A call to arms for innovation: corporations must invest in venture-backed start-ups, writes Bob Ackerman

The time has come for the equivalent of a 21st century Manhattan Project-like initiative - focused on the creation of value from ideas through innovation.  Partnering the market knowledge and distribution channels of large corporations with the imagination, creativity and risk capital that have shaped Silicon Valley as the focal point for technology-driven innovation for 50 years is paramount. Through integration with our universities, and with long-term research support from the federal government, the US can reverse the perilous slide in core and applied research that have been the foundation upon which the modern US economy has been built.  
    
The bottom line, corporations can and must help to redefine the role of American competitiveness and venture capital and leading-edge start-ups are their natural allies and compatriots.

Consider, for example, the fall of General Motors, once the biggest industrial company in the world and now the beleaguered ward of the US government. If it had removed its blinders and realised it could no longer pursue a business model based on the now defunct era of cheap energy, it might have invested in, say, Tesla Motors, the prominent California maker of all-electric vehicles. Then GM might have managed to avert its fate.

A significant reduction in the innovative role of major US corporations has been underway for three decades. Just a generation ago, AT&T’s Bell Labs, IBM’s Watson Labs and Xerox Palo Alto Research Center were key engines of American innovation and the envy of the developed world. In 1981, US corporations with more than 25,000 employees represented approximately 70 per cent of the investment in industrial innovation in the United States, according to the National Science Foundation. By 2006, that figure plummeted to 37 per cent.

Fortunately, a new model of US innovation emerged to pick up the slack. Backed by venture capitalists, and in partnership with major university research centres, the world’s best and brightest engineers and scientists demonstrated they could out innovate the corporate labs of the past. These innovation machines – venture capital-backed start-ups - proved that risk-oriented entrepreneurs, rewarded commensurately for success, could redefine an economy.

While corporate R&D nosedived, small companies increased their investment in R&D from ten per cent of US R&D to almost 40 per cent. In fact, public companies that were originally venture backed today represent 17 per cent of the US gross domestic product and have created more than 12 million high-paying jobs in the last 30 years.

Sadly, corporate investments in venture capital have subsequently declined precipitously. Corporations have shied away from VC investing because it is long term and does not mix well with shorter term corporate planning, or with Wall Street’s insistence on predictable quarterly earnings.

This has to change. And now is a great time for a turnaround in corporate venture investing: 1) start-up valuations are unusually low, 2) the cost of innovation in many areas has fallen precipitously, and 3) start-ups are willing partners as they seek to access major markets.  What is important is that this occurs before America’s long-standing and successful economic model, already badly frayed, deteriorates further. That could make today’s beleaguered American lifestyle permanent.

The legacy of this issue is not as obvious as it might seem.  Most knowledge-workers think of innovation as a straight line. The reality, however, is that it comes in waves. The semiconductor, the minicomputer, the microprocessor, client/server computing and the internet all induced tsunamis of innovation. As excitement about the technologies grew, so did the corporate interest in investing in start-ups at the cutting edge of these developments and the perceived value and valuations of these start-ups.

But the tide flows both ways, and corporate interest in entrepreneurial companies and their valuations comes and goes with the surges of innovation. One dramatic example was internet exuberance during the dot-com boom a decade ago. Money poured into internet start-ups and internet stocks from all corners of the investment world, and corporations went along for the ride. The rules were rewritten as corporate executives came under intense pressure to invest in the internet’s promise of a revolutionary economy.

Corporate venture capital investments soared from $1.8bn in 1998 to $15.9bn in 2000, accounting for 16 per cent of all venture capital invested that year. But as history foreshadowed, the trend was short lived. The NASDAQ nosedived, and the perceived value of entrepreneurial companies swung to the other extreme. Corporate investments in internet start-ups and others plummeted to $1.6bn in 2002, a decline of $14.3bn in 24 months.

Five years ago, corporate interest in entrepreneurial companies eventually began rebounding. It waned again sharply in 2008, however. The truth is that corporations have not had the patience or shareholder permission to flow with the tides of R&D. Corporations jump in and out of investing because they pay too much attention to short-term financial considerations, consumer trends and the health of the economy. This is a recipe for failure.

