where investments will ultimately yield high social and/or private returns.
While the sums of money involved are modest relative to public expenditures on defense procurement or retiree benefits, these programs are very substantial when compared to contemporaneous private investments in new firms. For instance, the SBIC program led to the provision of more than $3 billion to young firms between 1958 and 1969, more than three times the total private venture capital investment during these years. In 1995, the sum of the financing provided through and guaranteed by social venture capital programs in the United States was at least $2.4 billion. This sum was substantial relative to the $3.9 billion disbursed by traditional venture funds in that year. Perhaps more significantly, the bulk of the public funds were for early-stage firms, which in the past decade have only accounted for about 30% of the disbursements by traditional venture funds. Some of America’s most dynamic technology companies received support through these programs while still private entities, including Apple Computer, Chiron, Compaq, Federal Express, and Intel. Public venture capital programs have also had a significant impact overseas. Germany, for instance, has created over the past two decades about 800 federal and state government financing programs for new firms, which provide the bulk of the external financing for technology-intensive start-ups.
Many of the same problems that haunt corporate venture programs, however, also bedevil social venture initiatives. Among them are the difficulty of balancing multiple objectives, the investors’ frequent failure to appreciate the long-run nature of these investments, and the struggle to design appropriate compensation schemes. In this module, we will examine one community development venture fund’s efforts to overcome these barriers.
Practitioner accounts and studies about corporate venture capital:
Asset Alternatives, "Corporate Venturing Bounces Back, With Internet Acting as Springboard," Private Equity Analyst, 6 (August 1996) pages 1 and 18-19.
Zenas Block and Oscar A. Ornati, "Compensating Corporate Venture Managers," Journal of Business Venturing, 2 (1987) pages 41-52.
Norman D. Fast, The Rise and Fall of Corporate New Venture Divisions, Ann Arbor, UMI Research Press, 1978.
G. Felda Hardymon, Mark J. DeNino, and Malcolm S. Salter, "When Corporate Venture Capital Doesn't Work," Harvard Business Review, 61 (May-June 1983) pages 114-120.
E. Lawler and J. Drexel, The Corporate Entrepreneur, Los Angeles, Center for Effective Organizations, Graduate School of Business Administration, University of Southern California, 1980.
Kenneth W. Rind, "The Role of Venture Capital in Corporate Development," Strategic Management Journal, 2 (April 1981) pages 169-180.
Robin Siegel, Eric Siegel, and Ian C. MacMillan, "Corporate Venture Capitalists: Autonomy, Obstacles, and Performance," Journal of Business Venturing, 3 (1988) pages 233-247.
Practitioner accounts and studies about social venture capital:
Peter Eisenger, "The State of State Venture Capitalism," Economic Development Quarterly, 5 (February 1991) pages 64-76.
Peter Eisenger, "State Venture Capitalism, State Politics, and the World of High-Risk Investment," Economic Development Quarterly, 7 (May 1993) pages 131-139.
Josh Lerner, "The Government as Venture Capitalist: An Empirical Analysis of the SBIR Program," Harvard Business School Working Paper #96-038, 1996.
Charles M. Noone and Stanley M. Rubel, SBICs: Pioneers in Organized Venture Capital, Chicago, Capital Publishing, 1970.
Steven J. Waddell, "Emerging Socio-Economic Institutions in the Venture Capital Industry: An Appraisal," American Journal of Economics and Sociology, 54 (July 1995) pages 323-338.
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