Can Big Companies Become Successful Venture Capitalists

STRATEGY

Can big companies
become successful
venture capitalists?

50 THE McKINSEY QUARTERLY 1998 NUMBER 2

Maybe, but first they need to understand what makes the model work

Four good reasons to try… pick only one

Paul Brody and David Ehrlich

T’S HARDLY SURPRISING that big companies are attracted to the venture

I capital (VC) model for new business development.* Its track record is
enviable: the industry as a whole outperformed the S&P 500 in five of
the past six years, and US venture-backed companies have raised more than
$40 billion in initial public oƒferings since 1990 (exhibit). Moreover, the model
tempts management with the prospect of improved access to business
innovation, better retention of entrepreneurial talent, and greater growth in
demand for core products.

Yet more oƒten than not, big company attempts at applying the VC model
produce disappointing results. Most find it diƒficult to establish the systems,
capabilities, and cultures that make good VC firms successful. Corporate
managers seldom have the same freedom to fund innovative projects, or to
cancel midstream those that clearly won’t live up to promise. Their skills are
typically honed for managing mature businesses, not nurturing startup eƒforts.
And they lack vital contacts in the startup community.

Even so, big companies can apply the VC model successfully. Consider
soƒtware manufacturer Adobe Systems, which launched a $40 million venture
fund in 1994 to invest in companies strategic to its core business, such as
Cascade Systems Inc and Lantana Research Corporation. So successful has
this eƒfort been in boosting demand for its core products that Adobe recently
launched a second $40 million fund.

If a firm is to apply the VC model successfully, it must first understand those
characteristics of the model that are essential to success, and then tailor its
VC program to its own circumstances without losing sight of these essentials.
Above all, it needs to be absolutely clear about its reason for launching the
≠ For the purposes of this article, we focus primarily on startup or early stage VC financing.
We would like to thank Nobuo Domae, Doug Harned, Wolfgang Huhn, Sarah Kaplan, Tetsuo
Komori, Jürgen Laartz, Seongyeon Lee, Wayne Pietraszek, Eberhardt Schmidt, Lothar Stein,
Sungwon Suh, and Jim Wendler for their contributions to our thinking.

Paul Brody, formerly a consultant in McKinsey’s Los Angeles oƒfice, is a specialist in high-
technology markets at i2 Technologies; David Ehrlich is a consultant in the Kuala Lumpur
oƒfice. Copyright © 1998 McKinsey & Company. All rights reserved.

THE McKINSEY QUARTERLY 1998 NUMBER 2 51

CAN BIG COMPANIES BECOME SUCCESSFUL VENTURE CAPITALISTS?

Venture capital’s track record
Annual returns 1991–97 Funds raised in US venture-backed IPOs
Percent $ million
US VC industry 1980 420
S&P 500 Top VC
firms earn 1981 770
1992 11.6 an ROI 1982 548
7.6 20–30% 1983 3,031
above
1993 18.8 industry 1984 743
10.1 average 1985 843
1994 13.1 1986 2,128
1.3 1987 1,839
1988 788
1995 49.5
1989 996
37.6
1990 1,188
1996 40.3 1991 3,732
22.9 1992 4,317
1997 28.7 1993 5,033
33.3 1994 3,581
Source: Private Equity Performance 1995 6,736
Database, April 1998, Venture Economics 1996 12,070
Information Services; S&P 500 Composite
Daily Return Index 1997 4,750

program. Is it to capture more value from strategic assets? To keep up with
the pace of innovation in a fast-moving industry? To boost demand for core
products? The answer has far-reaching implications for the design of an
eƒfective program.

Six essential characteristics of the VC model
Success in the venture capital industry rests on six essential characteristics.
Each poses a challenge for managers in a corporate setting.
Clarity of focus
Venture capital firms have a simple goal: take a pile of money and make it
bigger. Their steady focus on financial returns facilitates decision making:
all VC professionals have the same ultimate objective, and their performance
is easily measured. In addition, VC firms usually have a clear idea of what
constitutes an attractive investment. They are likely to focus on specific
industry niches; to look for business concepts that will excel if the industry
evolves as they believe it will; and, most important, to insist on the presence
of a strong management team.

