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limo B.

Poser
The Impact of Corporate Venture Capital
GABLER EDITION WISSENSCHAFT
Timo B. Poser

The Impact of
Corporate Venture Capital
Potentials of Competitive Advantages
for the Investing Company

Deutscher Universit~its-Verlag
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Dissertation Wissenschaftliche Hochschule fUr UnternehmensfUhrung (WHU)


Vallendar, 2002

1. Auflage Marz 2003


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ISBN-13:978-3-8244-7776-0 e-ISBN-13:978-3-322-81468-5
001: 10.1007/978-3-322-81468-5
To Parissa and Fabienne
VII

Preface
This research project was driven by curiosity about the actual impact of Corporate Venture
Capital activities on the investing company. At the end of 1998 when I developed the idea of
analyzing CVC further, corporate venturing activities began to increase again after they had
gone through two earlier boom and bust cycles. At that time, I did not envision how large the
dimensions of CVC investments would become and how sharp the decrease afterwards would
be. This latest cycle confirmed my desire to determine the impact of CVC and contribute to
the understanding of CVC ,in theory and management practice.

This research project was accepted as a dissertation by the "PromotionsauBschuss der


Wissenschaftlichen Hochschule fUr Unternehmensfiihrung (WHU), -Otto-Beisheim-
Hochschule-", in Vallendar entitled "Impact of Corporate Venture Capital on Sustainable
Competitive Advantage of the Investing Firm - A Resource Based Approach" in June 2002.

I want to thank several people who contributed to this research project. I am grateful to Prof.
Dr. Klaus Brockhoff and Prof. Dr. Markus Rudolf for their guidance and support. I want to
thank several interview partners from industry for their time and insights. Thanks also to
NVCA, EVCA and Asset Alternatives Inc. for the permission to cite Corporate Venture
Capital figures.

I also want to express my gratitude to other people who supported me: Dr. Andreas Eggert
for his perspectives from theory; Oliver Lohfert and Dr. Alexander Moscho for their
feedback; Ginni Light for proofreading; Dr. Jiirgen Meffert and Dr. Lother Stein for the
impetus and opportunity to explore corporate ventures; Claudia Schiirger, Frank Galenza and
Wolfgang Limbeck for many books and articles. Last but not least, my wife for the right mix
of patience and pressure that helped me to finish this work.

Timo B. Poser
IX

Table of contents

List of illustrations XIII


List of tables XVII
Abbreviations and terms XIX
1. Introduction 1
1.1. Relevance of topic
1.2. Open issues and research objective 5
1.3. Structure and Approach 7
2. Theoretical foundation 9
2.1. Sustainable competitive advantage 9
2.1.1. DefInition of sustainable competitive advantage 9
2.1.2. Market-based view 11
2.1.3. Resource-based view 13
2.1.3.1. Resource types 15
2.1.3.2. Attributes of sustainable competitive advantage 18
2.1.3.3. Integrated view on attributes of sustainable competitive
advantage 27
2.1.4. Resource-based vs. market-based view 32
2.2. Venture capital 34
2.2.1. DefInition of venture capital 35
2.2.2. Situation in the venture capital market 42
2.2.3. Venture capital investment process 46
2.2.3.1. Raising capital 47
2.2.3.2. Generation of deal flow 58
2.2.3.3. Assessment of investment opportunities 61
2.2.3.4. Investment in start-ups 66
2.2.3.5. Interaction with start-ups 71
2.2.3.6. Exit investments 73
2.3. Corporate Venture Capital: defInition and objectives 81
2.3.1. DefInition of corporate venture capital 81
2.3.2. Objectives of Corporate Venture Capital 87
2.3.2.1. Build technology and market knowledge 94
2.3.2.2. Change attitude towards innovation and change 96
2.3.2.3. Acquire skills and increase company attractiveness for
employees 97
2.3.2.4. Build and leverage a partner network 98
2.3.2.5. Source and leverage technologies 101
2.3.2.6. Create additional revenue by leveraging company resources 101
2.3.2.7. Benefits as resources 102
2.3.3. Theoretical reasoning for Corporate Venture Capital 103
2.4. Corporate Venture Capital process 108
2.5. Process of setting up Corporate Venture Capital activities 110
X

2.5.1. Setting Corporate Venture Capital objectives 112


2.5.2. Corporate Venture Capital investment approach 113
2.5.2.1. Direct vs. indirect investment approach 113
2.5.2.2. Investment strategy 119
2.5.2.3. Additional issues regarding the investment approach 121
2.5.3. Organizational linkages 122
2.5.3.1. Role of the organization in the Corporate Venture Capital
process 124
2.5.3.2. Positioning of Corporate Venture Capital inside the
organization 128
2.5.4. Corporate Venture Capital staffing and compensation 131
2.5.4.1. Staffing Corporate Venture Capital managers 131
2.5.4.2. Compensating Corporate Venture Capital managers 134
2.5.5. Corporate Venture Capital monitoring 136
2.6. Process of running Corporate Venture Capital activities 138
2.6.1. Generation of deal flow 140
2.6.2. Assessment of investment opportunities 142
2.6.3. Investment in start-ups 145
2.6.4. Interaction with start-ups 146
2.6.4.1. Monitoring and supporting start-up development 147
2.6.4.2. Realizing strategic benefits through interaction with start-ups 148
2.6.5. Exit investments 149
2.6.6. Monitoring Corporate Venture Capital activities 151
2.7. Challenges for generating benefits through Corporate Venture capital 151
2.8. Overview of previous research on Corporate Venture Capital 153
3. eVe-Impact-Model 161
3.1. CVC-Impact-Model: linking CVC to sustainable competitive advantage 161
3.2. Operationalizing the CVC-Impact-Model 164
3,2.1. Operationalizing variable I: Level of CVC activity 164
3.2.2. Operationalizing variable 2: Level of benefits 166
3.2.3. Operationalizing variable 3: Level of potential to create competitive
advantage 169
3.2.3.1. Attributes determining sustainable competitive advantage 169
3.2.3.2. Testing CVC activities vs. CVC benefits 171
3.2.3.3. Testing benefits vs. sub-benefits 173
3.2.3.4. Ways to impact sustainable competitive advantage 174
3.2.3.5. Limitation to identifying resources that may impact
sustainable competitive advantage 176
3.2.3.6. Testing benefits from single cases vs. CVC results overall 177
3.2.3.7. Measuring attributes 178
3.3. Critical activities for impacting sustainable competitive advantage 182
4. ease studies 187
4.1. Research approach 187
4.1.1. Objectives of case studies 187
4.1.2. Case study interview design 188
XI

4.1.3. Quality ofresearch design 191


4.1.4. Case study targets 192
4.2. Company background 194
4.2.1. Intel Capital- Background 194
4.2.2. Media X Venture Capital - Background 195
4.2.3. Philips Corporate Venturing - Background 196
4.2.4. Novartis Venture Fund - Background 197
4.3. CVC activity 198
4.3.1. Intel Capital- CVC activity 198
4.3.2. Media X Venture Capital - CVC activity 199
4.3.3. Philips Corporate Venturing - CVC activity 200
4.3.4. Novartis Venture Fund - CVC activity 201
4.3.5. Overall firidings on the level ofCVC activity 203
4.4. Targeted and realized benefits 204
4.4.1. Intel Capital- Targeted and realized benefits 204
4.4.2. Media X Venture Capital- Targeted and realized benefits 208
4.4.3. Philips Corporate Venturing - Targeted and realized benefits 212
4.4.4. Novartis Venture Fund - Targeted and realized benefits 216
4.4.5. Overall findings on the level ofCVC benefits 220
4.4.5.1. Operationalization of determining level of CVC benefits 220
4.4.5.2. Targeted benefits 221
4.4.5.3. Realized benefits 223
4.5. Potential impact on sustainable competitive advantage 225
4.5.1. Intel Capital- Potential impact on sustainable competitive advantage 225
4.5.2. Media X Venture Capital- Potential impact on sustainable competitive
advantage 228
4.5.3. Philips Corporate Venturing - Potential impact on sustainable
competitive advantage 231
4.5.4. Novartis Venture Fund - Potential impact on sustainable competitive
~advantage 234
4.5.5. Overall findings on potential impact on sustainable competitive
advantage 235
4.5.5.1. Operationalization of level of potential impact on sustainable
competitive advantage 235
4.5.5.2. Results on assessment of attributes of sustainable competitive
advantage for CVC sub-benefits 236
4.5.5.3. Sub-benefits potentially meeting attributes of sustainable
competitive advantage 239
4.5.5.4. Further findings on attributes of sustainable competitive
advantage 240
4.6. CVC challenges 242
4.6.1. Intel Capital- CVC challenges 242
4.6.2. Media X Venture Capital- CVC challenges 245
4.6.3. Philips Corporate Venturing - CVC challenges 248
4.6.4. Novartis Venture Fund - CVC challenges 251
4.6.5. Overall findings on CVC challenges 254
4.6.5.1. Assessment of CVC challenges 254
XII

4.6.5.2. Conclusions from assessment ofCVC challenges 257


4.7. Overall applicability 261
5. Summary 263
5.1. Implications for research 263
5.2. Implications for management 266
5.3. Limitations and outlook 268
Appendix - Questionnaire 271
Bibliograpby 279
XIII

List of illustrations
Figure 1-1: US eve investments 2
Figure 1-2: US ve investments 3
Figure 2-1: Two main theories explain the sources of competitive advantage 11
Figure 2-2: Comparison of views on attributes of sustainable competitive advantage 20
Figure 2-3: Combination of resource-based and market-based view 32
Figure 2-4: Capital cOI11IIlitted to and disbursed by ve funds 43
Figure 2-5: Capital under management in US venture funds 44
Figure 2-6: US ve disbursements 2000 by industry 46
Figure 2-7: ve commitments in limited partnerships in the US during the year 2000
by investor type 48
Figure 2-8: Three resources that impact venture capitalists' competitive advantage 50
Figure 2-9: Approaches to generate deal' flow 59
Figure 2-10: Venture capitalists' characteristics important to start-ups 60
Figure 2-11: Attributes of eve investments 86
Figure 2-12: Potential benefits of eve 93
Figure 2-13: Benefits of eve as resources 103
Figure 2-14: Processes of setting up and running eve 110
Figure 2-15: Activities of setting up eve III
Figure 2-16: eve investment approach options 114
Figure 2-17: Linkages of eve, the organization and the external world 123
Figure 2-18: eve benefits for and support requirements from the organization 125
Figure 2-19: Sources of potential conflicts about eve activities 125
Figure 2-20: Involving the organization in eve 127
Figure 2-21: Different skill sets of eve managers 133
Figure 2-22: Activities of running eve - Investing in start-ups 139
Figure 2-23: Exit decision matrix of eve 150
Figure 3-1: eVe-Impact-Model: Hypotheses 162
Figure 3-2: Items for measuring variable 1 - level of eve activity 165
Figure 3-3: Measuring targeted and realized eve benefits (112) 168
Figure 3-4: Measuring targeted and realized eve benefits (2/2) 168
Figure 3-5: Attributes of SeA applied to eve activities and benefits 173
Figure 3-6: Example for measuring variable 3 182
XIV

Figure 3-7: Testing role of CVC activities for impacting sustainable competitive
advantage (112) 185
Figure 3-8: Testing role of CVC activities for impacting sustainable competitive
advantage (2/2) 185
Figure 3-9: Possible conclusions from analysis of CVC challenges 186
Figure 4-1: Intel Capital's level ofCVC activity 199
Figure 4-2: Media X,'s level of CVC activity 200
Figure 4-3: Philips Corporate Venturing's level ofCVC activity 201
Figure 4-4: Novartis Venture Fund's level ofCVC activity 202
Figure 4-5: Intel Capital's CVC objectives 204
Figure 4-6: Intel Capital- Targeted and realized CVC benefits (1/2) 207
Figure 4-7: Intel Capital- Targeted and realized CVC benefits (2/2) 207
Figure 4-8: Media X's CVC objectives 208
Figure 4-9: Media X Venture Capital- Targeted and realized CVC benefits (112) 211
Figure 4- I 0: Media X Venture Capital - Targeted and realized CVC benefits (2/2) 211
Figure 4-1 I: Philips' CVC objectives 212
Figure 4-12: Philips Corp. Venturing - Targeted and realized CVC benefits (112) 215
Figure 4-13: Philips Corp. Venturing - Targeted and realized CVC benefits (2/2) 215
Figure 4-14: Novartis' CVC objectives 216
Figure 4-15: Novartis Venture Fund - Targeted and realized CVC benefits (112) 218
Figure 4-16: Novartis Venture Fund - Targeted and realized CVC benefits (2/2) 218
Figure 4-17: Comparison of targeted and realized benefits (112) 222
Figure 4-1 &.: Comparison of targeted and realized benefits (2/2) 223
Figure 4-19: Intel Capital - Attributes of sustainable competitive advantage 225
Figure 4-20: Media X Venture C. - Attributes of sustainable competitive advantage 228
Figure 4-2 I: Philips Corporate Venturing - Attributes of sustainable competitive
advantage 232
Figure 4-22: Sub-benefits that may have the potential to impact sustainable
competitive advantage 239
Figure 4-23: Intel Capital - Challenges for generating CVC benefits (112) 243
Figure 4-24: Intel Capital - Challenges for generating CVC benefits (2/2) 243
Figure 4-25: Media X Venture Capital - Challenges for generating CVC benefits (112) 246
Figure 4-26: Media X Venture Capital- Challenges for generating CVC benefits (2/2) 246
Figure 4-27: Philips Corp. Venturing - Challenges for generating CVC benefits (1/2) 249
Figure 4-28: Philips Corp. Venturing - Challenges for generating CVC benefits (2/2) 249
xv
Figure 4-29: Novartis Venture Fund - Challenges for generating evc benefits (1/2) 251
Figure 4-30: Novartis Venture Fund - Challenges for generating evc benefits (2/2) 252
Figure 4-31: Comparison of assessment of challenges (112) 256
Figure 4-32: Comparison of assessment of challenges (2/2) 256
Figure 4-33: Conclusions from analysis ofCVe challenges (1/2) 259
Figure 4-34: Conclusions from analysis of cve challenges (2/2) 259
XVIl

List of tables
Table 1-1: Examples of companies currently active in CVC by industry 2
Table 2-1: Resource types 18
Table 2-2: Summary of different views regarding attributes determining sustainable
competitive advantage 19
Table 2-3: Attributes of resources determining competitive advantage and
sustainability 28
Table 2-4: Isolating mechanisms discussed in the literature 31
Table 2-5: Attributes of Venture Capital 37
Table 2-6: Number and size of US VC firms and funds 45
Table 2-7: Number of companies receiving funding in the US 45
Table 2-8: VC investment stages 52
Table 2-9: Follow-on investment of US VC disbursements 68
Table 2-10: Targeted IRR per stage 69
Table 2-11: Number and value of venture-backed trade sales in the US 77
Table 2-12: Number of venture-backed IPOs in the US 78
Table 2-13: IRR of US VC funds 79
Table 2-14: CVC objectives discussed in the literature 90
Table 2-15: Coverage of benefits in the CVC literature 94
Table 2-16: Roles of venture capitalists and CVC investors in direct and indirect
investments 1I5
Table 2-17: Advantages and challenges of direct vs. indirect investments 1I6
Table 2-18: evc managers' ideal skill sets 132
Table 2-19: Comparison of compensation options 135
Table 2-20: Investment criteria most frequently rated as essential by corporate venture
Capitalists vs. independent venture capitalists 144
Table 2-21: Challenges of setting up and running CVC activities 152
Table 2-22: Summary of empirical CVC studies 153
Table 3-1: Description of attributes of sustainable competitive advantage 170
Table 3-2: Possibilities for meeting the attribute rareness 172
Table 4-1: Case study targets 193
Table 4-2: Number of targeted benefits realized 224
Table 4-3: Possible substitutes of CVC benefits realized by Media X 230
Table 4-4: Distribution of assessment of CV C challenges 255
XVIII

Table 4-5: Number of eve activities by criticality for realizing sustainable


competitive advantage 258
XIX

Abbreviations and terms

CVC - Corporate Venture Capital

Deal - Term used by venture capitalists to describe an investment


opportunity or an investment

Deal flow - Term used by venture capitalists to describe their access to


investment opportunities (incoming deals per time period)

Due diligence - Term used by venture capitalists, investment bankers and others to
describe the process of thorough investigation of an investment
opportunity

EVCA - European Venture Capital Association

!PO - Initial Public Offerin,.g

IRR - Internal rate of return

IT - Information technology

MBI - Management buy-in

MBO - Management buy-out

NVCA - National Venture Capital Association

SCA - Sustainable competitive advantage

MBV - Market-based view

RBV - Resource-based view

VC - Venture capital
Chapter 1: Introduction 1

1. Introduction

1.1. Relevance of topic

Corporate Venture Capital (evC) is the purchase of mostly minority equity positions in
independently managed start-ups or growth companies by an established corporation.! eve
is an important topic for academic research for three reasons: first, eve is heavily used in
practice. Second, although ,
eve may potentially lead to significant benefits, success has
been limited in the past. Third, the academic literature has not discussed certain aspects of
eve to a sufficient extent. These points will be discussed in more detail in this section.

