It’s hardly surprising that big companies are attracted to the venture capital (VC) model for new business development.¹ 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 offerings 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 often than not, big company attempts at applying the VC model produce disappointing results. Most find it difficult 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 efforts. And they lack vital contacts in the startup community.

Even so, big companies can apply the VC model successfully. Consider software 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 effort 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 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 effective 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 often 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 sufficient, while other objectives—acquiring new technologies, entering new markets, reenergizing corporate culture—often 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 often 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 difference to overall returns.

Abandoning ventures in this way has never been easy for large corporations, whose projects are often 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 often 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 often sit on the boards of the companies in their portfolio, offering 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 often 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 difficult 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 often 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 off 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 offered, 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 differences 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 difficult 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 software.²

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 difficulty 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 often-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 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 technologies. 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 affected 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 spinoff). 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 differ 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 company gradually transform its skills and culture as employees are offered 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 engineering, 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’ efforts 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 often 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 difficult 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 difficult 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 difficult 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 after 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 difficult 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 efforts 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 difficult 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 offered 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 off 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, spinoff, or sale—only after 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 effectively?
• 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 different set of skills, assets, or relationships?
• Can the venture be broken up into different 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 offer 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 investment. 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 insufficient 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 leveraging professional VC capabilities, exposure to a wide range of relevant business 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 offering 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 difficult.

If a company chooses to invest with the assistance of established VC firms, it must also identify target firms and develop an effective 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 effective 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, often 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-off, 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, often 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 often a company holds on to an investment long after 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 efforts to apply the VC model to their own business development efforts. But the model can be more difficult 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.