Although corporate managers oƒten have just as clear a strategic focus in
their core business, they typically run into greater ambiguity with venture
programs. Their biggest challenge is to establish clear, prioritized
objectives. Simply making a good financial return is unlikely to be
suƒficient, while other objectives – acquiring new technologies, entering
new markets, reenergizing corporate culture – oƒten compete for attention.
Moreover, corporate managers are unlikely to receive the regular exposure



to new ideas that VC firms enjoy, and the criteria they use to evaluate
ideas are oƒten intolerant of the risks inherent in launching a new type
of business.
Willingness to weed out the losers…
Venture capital firms view each funding decision not as a project approval
but as an option on future decisions. They reduce their exposure by investing
in small increments until the key risk factors are resolved. With only one in
ten ventures becoming a hit, VC firms manage their portfolios ruthlessly,
weeding out likely losers early. Cutting losses on failing ventures can make a
big diƒference to overall returns.

Abandoning ventures in this way has never been easy for large corporations,
whose projects are oƒten underpinned by personal relationships, political
concerns, and vague strategic objectives. In addition, many make funding
decisions as part of an annual budgeting cycle rather than in accordance with
project-specific milestones.
…and support the potential winners
Struggling startups are oƒten in need of seasoned managers. “The real
shortage is not ideas or money,” several VC firms told us, “it’s management
talent.” The best VC firms supply both guidance and management resources.
They oƒten sit on the boards of the companies in their portfolio, oƒfering
advice based on years of startup experience. They also search for and develop
lasting relationships with skilled entrepreneurial managers.

Leading VC firms are renowned for their dedication to finding top talent
for their ventures. Kleiner Perkins Caufield & Byers hires entrepreneurial
managers as CEOs in waiting, keeping them on hand for a portfolio
company in need. Such firms also build up active networks with large
corporations, helping develop strategic relationships when a portfolio
company is in need of manufacturing expertise, a specific technology, or
access to a particular market.

Rich in talent though they may be, large corporations oƒten struggle to find
managers with startup experience. Approaches that work well in a corporate
environment may fail when decisions need to be made quickly on scant
information. Worse, the most appropriate corporate partner for a new venture
may turn out to be a competitor of the parent company, making it diƒficult for
the venture to secure access to important capabilities.
Knowing when to quit
The fourth characteristic that distinguishes the successful VC firm is a
readiness to terminate investment when the firm can no longer bring
distinctive value. Most VC firms boast expertise in managing startup risk



and growing new companies, but readily admit their inexperience when it
comes to adding value to mature businesses.

Corporate managers, on the other hand, usually do possess the skills to
manage a venture that has reached maturity. They are oƒten justified in
keeping and supporting a business that has encountered growth pains. Even
so, a change in competitive dynamics sometimes makes getting out the right
decision. Unfortunately, the option of spinning oƒf or selling a venture that
has run into trouble is seldom considered until it is too late.
Flat organizations and quick decisions
Venture capital firms share several attributes with the startups they fund.
They tend to be small, flexible, and quick to make decisions: even major
investments can be concluded in a few weeks, perhaps days. They have flat
hierarchies and rely heavily on equity and other incentive pay.

Corporate managers usually operate in a more traditional setting. Decisions
can take months, especially if large sums are involved. Where oƒfered, equity
and incentive pay rarely reach the share of overall compensation or the raw
amounts to which VC professionals are accustomed.
Reputation as attractive capital investors
VC firms rely heavily on their reputation and networks of personal contacts.
These are invaluable assets in identifying and gaining access to promising
ventures, and in finding skilled management to help lead them. Once a VC
firm has established itself as a successful incubator, it will be among the first to
gain access to the best new ventures and the hottest management talent.

Most corporate managers, by contrast, lack strong networks of contacts in
the startup community. Worse, corporations have a poor reputation as startup
investors; one entrepreneur describes them as investors of last resort. They
are notorious for imposing their bureaucracy on the companies in which they
invest, distracting busy entrepreneurs from getting their products to market.

Designing a tailored program
These diƒferences between VC firms and the typical corporation suggest that
most big companies face an uphill struggle in applying the VC model. The
key to success lies in tailoring a VC program to their particular circumstances
and capabilities, while keeping in mind the essentials just discussed.
Why are we doing this?
Clarifying and setting priorities for the objectives of a venture program is a
diƒficult but essential first step. When conflicts over goals remain unresolved,
unintended consequences may ensue.