In the past, eve has been used to a varying degree. As shown in figure 1-1, the absolute
level of eve investments has varied significantly over time, and was at an all time high in
2000. In the US the total amount of eve invested was USD 20.8 billion, which is almost 30
times as much as in 1995. 2 The share of direct eve investments has increased significantly
over the last years. In 2000, USD 17.4 billion were invested in start-ups directly representing
about 84 percent of eve investments. USD 3.4 billion were invested indirectly by non-
financial corporations and committed to ve funds as limited partners, representing about 16
percent of the eve investments. From 1995 to 1999 between 46 and 83 percent of eve
were invested indirectly.

Companies like Dow, DuPont, Exxon, Ford or General Electric started doing eve in the late
60s (Sykes 1990: 38). In 1990 about 80 companies in the US were active in eve (Sykes,
1990: 37). After a decrease in US eve activity in the early 1990s, eve is currently
experiencing a yery powerful comeback. Asset Alternatives Inc. (2000) lists more than 160
corporate venture capital funds that were active in the US in 2000. Impulse (2001) identifies
33 companies active in eve in Germany and another 44 in the rest of Europe. Companies
from different industries are making eve investments today. However, as indicated in Table
1-1, there is a strong focus on high-tech and Internet industries like software,
communications and Internet content.

As discussed in 2.3.1, in this study eve is defined as the process of investing in external, independently
managed start-ups. Other authors may also use the term eve for the process of starting ventures within
established companies. This is called internal venturing in this study.
2 Direct and indirect eve investments are only added up to demonstrate the overall level of corporate
commitment. Actually they are quite different numbers and should not be added since indirect investments
are commitments to independent ve funds that are not necessarily invested in the same year, while direct
investments are actual disbursements in the same year directly by the corporation.
2 Chapter 1: Introduction

Figure 1-1: US eve investments3


_ Direct CVC investments
D Indirect eve investments
USDbillion
25

20

Capital 15
committed by
corporations
10

0
n~~ nnn n""n~~
Year
Includes strategic as well as purely financial eve investments; does not include investments by financial
institutions; no data on direct investments before 1995
Source: National Venture Capital Assooiation Yearbook (2001a: 24, 38)

Table 1-1: Examples of companies currently active in eve by industry


Industry Software Electronics Communi- Internet Chemical Other
cations content! and life industries
media sciences

Com- Adobe Acer AT&T AOL BASF 3M


panies Informix Cadence Cisco Bertelsmann Bayer ABB
Microsoft Dell 3COM CBS Dow Allstate
~ovell EMC Deutsche E*Trade Chemical Daimler-
Oracle IBM Telekom Lycos Humana Chrysler
Quark Intel Lucent NBC J&J UPS
SAP NEe Motorola Reuters Merck Visa
Philips Nokia Tribune Novartis
Siemens NTT Softbank SmithKline
Sun Qualcomm Washington Beecham
TI Telecom Post
Italia Yahoo
Source: Press clIppmgs

The upturn in eve is in line with an overall increase in the level of venture capital (VC)
financing which is currently at an all time high as shown in Figure 1-2. The relative
importance of eve, however, has increased significantly in recent years from 5 percent of all

It should be noted that the statistics provided by the National Venture Capital Cooperation (NVCA) vary
significantly from year to year and should be used with caution.
Chapter 1: Introduction 3

disbursements to portfolio companies in 1995 to about 17 percent in 2000. 4 The high level of
VC investments is, to some extent, a result of the recent successes in the VC industry
especially in funding Internet related start-ups. This, again, is at least partially based on the
stock market rally of the last few years and especially on the strong IPO market until the year
2000. 5 The effects of the recent downturn in the stock markets and the bursting of the
Internet bubble on the VC and CVC activity levels need to be observed in the future. In the
second quarter of 2001 the capital disbursed to portfolio companies by US VC funds was
down more than 60 percent to USD 10.6 billion compared to one year earlier according to the
National Venture Capital 'Association (NVCA, 2001b: 2). Although this is a substantial
decrease, the level is still very high compared to the years before 1999. In Europe the same
number was only down 27 percent to 5.3 billion according to the European Venture Capital
Association (EVCA, 2001: 1).

Figure 1-2: US VC investments

USDbiliion
120,----------------------------------------.
100+-------------------------------------~

80+-------------------------------------~
Invest~

menu 60+-------------------------------------~

~+-----------------------------------~

20

. .. " nnnnnnnnnnnnnnnir
;'" "i!.:
." 5'" !'" = ;. ; ; ; ;.. ;
:2
i!.: ~ i!.: i!.:
r;;
i!.: ;'"
~
~ ~
...
'" i!.:~ ~ I
~ ~
IS
:;:
Year
Disbursements to portfolio companies by limited partnerships
Source: National Venture Capital Association Yearbook (2001 a: 27)

CVC may potentially lead to significant benefits for the investing company. The basic idea is
that established companies can help start-ups by providing valuable resources, e.g., sales
channels, teclu;tology expertise, industry contacts etc. At the same time, the established
companies may gain benefits from working with start-ups since start-ups drive innovation in

NveA (200 I a: 38). These percentages only include direct eve investments and not commitments to ve
funds.
See 2.2.2 for a more detailed discussion of the ve market.
4 Chapter I: Introduction

many industries, partially creating new industries. 6 Observing start-ups closely and working
with them early on may give companies a lead in building valuable technology and market
knowledge. 7

Typically, established companies target strategic and financial objectives with eve.
Strategic objectives are generally considered most important for corporations8 and varying
strategic objectives are discussed in the literature. 9 Sykes (1990: 41), for example, lists six
different strategic objectives of eve: identify new opportunities, develop business
relationships, find potential acquisitions, leam how to do venture capital, change corporate
culture and assist spin-outs from the corporation.

The success of eve 'investments, however, has been limited; one strong indicator being the
average lifetime of eve activities as most eve programs are discontinued after only a few
years in operation. Gompers and Lerner (1998) state that the average eve program between
1983 and 1994 lasted an average of 2.5 to 4.4 years. Another indicator of eve success is
how satisfied management is with eve. Schween (1996) concludes from interviews that
most German eve programs reached neither their strategic nor their financial objectives.
75% of eve programs that Schween analyzes were planned to be discontinued in 1995.
Self-assessments by eve managers in the US seem to indicate somewhat better results of
eve. Siegel, Siegel and MacMillan (1988: 242), for example, find a general satisfaction of
eve managers relative to their objectives that rates from 1.75 to 2.8 (I-unsatisfactory, 2-
satisfactory, 3-highly satisfactory, 4-outstanding). Not one eve manager, however, assesses
his own activities as highly satisfactory.

The level of eve activity as well as the potential benefits from eve in combination with its
limited sucpess has already attracted some academic research on eve.!o eertain aspects like
specific targeted eve benefits, eve success measures or the eve impact on overall
company success, however, have not been discussed to a sufficient extent, as shown below.

6 E.g., Apple, Compaq and Dell in the PC industry; Microsoft in PC software; Intel and AMD in
microprocessors; Cisco in Internet infrastructure technology; Yahoo as an Internet portal and Amazon in
Internet retailing.
7 See 2.3.2 and especially 2.3.3 for a reasoning for CVC.
8 See, for example, Schween (1996: 79).
9 See 2.3.2 for a detailed discussion ofCVC objectiveslbenefits.
10 See 2.8.
Chapter 1: Introduction 5

1.2. Open issues and research objective

As further discussed in chapter 2, especially in 2.3.2 and 2.8, quite a lot of research has been
undertaken on eve. II Although there has been little recent research on eve, a number of
studies have been undertaken to determine the success factors of eve, e.g., Gompers and
Lerner (1998), Schween (1996), Siegel, Siegel and MacMillan (1988), Sykes (1990), Yates
and Roberts (1991). Factors that are identified as impacting the success of eve include:
formulating clear objectives with a financial and strategic focus, commitment from top
management, staffing skilled eve managers with appropriate compensation, frequent contact
and working relations with the funded start-ups etc.

In addition to the research on eve success factors, some research has been done on eve
objectives. This research, however, stays at a rather abstract level, differentiating financial
from strategic objectives and discussing several high level strategic eve objectives. So far
there has been little emphasis on specifi9 eve benefits that need to be realized in order to
generate strategic objectives. Little emphasis is also put on the exact processes that may lead
to achieving eve objectives. For example, how eve is supposed to open a "window on
technology" which is one of the most often cited objectives is not discussed in detail. Siegel,
Siegel and MacMillan (1988: 246) state the need for further research "in order to determine
how corporate venture capitalists successfully integrate financial and strategic considerations,
and which benefits are most likely to be achieved." McNally (1997: 225) argues along the
same lines and states "a need for further research, possibly of a more qualitative nature."

While there has been some research on eve objectives, there has been limited research on
success measures for eve that help to determine whether strategic objectives are being
met. 12 The literature indicates difficulties in measuring eve's strategic success, e.g., Siegel,
Siegel and MacMillan (1988: 241), Berger and Dordrechter (1998: 90).\3 Sometimes
financial success is proposed as an indicator for strategic success. While financial success
may be necessary to achieve strategic objectives it is not sufficient. 14 As the only exception,
Kann (2001: 113-141) proposes a valuation framework for eve that is partially based on
option values. For this valuation framework, however, applicability and advantages remain
to be shown. Not having any measurements of success creates two major disadvantages:

II In the following study only research related to the investing company is considered. The whole study
focuses on the role of eve for the investing company. The funded start-up is only considered when
necessary from the view of the investing company. eve may also be analyzed from the perspective of the
funded start-up and also that of non-corporate venture capitalists who work with the investing company.
12 This is in line with the assessment by Kann (200 I: 153).
13 See 2.5.5, for a brief discussion of the issue of measuring strategic eve success, including a brief
discussion of possible dimensions of measurement.
14 See 2.3.2 for a more detailed discussion of the relationship between financial and strategic objectives.
6 Chapter 1: Introduction

fIrst, without success measures, top management has no way of understanding how
successful eve is done. This might be one reason, why top management has discontinued
eve activities in so many cases. Second, it is difficult to improve the use of eve to achieve
objectiveslbenefIts better without knowing how well the activities are currently being
performed.

Finally, no research has been done so far on trying to determine the overall and possibly
lasting impact of eve on company performance. IS Previous studies implicitly assumed that
objectives that have ~een achieved have a positive effect on company performance. The
main research objective of this study is to analyze the impact of evc on overall company
performance which may provide valuable insights on whether to do eve or under what
conditions. Insights on the impact of eve on overall company performance may also help to
optimize the use of eve directly or indirectly by providing additional insights on factors of
success for eve, the specifIc benefIts of eve and success measures for eVC)6

In this study, the impact of eve on overall company performance will be analyzed indirectly
by determining whether eve potentially has an impact on sustainable competitive advantage
of the investing company.t7 The following research question is formulated:

Does Corporate Venture Capital (evC) have the potential to impact sustainable
competitive advantage of the investing company?

In order to discuss the research question, this study tries to achieve three objectives:

1. To develop a conceptual model to determine the potential impact of eve on


sustainable competitive advantage of the investing company)8

2. To show the applicability of the developed conceptual model.

3. To improve/optimize the developed conceptual model allowing its application for


conducting future research and for optimizing the use of eve in practice.

The approach used to achieve these objectives is discussed below.

IS Although they do not try to evaluate the impact of eve on overall company success, Kurz and Wehmeyer
(1999) help to close this gap to some extent by assessing the impact of eve on company strategies like
differentiation or cost leadership.
16 It may even be argued that the understanding of the impact of eve on overall company performance
provides the basis for determining factors of success, benefits or success measures.
17 As discussed in 2.1.1, sustainable competitive advantage may be defined as leading to above average
returns.
18 In this study only the potential positive impact of eve on the investing company is analyzed. eve may
also have a negative impact on competitive advantage, for example, because it distracts management from
focusing on possibly more important issues.
Chapter 1: Introduction 7

1.3. Structure and Approach

The research question and objectives of this study that have been introduced above will be
discussed as follows.

In chapter two, the basic cO,nstructs that are part of the research question are introduced:
sustainable competitive advantage and CVC. First, sustainable competitive advantage is
discussed (2.1). Two theories are introduced that explain sustainable competitive advantage:
the market-based view (2.1, .2) and the resource-based view (2.1.3). The resource-based view
is chosen as a basis for discussing the impact of CVC on sustainable competitive advantage
(2.1.4). Next, venture capital (VC) is discussed as a basis of CVC (2.2), VC is defined and
the VC process is described in detail. Finally, CVC is introduced in three basic steps: CVC is
defined (2.3.1), CVC objectives and specific targeted benefits are derived (2.3.2-2.3.3) and
the CVC process is described in detail (2.4-2.7). The CVC process is divided into two sub-
processes: setting up CVC and running CVC. In the discussion of these processes, previous
findings on CVC are incorporated. Previous empirical research on CVC is summarized (2.8).

Based on the resource-based view of the firm, a conceptual model is developed in chapter
three. This CVC-Impact-Model explains how CVC may impact sustainable competitive
advantage of the investing company (3.1). The model builds on two hypotheses: first, CVC
results in benefits. Second, the benefits of CVC have the potential to impact on sustainable
competitive advantage. These two hypotheses of the CVC-Impact-Model are operationalized
with the help of three variables (3.2). The focus of the CVC-Impact-Model is on analyzing
possible positive effects of CVC on the company. CVC may also negatively impact
sustainable competitive advantage. This possible negative impact is not considered in this
study.

The CVC-Impact-Model is applied in case studies to illustrate its applicability for analyzing
the potential impact of CVC on a sustainable competitive advantage and to improve/optimize
the model based on first findings in chapter four. The case study approach is introduced in
4.1. Four case studies have been conducted and are presented and analyzed in subchapters
4.2 to 4.7.

