With most of the venture capital industry in dot-com shock, corporate investors are trying to take up the slack. They can stay in the game because profit isn’t their only motive.
By Steven Brull
June 2001
Institutional Investor Magazine
With most of the venture capital industry in dot-com shock, corporate investors are trying to take up the slack. They can stay in the game because profit isn’t their only motive.
Executives at Knight Ridder could scarcely believe their good fortune. As the dot-com bubble inflated, the publishing giant’s $1 million investment in Netscape Communications Corp. had suddenly ballooned to $38 million. Emboldened, Knight Ridder followed Netscape’s 1995 IPO bonanza by making venture capital investments in wireless systems developer InfoSpace, online grocer Webvan Group and consumer information portal Zip2 Corp., among other hot technology prospects. But over the past half year, as those holdings’ values collapsed and its core business softened, Knight Ridder had had enough. “We’re out. We’ve exited. We’re going to sit on the sidelines for a while,” says Polk Laffoon, vice president of corporate relations.
Last year, before such second thoughts set in, a record-high 312 corporations had venture investing programs, nearly double the number in 1999 and almost eight times as many as in 1996, according to The Corporate Venturing Report, a newsletter published by Asset Alternatives. Corporations accounted for $17 billion, or roughly 17 percent, of venture capital investments last year, compared with only $1.3 billion (8 percent) in 1997. But they are hitting a wall. Knight Ridder and others that dived enthusiastically into the venture capital pool, only to get a bad case of the cramps when the waters turned chilly - including Amazon.com, Comdisco and Starbucks Corp. - are in the vanguard of a rapid and potentially wrenching retreat.
If the economy stays on its present, slow-growth course, fewer than 100 corporate venture programs will be active a year from now, reckons Jesse Reyes, a vice president of Venture Economics, an industry research firm, in Newark, New Jersey. The exodus will reinforce the reputation of corporate venture capitalists as notoriously fickle, “dumb money” that jumps on the bandwagon late, pays high prices and bails out as soon as trouble hits - like when it’s time for general corporate cutbacks, says Reyes. “The riskiest part, and the easiest to get rid of, is corporate venturing.”
But this shakeout will be different in one key respect: There is a surviving core of corporate investors that have deep pockets and a genuine, longer-term calling; namely, the pursuit of strategic benefits directly linked to their main lines of business.
Nokia Corp. of Finland, for one, makes equity investments to promote new wireless technologies and mobile commerce. Patrick Lilley, CEO of Digital Transit, a Dana Point, California, software company that received $1 million of first-round funding from Nokia Venture Partners, says the money is only part of the deal. “It gives us an immediate credibility boost,” he says, adding that Nokia is “well connected in the mobile wireless industry and helps us hire operational people - and not just analysts or others without real experience. They’ve helped on not only a Rolodex basis but also an operational basis.”
There are dozens of others proclaiming that strategic interests will sustain venture capital programs through any cyclical downturn. Intel Corp. invests all over the high-tech map in hopes of making its computer chips ever more ubiquitous. General Electric Co.'s GE Equity and J.P. Morgan Chase & Co.'s LabMorgan are especially active in financial and e-commerce innovations. Motorola and Qualcomm share Nokia’s interest in, as Lilley puts it, “seeding the wireless market environment for strategic benefit.”
Says Warren Holtsberg, director of Motorola Ventures: “Our goal is to accelerate existing businesses, get talent and open new markets. We’re looking for an advantage in the marketplace - not necessarily an acquisition or IPO.”
To be sure, Motorola and other troubled technology companies may not be sounding so noble as they work through current financial difficulties. But high-tech companies have another incentive to stay in the venture capital chase: They see the investments as complementing or augmenting internal research and development activities. Indeed, top executives have grown increasingly skeptical of the classical, ivory-tower R&D model, in which scientists pursue long-term projects with almost no regard for profit-and-loss considerations. “There’s a lot of science done that’s not the best, and it’s not of much practical use,” says Joshua Lerner, a professor of business administration at Harvard Business School. Corporate venturing alone won’t replace R&D. But it can play a strategic role in combination with alliances, acquisitions and enhanced collaboration with universities. At Microsoft Corp. - which has some $18 billion of investments in other companies and a $4 billion R&D budget - the R&D total includes $250 million for research, of which 15 percent goes directly to universities, according to CEO Steve Ballmer. Despite market pressures, “we’ve never felt more excited about our research investment,” Ballmer told a conference in March sponsored by the Association for Computing Machinery.
