The lifecycle of corporate venture capital

As opposed to producing innovation internally through research and development (R&D) or purchasing external innovation through mergers and acquisitions (M&A), corporations create corporate venture capital (CVC) divisions to make systematic minority equity investments in early-stage entrepreneurial ventures. Consider, for example, GM Ventures, the CVC unit initiated by General Motors in 2010. On behalf of General Motors, GM Ventures invested in dozens of auto-related technological startups, including automotive cleantech, advanced materials, among other fields, through minority equity stakes. The case of GM Ventures is hardly an isolated occurrence. According to US trade body the National Venture Capital Association, CVC investments accounted for about 20% of venture investment in 2015, and are undertaken not only by technology firms in the media spotlight but also by moderately-sized firms in a variety of industries.

Firms state that they conduct CVC investment to acquire information – that is, to gain exposure to new technologies and markets which in turn benefit their capacity for innovation and broader corporate decisions. As GM Ventures states, its mission as a CVC is to “invest in growth-stage companies to enhance GM’s ability to innovate”. Theoretically, this information acquisition rationale echoes a long-held framework in the economics of managing and organising innovation. Under this framework, the innovation process is framed as a two-stage sequential process, in which firms acquire information and generate ideas – first stage – before they invest in and produce those ideas – second stage. Focusing on CVC provides a uniquely valuable empirical setting to understand how firms seek out and generate new ideas in the broad innovation process.

Motivated by the empirical significance and value of CVC for understanding the process of innovation, in a recent paper, The Lifecycle of Corporate Venture Capital, I develop empirical tests to assess how established corporations use CVC as a way to acquire information and technological knowledge from the highly innovative entrepreneurial sector. Those tests examine each stage of a CVC, from why it is initiated, to how it is operated, to when it is terminated. The results establish an investment pattern, labelled the CVC lifecycle, that shows how CVC fits into the process of corporate innovation – firms in need of catching up with new innovation knowledge launch CVC activity; they invest in portfolio companies at the frontier of related technologies and use valuable information and knowledge gained through CVC; and they terminate CVC after regaining an edge in innovation, therefore informational benefit shrinks – lending support to the information acquisition rationale. Based on these findings, I further explore alternative forces that could determine CVC investment and the management of innovation in general, as well as the implication of the CVC lifecycle on corporate innovation at both the firm and industry levels.

CVC initiations: the effect of innovation deterioration

What motivates firms to initiate a CVC program in the first place? The CVC lifecycle begins with the initiation stage, in which a firm launches CVC investment, typically following a period of deteriorating internal innovation. That is, when firms experience a decline in internal innovation, and therefore can benefit from potential informational gains by connecting to highly innovative entrepreneurs, they are more likely to initiate CVC investment.

Four years before initiating their CVC units, CVC parents were more innovative than their peers, producing around 35% more patents each year. This advantage shrinks continuously by about 25% until the year of CVC initiation. CVC parent firms’ innovation enjoys 15% higher average citations compared with their industry peers four years before CVC initiation, and this number decreases to well below 0 at the time of CVC initiation. This performance deterioration pattern can be found in other corporate performance measures, such as return on assets and sales growth.

Looking closer at the technological profiles of those CVC parents, I find that innovation owned by this group of firms becomes obsolete much faster during the years leading to CVC initiation. Specifically, those CVC parent-owned innovations are less likely to be cited and appear to be lagging in the technological upgrade. This does not mean, however, that the whole industry of CVC investors is becoming obsolete. In fact, CVC activities in an industry typically cluster – forming industry CVC waves – during periods when the industry is undergoing an important technological change and expansion of new innovation. Within those industry waves, it is those whose technologies are negatively affected by the technological upgrade that initiate CVC units to keep up with the evolution.

CVC operations: select, acquire and integrate information

How do CVCs select and use information and innovative knowledge? At the operation stage of the CVC lifecycle, I examine how CVC units strategically select which portfolio companies to acquire information from. I find that CVCs primarily invest in startups that are innovating in technological areas that are close to the parent firm, suggesting that CVCs prefer to invest in companies whose technologies can be adapted to parent firms’ innovation. Interestingly, the portfolio companies appear to possess incremental knowledge, measured using fewer previous overlaps of innovation profiles and patent citations, which suggests that CVC parents aim to acquire updated knowledge with higher informational gain. This means, for example, that an automobile CVC parent firm is likely to invest in an engine startup, particularly when this startup specialises in cutting-edge cleantech that the outdated parent firm does not possess.

Can parent firms efficiently use CVC-acquired information, and how? I perform two analyses to isolate how CVC-acquired information is incorporated into parent firms. First, CVC parent firms appear to internalise acquired knowledge through research incorporating the information acquired from their portfolio companies. I find that after a CVC invests in a startup, the parent firm becomes more likely to use technologies produced in this startup, and this move in general leads to better quality innovation. Second, it capitalises on information by gaining efficiency when making information-sensitive decisions, such as external acquisitions of companies and innovations.

I identify one important channel that CVC parents manage actively to facilitate the information acquisition process – human capital renewal. Indeed, inventors, usually highly-educated scientists and engineers, are key in absorbing, processing and using information to produce innovation. I find that CVC parent firms have 11.9% more inventors leaving the firm than in the period before CVC investment. The vacancies created by leavers are filled by newly-hired inventors – CVC parents hire about 11% more new inventors compared with the years before CVC investment, benchmarked by their industry peers. Is that new blood crucial for the firm? The answer is a firm yes. New inventors contribute significantly to the CVC parent’s innovation, particularly that involving technologies learned from portfolio startups.

CVC terminations: staying power and investment dynamics

In a frictionless world, CVC parents would want to keep investing in CVC to acquire information from entrepreneurs. With frictions, however, CVC could become less appealing as the parent firm’s internal innovation recovers. When do firms terminate their CVC operations and what can those terminations tell us?

The CVC lifecycle ends with the termination stage, when CVC parents stop making incremental investment in startups, typically when internal innovation begins to recover. The median duration of the lifecycle is about four years, and a significant portion (46%) of CVCs invest actively for three years or less. When CVC divisions last more than four years – 27% of firms operate CVCs for more than 10 years – firms typically hibernate CVC activities during years when internal innovation remains productive. This evidence is consistent with the information acquisition rationale, which predicts decreased CVC activity when the marginal benefit shrinks after information is assimilated into parent firms.

One might conclude that the short average CVC lifecycle indicates that some CVC parent firms are incompetent in the VC business and thus terminate their CVC divisions too quickly. To rule out this concern, I calculate the success rate of deals invested by CVCs categorised by CVC durations, where an investment deal is defined as a success if the entrepreneurial company was acquired or went public. Success rates of investments do not correlate with CVC duration, and are inconsistent with the idea of CVC incompetence. When examining the industry-year adjusted innovation measures, we observe statistically significant improvements at the CVC termination point compared with the initiation stage – larger improvements of innovation from the initiation year motivate parent firms to terminate CVC investment.

Conclusion

In this study, I present the CVC lifecycle in the course of examining a CVC’s role of acquiring information in the process of innovation. Essentially, the CVC unit serves as a transitory information-acquiring step in regaining an upward innovation trajectory through connecting to the entrepreneurial sector, typically after a firm experiences a deterioration in internal innovation. 

This is an edited extract from the full paper available at: faculty.som.yale.edu/songma/

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