In chapter five, the results of this study are summarized as implications for research (5.1) and
for management (5.2). Finally, the limitations of this study are discussed and possible future
research is suggested (5.3).
Chapter 2: Theoreticalfoundation 9

2. Theoretical foundation

As fonnulated in 1.2, the research question that is discussed in this study is: 'Does Corporate
Venture Capital (CVC) have the potential to impact sustainable competitive advantage of the
investing company?' To discuss the research question, two tenns need to be defined and the
underlying concepts discussed first: sustainable competitive advantage and CVC. First, the
theory of sustainable competitive advantage will be reviewed (2.1) with a special emphasis
on the resource-based view. Next, venture capital (VC) will be introduced as a basis for
CVC (2.2), then CVC will be discussed extensively (2.3-2.8). On the basis of the definitions
introduced an approach will be developed, in chapter 3, to test whether CVC has the potential
to impact sustainable competitive advantage of the investing company.

2.1. Sustainable competitive advantage

Sustainable competitive advantage needs to be defined in order to specify the research


question, fonnulated in 1.2. Sustainable corripetitive advantage is discussed in 2.1.1. Two
theories that try to explain the sources of sustainable competitive advantage are the market-
based view (see 2.1.2) and the resource-based view (see 2.1.3). In 2.1.3.2 attributes are
discussed that determine whether certain finn resources can lead to sustainable competitive
advantage. The resource-based view is identified as the more appropriate approach for this
study (see 2.1.4). In chapter 3, the attributes that detennine whether a resource can lead to
sustainable competitive advantage will be used to analyze the potential impact of CVC
activities on sustainable competitive advantage.

2.1.1. Definit~on of sustainable competitive advantage

"The pursuit of competitive advantage is an idea that is at the heart of much of the strategic
management literature ... " (Fahy, 2000: 94). Nevertheless, there is no generally accepted
definition of competitive advantage according to Faix and Gergen (1994: 160). Some
attributes that may explain the nature of competitive advantage are the following: Faix and
Gergen (1994: 160) state that competitive advantage leads to superior customer value.
Simon (1988: 464) stresses the notion of a relative advantage over competitors as an attribute
of competitive advantage. 19 According to Grant (1998: 174) competitive advantage
potentially leads to a higher rate of profit.

Competitive advantage does not only need to be a relative advantage over competitors that is
important to customers, as discussed above. In addition, it is important that " ... a finn's
10 Chapter 2: Theoreticalfoundation

competitive advantage resists erosion by competitive behavior or industry evolution." (Porter


1985: 20) In other words, competitive advantage needs to be sustainable. Barney (1991: 102)
explains sustained competitive advantage as an objective of strategy formulation: "A firm is
said to have a sustained competitive advantage when it is implementing a value creating
strategy not simultaneously being implemented by any current or potential competitors and
when these other firms are unable to duplicate the benefits of this strategy."20 If a
competitive advantage is not sustainable it is lost at some point in time through duplication.
The notion that a competitive advantage needs to be sustainable is not only discussed by
Barney. Simon (1988: 465) also states that a competitive advantage21 should not equally be
achieved by competitors quickly. According to RumeIt (1984: 567), a competitive advantage
is sustainable if isolating mechanisms22 " . . . make competitive positions stable and
defensible."23 Although a sustainable competitive advantage may not be eroded through the
duplication efforts of others, it may cease to exist through unanticipated changes in the
economic structure ofan industry (Barney, 1991: 103; Rumeit, 1984: 569).24

In the literature, sustainable competitive advantage is typically explained by discussing its


sources. Two major different approaches exist that try to explain the sources of competitive
advantage,25 one focusing on the external view the other on the internal view of a firm: the
market-based view and the resource-based view. 26 Figure 2-1 shows the basic reasoning of

19 Corsten (1998: II) also stresses the notion that competitive advantage is a relative advantage over
competitors rather than an absolute advantage.
20 Bhide (1986) questions the importance of sustainable competitive advantage, at least in the financial
services industry. He argues that superior execution and hustle are the basis for success in the fmancial
services industry. Important in the financial services industry are, for example, control systems, people and
vision since they enable a firm to execute well and fast. Control systems, people and vision, however, are
resources that impact the competitive advantage according to the resource-based view as discussed in 2.1.3.
21 Simon (1988: 464) uses the term "strategischer Wettbewerbsvorteil" (strategic competitive advantage).
22 See 2.1.3.3 for a discussion ofisolating mechanisms.
23 Rumelt (1984: 564) argues that a competitive advantage based on unique skills and strengths is stable.
24 Williams (1992: 29) states that time " ... eventually renders nearly all advantages obsolete." Christensen
(200 I) argues that competitive advantage is very specific to particular factors, conditions and times and
therefore typically will cease to exist when circumstances change especially through disruptive
technologies.
25 See, for example, Lado, Boyd and Wright (1992: 77).
26 Besides these major approaches to explain the basis of sustainable competitive advantage, there are other
discussions too. It may be argued that these approaches also are a part of either the resource-based or the
market-based approach. Covin and Miles (1999), for example, state that quick response is also a basis for
competitive advantage. Stalk (1988) argues that time is a source of competitive advantage, e.g., reducing
manufacturing time, sales and distribution time and time for innovation. (Also see Bhide, 1986.)
Chapter 2: Theoreticalfoundation 11

both theories. The creation of sustainable competitive advantage based on the market-based
view will be discussed in 2.1.2; the resource-based view will be discussed in 2.1.3.27

Figure 2-1: Two main theories explain the sources of competitive advantage

Market-based view I Market,structure H Conduct H Performance

Analyze market! Choose strategy to Above average


induslQ" structure establish a favorable performance - based
position on market
(differentiation or cost~ imperfection
leadership) leading to

H H
competitive advantage

Resource-based view Resource base ,Conduct Performance

Build resources as a Choose strategy Above average


basis of competitive exploiting resource- performance - based
advantage based advantage on valuable resources
that are hard/expensive
to copy

Source: Based on Carsten, 1998: 17

2.1.2. Market-based view

As shown in Figure 2-1, according to the market-based view, a firm may be able to create
sustainable competitive advantage in three steps. First, a firm analyzes the industry structure.
Second, based on the industry structure, a firm chooses a strategy to position itself favorably
in the market. Third, above average returns result from the competitive advantage, which is a
superior market position.

The market-based view is based on work done by Porter. 28 Porter suggests a framework for
analyzing the industry structure. This framework is often called Porter's five forces. Porter
assumes that industry structure can be influenced by five different forces: rivalry among
existing firms (industry competitors), the bargaining power of suppliers, the bargaining
power of buyers, the threat of potential new entrants and the threat of substitute products or
services (Porter, 1985: 5). Different determinants impact every single source (Porter, 1985:

27 It should be noted that strategy and therefore a sustainable competitive advantage based on a strategy may
not necessarily be the consequence of a deliberate strategy formulation and execution. Strategies may
emerge as Mintzberg (1987: 68) argues.
28 Porter (1980). For a comprehensive discussion of Porter's ideas see, for example, Porter (1985).
12 Chapter 2: Theoreticalfoundation

6). Rivalry determinants are, for example, industry growth, brand identity or exit barriers.
Determinants of supplier power include, for example, differentiation of inputs or supplier
concentration. Buyer volume, buyer switching costs or price sensitivity are examples of
determinants of buyer power. Entry barriers are, for example, economies of scale or access
to distribution. Determinants of the substitution threat include the relative price performance
of the substitute or buyer propensity to substitute.

Based on the industry structure, firms can create competitive advantage by positioning
themselves in the mm;ket. Porter (1985: 11-16) proposes three generic strategies, firms can
choose to position themselves in the industry: cost leadership, differentiation and focus. A
firm can try to gain, cost leadership by becoming the low-cost producer in the industry,
serving many different market segments. A firm can also choose the generic strategy of
differentiation. In this case a firm tries to become unique along some dimensions in order to
offer product or service attributes that meet specific needs in the industry for a premium
price. Finally, firms may also choosjl to focus on specific market segments in order to serve
these based on a cost or differentiation advantage. 29

Porter (1985: 33-53) suggests the concept of the value chain as a tool to support the
implementation of the strategy chosen within an organization. The value chain disaggregates
the firm into its strategically relevant activities. Porter identifies five primary activities and
four support activities. Primary activities are inbound logistics, operations, outbound
logistics, marketing and sales and service. Support activities are procurement, technology
development, human resource management and firm infrastructure. In order to implement a
strategy, all elements of the value chain need to be set up or managed in a way that is
consistent with the strategy chosen, i.e., in a way that creates the basis for a cost or
differentiatIon advantage. 3o

The strategy a firm chooses may lead to a superior positioning within an industry. A superior
positioning is the source of competitive advantage and this determines the performance of a
firm. Each generic strategy, cost leadership, differentiation or focus, may lead to a
competitive advantage. Competitive advantage, however, needs to be sustainable in order to
lead to above-average performance. In order to create sustainable competitive advantage, a
firm needs to create barriers to prevent imitation. Porter discusses different barriers that may
prevent imitation (porter 1985: 112-113; 158-160; 266-269) which include the following:

29 Specific sources of cost advantages can be economies of scale, experience curve effects, process
technologies, product design, input costs or capacity utilization. Specific sources of differentiation
advantages can be superior product quality, customer service, value-added features, innovativeness,
logistical support or branding. (Partially based on Corsten (\998: 95-96).)
30 For a more detailed discussion see Porter (\985: 33-61).
Chapter 2: Theoretical foundation 13

scale, interrelationships with sister business units, proprietary learning, first mover
advantages or customer switching costs. The concept of barriers to imitation is similar to the
concept of isolating mechanisms in the resource-based literature. Isolating mechanisms will
be briefly discussed in 2.1.3.3.

The market-based view overall and the generic strategy options in particular have been
critically and widely discussed in the literature. Other authors suggest additional strategic
options for a firm including hybrid and dynamic strategies. 31 Gilbert and Strebel (1987), for
example, suggest a dynamic outpacing-strategy-approach that combines cost leadership and
differentiation based on the current mode of competition. Generic strategies overall may
only serve to a limited extent as sources of sustainable competitive advantage since they are
imitable by definition (Thiele, 1997: 33). Another possible limitation of the market-based
view is the strong focus on company-external factors in order to explain competitive
advantage (e.g., Rasche and Wolfrum 1994: 502). According to the market-based view,
competitive advantage is based on a positioning advantage, which takes advantage of a
market situation. A significant focus of the market-based view is on company-external
factors although Porter emphasizes the role of company-internal activities as well, for
example, by describing the value chain concept. 32 Nevertheless, the resource-based view
puts a stronger emphasis on company-internal factors, as discussed in the next subchapter.
The discussion in 2.1.4 will show that the market-based and resource-based view can be
considered as complementary based on their different emphasis on company-external and -
internal factors of competition.

2.1.3. Resource-based view

In addition to the market-based view, the resource-based view tries to explain the sources of
sustainable competitive advantage. As indicated above, Porter's work is widely accepted as
an overarching framework of the market-based view with a more or less consistent
terminology,33 There is no equivalent widely accepted and coherent body of theory on the
resource-based view and no common terminology exists. 34 Instead, the resource-based view

31 For a summary see Corsten (1998: 98-135).


32 For additional reasoning, why the market-based view takes company-internal factors into consideration see,
for example, Knyphausen (1993: 781-785) or Porter (1985: XIV).
33 Different authors discuss additions, limitations and changes to the frameworks introduced by Porter, see, for
example, footnote 31.
34 See, for example, Collis (1991: 50), Corsten (1998: 137), Friedrich (1995: 326), Peteraf(1993: 179-180),
Rasche and Wolfrum (1994: 511-513).
14 Chapter 2: Theoreticalfoundation

builds on the work of many authors focusing on different specific issues, as partially shown
below. 35

The basic idea of the resource-based view is that a firm's success is based on the existence of
(unique) resources that cannot be copied by competitors. As shown in Figure 2-1, the
resource-based view assumes that all market players have different control over unique
resources that may be the basis of competitive advantage. This competitive advantage can be
leveraged through distinct strategies and may lead to an above average performance of a
firm.36 Therefore, ~cording to Wemerfelt (1984: 171) a firm is not seen through its
activities in the product market but as a unique bundle of tangible and intangible resources, or
as Rumelt (1984: 55,7) states, "... a firm's competitive position is defined by a bundle of
unique resources and relationships ... ". Firms are different and competitive advantage may
be sustainable, because of the uncertain imitability of unique resources (Rumelt, 1984:
561).37 Uncertain imitability is further discussed as a necessary attribute for resources to be
the source of sustainable competitive advantage in 2.1.3.2 and 2.1.3.3.

Resources are seen as inputs to the production process (Grant, 1991: 118).38 Wemerfelt
(1984: 172) states: "By a resource is meant anything which could be thought of as a strength
or weakness of a given firm." Wemerfelt includes all tangible and intangible assets and gives
examples of resources: "Brand names, in-house knowledge of technology, employment of
skilled personnel, trade contacts, machinery, efficient procedures, capital etc." Barney (1991 :
10 1) defines resources as "... all assets, capabilities, organizational processes, firm attributes,
information, knowledge etc. controlled by a firm that enable the firm to conceive of and

35 The resource-based view is typically not considered to be a new concept but a reformulation and
enhancement of existing ideas formulated, for example, by Penrose (1959) or Schumpeter (1934).
According to Wemerfelt (1995: 172), Wemerfelt (1984) and Rumelt (1984) were the first authors in a
recent stream of resource-based publications, although the basic ideas go back to Andrews (1971).
36 The management plays an important role since it needs to implement a strategy that leverages resources to
achieve a: superior performance from resources (Fahy, 2000: 98-99).
37 The resource-based view is also discussed outside the strategy literature. The resource-based view may
represent a new theory of the firm in industrial organization research, e.g., Lippman and Rumelt (1982) and
Rumelt (1984). Conner (1991) analyzes this question. In addition, " ... the resource-based view may
arguably be considered a fifth branch of the organizational economics' tree of knowledge ... " (Mahoney
and Pandian 1992: 363). Bamberger and Wrona (1996) also discuss how the resource-based view may be
linked with other economic theories. In the marketing literature Hunt and Morgan (1995) suggest the
"comparative (or resource) advantage theory of competition" as a new theory that also draws on the
resource-based view. (Also see Deligonill and <;:avusgiJ (1997), Hunt (1995), Hunt (1997), Hunt and
Morgan (1996), Hunt and Morgan (1997)) For a distinction between the resource-based and market-based
view see 2.1.4.
38 Grant distinguishes between resources and capabilities. "Resources are inputs in the production process
[ ... ] A capability is the capacity for a team of resources to perform some task or activity." (Grant, 1991:
118-119) Other authors make similar distinctions. Day and Wensley (1988: 2-3), for example, defme skills
as "distinctive capabilities of personnel" and resources as "more tangible requirements for advantage".
These distinctions are not used in this study. Instead capabilities are regarded as specific resources.
Chapter 2: Theoreticalfoundation 15

implement strategies that improve its efficiency." Resources can be categorized as different
resource types as discussed in 2.1.3.1.

Two prerequisites need to be met to generate sustainable competitive advantage based on


resources. First, strategic resources need to be heterogeneously distributed among firms.
Second, resources may not be perfectly mobile (Barney, 1991: 101, 103-105, Rumelt 1984:
560). Without resource heterogeneity among fIrms, no firm would be able to outperform
another, since superior resources, which are the basis of competitive advantage, would not
exist. Without immobility, of resources among firms, heterogeneity would not exist. In
contrast to the economic perspective, resources are not seen as immediately accessible but as
factors of production that develop over time and are often immobile (e.g., Collis, 1991: 50).
Critical resources are accumulated rather than acquired in "strategic factor markets" (Barney,
1986b, Dierickx and Cool, 1989).