Corporate venture programs can seem problematic even when times are good. Such investments typically mature over five to ten years, during which changes in corporate agendas and transitory pressures on earnings and share prices are almost inevitable. Compensation is another thorny issue, since most CEOs are loath to pay higher salaries than their own to in-house investors; that could happen easily if investors took home a 20 percent share of investment returns, as is typical among conventional venture capitalists. “The challenge is to make sure that a company’s strategic goals don’t end up making it tactically impossible for the corporate venture team to operate,” says Lerner. The solution? Most successful programs are insulated, to some degree, from their corporate parents. Survivors will tend to be big, well-positioned technology firms that allow the leeway.
They’ll have to be solid to survive the venture capital market downdraft. Last year all venture firms invested a staggering $102.55 billion, an increase of 64 percent from the year before. This year spending is on a pace to fall below $50 billion, according to Venture Economics. Returns in the fourth quarter of 2000 were -6.3 percent, the first deficit since 1998 and the fourth consecutive quarter of declining returns. Sources of funding have grown scarce - though sitting on an estimated $35 billion of committed money, venture capital funds have begun to say no to new investors - as have outlets for those funds. In December Geocapital Partners returned some $200 million it had raised.
Corporate venture capitalists have slowed their investing pace in lockstep with the independents, partly because they often co-invest in the same deals. Still, some see no reason to give up. “There are obviously some challenges these days, but the opportunities are great for people who have staying power,” says Michael Fisher, a managing director at GE Equity, a unit of General Electric Co.'s GE Capital Corp. financial services subsidiary.
If any corporation has the wherewithal to stay in the hunt, it’s GE, now the biggest in the world in market capitalization and second only to Intel last year in number of corporate venture capital deals (95 versus 176). GE’s portfolio approaches $5 billion; about 10 percent of it is in 40 companies in the financial services and health care group co-headed by GE Capital veterans Fisher and Jerome Marcus. GE has also invested in the business services, media and Internet, and technology and communications categories - all strategically linked to its various core businesses. For example, in the case of TelePacific Communications Corp., a Los Angeles-based broadband company, GE provided a $50 million credit facility in 1999 and followed last year by taking a $15 million equity position.
“We’re not traditional VCs,” Fisher is quick to point out. And don’t GE’s portfolio companies know it, because this is one active and involved investor that puts them through their paces. “It may disappoint some people when we don’t go in and rubber-stamp their proposals, but we have to answer to our management,” says Fisher. He adds that an unyielding devotion to “the fundamentals” limited their exposure to dot-coms, which may explain why they sound more optimistic than some counterparts at other firms.
GE generally invests at least $5 million for a 5 to 49 percent interest; the biggest financial sector stake is $50 million in the well-established transaction processor First Data Corp., linked to a credit card servicing contract. GE sees big opportunities in transaction processing and promotes intercompany synergies: It owns pieces of Dione, a U.K.-based maker of point-of-sale terminals; Gemplus of France, the leading manufacturer of smart cards; and PaySys International, a credit card software vendor. The portfolio companies have relationships with one another, and GE owns lending institutions that can offer business financing and profit from consumer credit.
The management disciplines lionized in many a business book and magazine article as “the GE way” filter out through the private equity relationships. The company views its investment targets as business partners; GE executives sit on their boards and will seek out joint selling opportunities. GE will often become a major customer of its partner, as happened in the case of Noosh, a Silicon Valley firm that automates the procurement of printing and documentation services. Marcus led that investment and serves as a Noosh director. As part of the deal, GE trained Noosh’s management in its vaunted Six Sigma quality assurance program. Says Marcus: “These young companies are selling to some very large and demanding customers. Six Sigma makes them better at it” - and, GE hopes, a stronger complement to its own business-to-business commerce services.