Consider Apple Computer, which established a venture program in 1986 with
the dual objectives of earning a high financial return and supporting third-
party development of Macintosh soƒtware.*

Determined to avoid the mistakes of other corporate venture programs,
Apple modeled its compensation mechanisms, decision criteria, and operating
procedures on those of top VC firms. Thus, while the venture group
considered Macintosh support an initial screening factor, its funding decisions
and day-to-day management were aimed at optimizing financial returns.

The result was an internal rate of return of approximately 90 percent over five
years, but little success in improving the position of the Macintosh. The
program’s managers later admitted that the strategic potential of their
investments had not been realized. Moreover, the financial returns, though
attractive, had minimal impact on the company’s overall performance.

Seen in context, a venture program is simply one instrument for pursuing a
company’s business mission. As such, its primary objective should clearly
reflect the company’s overall strategy. In our experience, only four objectives
can legitimately claim to do so:

Improve the capture of value from strategic assets. Improving asset
utilization is most appropriate for companies able to exploit traditional assets
such as world-class manufacturing skills, extensive distribution networks, or
strong brand equity. If such a company lacks enough good product ideas to
capture full value from its assets, a venture program can provide a more
robust flow of ideas and the champions needed to turn them into marketable
products. Large pharmaceutical companies such as Merck and new product
proliferators like 3M have pursued venture programs for this reason.

Improve the capture of value from good ideas. Deriving more value from
ideas is most appropriate for companies that compete in a knowledge-
intensive industry and are good at generating ideas, but struggle to bring
many of them to market. Their diƒficulty could be, simply, such an abundance
of ideas that none gets adequate attention, or, more seriously, an inability to
match the speed to market of entrepreneurial rivals. (Xerox PARC in the
1970s is an oƒten-cited example of the latter.) A well-tailored venture program
can provide an avenue for pursuing a greater number of ideas, or inject a
much-needed dose of market focus and entrepreneurial spirit.

Respond more competitively in a rapidly evolving industry. Timely
response can mean survival. Incumbents in fast-moving industries may be
unable to innovate quickly or broadly enough to defend themselves against
≠ “Apple Computer – Strategic investment group,” case study, Stanford Graduate School of
Business, 1995.



new competitors. They may fear cannibalizing leading products, be uncertain
as to which way the industry will evolve, or simply have too conservative a
culture. No matter which, a venture program can provide a platform to boost
successful product innovation. Moreover, strategic bets can be used as a
defence mechanism to keep competitors from accessing key evolving tech-
nologies. Cisco Systems is one company that has successfully pursued a
venture program to gain control of important technologies.

Support demand for core products. This objective applies when the
demand for a company’s core products is aƒfected by the evolution of a
separate industry niche. A well-structured venture program can be useful in
shaping the direction of this evolution. Adobe Systems and Intel have both
pursued venture programs to support new technologies that drive demand for
their own core products.

Some might claim that earning superior financial returns is a legitimate
primary objective for a venture program. However, since a company’s
shareholders can decide for themselves to invest their money in a venture
fund, either directly or through institutional investments, there is no obvious
reason why they would wish the managers of their corporate capital to do
the same.

Internal or external programs?
Once a company has defined the objective of its venture program, it must
decide whether an internal or external program best serves its purpose.
Internal venture programs replicate all the characteristics of the VC model
within the company itself (although some involve a partial spinoƒf). A
venture board of company managers is set up to act as an internal VC firm,
and employees submit business plans to this board for funding. External
venture programs, on the other hand, involve establishing a company fund
for making investments in the wider startup community, either directly or
via established VC firms.

Although both approaches can help companies acquire new business lines, they
diƒfer in the other objectives they support and in the capabilities required for
successful execution. Choosing between them calls for careful consideration.
Internal programs
Internal programs are most appropriate for companies seeking to increase
the volume of ideas they generate, to capture greater value from their ideas,
or to increase internal entrepreneurialism. Such programs can help a com-
pany gradually transform its skills and culture as employees are oƒfered
entrepreneurial opportunities and see the rewards that accompany success-
ful innovation.