Different attributes of resources ensure the heterogeneity and immobility of resources and
determine the potential of single resources to create sustainable competitive advantage.
These attributes are discussed in detail in 2.1.3.2 and 2.1.3.3. "The essential theoretical
concept for explaining sustainability [... ] is 'isolating mechanisms.'" (Mahoney and Pandian,
1992: 371). Isolating mechanisms, which prevent imitation of resources, are briefly
discussed in 2.1.3.3 as welJ.39 In 2.1.4, it is argued that the market-based view and the
resource-based view are complementary.40

2.1.3.1. Resource types

In order to provide a better insight into the resource-based view different resource types will
be discussed in the following section. Different authors discuss resource types and list

39 For a critical discussion of the resource-based view see Thiele (1997: 62-64).
40 Prahalad and Hamel (1990) introduce the concept of core competencies. The concept of core competencies
was developed on the basis of the resource-based view (KrUger and Homp, 1997: 62; Rasche, 1994: 92;
Thiele, 1997: 66). While there is no generally accepted definition of core competencies (Thiele, 1997: 73),
core competencies are considered as bundles of skills and technologies (Hamel and Prahalad, 1994: 223).
Therefore, core competencies are unique bundles of resources. Core competencies are considered to have
certain properties. Thiele (1997: 73) lists three properties: strategic relevance in several markets, a high
innovation and diversification potential based on a specific competence and strategic relevance for survival
in the market in the long run. Hamel and Prahalad (1994: 224-228) propose testing three properties to
identifY core competencies: disproportionate contribution to customer-perceived value, competitively
unique and extendable. Extendable means that the bundle of resources "... provides a potential basis for
entry into new markets." (Hamel and Prahalad, 1992: 165) This requirement for extendibility and the
dynamic notion that what is core and non-core changes over time (Hamel and Prahalad, 1994: 232)
differentiates core competencies from the resource-based view.
16 Chapter 2: Theoretical foundation

resources. The differences in distinguishing resource types are typically not significant but
reflect different levels of emphasis that are placed on different resources. 41 This study will
use an integrated structure of resource types that is based on the work of several authors as
discussed in the following section.

As an overall structure, this study will differentiate between tangible and intangible resources
(Wernerfelt, 1984: 172).42 Tangible resources are resources that often appear on the balance
sheet. 43 These can be divided into financial and physical resources (e.g., Grant, 1998: 113).
Financial resources include sources of capital like internal cash flow or debt. Physical
resources include resources like plant, equipment and location (e.g., Barney, 1991: 101).44

Intangible resources45 typically do not appear on the balance sheet. 46 Intangible resources
will be categorized as either human resources (e.g., individual skills and knowledge) or
organizational resources (e.g., reputation and reporting systems). Organizational resources
will be categorized as either organizational assets or organizational capabilities. 47
Organizational assets include intell~ctual property rights48 or contracts that can typically be

For a further discussion of core competencies also see Corsten (1998), Hamel and Prahalad (1993), Hamel
and Heene (1994), Hammann and Freiling (2000), Lado, Boyd and Wright. (1992), Leonard-Barton (1992),
RUhli (1995), Sanchez, Heene and Thomas (1996), Sanchez and Heene (1997), Steinle, Bruch and Nasner
(1997). A similar concept to core competencies (Hamel and Prahalad, 1992: 164) are core capabilities, e.g.,
Stalk, Evans and Shulman (1992).
41 This becomes apparent when comparing the overall structure that different authors use: Barney (1991: 101)
differentiates between physical capital resources, human capital resources and organizational capital
resources. Grant (1998:113) also discusses human resources. He adds fmancial assets to physical assets
and calls them tangible assets. What is called organizational capital resources by Barney is called intangible
assets by Grant. Bamberger and Wrona (1996: 133) uses a distinction between physical, financial,
intangible and organizational resources. Intangible resources include the human resources as well as
organizational assets. Beyond these sources especially in the discussion of core competencies or capability
platforms, e.g., Baghai, Coley and White (1999: 91), there are also discussions of resource types that differ
from those discussed in this subchapter.
42 Grant differentiates between tangible, intangible and human resources. Human resources are, for example,
skills, knowledge or motivation. These human resources are regarded as intangible resources in this study.
43 See, for example, Grant (1998: 112).
44 The value of a tangible resource stated on the balance sheet may be substantially below the actual value a
resource has for a company, e.g., real estate quoted at purchase price.
45 The concept of intangible resources (intangible assets) received wide recognition through the discussion by
Itami and Roehl (1987). Hall (1993) analyzes the role of nine different intangible resources in business
strategy.
46 See, for example, Grant (1998: 115).
47 This is in line with the approach by Hall (1992: 136) or Bamberger and Wrona (1996: 133) who categorize
intangible resources as being assets or skills.
48 These may be included on the balance sheet in some countries.
Chapter 2: Theoretical foundation 17

owned. Organizational capabilities include skills and knowledge that are not based on single
individuals, e.g., organizational routines or supplier networks.49

Other authors use all three categories of intangible resources discussed above, although not in
that specific combination. Human resources are described throughout the resource literature
(e.g., Barney 1991: 101, Grant, 1998: 113, Hofer and Schendel, 1978: 174-175). Human
resources include personal skills and knowledge, experience, judgment, intelligence, personal
relationships, personal insights and motivation. Organizational assets are discussed, for
example, by Bamberger and Wrona (1996: 133). These include intellectual property rights,
contracts, trade secrets, databases and reputation50 or brands. Organizational capabilities are
discussed, for example, by Barney (1991: 101) who calls them organizational capital
resources. Organizational capabilities include culture, a formal reporting structure, internal
informal relationships among groups, external networks (e.g., relationships with customers),
formal and informal planning, controlling and coordination systems as well as technology.51
The types of resources discussed above are summarized in Table 2-1.

It should be noted that some intangible resources may have the characteristics of
organizational resources as well as of human resources. Contracts, for example, are
organizational assets but they may very well depend to a large extent on human resources like
personal networks or the personal negotiation skills of a key employee.

49 This study basically uses two dimensions to structure intangible resources: skills and assets as well as
organizational and individual resources. Using this structure, theoretically four different types of intangible
resources can be identified: organizational skills (called organizational capabilities), organizational assets,
individual skills and individual assets. The differentiation between individual skills and assets, however, is
not practical since individuals within firms typically do not own intangible assets like property rights,
except, e.g., for artists.
50 Separated into firm reputation and product reputation by Hall (1992: 141).
51 Technology is understood as organizational know-how that is based on a mix of different individual skills,
experience, working relationships, communication among people etc. Barney (1991) views technology
from a technical perspective and categorizes it as a physical capital resource.
18 Chapter 2: Theoreticalfoundation

Table 2-1: Resource typesS2


Tangible Resources Intangible Resources


Financial Human
Cash Personal skills and knowledge


Debt Experience
Physical Judgment
Plant

Intelligence
Equipment Personal relationships

Location 53

Insights
Motivation


Organizational assets
Intellectual property rights
Contracts
Trade secrets


Databases
Reputationibrands


Organizational capabilities
Culture


Formal reporting structure
Internal informal relationships among groups
External networks


Formal and informal planning
Controlling and coordination systems
Technology

2.1.3.2. Attributes of sustainable competitive advantage

In the resource-based view, firms are seen as unique bundles of tangible and intangible
resources (Wernerfelt, 1984: 171, 172). Not all resources, however, have the potential to
create sustainable competitive advantage. Several authors derive attributes that determine
whether resources have the potential to create sustainable competitive advantage.

The attributes discussed by five different authors are summarized in Table 2_2.54 The
different views on the resource attributes necessary for sustainable competitive advantage
that are shown in Table 2-2 are to a large extent similar as shown in Figure 2-2. 55

52 The specific resources listed are examples and do not present a complete list.
53 Location is not a clear-cut tangible resource and its value is only partially reflected in a balance sheet. The
balance sheet value of a location may not reflect the positive effects it may have on business, e.g., retail
location with high customer traffic, location of a plant close to suppliers.
54 In addition to the authors mentioned here, others also discuss resource attributes for sustainable competitive
advantage, e.g., Thiele (1997: 46-55), Rasche (1994: 68-90), Friedrich (1995: 331-334). The sources
discussed in this study, however, provide a comprehensive overview of resource attributes and other sources
do not provide significant additional insights.
Chapter 2: Theoretical foundation 19

Table 2-2: Summary of different views regarding attributes determining sustainable


competitive advantage
Source Attributes determinin2 sustainable competitive advantage
Bamey, 1991 Resources need to have four attributes to have the potential for sustainable


competitive advantage:
Value


Rareness
Imperfect imitability (based on
-HiStorical dependency
-Causal ambiguousness


-Social complexity)
No strattlgicalJy eguivalent substitutes


Grant, 1991 Grant describes two factors that determine the returns to a resource:
Ability to appropriate returns from resources
Sustainability of the competitive advantage


Sustainability has four determinants:
Durability


Transparency
Transferability
RflPlicability


Peteraf, 1993 Four conditions underlie sustainable competitive advantage and all need to be met:
Superior resources


Ex post limits to competition
Imperfect resource mobility
Ex ante limits to competition
Collis and Competitive advantage can be attributed to resources which pass a number of external


Montgomery, 1995 market tests:
Test of inimitability


Test of durability
Test of appropriability


Test of substitutability
Test of competitive superiority


Bamberger and Competitive advantage is based on two attributes of resources:
Wrona, 1996 Value
Rareness


Sustainability is based on four more attributes of resources:
Durability


Transferability
Imperfect imitability
Imperfect substitutability
Finally, resources need to be appropriable to create sustainable competitive advantage

55 Amit and Shoemaker (1993: 38-40) discuss eight similar attributes as "primary determinants of the rent
producing capacity of a fIrm's Strategic Assets". Besides scarcity (rareness), appropriability, inimitability,
limited substitutability and durability, they discuss complementarity, overlap with strategic industry factors
and low tradeability. Complementarity exists when the combined value of the fIrm's resources may be
higher than the individual value, overlap with strategic industry factors describes the applicability of the
fIrm's resources to a particular industry setting. Therefore, both influence the value of resources.
Tradeability is subsumed under imperfect imitability in this study.
20 Chapter 2: Theoretical foundation

Figure 2-2: Comparison of views on attributes of sustainable competitive advantage

_ I,dudod
Value Ratenc:u Imperfect Imperfca Appro- Outatiht)' _ Imphcll1y
IIIIILltnhl)' JUb.stI~ pnabthl)' UK:itHkd

Barney. 1\191

Grant. 1991

Pdcra!.1993

CoIhs,and
MOIUCgmc:ry,
I\I9S

Oomb<ra
and Wrona.
1\196

Rephc-allOtl ahemall\'Cly may lead 1.0 SUbsilll.llc resourcC$ In some CUC:l

The attributes of sustainable competitive advantage that are discussed by different authors are
reviewed in more detail in the following section. Barney's view on resource attributes that
lead to sustainable competitive advantage is used as a basis for the discussion of Grant's,
Peteraf's, Collis and Montgomery's and Bamberger and Wrona's findings. The integrated
view that is used in this study is presented in 2.1.3.3.

Attributes ofsustainable competitive advantage according to Barney, 1991

According to Barney (1991), resources have the potential to create sustainable competitive
advantage if they have four attributes. 56 They need to be valuable s7 , rare, imperfectly
imitable and may not have strategically equivalent substitutes58 . If resources have all four
attributes, than they have the potential to create sustainable competitive advantage. 59 If
resources meet all four attributes, they have the potential to create sustainable competitive

56 Barney's discussion builds on his earlier work, e.g., Barney (1986a).


57 Valuable in this context does not directly mean valuable in a financial sense. Instead, valuable is used more
in the sense of advantageous. As discussed below, resources may lead to increased efficiency or
effectiveness and therefore are advantageous for a firm. Increases in efficiency or effectiveness, however,
should ultimately also lead to increased value in the financial sense.
58 The attribute 'no strategically equivalent substitutes' is called imperfect substitutability in this study.
59 In such a case, resources can lead to a sustainable competitive advantage if they are leveraged with the help
of a strategy that is based on these resources.
Chapter 2: Theoreticalfoundation 21

advantage because they are heterogeneous and immobile. 6o "These attributes of firm
resources can be thought of as empirical indicators of how heterogeneous and immobile a
firm's resources are and thus how useful these resources are for generating sustained
competitive advantage." (Barney, 1991: 106) The four attributes introduced by Barney,
value, rareness, imperfect imitability and imperfect substitutability, are discussed in the
following paragraphs.

A resource needs to be valuable in the sense that it helps to exploit opportunities and/or to
neutralize threats in a firIn's environment in order to have the potential for sustainable
competitive advantage. Environmental models of competitive advantage (e.g., Porter's Five
Forces) can help to dete~e whether a resource is valuable in this respect. Generally
speaking, a resource is valuable if it helps to increase the firm's efficiency or effectiveness. A
valuable resource holds the potential to create sustainable competitive advantage. 61
Resources must have additional characteristics in order to lead to sustainable competitive
advantage as explained in the following.

A resource needs to be rare in order to have the potential to create sustainable competitive
advantage. Resources that are possessed by a large number of firms cannot be a source of
competitive advantage since all firms can copy strategies that build on such valuable
resources. Implementing a common strategy, however, does not create a competitive
advantage for any firm. It is not easy to determine how rare a valuable resource needs to be
to create competitive advantage. If a single firm has a valuable resource or bundle of
resources it may be able to generate competitive advantage. When several firms in an
industry own a valuable and rare resource it can still be a source of competitive advantage as
long as the number of firms is less than the number needed to generate perfect competition
dynarnics in an industry. (See Barney, 1991: 107) A valuable and rare resource can help the
firm to generate a competitive advantage. Whether such a competitive advantage is
sustainable depends on additional attributes.

A valuable and' rare resource can be a source of competitive advantage. This competitive
advantage, however, is not sustainable if other players imitate the resource it is built on.
Therefore resources need to be imperfectly imitable in order to be sources of sustainable
competitive advantage. Ways of preventing imitation are also discussed as isolating
mechanisms in the literature (a term coined by Rumelt, 1984). See 2.1.3.3 for a more
detailed discussion of isolating mechanisms. According to Barney, a resource can be

60 See 2.1.3.
61 When investing in building valuable resources, companies need to consider not only the benefits of
resources but also the costs of building these, e.g., Rasche and Wolfrum (1994: 507).
22 Chapter 2: Theoreticalfoundation

imperfectly imitable for one or more of three reasons: unique historical conditions, causal
ambiguity and social complexity.

The ability of a firm to obtain a resource may be dependent upon unique historical
conditions. The history of a firm may impact its ability to acquire and exploit certain
resources. This is called path dependency. If a firm obtains a valuable and rare resource
because of its unique path through history, it will be able to exploit those resources since
firms without that specific path through history cannot obtain that resource.

The causal link between the resource possessed by a firm and a firm's sustainable competitive
advantage may be ambiguous and therefore prevent imitation. Barney uses the term causal
ambiguous to describe that it is not understood (or very imperfectly understood) how a
resource may create sustainable competitive advantage. 62 This makes it difficult for
competing firms to copy a strategy based on resources since they do not understand which
valuable and rare resources are essential and need to be duplicated for that specific strategy.
It is important that not even the firm with the competitive advantage understands how
resources create the advantage. If the firm knew, competitors would potentially be able to get
access to that knowledge e.g., by hiring key employees from the competitor, and acquire the
necessary resources for duplicating the strategy that leads to competitive advantage.