When corporations decide to invest in start-ups, they must be mindful of an inherent mismatch in cultures. Large corporations measure themselves by how many employees they have, their public market value and their brand recognition. They’re cautious in their approach to investing in new technologies and are resistant to change. The venture-backed entrepreneurial community is exactly the opposite. Start-ups take pride in being small, fast, efficient and bold.

It’s no surprise, then, that partnerships between the two can create huge frustrations.

The process of combining the two cultures requires acknowledgment from both parties of what each type of company does well and what it does not. The attitude should be not to arrive on the scene in order to make kings of princes, but to step toward the common goal of learning from one another.

The key is to create the right type of relationship at the right time – an ecosystem – hence my reference to the Manhattan Project. To make the most of their investment dollar, corporations must ask two questions: When should we invest in start-ups? How much should we invest in start-ups? Three points in time on a start-up’s evolutionary ladder must be considered in making these decisions.

The first stage is what I call the “Discover Stage”. At the very early stage, a start-up’s product or service is more dream than substance. The corporation doesn’t have much leverage to offer in most cases – the entrepreneur just needs cash to vet his dream and test it with reality. The valuation volatility of the start-up is high because it faces an uncertain future, but the required corporate capital commitment is low.

At this point, the corporate venture arm should consider investing in the start-up through a partnership with an established VC firm that knows how to manage the risk. By becoming a limited partner in a venture fund, the corporation gets in on early investments, makes minimal capital commitments and mitigates high volatility by spreading it among 20 other limited partners.

The corporation can take advantage of the long-term historical rate of return enjoyed by VC firms and essentially gets a placeholder for a direct investment in a promising start-up. The corporation can also keep an eye on new developments to help find valuable new commercial technologies.

The second stage is what I call the “Leverage Stage”. As the start-up matures, the risk shifts from innovation to bringing a product to market, and the corporate investor has some leverage to offer. It can guide the start-up in how best to introduce its product to market and may also be able to provide manufacturing or distribution channels.

At this point, the corporation may also consider a direct investment in the start-up so that it can participate in enhancing its value. This also creates an opportunity for the two organisations to get to know each other and to start developing a reciprocal relationship and lessen the cultural conflict between the two companies. The corporation should tie the start-up to one of its business lines and rigorously track the progress of its investment.

The third stage is what I call the “Integrate Stage”. Once an entrepreneurial company proves there is strong demand for its product, the investment risk shifts to the quality of the start-up’s execution. The start-up needs to scale up operations and establish a strong market position. At this point, the corporation has the most leverage to offer. If the start-up’s product appears to be something that could play an important strategic role at the corporation, it may be time for the corporation to consider buying the start-up outright. If there is an acquisition, it’s important to integrate the start-up team into the corporation and hold onto the people.

As already noted, now is the time for corporations to return to the venture game. For all the strength of their brands, distribution networks and extensive customer relationships, their future viability will increasingly rely on the start-ups of Silicon Valley and their brethren in other centres of innovation. Amid a problem-plagued economy and fierce global competition, US corporations are in no position to return to the halcyon era of internal R&D spending.

Heightened corporate investment in venture capital funds and venture-backed start-ups won’t solve all of America’s technology investment problems. There must also be a proactive government effort to attract and retain the world’s best technology talent to work at the best start-ups, as well as recognition that increasingly onerous financial regulatory policies are counterproductive.

Nonetheless, leveraging the top-flight innovation that is ubiquitous in venture capital circles is the most overlooked opportunity to address the deterioration in American R&D. US corporations must rise to the occasion and help restore the lustre of venture capital and America’s technological moxie.

Robert R. Ackerman, Jr. is the founder and managing director of Allegis Capital (www.allegiscapital.com), a seed and early-stage venture firm headquartered in Palo Alto, California. Ackerman has worked with more than 50 corporate investment partners over the past 20 years as both a venture capitalist and a start-up executive.