But internal programs can run into trouble if few of the required capabilities
exist in house. Whereas a company with distinctive skills in product engi-
neering, say, can use a venture program to improve the market orientation
of product development teams, a world-class manufacturer with little
experience of product innovation may struggle to generate an adequate
volume of new product ideas.

To implement an internal venture program successfully, companies must
adopt best practices at each of the four phases of investment:

1. Gathering ideas. Just as VC firms use industry expertise to narrow the
field of the ideas they consider, venture boards should set boundaries for idea
generation. This helps focus employees’ eƒforts on opportunities that will
make the most of the company’s strengths and knowledge and further the
venture program’s primary objective. Venture boards should also clearly
define and communicate their criteria for evaluation.

When idea generation needs priming, venture boards should resist shortcuts;
brainstorming alone seldom unleashes enough great ideas. Instead, they
should adopt a systematic process involving three steps: breaking traditional
patterns of thinking through creativity exercises or immersion in new
cultures; increasing knowledge through prolonged exposure to customer
needs; and generating ideas through structured exercises alternating with
unrelated diversionary activity. Lastly, they should be sure to get the
company’s most innovative employees involved, even if it means taking them
away from other priorities.

2. Evaluating ideas. Two important ingredients are oƒten missing in this
phase: experience and impartiality. VC professionals gain their experience
through years of apprenticeship, and have a strong incentive to make
impartial decisions. Corporate managers, on the other hand, rarely bring such
relevant experience to bear, and may find it diƒficult to ignore the broader
political context of their decisions.

The best way to inject experience and impartiality into the evaluation process
is also the hardest: finding a seasoned VC professional to take part. Another
approach to boost impartiality is to establish powerful incentive systems for
the venture board: for instance, tying members’ compensation to the long-
term performance of the ventures they support. Unfortunately, this too can be
diƒficult to implement, requiring complicated schemes for assessing venture
performance and accommodating changes in a board member’s position or
employment status over time.

3. Building business value. Venture boards, like VC firms, can improve their
performance by weeding out likely losers and throwing their weight behind



likely winners. To ensure that losers are spotted early, they should set up a
system of multiple funding “gates,” making only incremental investments and
encouraging venture teams to resolve key uncertainties between decisions.

Even then, venture boards may find it diƒficult to deny additional funding to
an existing program. Not only can political considerations get in the way, but
board members may be reluctant to cancel funding for a highly motivated
and skilled team. For this reason, it is important to find ways to reward “good
failures” generously, and to develop a clear set of post-venture career options.
This will encourage risk taking in an environment where many ventures fail,
and make it easier for board members to terminate projects pursued by
enthusiastic teams. Since many breakthrough innovations occur only aƒter
repeated failures have refined an entrepreneur’s understanding of a problem,
a venture program that does not reward learning through failure has little
chance of success.

To support likely winners, venture boards need to play a diƒficult double role:
supplier of resources and protector of the venture environment. The supplier
role can be vital. Rarely will a newly formed venture team have all the skills
it needs. Sometimes the missing capabilities can be found in house; if so, the
venture board must use its influence to free a star performer from other
duties. Or perhaps the necessary skills can be acquired only through
cooperation with a competitor; in that case, the venture board must facilitate
eƒforts to work with the rival, despite opposition from other managers.

The protector role is equally important. The venture board must establish a
culture that is truly entrepreneurial, perhaps much more so than elsewhere in
the company; it may feature new decision-making rules, work norms (dress
codes, working hours, hierarchy), and incentives. In such cases, success will
depend on a healthy separation from the parent company, as too frequent
contact can inhibit the formation of a new culture.

The board will also need to design an incentive system that motivates the
venture team to behave like entrepreneurs – probably working longer hours
and taking bigger risks, almost certainly becoming passionately involved in
the success of the venture. An appropriate system will include non-financial
elements, such as opportunities for advancement, prestige, and greater freedom
at work, as well as financial rewards. These systems can be diƒficult to design:
the earnings of a new company in its early years are a poor indication of value
creation. Moreover, the venture board may have to defend the incentive system
against resentment from employees outside the program who are not oƒfered
the same benefits.