A similar issue to causal ambiguity is discussed as the tacit knowledge phenomena.


According to the theory, firms may have knowledge that is not explicit. This kind of
knowledge is called tacit knowledge (Nonaka 1994: 16).63 While Nonaka calls that type of
knowledge tacit that is not articulated no matter why, Winter (1987: 170) differentiates
between tacit knowledge vs. knowledge that can be articulated claiming that individuals (or
groups of iQ.dividuaIs) may not be able to articulate tacit knowledge. 64 Sometimes firms may
not be aware of the role of knowledge that is not articulated6S , sometimes the owner of the

62 Also see Rumelt (1984: 561-562).


63 Tacit knowledge includes theoretical knowledge components as well as practical skills (RUdiger and Vanini,
1998: 470).
64 This, just like the term and basic idea of tacit knowledge, goes back to Polanyi who introduced the term
"tacit knowing" and describes it, for example, as "we can know more than we can tell" (1966: 4).
6S RUdiger and Vanini (1998: 470-472) develop a more specific definition of tacit knowledge. They pick up
the two differentiations explicit vs. not articulated and possible to articulate vs. not possible to articulate (or
efficiently vs. not efficiently possible to articulate) and add a third dimension. The owner of the knowledge
mayor may not be aware of the relevance of the knowledge. RUdiger and Vanini use the term implicit
knowledge for knowledge that is not articulated. Tacit knowledge is a certain form of implicit knowledge
that cannot be articulated or for which the owner of the knowledge is not aware of the relevance of the
knowledge (or both).
Chapter 2: Theoretical foundation 23

knowledge may be unwilling to articulate that knowledge. 66 No matter what the exact
reasons for tacit knowledge are, tacit knowledge is hard to imitate for competitors. Typically
intangible resources (especially human and organizational capabilities) may have a tacit
knowledge dimension, because intangible resources often include experiences, routines or
networks that are not reflected on. Resources that have a tacit dimension may meet the
attribute imperfect imitability.

The resource generating a firm's advantage may be socially complex and therefore hard to
imitate. If social phenomlma that result in competitive advantage are so complex that they
cannot be systematically managed and influenced, then other firms cannot imitate such social
phenomena and they are a,source of sustainable competitive advantage. Such complex social
phenomena may be interpersonal relationships among managers, the culture within a firm or
the finn's reputation among suppliers or customers.

In order for a resource to generate sustainable competitive advantage it is not enough for the
resource to be valuable, rare and imperfectly imitable. If a strategically equivalent substitute
that is not rare or imitable exists for a valuable, rare and imperfectly imitable resource, then
competitive advantage is not sustainable. Two resources are strategically equivalent
substitutes when they can be exploited to implement the same strategies. If such a substitute
exists, then a strategy that is based on exploiting a valuable and rare resource can be copied
by other firms because they can exploit another resource that is not rare or imitable to
implement the same strategy. This substitute resource can either be similar or very different
from the resource it substitutes as long as it results in an equivalent strategy. An example of
a similar substitute are two top management teams that are not the same but similar and able
to introduce a certain strategy successfully. A very different substitute for a charismatic
leader with a vision for the firm may be a sophisticated formal planning system that leads to a
similar vision. 67

The four different attributes of sustainable competitive advantage that Barney describes may
be separated into two different sets of attributes. When a resource is valuable and rare it may
be a source of a competitive advantage. A competitive advantage that is based on a valuable
and rare resource is also sustainable if the resource is imperfectly imitable and imperfectly
substitutable.68

66 Pearson, Brockhoff and Boehmer (I 993: 256) differentiate between different reasons for tacit
knowledge/sticky information: people are unable to transfer, people are unwiIling to transfer, people do not
perceive it worthwhile transferring.
67 See Barney (1991: 111-112) for a more detailed discussion of the examples,
68 A similar differentiation of attributes of competitive advantage and attributes of sustainability is proposed
by Bamberger and Wrona (I 996).
24 Chapter 2: Theoreticalfoundation

Attributes of sustainable competitive advantage according to Grant, 1991

Grant published his ideas about resource-based sustainable competitive advantage in the
beginning of 1991, independently from Barney (1991). Like Barney, Grant discusses
different attributes of sustainable competitive advantage. Grant discusses four attributes that
impact the sustainability of competitive advantage: durability, transparency, transferability
and replicability. In addition, Grant introduces appropriability as an attribute that resources
must have in order to lead to sustainable competitive advantage. While Barney discusses the
basic ideas underlyin~ the attributes of transparency, transferability and replicability, as
discussed below, he does not discuss durability and appropriability.

Durability describes how fast the value of resources depreciates. Some resources may have a
short useful life span, like certain production technologies. However, these resources will not
be sources of sustainable competitive advantage. The value of other resources may
depreciate slowly, e.g.,. the ability to continuously improve production technologies,
reputation or brand names. CompetitIve advantage based on these resources is more likely to
be sustainable. 69

Transparency, transferability and replicability describe how easy it is for competitors to


imitate or substitute resources. While Barney differentiates reasons for imperfect imitability,
as discussed above, Grant distinguishes possible steps of the imitation (substitution) process.
First, understanding the competitive advantage, i.e., what the competitive advantage is, what
resources create it and how they create it (transparency). Second, how competitors can
access (buy) the exact same resources to imitate a strategy that leads to the same competitive
advantage (transferability). Finally, how competitors can accumulate similar or comparable
resources iqternally in order to imitate (or possibly substitute) a strategy that leads to the
same competitive advantage (replicability). Imperfections in transparency may arise from
complex resource bundles (see the explanation for causal ambiguity as discussed by Barney).
Imperfections in transferability may arise from different sources e.g., geographical
immobility may result in large costs to relocate resources. Limited replicability may be
based, for example, on complex organizational routines. Limited transferability and limited
replicability may result from path dependency or social complexity, which are discussed by
Barney as possible reasons for imperfect imitability.

The return from resources to a firm does not only depend on sustainability but also on the
firm's ability to appropriate these returns. Returns from physical assets may be easy to
appropriate by a firm but returns from certain intangible assets like property rights and

69 How durable certain resources are may differ, for example, across industries.
Chapter 2: Theoreticalfoundation 25

employee skills, in particular, may be harder to secure. The scope of property rights like
patents, copyrights, brand names or trade secrets may lack precise definition and therefore
returns may be harder to appropriate than those from physical assets. Even harder to
appropriate are returns from employee skills because it is difficult to draw a clear line, for
example, between technologies that belong to the firm and the human capital/skills of the
individual to leverage the technologies. Moreover, the firm has little control over to which
level employees provide services. Finally, employees are typically mobile and they can
easily be lost as resources or bargain to appropriate the major share of their value added.
Grant (1991: 129) summarizes the appropriability of employee contributions: "If the
individual employee's contribution to productivity is clearly identifiable, if the employee is
mobile, and the employee's skills offer similar productivity to other firms, then the employee
is well placed to bargain for that contribution." One way in which firms can decrease the
bargaining power of single individuals is to embed employees deeply in organizational
routines within groups of individuals. If the value added of an individual employee depends
to a large extent on organizational support, then the firm will be able to appropriate a larger
share of the employee contribution.

Attributes of sustainable competitive advantage according to Peteraf, 1993

Peteraf (1993) tries to integrate the work of other authors on resource-based competitive
advantage by formulating four conditions for sustainable competitive advantage. According
to Peteraf heterogeneity, ex post limits to competition, imperfect mobility and ex ante limits
to competition are the four conditions necessary for a resource to be a source of sustainable
competitive advantage. As discussed below, the four conditions described by Peteraf do not
deliver new insights into the structure or content of attributes that determine whether a
resource has the potential to create sustainable competitive advantage. However, Peteraf
summarizes isolating mechanisms that prevent imitation of resources more extensively than
other authors, as discussed below.

According to Peteraf, heterogeneity of resources across firms is the prerequisite for individual
firms to achieve superior returns. 70 Like Barney, Peteraf considers differences in resources
among firms as a necessary prerequisite for sustainable competitive advantage. Barney and
others, however, regard resource heterogeneity as a result of other resource attributes (see
above). If resources are rare, hard to imitate and substitute then resource heterogeneity will
be a result. Peteraf (1993: 185) agrees with this view and states: "For the most part, ex post
limits to competition imply heterogeneity ... " Ex post limits to competition are explained in
the next paragraph.

70 Peteraf describes superior returns from heterogeneous resources as monopoly or Ricardian rents.
26 Chapter 2: Theoretical foundation

Heterogeneity must be relatively durable to add value. Ex post limits to competition are
factors that ensure durable heterogeneity and therefore potentially sustained superior returns.
Ex post limits to competition are imperfect imitability and imperfect substitutability, as
already discussed by Barney. As far as imperfect imitability is concerned, Peteraf (1993:
182-183) summarizes and discusses isolating mechanisms. Isolation mechanisms "... include
property rights to scarce resources or quasi-rights in the form of lags, information
asymmetries and frictions which impede imitative competition". Besides causal ambiguity,
Peteraf mentions additional quasi-rights: producer learning, buyer switching costs, reputation,
buyer search costs, channel crowding, and economies of scale when specialized assets are
required. 7)

According to Peteraf, a third condition for resources to be a source of sustainable competitive


advantage is imperfect mobility. A resource that is imperfectly mobile ensures that rents are
sustained within the firm. If resources, on the other hand, are perfectly mobile, competitive
advantage is not sustainable. Imperfect mobility, like heterogeneity, is considered as a result
of other resource attributes by Barney and others.

Peteraf introduces a final condition for sustainable competitive advantage not mentioned by
other authors who discuss attributes of resources that lead to sustainable competitive
advantage. According to Peteraf, ex ante limits to competition are a necessary condition for
resources to create sustainable competitive advantage. Peteraf (1993: 185) describes ex ante
limits to competition as follows: "... prior to any firm's establishing a superior resource
position, there must be limited competition for that position." Otherwise, superior returns
may be offset by the costs of acquiring the necessary set of resources. This condition seems
to be true in (almost) every case and therefore will not be considered.72

71 Peteraf summarizes additional examples of isolating mechanisms that were discussed by other authors, see
2.1.3.3.
72 A combination of at least four reasons ensures that the condition of ex ante limits to competition is met. If
any of the following four prerequisites are not met, ex ante limits to competition exist. First, all the players
need to understand that a resource leads to sustainable competitive advantage otherwise they will not try to
acquire the resource. Second, if the resource was rare (which is a prerequisite according to Barney) and
therefore could only be acquired by one or a few players, all the players would need to acquire the
knowledge about the potential resource at the same time. Otherwise the player who knew first could
acquire the resource before others were able to bid up the price. Third, all the players need to have the same
assumptions about the value of the resource, which includes similar assumptions about the costs of
exploiting the resource and potential profits from the resource. If this was not true, every player would have
a different maximum price for acquiring the resource and therefore one player would be able to at least earn
the difference in value the resource has to him vs. the value it has to the second highest bidder. Finally, all
the players who understand the potential of a resource at the same time and value it at the same price need
to have access to the resource in order to bid up the price. It is very unlikely that all four prerequisites are
met for a resource.
Chapter 2: Theoretical foundation 27

Attributes of sustainable competitive advantage according to Collis and Montgomery,


1995
According to Collis and Montgomery, (1995), competitive advantage can be attributed to
resources which pass a number of external market tests. Beyond some intuitive tests, such as
a resource must contribute to something customers want at a price they are willing to pay,
Collis and Montgomery discuss the following five tests: the test of inimitability, the test of
durability, the test of appropriability, the test of substitutability and the test of competitive
superiority. The underlyiI).g attributes for all the tests have been discussed above. This is
obvious for the tests of inimitability, durability, appropriability and substitutability. The test
of competitive superiority surmnarizes the attributes value and rareness. Collis and
Montgomery emphasize how important it is that resources are unique (rare) and superior to
those of other players (valuable).73

Attributes of sustainable competitive advantage according to Bamberger and Wrona,


1996

Bamberger and Wrona (1996) build on the same attributes determining sustainable
competitive advantage that were discussed above. They introduce, however, an overall
structure for the attributes by defining three different sets.

First, a resource needs to have the potential to create competitive advantage which is possible
if the resource is valuable and rare. Second, a resource that has the potential to create
competitive advantage also needs to offer the potential to create sustainable competitive
advantage. Therefore the resource needs to be durable, not transferable, imperfectly imitable
and imperfectly substitutable. Third, a resource only offers sustainable competitive
advantage if it is appropriable. Above average returns can only be achieved in the long run,
if a competitive advantage is both sustainable and appropriable.

2.1.3.3. Integrated view on attributes of sustainable competitive advantage

As shown in Figure 2-2 and as explained above, the discussion of resource attributes
determining sustainable competitive advantage by different authors evolves around similar

Therefore aU these prerequisites taken together will lead to ex ante limits of competition in (almost) every
case and therefore ensure that the condition is met. Since the condition is met it does not need to be
considered any further. This is true especially for complex resources (based, for example, on social
complexity, or historical dependency), which are typically the source of sustainable competitive advantage.
28 Chapter 2: Theoreticalfoundation

basic ideas. This study uses an integrated view that is based on the initial fmdings of Barney
(1991) and Grant (1991) and which reflects the views of Collis and Montgomery (1995) as
well as Bamberger and Wrona (1996). The list of attributes in Table 2-3 summarizes the
results of the discussion above partially using the structure proposed by Bamberger and
Wrona (1996).14

Table 2-3: Attributes of resources determining competitive advantage and sustainability


Resource potentially source of Sufficient resource attributes
Competitive advantage l.Value (and)
2. Rareness (and)
3. Appropriability
Sustainability 4. Imperfect imitability (and)
5. Imperfect substitutability (and)
6. Durability

Value and rareness, discussed by Barney 1991, are essential for creating competitive
advantage. A resource that is not valuable will not create superior returns. If it is valuable
but not rare, a resource can equally well be used by competitors and will therefore not lead to
superior returns. The capability to manufacture high quality products in terms of number of
defects may be very valuable but if competitors have a similar capability then high quality
may be a prerequisite to compete rather than a source of competitive advantage. In addition,
appropriability (discussed by Grant, 1991) is a prerequisite for a firm to achieve competitive
advantage.' Without appropriability superior returns may not be realized by the firm but by
somebody else.

While a resource may potentially be the source of competitive advantage if it is valuable, rare
and appropriable, a resource needs to have additional attributes in order to ensure that

73 Collis and Montgomery propose a practical process to detennine competitive superiority. First, finns
should disaggregate bundles of resources (core competencies) until they identifY very specific resources that
are actually unique. Then, finns should evaluate how superior the resource is by analyzing objective data
from the market. Sometimes, disaggregating resources will not lead to results, when "... the valuable
resource is a combination of skills, none of which is superior by itself but which, when combined, make a
better package".
74 Other authors come up with similar lists of attributes for sustainable competitive advantage, e.g., Corsten
(1998: 138-139).
Chapter 2: Theoreticalfoundation 29

competitive advantage is sustainable.15 If a resource is imitable (Barney, 1991), competitors


can copy it.16 Ifa resource has a (strategically equivalent) substitute (Barney, 1991), then the
strategy leading to competitive advantage can be copied. Finally, if a resource is not durable
(Grant, 1991), its value will depreciate. All three situations will lead to the erosion of the
competitive advantage that the resource may initially create. If it is hard to imitate the
resource, the resource has no substitutes and is durable, then the potentially created
competitive advantage is sustainable. 77

eve for its potential to create


In chapter 3, the attributes ,derived above will be used to test
sustainable competitive advantage. The single attributes that determine sustainable
competitive advantage are summarized again and briefly described in Table 3-1.