Not all corporations are so meddlesome. Intel, the largest corporate venture capitalist, doesn’t take board seats. It aims squarely at promoting the microprocessor business. “You can hardly see an Intel business initiative without an investment component,” says Leslie Vadasz, the feisty 65-year-old who runs Intel Capital and who, because of a clerical error when he joined Intel in 1968, got employee badge No. 3, one ahead of chairman Andrew Grove. “We’re working to create a market ecosystem from end to end, to accelerate its development,” Vadasz explains. Intel can boost revenues significantly by accelerating demand for its products before they fall prey to commoditization. In 1998, for instance, Intel invested in Red Hat, a leader in open-source Linux software. The relationship smoothed the way for Red Hat to optimize its code for Intel’s processors, satisfying Intel customers keen to embrace Linux.
Intel has lavished billions to help nurture software, content, applications and technology companies - $3 billion for more than 600 companies in just the past three years. Over time, once it deems that strategic goals have been met, Intel liquidates its positions, as would a conventional venture investor. The focus on strategic benefits leads to smarter investment decisions, Vadasz says. “The first question we ask is, ‘Is Intel going to be helped?’ If the answer is no - I don’t care, we don’t invest.” Still, to ensure financial rigor, Intel always co-invests with other venture capitalists while allowing its in-house specialists enough autonomy to make hard decisions. “You need a somewhat independent bastard like me who is not 100 percent aligned with every business unit,” Vadasz adds.
Nonetheless, in the sobering aftermath of the dot-com implosion, critics say Intel Capital grew too fast and lost discipline. Says one venture capitalist: “They got too promiscuous and sprayed too much money around and changed from a ‘strategic-window-on-technology’ focus to a ‘let’s-make-a-deal’ focus. The investment tail was wagging the strategic dog.” Alleged excesses include investments in eToys, which folded in April, and in a Chinese Internet portal, from which Intel disinvested earlier this year.
Vadasz disagrees, arguing that eToys returned several hundred percent. In addition, Intel helped eToys optimize its software for the Pentium III processor, spurring demand for the chip. As for portals, investments in China and elsewhere provided insights into cultural aspects of the Internet overseas and promoted overall development of the Internet, he says.
Yet the dot-com mania pumped up Intel Capital’s portfolio to a scale that would challenge any venture capital firm. Last year, for instance, Intel averaged nearly one new investment per day and an IPO a week. Meanwhile, portfolio gains in 2000 soared to $3.76 billion from $883 million in 1999; that contributed nearly one third of Intel’s 2000 earnings of $12.1 billion.
This year’s meltdown, particularly of Nasdaq-listed shares that Intel Capital owns, caused the portfolio to shrink to $3.3 billion as of March 31, well below the $10.8 billion peak a year earlier. Intel Capital reported no net gains during the first quarter.
From the outside, Intel Capital appears to be in flux, if not retrenching. Stephen Nachtsheim, 56, a vice president and director, is retiring in June. And four new executives were named to senior positions. Intel admits that it’s running “significantly behind” in its goal of matching last year’s investment total of $1.3 billion. But Vadasz plays down talk of a major shakeup: “In the U.S. there’s been restructuring along more logical lines because we’ve been very horizontal. Now the groups are better segmented.” He says a bigger organizational change relates to a beefing up of international operations. Investments outside North America, now 35 percent of the total, will reach 50 percent in several years, he notes.
To insulate a venture program from corporate pressures, some firms have essentially outsourced investment picking, relying on top-flight venture capitalists who make return on investment the top priority. Lucent Venture Partners, for instance, was set up in 1998 as a semiautonomous division of Lucent Technologies. Lucent provides the capital, but the compensation of Lucent Venture Partners employees is in line with that of conventional venture capitalists, says John Hanley, managing partner.
Over the past three years, Hanley has invested in about 50 firms, of which 42 remain active and about one third have some sort of alliance with Lucent - from supply deals to technology transfers to acquisitions. A big transaction occurred in May 2000, when Lucent acquired Chromatis Networks, a company with technology that cuts in half the cost of building metropolitan fiber-optic networks. Lucent Venture Partners held 7 percent; Lucent Technologies acquired the rest in a stock transaction that valued Chromatis at $4.5 billion.
