Why Corporations Invest in Start-Ups (Rather than Simply Becoming Customers)

Over the past 10 years, incumbent corporations have recognized the growing importance of venture collaboration.? Emerging technologies of all kinds, from Artificial Intelligence, to Robotics, to Analytics, to Augmented Reality are creating new building blocks for corporate business models, unlocking new arenas for growth, and even changing customer expectations.? Shrewd corporations realize that although some of these advances may be created internally through their own innovation programs built by their own engineers, partnerships with startup ventures can both accelerate and expand innovation.? Why would a bank try to develop a new customer service platform based on virtual reality when a venture who’s entire focus is on this technology could do so far more effectively and efficiently? Indeed, the differentiated expertise, speed, and intellectual property of ventures makes collaborating with them a strategic imperative.? There are simply too many novel technologies upending too many dimensions of corporate business models for corporations to go it alone.?

To address this opportunity, corporations in greater numbers are putting in place programs to identify and engage promising new ventures. Some pursue participation in accelerators and scouting programs, others engage outside consultants and advisors. Today there are scores of databases tracking the emergence of new startups and it’s easier than ever for corporations to identify the most promising ones. At the same time, there has been a significant increase in the number of corporate venture capital programs operating in the world. Over the past ten years the number of corporate venture investors active in the market has grown more than 6x to ~4000 by 2020[1] .? The key differentiating feature of Corporate Venture Capital programs is that through such programs corporations invest financially in the ventures they engage with.? ?

The rise of corporate venture capital alongside the myriad of other avenues available to engage startups begs the question: “Why do I need to invest in ventures; isn’t it easier (and cheaper) (and less risky) to simply become a customer?” It’s a logical question. Afterall, ventures are eager to make corporations their customers.? And in the vast majority of cases, corporations will never acquire the startups they interact with (a circumstance where perhaps an investment may have been a productive step), but simply look to them as strategic vendors or partners. What does venture investment deliver that an ordinary customer/vendor relationship does not?

To begin, let’s clarify that not all ventures/vendors a corporation does business with require investment. But for certain kinds of ventures, specifically those with a high long-term transformational potential, investment can be powerful.? By definition, the technologies these startups are developing are novel and likely not to become “hardened” for many months or years.? If successful, their solutions can transform a corporation’s business—unlocking new drivers of profit, growth, and value. But getting there will require significant investment, learning, and continued development over long periods of time. What’s more, the success of these kinds of ventures may be dependent on considerable collaboration with incumbent corporations over time, where a corporation's insights into markets, use cases, and customer dynamics are critical building-blocks for a startup.

In these situations, investment improves both the chances the venture will be successful and the chances the corporation will realize value from it. To understand how and why, you need to understand the many different but interrelated benefits investment can deliver. Here is what investment “buys” that an ordinary transactional/vendor relationship with a startup generally cannot:

1/ Shared Interests Investment aligns the interests of ventures with corporations in ways transactional relationships may not. For the corporation, investment buys an economic stake in a venture’s the long-term success and with that comes a greater level of care and action and encourages the corporation to make the venture’s objectives its own. For the venture, corporate investment helps to prioritize that corporation’s use cases and needs. (We have seen many cases where a venture prioritizes its “invested customers” over transactional customers). The net effect is to move the relationship from a transactional footing to one based on long-term shared interest in mutually-beneficial outcomes.?

2/ Long-Term Horizons Indeed the word “long-term” matters. Transformational ventures are, by definition, long-horizon propositions, requiring iterative development, testing, and learning, often over years. Transactional relationships can stifle important early touchpoints between ventures and industry (“come back when your product works,” corporations may say) which in turn can elongate development and even doom ventures to failure.? Investment, on the other hand, turns time into an asset for both parties. For the venture, it creates breathing room to try, test, learn, and collaborate with industry to properly shape the solution(s) the market needs. For the corporation, it creates breathing room to make sense of an emerging technology, plan for it, and to ready the organization to adopt it.? Adoption and integration of new technologies can be hard and complicated. The ability to synchronize the emergence of transformational solutions with organizational readiness over time is a powerful thing.

3/ Risk Management Whereas venture investing is often associated with great risk (“I might loose my investment if the startup fails!”), investment can actually mitigate risk, and does so in two key ways.? First, as emerging technologies transform industries, corporations that don’t adopt winning technologies at the right time risk losing market share, the chance to grow, or the chance to increase profit; that inaction can carry far greater financial risk than the loss of a small venture investment. Investing in ventures can deliver proprietary learnings, hands-on interaction, and advanced understanding of emerging technologies—with sufficient runway before such technologies are widely adopted in the industry. It’s powerful way to manage long-term strategic risks to the corporation.? A second benefit investment delivers is an ability to help engineer the success of the venture. Engaged and invested corporations have an ability to shape the fate of ventures by offering technical guidance, by becoming customers, by offering business advice, etc.. These kinds of contributions are often pivotal and deterministic to a venture’s success.? ?Investment is thus not a risky “bet,” as much as a mechanism to guide a promising venture, materially contribute to its financial success, and actively control risk.