One of the most discussed attributes of sustainable competitive advantage is imperfect


imitability. Ways to prevent imitation are frequently analyzed in the literature. As
mentioned above, Rumelt (1984: 567) coined the term isolating mechanism to describe ways
to prevent imitation and to make competitive positions stable and defensible. According to
Mahoney and Pandian (1992: 371) isolating mechanisms are similar to entry and mobility
barriers: "The notion of isolating mechanism (at the firm level of analysis) is an analogue of
entry barriers (at the industry level) and mobility barriers at the strategic group level ... "
Since imitability is a key attribute when analyzing the potential of eve benefits to create
sustainable competitive advantage, isolating mechanisms that have been discussed in the
literature are summarized below. Although it is not complete, Table 2-4 gives an overvie,w of
isolation mechanisms discussed in the literature.18 The intention of Table 2-4 is to
demonstrate the breadth of approaches used to identify and structure isolating mechanisms.
The isolating mechanisms discussed will not be critically reflected upon or compared.

75 According to the resource-based view, a resource that meets the attributes discussed, only leads to
sustainable competitive advantage, if it is leveraged through a strategy. A resource that has the necessary
attributes, therefore, is considered as a potential source of sustainable competitive advantage.
76 Direct transfer of resources which seems to be unlikely for most resources, in particular for the more
important group of intangible resources, is considered as a form of imitation in this study
77 It needs to be mentioned that resources may still be very valuable even if they are not identified as being
able to create sustainable competitive advantage. Although achieving sustainable competitive advantage is
the preferred outcome of building resources, achieving competitive parity is also a valuable outcome and
may help to ensure the survival of a company.
78 Other authors that also discuss isolating mechanisms include: [tami and Roehl (1987) who discusses the role
of invisible assets, Reed and DeFillippi (1990: 89) who argue that causal ambiguity is based on tacitness,
complexity or specificity of resources, Yao (l988).
30 Chapter 2: Theoretical foundation

There have been few attempts to integrate all the different discussions on isolating
mechanisms.1 9 Mahoney and Pandian (1992: 371) consider the concept of isolating
mechanisms as "an insightful and unifying concept". They further suggest that all isolating
mechanisms are based on two determinants of the transaction cost theory: asset specificity
and bounded rationality. Bamberger and Wrona (1996: 138) agree with this view. 8o

When the imitability of resources is analyzed, the diverse isolating mechanisms discussed
above may help to find out whether isolating mechanisms may exist in a specific situation.

79 Mahoney and Pandian (1992: 371-373), for example, summarize different isolating mechanisms discussed
in the resource-based view/strategy literature, the organizational economics literature and the industrial
organization literature. Rather extensive discussions of isolating mechanisms are presented by Rasche
(1994: 68-90) as well as Thiele (1997: 49-52).
80 Grant (1998: 180-184) differentiates between four requirements for imitation of resources: identification,
incentives, diagnosis and resource acquisition. Based on these requirements Grant formulates strategic
options that may function as isolating mechanisms.
Chapter 2: Theoreticalfoundation 31

Table 2-4: Isolating mechanisms discussed in the Iiterature81


Isolating mechanisms potentially leading to imperfect imitability Discussed by

Rumelt introduces various isolating mechanisms, cautioning that he does not provide Rumelt,1984:

an "unambiguous mutually exclusive list" (1987: 146): 566-568; Rumelt,


Causal ambiguity 1987: 146-148
Special assets
Buyer switching, search and evaluation costs
Consumer and producer learning
Team-embodied skills
Unique resources
Special information
Patents and trademarks
Reputation and image
Legal restrictions on entry
Response lags
Economies of scale
Communication good effects (if products increase in value as the number of users
increases)
Advertising and channel crowding
Dierickx and Cool focus on factors, which prevenfimitation of valuable but nOn- Dierickx and
tradeable asset stocks. How imitable an asset is depends upon the nature of the Cool, 1989:
process by which it was accumulated. Characteristics serving to impede imitation are: 1507-1509
time compression diseconomies (to build resources takes time and effort and this
time aspect cannot easily be reduced by increasing the effort put into building the
resource), asset mass efficiencies (improving existing resources may be easier than
building them from scratch), interconnectedness of asset stocks (building resources
may be supported by other resources), asset erosion (a low erosion of resources or a
behavior that makes up for erosion, for example, presents a threat for others to enter a
market) and causal ambiguity (the accumulation process of resources is stochastic
and discontinuous based on the inability to identi6- or control relevant variables).
As already discussed in 2.1.3.2, Barney describes three reasons that may prevent Barney, 1991:
imitation of resources: the ability of a firm to obtain a resource depends on unique 107-1 "
historical conditions, the resource impact on sustainable competitive advantage is
causal ambiguous or the resource is socially complex.
Grant discusses three reasons that prevent imitation of resources that lead to Grant, 1991: 125-
competitive advantage: first, a resource may not be transparent (Le., information on 128
resources or their value may not be available), second, it may not be transferable
(i.e., the resource cannot be acquired because of, e.g., geographical immobility,
immobility of capabilities or because it is specific to a single firm) or, finally, a
resource may not be replicable (i.e., the resource cannot be built internally by
competitors because it is based on highly complex organizational routines).
A resource is physically unique, path dependent, the relationship between resource Collis, 1995:
and sustainable competitive advantage is causal ambiguous or firms may try to 121-122
preempt competitors by making a sizable investment in a resource to keep competitors
from replicating the resource because of limited market potential (economic
deterrence).

81 Isolating mechanisms are presented chronologically based on year of publication.


32 Chapter 2: Theoreticalfoundation

2.1.4. Resource-based vs. market-based view

Many authors consider the resource-based and the market-based views as complementary,
e.g., Collis (1991: 65), Corsten (1998: 18-19), KrUger and Homp (1997: 64), Mahoney and
Pandian (1992: 371), Rasche and Wolfrum (1994: 513). From a resource-based view,
insights into the market structure can be leveraged to determine which resources need to be
developed to create sustainable competitive advantage. From a market-based view, resources
can be viewed as the basis for positioning advantages. As shown in Figure 2-3, Day and
Wensley (1988: 3) consider resources as the basis for positional advantages, which then lead
to superior performance.

Figure 2-3: Combination of resource-based and market-based view

Sources of Positional Performance


advantage
,..
advantages outcomes
Superior skills Superior Satisfaction
Superior f-o customer value f-o Loyalty
resources Lower relative Market share
costs Profitability

r sustain
Investment of profits tol
I advantage
I

Source: Day et aI. (1988: 3)

Just like Day and Wensley, significant contributors to the resource-based and the market-
based view emphasize the complementary relationship of both streams of research.
According to Barney, 1991: 99-101 both views highlight the two different aspects of the
SWOT framework. 82 The resource-based view focuses on the strengths and weaknesses of a
company, the market-based view on the opportunities and challenges a company faces.
Barney (1991: 99) specifically states, "Firms obtain sustainable competitive advantages by
implementing strategies that exploit their internal strengths. Through responding to
environmental opportunities, while neutralizing external threats and avoiding internal

82 This framework is based on work by Andrews (1971), Ansoff(1965) and Hofer and Schendel (1978).
Chapter 2: Theoreticalfoundation 33

weaknesses." Barney (1991: 105) also argues that the concept of the value chain developed
by Porter helps managers to identify resources that may be sources of sustainable competitive
advantage. The resource-based view goes one step further, however, by examining the
attributes resources must have in order to be sources of sustainable competitive advantage.

Porter agrees, for example in the 1998 edition of his book "Competitive Advantage" (porter,
1985: XIX), that the resource-based and market-based view are complementary: "Contrasting
competitive strategy (porter, 1980) and core competencies/critical resources misses the mark,
and sets up a false dichotomy. It is simplistic to think that positions (product market
competition) and supposedly more enduring internal skills, reputation, and organizational
competencies can be disconnected."

Since the resource-based and the market-based view are complementary, either one can be
used to explain the impact of eve on sustainable competitive advantage. The resource-
based view is well suited to discussing the potential of eve to impact sustainable
competitive advantage since there is a direct link between eve and resources, as discussed
below. The market-based view is less well suited to discussing the potential of eve to
impact sustainable competitive advantage since the link of eve to market structure or
positioning advantages is less direct. Therefore, this study will use the resource-based view
to analyze the potential of eve to create sustainable competitive advantage.

The impact of eve on the resources of a company is apparent, when looking at the potential
eve benefits discussed in 2.3.2. Potential outcomes of eve include gaining knowledge,
changing attitudes, building skills, setting up business relationships or accessing
technologies, all of which are company resources. Therefore, eve may help to strengthen or
build resources: Kann (2000: 9, 106-108) also uses the resource-based view of the firm to
explain the motivation for eve and considers the benefits from eve to be either acquiring
resources or helping to leverage existing resources better. The strengthened or built
resources may be leveraged to create positioning advantages, as discussed by Day and
Wensley, see above.

In contrast, not all eve outcomes can be expressed as insights into the industry structure that
may lead to positioning advantages. For example, a change in employee attitude towards
innovation is hardly an insight into the industry structure. In addition, it is difficult to
determine directly the impact from eve benefits on a firm's positioning in a market. It is
34 Chapter 2: Theoreticalfoundation

difficult, for example, to detennine the impact of most benefits of eve on cost-advantages or
advantages for differentiation. 83

A final advantage of the resource-based view is that it offers the ability to analyze whether a
resource may be the source of a sustainable competitive advantage. As discussed by Barney
(1991: 105), see above, the attributes discussed in 2.1.3.2 can help to analyze a resource for
its potential to create sustainable competitive advantage. Analyzing the potential impact
rather than the actual impact from eve allows the detennination of the merits of eve with
little influence from ~ther factors such as execution skills or time in operation. In chapter 3,
an approach will be designed that allows the analysis of the potential of eve to create
sustainable competitive advantage with the help of these attributes.

2.2. Venture capital


In order to discuss corporate venture capital (eVe), venture capital (Ve) needs to be
introduced first, since eve is a special fonn ofVe (see 2.3.1). Therefore, ve is defined in
2.2.1, the current situation in ve is briefly introduced in 2.2.2 and the ve process is
explained in 2.2.3 as a basis for the eve process introduced in 2.4.

Venture capital is defined as equity investments in private start-ups as described below.


Besides ve, there are different ways for start-ups to raise capital. 84 Different reasons exist
that limit the access of start-ups to traditional fonns of financing like bank loans or the
issuance of public stock. 85

83 Kurz and Wehmeyer (1999) use the market-based view to analyze CVC. They develop some hypotheses on
the role of CVC for impacting company strategies like differentiation and cost leadership by mapping CVC
benefits to factors that are potential sources positioning advantages, e.g., brand name, technology or
economies of scale. Kurz and Wehmeyer, however, do not assess the impact of CVC on sustainable
competitive advantage of the investing company.
84 A start-up or smaIl growth company without sufficient own funds has different options for raising equity
besides venture capital funds (see, for example, Roberts, 1990). These include founders' friends and
families, angel investors (wealthy individuals that often provide capital in very early financing stages),
private placements (often done to bridge the time to an IPO and possibly investment banker-sponsored, see
Bergmann (1998: 16 or IPOs (see Lipman, 1998: 37). Beyond equity financing, debt may be an additional
potential source of capital for small growth companies in specific situations. Additional ways to deal with
capital needs may reach from leasing to franchising (see Gamer, Owen and Conway, 1994).
85 Gompers and Lerner (1999: 127-128), however, argue that four critical factors limit the access of start-ups
to traditional forms of financing like bank loans or the issuance of public stock: uncertainty, asymmetric
information, the nature of firm assets and the conditions in the relevant financial and product markets. First,
young companies are associated with significant levels of uncertainty in the sense that many potential
outcomes exist for the projects of the company as well as the overall development of the company. Such
uncertainty limits the willingness of investors to provide capital.
Chapter 2: Theoreticalfoundation 35

As discussed in 1.2 and 1.3, this study will focus on eve and therefore introduce ve as a
basis for eve. This study will discuss neither further financing options for start-ups nor
their advantages or disadvantages.

2.2.1. Definition of venture capital

No single widely accepted definition ofVe exists. Definitions ofVe in the literature show a
lot of similarities but vary to some degree. The major difference between ve definitions in
the literature is the focus of the definitions. While most authors define ve with attributes of
the investment, some include attributes of the investment target while others focus on
attributes that describe the role of the venture capitalist.

Albach, Hunsdieck and Kokalj (1986: 166) include attributes of all three types. 86 They
define ve as equity or equity-linked investments in young, small and medium-sized
companies. According to Albach, Hunsdieck and Kokalj ve additionally includes
management support provided by the venture capitalists to the funded company. Moreover,
venture capitalists have a long-term focus and generate returns from capital gains. Albach,
Hunsdieck and Kokalj's defmition includes investment attributes like 'equity capital', 'long-
term focus' and 'returns from capital gains', attributes of the investment target, 'young' and
'small and medium-sized companies' and the role of venture capitalists, 'management
support'87.

Schefczyk (1999: 1123) defines ve with the help of investment attributes as well as
attributes that describe the role of venture capitalists. He defines ve as minority equity
investments for a limited time. In addition to these investment attributes, Schefczyk also uses
two attributes that describe the role of the venture capitalist. These are significant control
rights and management support by the venture capitalist.

Then, asymmetric information exists between entrepreneurs and investors since the entrepreneur is involved
in and therefore knows more about the day-to-day business of the company. Such asymmetric information
may lead to activities of the entrepreneur that are in hislher best interest but not in the best interest of the
investors without the investor being able to fmd this out. Therefore the existence of asymmetric
information also limits the willingness of investors to provide capital. Next, a lot of assets of young
companies are often intangible, e.g., ideas, expertise, networks etc. Such intangible assets are harder to
evaluate for investors than tangible assets like machines. In addition, intangible assets offer little security to
the investor if the company is liquidated. As a consequence, investors are less willing to provide capital to
companies based mainly on intangible assets. Finally, the conditions in the capital and product markets of
young companies may vary significantly over time due to changes in competition. Such changes can impact
the success of the company and the investor to a large extent and therefore limit the investor's willingness to
invest. See Gompers and Lerner for a more detailed discussion.
86 Albach, Hunsdieck and Kokalj (1986) base their defmition ofVC on Fast.
87 In the German literature, VC is often translated and two different translations are defined differently:
'Wagniskapital' and 'Risikokapital'. See Schween (1996: 14-15) for a discussion of the differences.
36 Chapter 2: Theoreticalfoundation

Like Schefczyk, Zemke (1998: 215) also defmes VC with attributes of the investment and
attributes that describe the role of the venture capitalist. Zemke combines the notions of
long-tenn and limited time focus and states that VC is an equity investment with a long-tenn
but limited time focus. Furthennore, the funded company receives active management
support from the venture capitalist.

Gompers and Lerner (1999: 11) define VC with the help of attributes of the investment and
attributes of the investment target. They define VC as "... independently managed, dedicated
pools of capital that ,focus on equity or equity-linked investments in privately held, high-
growth companies." An attribute of the investment is 'equity or equity-linked investment'.
The two attributes of the investment target that Gompers and Lerner mention are not covered
by the authors discussed above, 'Investment in privately held' and 'high-growth companies'.
In contrast to other authors, Gompers and Lerner also include an attribute of the venture
capitalists: 'Independently managed, dedicated pools of capital'.