Even as Lucent Technologies hemorrhages billions in red ink (which made it receptive to Alcatel’s takeover overtures), it plans soon to announce an increase in its venture capital commitment, now totaling $250 million in two funds. “We view LVP as an important component of long-term strategy, and we look to it to identify and support technologies and market approaches,” says William O’Shea, Lucent Technologies executive vice president in charge of corporate strategy and business development.
To assure independence, Nokia in 1998 set up Nokia Venture Partners in Menlo Park, California, more than 6,000 miles away from the Finnish company’s headquarters. Its $650 million fund, most of it from Nokia Corp., aims to develop the wireless Internet, but it stresses principles that guide conventional venture capitalists. “We’ve been driven by return on investment from the start,” says founding partner John Malloy. “Nokia doesn’t have participation in investment decisions on a per-deal basis, but we share the same road map,” adds John Zeisler, a veteran Silicon Valley operator who joined as a partner in April. “The great thing is that Nokia is always learning from every entrepreneur who comes in the door.”
Malloy points to a 1999 investment in PayPal, which has enrolled nearly 8 million members in its person-to-person Internet payment service. Especially popular among eBay auction participants, Palo Alto-based PayPal is spreading internationally and moving beyond computer desktops to mobile devices. In March it closed a series-D round, adding $90 million to total investments exceeding $200 million, with institutions such as ING Group of the Netherlands and Providian Financial Corp. of San Francisco taking equity positions with a strategic purpose.
Malloy sits on the board of PayPal and other NVP investments. He stays in close touch with Nokia president Pekka Ala-Pietil,, an NVP advisory board member. There are also weekly conferences with the venture arm’s partners, two of whom are based in Helsinki.
Even so, the arm’s-length arrangement means interests aren’t always aligned. For instance, Nokia Venture Partners, along with Sony Music Entertainment, invested early in MongoMusic, an advanced music search system. Nokia deemed the technology crucial to the delivery of music to mobile phones and other handheld devices. But last fall Microsoft spent an undisclosed sum to acquire Mongo, which is now central to its MSN Music Service. Nokia then joined forces with Real Networks and Beatnik, which are developing a rival service. Zeisler says that Nokia prefers not to end up as the owner of start-up companies. “We’d rather make it a stand-alone company.”
That attitude appeals to Lilley of Digital Transit, which develops technology for dynamic over-the-air updating of mobile-device software. “Did we see a risk of becoming beholden to No-
kia?” says Lilley. “Sure, when we started talking to Nokia Venture Partners, that was a concern. But as we went further, two interesting things were borne out: One, NVP is closely affiliated with Nokia, but it’s a limited partnership that’s separate; their charter is not to be an acquisition mill for Nokia.”
Second, “NVP has been active with us but has not put any pressure on us at all to not work with competitors of Nokia. In fact, their belief is that maximum financial return will come from us getting widespread adoption in the mobile space. We don’t want to be in a situation where Nokia is the only investor from the mobile wireless space. But we do want NVP to participate in future rounds.”
Lilley says that Digital Transit is closing in on a second investment round that will raise $10 million to $12 million, with participation from other corporate investors that he declined to name. The company forecasts profitability in late 2002.
As corporate VCs seek ways to avoid the troubles of their hard-pressed parents, collaboration with traditional venture capitalists is on the rise. Most on the corporate side prefer to let conventional firms take the lead, if only to provide reality checks on start-ups’ business plans. The traditional groups, in turn, benefit from the fact that corporations, to the extent funding stays available, tend to be more stable than other investors, largely because of the strategic connection. At least, that’s the abiding hope.
“With the IPO market shut, and mergers and acquisitions the route to liquidity, who better to have in a deal than the most strategic of partners, a corporation that can help create the M&A event,” says Larry Buchsbaum, director of e-sourcing strategies at the Boston-based research firm Yankee Group.
“I laugh at the concept of corporate VCs being dumb money,” says Jeff Jacobs, who runs a $500 million venture fund for Qualcomm, the San Diego, California-based champion of cellular technology founded by his father, Irwin. “There can’t be much smarter money in terms of people who understand the market and the technology and have relationships in place.” So long as the likes of Lucent and Motorola don’t go under, that strategic refrain will ring ever more true.