4/ Corporate Engagement? Despite the potential benefit to be gained from working with technology startups, a common problem is the inability for corporations to engage with them. Day jobs are challenging, operating budgets are spoken-for, and managers may not see what’s in it for them.? In a transactional setting, it can take months for a venture to hold a first meeting with a corporate customer, much less conduct a pilot project. The presence of an investment, however, often serves to impel corporate management to prioritize engagement: ”We have made this investment, now let’s capture the value.”? Sometimes that comes simply in the form of an edict from the top. Other times, venture-engagement is written directly into corporate employee OKRs and woven into divisional budgets. It’s a win-win for both the venture and the corporation that is made possible because of investment.

5/?Influence Arm’s-length transactional relationships may not motivate corporations to actively assist ventures as they evolve their offerings. Investment, on the other hand, creates the incentive to get deeply involved. Smart corporations don’t seek to control ventures (smart founders wouldn’t let them, anyway), but instead offer technical expertise, market insights, and deeper understanding of the specific use cases that are most valuable to the corporation (and the industry). ?Knowing a corporation has made a meaningful investment also makes the venture more open to influence, due to the aligned interest factor mentioned earlier. Active corporate guidance is immensely valuable to the startup and helps ensure venture solutions address corporate needs more precisely.

6/?Ensuring Venture Health Corporate managers may be reticent to commit time or energy to a startup if it fears the startup may not be in business over the long term. Startups can be fragile entities, especially if their business models are shaky, their founding teams are weak, they are poorly capitalized, or do not have defensible intellectual property—all things that can be hard to immediately discern as a customer.? The process of investing, however, gives greater assurance a venture may succeed over the long haul.? The due diligence that the goes into an investment decision involves deep reviews of a venture’s financial health, team, technology and strategy—and with access to a greater amount of proprietary information that would be available if the corporation were a mere customer.? While there can never be a guarantee of business success, a promising bill of health coming out of due diligence can be a big source of comfort for a corporation.?

7/ Two Kinds of Returns ?For the vast majority of corporations, corporate venture investing should be first and foremost about creating strategic value for the corporation (“strategic returns” = the economic benefit in terms of increased profit or new growth realized by utilizing a venture’s offerings).? But the concomitant presence of the potential also to earn financial returns (“financial returns” = the value appreciation a corporation’s equity stake in a venture) is a powerful feature for two reasons. First, financial returns can act to mitigate financial risk of a corporation’s total technology innovation efforts because venture investing can be a form of “subsidized R&D.”? Why? Assume a corporation has a green-lit a portfolio of R&D projects to be pursued with internal engineers.? Some projects will succeed—and go off and drive strategic value. Others will fail; and those that do are a net financial loss.? Imagine instead that rather than pursuing these projects as projects, they each had been a venture investment into startups developing the same technologies the projects would have developed.? And let’s assume the same proportion were winners and losers. The losers are still a net financial loss (venture investments were lost).? But the winners delivered two kinds of returns--strategic value to the corporation (“strategic returns”) and financial returns. In this case, there’s a good chance the financial returns of the winners offset (at least to some degree) the financial losses of the losers. If losses were totally offset, the entire R&D program portfolio was “subsidized.”? It’s a powerful benefit that can only come from venture investing. A second reason financial returns matter relates to a corporation’s incentive to provide meaningful guidance during a venture’s development. Often during a venture’s evolution, access to proprietary corporate insights, data, technologies, channels, etc. can create significant value for a startup.? In transactional relationships, there may be little incentive for a corporation to share such data or insights.? But with the potential for financial returns, a corporation may be incented share.? The equity stake is a mechanism and path to monetizing data.?

8/ Path to Acquisition Corporations that strategically engage large numbers of emerging ventures expect mainly to simply do business with them, not acquire them. But in those relatively targeted instances where an acquisition could eventually be appropriate, investment(s) early in the life of the startup can be a productive for both the startup and the corporation. This use case sometimes involves sensitive issues around the (two-way) protection of intellectual property or value-signaling or how to preserve strategic options for both the venture and the corporation. But experience shows these issues can all be addressed to mutual satisfaction and when they are, an investment-led relationship can be valuable. For the startup, it creates a stronger path to potential exit (while still preserving optionality). For the corporation, it can reduce risk and accelerate decisioning around a potential acquisition.

More and more, leading corporations are recognizing the value of investment-led venture relationships.? One instructive case study is the experience of a large, global industrial company.? This company certainly recognized the value of startup technologies and built an elaborate structure around venture sourcing and engagement—but without investment. This company’s venturing model was founded on the belief that meaningful engagement could and should occur through pilots and through arm’s length vendor contracts (only); the company was staunchly against venture investing.? But many months after the program’s founding, the company launched a full corporate venturing program—replete with investment.? What changed?? The company realized that without investment, the ventures it had tried to engage in the "customer-first" model lost interest on its priorities.? Worse, the corporation realized that its competitors—who had invested—were being prioritized and winning significant engagement.? Pure customer-only engagement only went so far.

Not all venture relationships require investment.? But for those that stand to be the most transformative and impactful over the long-term, investment can mean the difference between success and wasted effort.

[1] “Corporate VC Is Booming, but Is It What Your Start-Up Needs? ” INSEAD, August 2022