It is helpful to distinguish VC clearly from private equity, although there is no widely


accepted way to distinguish between the tenns. Sometimes, VC is seen as a subgroup of
private equity, sometimes both tenns are used interchangeably. The European Venture
Capital Association (EVCA, 2000a) describes this situation and the relationship of venture
capital to private equity as follows:

"Private Equity provides equity capital to enterprises not quoted on a stock market.
Private equity can be used to develop new products and technologies, to expand
working capital, to make acquisitions, or to strengthen a company's balance sheet. It
can also resolve ownership and management issues - a succession in family-owned
COIlWanies, or the buy-out or buy-in of a business by experienced managers may be
achieved using private equity.

Venture capital is, strictly speaking, a subset of private equity and refers to equity
investments made for the launch, early development, or expansion of a business.
Among different countries, there are variations in what is meant by venture capital
and private equity. In Europe, these tenns are generally used interchangeably and
venture capital thus includes management buy-outs and buy-ins (MBOIMBIs)[88].
This is in contrast to the US, where MBOIMBIs are not classified as venture capital."

88 Management buy-out (MBO) describes financing provided to enable current operating management and
investors to acquire an existing product line or business. Management buy-in (MB!) describes financing
provided to enable a manager or group of managers from outside the company to buy-in to the company
with the support of private equity investors (see EVCA, 2000b). MBO and MB! as well as turnaround
investments are typically made in companies that are more mature than companies funded with VC.
Chapter 2: Theoreticalfoundation 37

A different approach to define VC from those discussed above is used by Rind (1981: 169-
170). Rind defmes ve by considering what venture capitalists do. Therefore he includes
attributes in the definition of VC that are described as process steps and design elements of
VC in this study, e.g., due diligence or carried interest, see 2.2.3. In addition, Rind uses some
of the attributes of VC discussed above to define VC, e.g., the long-term focus. Rind also
uses one attribute in his definition ofve that is not used by other authors. He states that ve
is a high-risklhigh-reward investment.

Based on the definitions di~cussed above ve is defined in the following way in this study:

Venture capital is an equity investment with a long-term but limited-time focus in


privately held, high-growth start-up companies for the launch, early development
or expansion of a business. The venture capital investor provides active support to
and exercises significant control over the funded start-up.

This definitio/l includes seven attributes that are used to define ve in this study. As
summarized in Table 2-5 two attributes characterize the investment, three attributes
characterize the investment target and two attributes describe the role of the venture
capitalist.

The seven attributes used to define ve are described in the following section. The two
attributes that characterize the investment are: VC investments are equity investments and
VC investments have a long-term but limited-time focus.

Table 2-5: Attributes of Venture Capital


Attributes of investments

VC investments are equity investments.


VC investments have a long-term but limited-time focus.
Attributes of investment target


VC is invested in privately held companies.


VC is invested in high-growth companies.
VC is invested in start-up companies for the launch, early development or expansion of
a business.
Role of venture capitalists

Venture capitalists provide active support.


Venture capitalists exercise significant control.

VC investments are equity investments. All authors discussed above define ve as an


equity investment. According to some authors, e.g., Gompers (1999: 11), ve may also be an
38 Chapter 2: Theoretical foundation

equity-linked investment, e.g., transferable debt. This, however, is more common for private
equity investments other than VC. 89

VC investments have a long-term but limited time focus. As discussed above, Zemke
(1998: 215) combines two notions ofVC discussed by other authors and defmes VC as long-
term investments but at the same time as having a limited time focus.

VC investments have a limited time focus since they support the launch, development and
expansion of a start-up as discussed below. Once a former start-up goes public in an IPO or
is acquired by another company, VC is not needed any longer and VC firms exit their
investment to achieve financial returns. 90

VC is a long-term investment since it typically takes several years before a start-up goes
public or is acquired. How long it takes from the investment to the exit by the venture
capitalist is company specific and depends on many factors, e.g., the development stage at
which the investment was made, the growth rate of the start-up or the situation on the !PO
market. 91 According to AssetAItematives (1999: 33) VC investments were typically seen as
5 to 7 year investments. This time span has most likely been shorter for Internet start-ups.
Often the life of VC funds is limited as discussed in 2.2.3.1. In these cases the venture
capitalist may need to exit an investment before the fund is terminated.

Three attributes of VC characterize the investment target: VC is invested in privately held


companies, VC is invested in high-growth companies and VC is invested in start-up
companies for the launch, early development or expansion of a business

VC is invested in privately held companies. According to EVCA (2000a) and Gompers and
Lerner (1999: 11), VC is a way for private companies to raise equity. On the one hand,
companies that are quoted on a stock market can raise equity by issuing public stock. Going
public, on the other hand, is not an option for young start-ups that may receive VC
financing. 92

VC is invested in high-growth companies. According to Gompers and Lerner (1999: 11),


VC is invested in high-growth companies. VC funds only invest in companies that have high

89 Private equity finns may provide mezzanine financing. This is used to bridge the gap between debt and
equity. Characteristics of mezzanine financing typically are: the interest is higher than for senior debt; the
principal is paid at the end of the loan; warrants on equity stake are included; the participation of investors
in management is possible at least in cases where a company faces financial distress.
90 In less successful investments venture capitalists may only retrieve a portion of the investment if they exit.
91 See 2.2.3.6 for a discussion of venture capitalists exiting investments.
92 Typically doing an initial public offering (IPO) is not possible or feasible for a young, high growth
company before it has some track record and proof of concept and before it has reached a potential market
value that justifies the cost of an IPO.
Chapter 2: Theoretical foundation 39

growth targets because of the risk involved in start-up investments. The risk of financing
companies in the start-up phase can only be compensated for if the investment targets have
the potential to vastly appreciate in value. 93 Since the value of a company can be determined
by its expected future cash flowS 94 , VC funded companies need to have aggressive growth
targets for future cash flows. 95

VC is invested in start-up companies for the launch, early development or expansion of


a business. In this study, VC will be defined in the more narrow sense used by the EVCA
which excludes MBO~I investments. Like the EVCA, Albach, Hunsdieck and Kokalj
(1986: 166) and Gompers and Lerner (1999: 16) also emphasize the role of venture capital
for financing young fi01lS. 96 VC investments are made in young companies that are
launching or expanding their operations. Established private companies that do not grow as
fast may still receive equity investments. These, however, are not called VC, as discussed
above. 97 See Table 2-8 for a more detailed description of all the development stages in
which start-ups98 may receive venture capital.

Two attributes of VC characterize the role of the venture capitalists: venture capitalists
provide active support and venture capitalists exercise significant control. While some
authors include attributes that determine the role of venture capitalists in the definition ofVC,
other authors do not regard the active role of the venture capitalists as a necessary
requirement ofVC. This study, however, will regard the attributes that determine the role of
venture capitalists as a part of the definition of VC. Since support and control are a way in
which a venture capitalist can impact the success of a start-up after the investment is made,
these attributes are regarded as a vital part ofVC. The fact that the interaction with the start-
up is considered as a separate step in the VC process, see 2.2.3, emphasizes the importance of
support and control in VC investments.

93 Most likely start-ups need to promise high-growth rates over the entire targeted holding period to justifY
investments. This, however, may depend on the current situation of the start-up and the terms of the
investment.
94 According to discounted cash flow valuation approach, e.g., Copeland, Koller and Murrin (1994).
95 Zider (1998: 133) claims that VC firms invest in industries with high growth rates rather than individual
start-ups with high projected growth rates. If this is true, the industry a start-up is in may be an important
factor impacting whether companies receive VC funding.
96 Albach, Hunsdieck and Kokalj (1986: 166) also use the term small and medium-sized company to describe
a similar characteristic.
97 An exception to this may be privately held companies that have been operating for years with moderate
growth rates but want to leverage VC to expand more quickly, for example, after changing their strategic
focus.
98 In this study, the term start-up is used to describe young companies that are launching, developing or
expanding their business.
40 Chapter 2: Theoreticalfoundation

Venture capitalists provide active support. According to Albach, Hunsdieck and Kokalj
(1986: 166), Schefczyk (1999: 1123) and Zemke (1998: 215), venture capitalists provide
active support to funded companies. Venture capitalists will improve their own returns, if
they can actively help start-ups to become more successful which is why VC firms help
start-ups in various ways. VC firms leverage their own networks in the start-up and
corporate world to provide contacts to potential customers, suppliers and other potential
partners. The well-respected VC firm Kleiner Perkins Caufield & Byers speaks of a
'keiretsu'99 where former portfolio companies like AOL, Amazon, Netscape and Sun
Microsystems cooperate with new portfolio companies (Fortune, 1998: 112). VC firms also
provide additional management support. Experienced venture capitalists know what type of
problems start-ups often face and they can help to solve these problems,IOO

Venture capitalists exercise significant control. The active support described above is
often paired with significant control rights by venture capitalists. Schefczyk (1999: 1123)
regards this as a separate attribute of:VC. Control rights include at least the right to monitor
the development of the start-up. Beyond this, control rights may also include the right of the
venture capitalist to actively influence the business decisions of start-ups. Personnel
decisions are one area where venture capitalists exercise their control. If venture capitalists
are not satisfied with the performance of the current management, they may have the right to
remove certain managers in key positions. Other areas where venture capitalists may
exercise control rights are changes in strategy or agreements with business partners of the
start-up. 101

Some attributes ofVC that are discussed by some authors are not included in the definition of
VC in this study for the reasons explained in the following paragraphs.

Gompers and Lerner (1999: 11) describe VC through an attribute of the venture capitalist.
They define VC as independently managed, dedicated pools of capital. This will not be
regarded as a necessary attribute of ve in this study. When ve is viewed as independently
managed, dedicated pools of capital, this implies that the managers of a ve fund that raised
capital from investors decide independently which investments are made as long as they
invest the capital as ve. The investors have no influence on how the funds are invested once

99 Keiretsu is a Japanese expression that describes the cross-ownership and cooperation between different
companies. The cooperation may include the exchange of information, coordination of strategies etc.
100 See the subchapter on interacting with start-ups (2.2.3.5) for a further discussion ofVC support.
WI See 2.2.3.4 and 2.2.3.5 for additional information on the relationship between venture capitalists and funded
companies.
Chapter 2: Theoretical foundation 41

they have committed capital to a VC fund. 102 This is an attribute of the typical type ofa VC
fund, the limited partnership, as further discussed in 2.2.2.

VC, however, may not always be independently managed, which can be especially true for
CVC. When an industrial company, for example, uses a subsidiary to invest VC, the investor
may have significant impact, on investment decisions. In addition, this investor may not
provide a dedicated pool of capital but invest, when investment opportunities are identified.
There is no reason why such investments should not be regarded as VC. Although VC may
often be independently mapaged capital and collected in dedicated pools of capital, this will
not be regarded as a necessary attribute ofVC in this study.

Schefczyk (1999: 1123) regards VC as minority investments. While this is probably true in
most cases, venture capitalists may also own majority stakes in start-ups. Especially when
start-ups face serious problems and need additional financing, venture capitalists may only be
willing to provide such additional funding if they receive a large share of equity which may
result in a majority ownership of the start-up. Therefore, minority investments are not
regarded as a necessary attribute ofVC in this study.

Albach, Hunsdieck and Kokalj (1986: 166) describe another attribute ofVC: return on VC is
generated through capital gains. Instead of considering this as an additional attribute this is
regarded as a consequence of four other attributes in this study. Since VC investments are
limited-time equity investments in high-growth start-ups for the launch, early development
and expansion of a business they do not generate interest and will typically not pay dividends
and therefore generate no returns beyond capital gains. This also makes VC investments
high-risk investments. Therefore the attribute of VC investments introduced by Rind (1981 :
169-170) that VC is a high-risklhigh-reward investment is not considered a necessary
attribute ofVC in this study either.

The high risk of VC investments, however, has another consequence. Venture capitalists
typically use a .portfolio approach and invest in many different companies to reduce their
risk. 103 Many of these companies may fail and lead to a loss of or a low return on the capital

102 Certainly venture capitalists will probably try to satisfy investors since they may want to raise additional
funds in the future from their investors. The performance of the fund will most likely be more relevant for
satisfying investors than impact on single investment decisions.
103 The underlying idea of the portfolio theory is introduced by Markowitz (1952). Investments differ with
respect to returns and variance of returns and both are typically positively correlated. Markowitz shows that
a mixed portfolio of investments outperforms pure investments. The reason for this is that the combined
variance of returns of different investments may be lower than the individual variances of returns of the
single investments.
42 Chapter 2: Theoreticalfoundation

invested. Still the fund as a whole may generate a high internal rate of return (IRR) because
some of the equity investments are successful and appreciate significantly in value. 104

2.2.2. Situation in the venture capital market

In the following section some basic figures on the situation in the VC market are presented,
additional information being presented in the different subchapters of 2.2.3. The most recent
information provided covers the year 2000 which means that the consequences of the recent
developments in the stock and VC markets, especially the bursting of the Intemet bubble,
may only be reflected to a small extent. These developments may lead to a change in the VC
trends described below.

Many of the young firms that are highly visible today have been financed with VC. The list
of examples ofVC funded companies reads like the Who's Who of the high-tech industries,
e.g.: Apple, Cisco, Compaq, DEC, Genentech, Lotus, Microsoft and Oracle in the USIOS or
Brokat and Qiagen more recently,. in Europe.106 Besides high-tech companies, the
development of companies like Federal Express or Staples was funded with VC. \07 In the
last few years a lot of Internet companies funded with VC have become well known, e.g.,
Amazon, AOL, Intershop, Netscape and Yahoo.

The recent boom in the Internet business is at least one reason for the dramatic growth in VC
investments, as shown below. According to the National Venture Capital Association
(NVCA, 2000) capital committed to US VC funds and disbursed to portfolio companies by
VC funds reached record levels in 2000 as shown in Figure 2-4. Capital commitments to US
venture funds, the funds raised from investors, grew more than 400% from 1997 to 2000
totaling USD 92.9 billion. The disbursements to portfolio companies, as the investments in
start-ups are called, grew more than 500% to USD 103.5 billion in the same time period. The
level of VC investments is even more impressive in a long-term comparison. The capital

\04 Bygrave (1999: 313) describes this portfolio character ofVC: "In a successful venture capital portfolio, out
of evel)' ten investments, two will make or exceed the target rate of return, two will be total write-offs and
the remaining six will range from the 'living dead' where the companies never get big enough for a
significant harvest to the 'walking wounded' that need refmancing if they are to have a chance of making it."
Huntsman and Hoban (1980) provide the early insight that the return of venture funds is highly sensitive to
the number of vel)' successful investments.
105 See for example Harmon (1999: Chapter 2) for examples ofVC firms and their investments.
\06 For a description of European VC funded success stories see EVCA, 1999.
\07 See for example Bygrave and Timmons (1992: 2).
Chapter 2: Theoretical foundation 43

committed and the capital disbursed in 2000 were about 22 and 28 times higher than the
average levels from 1980 to 1995. 108

It remains to be seen what effect the development of the stock markets since March 2000 will
have on the VC market. Especially the corrections in valuations of Internet companies as
well as other players may limit the willingness of venture capitalists to provide capital,
especially for Internet start-ups. As already discussed in chapter 1, the capital disbursed to
portfolio companies by US VC funds was down more than 60 percent to USD 10.6 billion
compared to one year earlier in the second quarter of 200 1 according to NVCA (2001 b: 2).