Lastly, there are times when a venture poses a threat to an existing product
line. It is at such times that the venture is of greatest strategic value, and the



board’s protector role most essential. As one executive commented, “If I don’t
cannibalize my own products, someone else eventually will.”

One proven way to help venture boards succeed in their double role is to
appoint a respected senior executive to lead the program – one who has the
political weight both to obtain internal resources and to fend oƒf opposition.
It is critical that this executive have deep insight into the features of the VC
model and a passion for the culture of a startup. Otherwise, it is all too likely
that the venture’s culture and processes will come to resemble those of the
parent, sharply reducing the chance of success.

4. Exiting. As mentioned earlier, VC firms usually sell their interest before a
venture’s initial success has run out of steam. Large companies, on the other
hand, may have just the expertise needed to counter strategic challenges or to
optimize the business system as the market matures. They should determine
their long-term strategy – absorption, spinoƒf, or sale – only aƒter careful
consideration of a few key questions:
• How much value can be created by leveraging the parent’s capabilities
(for example, procurement and manufacturing scale, strategic planning
strength, distribution channels) more eƒfectively?
• How important to the venture’s long-term success is preservation of its
entrepreneurial culture?
• Would the venture be more valuable to a company with a diƒferent set of
skills, assets, or relationships?
• Can the venture be broken up into diƒferent businesses – for instance, a
product development business, a licensing business, and a marketing
business? If so, what type of organization would be the most natural owner
of each?
External programs
Compared with internal programs, external programs can provide access to
a wider variety of new products and technologies and generate better
opportunities for technology and skill transfer. They also oƒfer a chance to
block competitors from these very benefits. Finally, they represent a safer
financial bet, allowing a company both to spread its investments across a
more diversified portfolio and to leverage more easily the skills of professional
VC firms. External programs are thus the better solution for companies
seeking to import good ideas, play catch-up in a rapidly evolving industry,
hedge their bets across a broad array of nascent technologies, or shape the
development of a strategically important adjacent industry.

The companies most likely to succeed at external investment programs are
those that already have distinctive skills in forming partnerships and alliances



or strong relationships in the VC or startup community. Companies under
capital constraints, on the other hand, may prefer to avoid investing through
multiple VC firms, since bargaining leverage can be attained only by means
of a large-scale capital commitment.

The first step in an external program is to establish the role that VC firms
are going to play in the process. Companies have four options:
• Going it alone: setting up their own VC firm in competition with others.
• Co-venturing: forming a partnership with a VC firm on a specific invest-
ment. This is usually done when the company can bring a strategic asset to the
table to increase the value of the venture.
• Launching a “dedicated fund”: hiring a VC firm to manage a fund in which
the company is the sole investor.
• Investing in a “pooled fund”: investing in a standard VC fund along with
other investors.

The best way to understand the advantages and disadvantages of each is to
revisit the four phases of venture investment:

1. Gathering ideas. Gaining access to good venture ideas will be tough for
companies that decide to go it alone. Most companies lack good reputations
as startup investors and have few relevant relationships. Those entering the
business on their own may well get access only to those deals already turned
down by top VC firms.

Co-venturing can give a company better access to great ideas, while ensuring
that its own investment criteria play a role in selection. However, the number
of opportunities the company sees may be insuƒficient to meet program
objectives, since it will be asked to co-venture only when a VC firm believes
it has a unique contribution to make.

Dedicated funds provide a company with many benefits: the option of lever-
aging professional VC capabilities, exposure to a wide range of relevant busi-
ness ideas, and full access to portfolio company management. Their biggest
disadvantage is that since the company is the only investor in the fund, it must
provide all the capital. The scale of the commitment (typically $10 to $50
million) may impair the company’s ability to invest in a large number of
ventures or other programs (for example, co-venturing or pooled funds).

Pooled funds also make it possible to leverage professional VC capabilities,
while oƒfering exposure to the greatest number of deals. A common downside
is severely restricted access to portfolio company management. To protect
the entrepreneurial environment, VC firms usually exclude direct access as an



investor privilege. Indeed, a company may find that the returns from its
investment in a pooled fund are purely financial, with no access to portfolio
companies or information about other deals seen by the VC firm.

2. Evaluating ideas. When pursuing a go it alone strategy, managers should
replicate the best practices of top VC firms: develop deep expertise in the
target area, form strong relationships in the startup community, and establish
clear evaluation criteria based on program objectives. Hiring top VC talent is
highly recommended, though diƒficult.

If a company chooses to invest with the assistance of established VC firms, it
must also identify target firms and develop an eƒfective negotiating platform.
Although there are a great many VC firms in the market, only a few will
be attractive as investment partners. Most European and Asian firms, for
instance, provide funding to larger companies, acting more like merchant
banks or buyout firms than providers of early-stage capital. Moreover, most
firms specialize by industry and region. And notably, there are only a few top
VC firms that consistently implement the practices we have discussed.

Having identified the firms with which it wants to invest, a company faces
an even bigger challenge: developing a negotiating platform that will attract
a top VC firm while still promoting its own objectives. Working with VC firms
has recently become popular, and hordes of companies are now vying to work
with the few top firms. Amid such fierce competition, an eƒfective negotiating
platform has become vital.

Discussions with VC firms have identified three characteristics that make a
company an attractive investment partner:

• The willingness to invest a large capital sum ($5 million or more)
• The ability to bring value to portfolio companies through, for example,
market access, manufacturing expertise, or proprietary technology
• The qualities of a good VC investor: able to make quick investment
decisions, oƒten within a few weeks; tolerant of the natural ups and downs
of startup investing; consistent in investment goals and strategy over time;
respectful of the environment of the entrepreneur.

Just as important, companies should be aware that the interests of a VC firm
can easily conflict with their own. A company may be seeking technology
transfer opportunities, for instance, while the last thing the VC firm may want
is for a portfolio company to give away a valuable technology.

Companies must therefore make clear at the outset what they expect in return
for their participation. They can then safeguard their interests contractually,



or at least avoid investing in a losing proposition. They may want to address
such issues as access to business plans seen by the VC firm, contact with
portfolio companies, access to financing at preferred rates in later rounds,
and the blocking of direct competitors from similar privileges.

3. Building business value. To build value through an external program,
managers must develop mechanisms for pursuing their own investment
objectives without damaging the interests of their ventures. If a company
imposes too heavily on a venture in which it has invested, it may soon see
valuable entrepreneurial talent walking out the door. Conversely, if its
approach is too hands-oƒf, it may find that its objectives are not being met.
Companies should pursue a middle road, securing their objectives without
imposing undue hardship on their ventures.

Many companies will also need to overcome the “not invented here”
syndrome, a common barrier to successful technology transfer. One reason
why Apple’s venture program did not succeed in its strategic objectives was
that internal business divisions refused to adopt venture company
technologies, preferring to develop similar technologies for themselves, oƒten
from scratch. As a result, leading-edge products from some venture
companies focused on the more popular PC platform, never including a
Macintosh-compatible version. In this way, both Apple and its venture
companies were robbed of an important market opportunity.

Apple subsequently established a scheme more clearly focused on supporting
the Macintosh. In this strategic loan program, Apple’s line managers were
encouraged to sponsor loans to companies developing products for the Mac.
Although the program’s financial returns did not match those of the original
venture program, managers considered it far more successful in meeting
strategic objectives.

4. Exiting. Managers of an external program should develop a set of exit
criteria based on the program’s objectives. If these are primarily financial,
managers should adopt the same philosophy as VC firms. When a company
has invested through a VC firm, this decision is implicit.

If the objectives are not financial, managers should predetermine conditions
for terminating, continuing, or even increasing their investment. A financial
loss can be tolerated for quite a long time if important strategic objectives
are being met. But too oƒten a company holds on to an investment long aƒter
it should quit, simply because of inertia and undefined exit criteria.

The venture capital industry has attracted much attention thanks both to its
high financial returns and to its visible successes in spawning innovative new



businesses. Many corporations have taken note, and are understandably
making eƒforts to apply the VC model to their own business development
eƒforts. But the model can be more diƒficult to apply than it may seem at first
glance. For the best results, companies must truly understand what makes it
work, what benefits can be achieved, and how it might be tailored to their
specific circumstances.


Can Big Companies Become Successful Venture Capitalists

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