Figure 2-4: Capital committed to and disbursed by VC funds

o Capital committed to venture funds


_ Capital disbursed to portfolio companies

USDBiliion

120.-----------------------------------------,
100+---------------------------------------~

80+---------------------------------------~

60+-----------------------------------~rl

40+-------------------------------------~

Source: National Venture Capital Association Yearbook (2001a: 11)

108 The VC industry is a young industry that first developed in the US. The first modem VC finn was
American Research and Development (ARD) fonned in 1946 to commercialize the technologies developed
for World War II (Gompers and Lerner, 1999: 6; Mackewicz & Partner, 2000: 21). VC investment levels
became significant in the US in the early 1980s. An important factor for this growth was the 1979
amendment to the "prudent man" rule governing pension fund investments. This amendment explicitly
enabled pension funds to invest in high-risk assets.
44 Chapter 2: Theoreticalfoundation

Figure 2-5: Capital under management in US venture funds

USD Billion

2S0~----------------------------------------,

200+---------------------------------------~

150+---------------------------------------~

100+-------~----------------------------~

so+-------------------------------~~

Source: National Venture Capital Association Yearbook (2001a: 9)

In line with the increase in commitments to VC funds and disbursements to portfolio


companies, capital under management by US venture funds more than tripled in three years
from 1997 to 2000 as shown in Figure 2-5. By 2000 the capital under management reached a
level that is more than six times higher than in 1990 reaching USD 209.8 billion. In Europe
total venture capital disbursed reached a record level of Euro 19.6 billion according to
European Venture Capital Association (2001).109

The strong growth in VC financing is based on the emergence of new VC firms as well as the
growth of capital managed by a single VC firm as shown in Table 2-6. In 2000 693 VC firms
existed in the US, up from 87 in 1980. 110 These VC firms managed a total of 1443 funds up
from 123 in 1980. Each VC firm in the US managed USD 302.8 million on average in 2000,
more than eight times as much as in 1980.

109 European figures have only recently become easily comparable to US figures. Before, European figures
often included buy-out and replacement investments, therefore European figures will only be discussed in
the study when they solely include VC investments according to the definition in 2.2.1.
110 Examples of well known VC firms in the US are Kleiner Perkins Caufield & Byers which funded, for
example, AOL, Netscape and Sun Microsystems and has USD 2700 million under management according
to Venture Economics (2000); New Enterprise Associates which funded, for example, 3Com and Silicon
Graphics; Sequoia Capital which funded for example Apple, Cisco and Oracle. In Europe, 3i is among the
better-known VC firms having invested in firms like Mobilcom and Teles.
Chapter 2: Theoreticalfoundation 45

Table 2-6: Number and size of US VC firms and funds


1980 1990 2000
Number ofVC finns in existence 87 375 693

Number ofVC funds in existence 123 734 1443

Number of professionals 1035 3794 8368

Average VC capital under management per 34.9 85.3 302.8


finn (USD million)

Average fund size raised (USD million) 36.5 38.2 187.0

Largest VC fund raised to date (USD million) 1000 1775 5000

Source: NVCA Yearbook (2001 a: 9)

With the increased capital available, venture capitalists funded an increasing number of
companies: 5,412 in 1999 up from just 472 in 1980, as shown in Table 2-7. At the same
time, the average amount disbursed to companies increased fourteen times from less than
USD 1.4 million to USD 19.1 million.1 11

Table 2-7: Number of companies receiving funding in the US


1980 1990 2000
Number of companies receiving financing 472 1,317 5,412

Total disbursements (USD million) 645 3,262 103,494

Average disbursement per company (USD 1.4 2.5 19.1


million)

Source: NVCA Yearbook (2001a: 32)

VC is typically invested in young industries with a high level of uncertainty. According to


the NVCA Year.book (2001a: 27) 88.6% ofVC was disbursed to companies in infonnation
technology companies, 6.4% to medical, health and life science companies and 8.5% to non-
high technology companies. Figure 2-6 shows a more detailed breakdown of the industry
sectors that received funding. The online specific start-ups, in particular, received a large
share of the capital disbursed in the US. USD 48.1 billion were disbursed to online specific
companies in 2000, accounting for 46% of the total capital disbursed in the US in 2000. In

III This increase may be based on a general increase in the level of fmancing provided to start-ups and on a
change in the number of companies funded in different stages. Companies in the seed stage, for example,
receive less financing than companies in the expansion stage. A more detailed analysis is necessary to
determine the impact of both possible reasons.
46 Chapter 2: Theoretical foundation

1996, less than USD 1.2 billion were invested in this industry accounting for about 10% of
the total capital disbursed. In 1993 no online specific companies had as yet been funded. ll2
The broader category of Internet-related disbursements accounted for 76% of the total
disbursements in 2000 according to the NVeA Yearbook (200Ia: 36). Internet-related
disbursements do not only include online specific investments. In addition, many companies
from other sectors like communications, computer software and services, computer hardware
etc. are Internet-related. Internet-related companies received USD 78.9 billion in
disbursements in 2000, up from USD 7 billion two years earlier. 1I3

Figure 2-6: US VC disbursements 2000 by industry

Ptra:nl Otbr.,. roa . ts of:


BootcdInology 2.7%
CcxnpulCr hat~ 2.2%
Consumer-rel.cd 1,6%
Industnll/entl&Y 1.4%
OIlIer producu 5,2%
n:latcd
4%

Convnunlc:a11O
17%

Source: National Venture Capital Association Yearbook (2001 a: 30)

In the next subchapter, the ve process will be explained and additional figures will be
introduced. in this context.

2.2.3. Venture capital investment process

In the following section, ve is described in detail through describing the single steps of aVe
investment process. The structure of the ve process has been discussed by different authors.
In this section the structuring approaches of three authors are introduced and, based on these,
a ve process structure is developed that will be used in this study.

112 See National Venture Capital Association Yearbook (200Ia: 30).


113 Also see National Venture Capital Association Yearbook (2000: 30).
Chapter 2: Theoreticalfoundation 47

Gompers and Lerner (1999:3) describe VC as a cycle with three major steps. The first step is
raising capital for a venture fund, the second step includes investing in, monitoring of and
adding value to firms and the third step is exiting investments and returning the capital to the
investors. Once VC firms have completed steps one, two or three they may raise capital for a
new fund and the cycle starts again.

Step two of the process in~roduced by Gompers and Lerner can be divided into several
different tasks as already indicated above. Zemke (1998: 213), for example, shows a six-step
VC investment process that is similar to the process introduced by Gompers and Lerner but
more detailed. The first and the sixth steps, fund raising and exiting, are identical to
Gompers and Lerner's steps one and three. Steps two to five are deal flow, due diligence,
decision-making and monitoring. 11 4 These four steps describe in detail what Gompers and
Lerner introduce as the second step of the VC investment process. Baumgartner (1998: 59)
describes a similar six-step VC process as Zemke. I 15

This study will use a VC process that is similar to those that Baumglirtner, Gompers and
Lerner and Zemke describe. The six steps of the VC process used in this study will be
described in subchapters 2.2.3.1 to 2.2.3.6. Step one, 'raise capital' (2.2.3.1), introduces how
VC funds are structured in order to raise capital. Step two, 'generate deal flow' (2.2.3.2),
describes how venture capitalists get access to potential investment targets. Step three,
'assess investment opportunities' (2.2.3.3), discusses the due diligence process that venture
capitalists use. Step four, 'invest' (2.2.3.4), introduces how venture capitalists negotiate deals.
Step 5, 'interact with start-ups' (2.2.3.5), describes how venture capitalists monitor start-ups
and support them. Step six, 'exit investments' (2.2.3.6), discusses how venture capitalists exit
investments in order to pay back the capital and returns to the investors.

The objective is to provide an overview of the VC process in the following sections and not
to discuss all the issues concerning VC investments. I 16

2.2.3.1. Raising'capital

Venture capitalists raise money from investors in order to make equity investments in start-
ups. Both investors and their objectives as well as possible sources of a venture capitalist's
competitive advantage for raising capital will be discussed. Three factors are described that

114 Similar steps have already been described by Tyebjee and Bruno (1984: \052-\054). They describe five
steps: deal origination, screening, evaluation, structuring and post investment activities.
115 Baumgartner only uses different terms for some steps. Baumgartner calls step four deal negotiation and
step five management support.
116 Some other references, beyond the sources mentioned, that discuss VC financing in more detail are: Bartlett
(1995), Halloran, et ai. (1995), Levin (\995).
48 Chapter 2: Theoretical foundation

impact a venture capitalist's competitive advantage: the venture capitalist's qualifications, the
investment strategy and the structure of the venture fund. Two major elements of the VC
fund structure are the legal form of and compensation in a venture fund; additional structural
elements are also described.

VC fund investors and their objectives

Two parties are involved in raising a VC fund: the investors and the venture capitalists.
Investors provide capital for a VC fund that is invested in start-ups by venture capitalists.
Typical investors in VC funds are institutions such as pension funds, endowments and
foundations, financial companies like insurance companies and banks, non-fmancial
companies (industrial or trading companies) and government agencies. It is not only
institutions, which invest in VC funds, private individuals may also do so. See Figure 2-7 for
a breakdown of VC investors in limited partnerships in the US in 2000. 117 The category
foreign includes all types of investors from outside the US.

Figure 2-7: VC commitments in limited partnerships in the US during the year 2000 by
investor type

Percent

Corpo'aIions
Individuals &. 4%
families

Pension funds
40'1,
EncIo"111tnIS&'
foundaIions
21%

Finnnciol &.
insurance
23%

Source: National Venture Capital Association Yearbook (2001: 24)


Chapter 2: Theoretical foundation 49

The primary objective of VC investors is typically to generate a high financial return on their
investments. Besides that, other objectives may exist: financial institutions may want to
diversify their investment portfolio especially if they have long-term liabilities and can match
these with long-term investments in VC (e.g., pension funds). Industrial companies may try
to achieve strategic objectives like getting insights into new technological development. I 18
Public investors may have the objective of providing capital for regional development. 1l9

Many investors choose not to invest in start-ups directly since they do not have the time or
expertise for such high-risk investments. Instead they invest in VC funds managed by
venture capitalists, see, for example, Gompers and Lerner (1999: 127).1 20

Competitive advantage of venture capitalists

Venture capitalists need a competitive advantage over their competitors in order to get
investors to provide capital for their new VC funds. l2l The competitive advantage of a
venture capitalist is based on hislher resources. Some critical resources of venture capitalists
are described below as qualifications of venture capitalists, the investment strategy and the

117 The VC commitments by financial institutions has grown in recent years and varies from the average yearly
commitment from 1990 to 2000 which is about 10%. (Based on National Venture Capital Association
Yearbook, 2001a: 24.) In Europe, the role of banks and insurance companies is still much larger. In 1999
banks accounted for 29% of all VC commitments and insurance companies for 13 %. Other investor types
have a smaller share in VC commitments than in the US except for government sources, which make up
4.7% in Europe and which are not separately listed in the US figures. (Based on European Venture Capital
Association, 2000c.) These figures, however, can only give a rough indication of differences between
Europe and the US since the European figures include capital raised for buy-out financing which is not
included in the US figures.
118 See 2.3.2 for a -discussion ofCVC objectives and 2.3 to 2.6 for an overall discussion ofCVC.
119 Kortum and Lerner (1998) find that VC spurs innovation in a region by analyzing the impact of the level of
VC investments on the rate of patenting and other measures of innovation. Gompers and Lerner (1999:
137) caution: "Demonstrating a casual relationship between innovation and job growth on the one hand and
the presence of venture capital investment on the other is, however, a challenging empirical problem." Also
see Waddell (1995) for an analysis ofVC funds that incorporate social goals.
120 Even investing in VC funds, however, is risky. While there is a significant return potential, as shown in
2.2.3.6, VC also has some drawbacks. Three of these drawbacks are: VC investments are very risky,
require significant management resources and are illiquid. For these reasons, investors frequently hire
gatekeepers that provide information on VC funds or they may invest in "funds-of-funds" which invest in
different VC funds and manage the investments.
121 This is true, at least, when the competition for capital from investors is strong. It is an open question
whether this is true at the moment since the VC commitments overall and the disbursements per deal are at
record levels as described in 2.2.2. This is a field for additional research as, for example, Gompers and
Lerner (1999) suggest. See 2.2.3.6 for a brief introduction to the discussion about the cyclical nature ofVC,
which is based on a slow adjustment of supply to changes in demand and vice versa.
50 Chapter 2: Theoretical foundation

structure of the VC fund. 122 Figure 2-8 shows an overview of elements that impact the
resources of venture capitalists. These are discussed in the following section.

Venture capitalists typically prepare an information memorandum that describes their


qualifications, investment strategy and the structure ofthe VC fund and present it to potential
investors. Raising a VC fund, including designing a fund concept, marketing it to investors
and negotiating terms often takes 12 to 18 months.

Figure 2-8: Three resources that impact venture capitalists' competitive advantage

Qualifications Investment strategy Structure ofVe fund

Skills of managing different Management approaches for -Legal form


steps of VC process, e.g., - Accessing deal flow - Limited partnership
generating deal flow, doing - Performing due diligence -Other
due diligence, etc. - Monitoring/supporting Compensation
Track record start-ups - Management fee
VC manager experience Investment focus on - Carried interest
VC manager expertise - Stage Fund size
Size of the management - Sector Fund term
team in relation to the fund - Geographical region - Self-liquidating
size - Evergreen
Turnover of staff Capital call practices
Management incentives Investment restrictions

Qualifica~ons of venture capitalists

The various qualifications of venture capitalists can be regarded as resources. These


resources include the ability of venture capitalists to manage the six steps of the VC process,
described in 2.2.3. These resources are: the skill to raise money, the skill to generate deal
flow, the skill to do due diligence, the skill to structure and negotiate investments, the skill to
monitor and support start-ups and the skill to exit investments.

Further, the venture capitalist's track record is a valuable resource that shows some proof of
past performance. Then, the management team is an essential resource, especially the
experience of the venture capitalist in making VC investments as well as his/her
industry/functional expertise. Finally, there are additional resources that may be important.

122 Brooks (l999: 102-111) describes similar requirements as qualifications, investment strategy and structure
in more detail. She describes six main issues that influence the investor's decision: market analysis,
Chapter 2: Theoreticalfoundation 51

The efficiency of the management team may be a valuable resource that is partially reflected
in the size of the management team in relation to the fund size. A low turnover of staff may
indicate leadership qualities that are another potentially important resource. Management
incentives may lead to a superior motivation of venture capitalists, which is most likely a
valuable resource as well.

Investment strategy ofVC fund

In addition to the qualification of venture capitalists, a compelling investment strategy is an


important resource that sigillficantly impacts the competitive advantage of venture capitalists.
The investment strategy is based on qualifications like industry expertise, analysis
capabilities or VC experience. An investment strategy has different elements: management
approaches for accessing deal flow, performing due diligence and monitoring/supporting
start-ups l23 as well as possibly a specific investment focus. The investment focus is an
important element of an investment strategy since it predetermines what types of investments
a fund intends to make.

In order to create a compelling investment strategy, venture capitalists typically focus on


funding certain groups of start-ups. Such a focus may have different reasons: the venture
capitalist has certain fields of expertise or a primary access to deal flow, the venture capitalist
has specific expectations about technological development, the IPO market (a very attractive
exit option as described in 2.2.3.6) may be receptive to certain groups of start-ups, certain
fields may lack a supply of venture capital etc. Three criteria are often used to fOCliS an
investment strategy: the investment stage, the sector and the geographical region.

An investment focus may be on a specific investment stage: seed, start-up, expansion etc.
See Table 2-8 for a description of VC investment stages based on EVCA (2000b), Lipman
(1998: 10-13) and NVCA Yearbook (2000: 107-108).124

investment strategy, management team, track record, legal form of the fund and terms and conditions.
123 See sections 2.2.3.2, 2.2.3.3 and 2.2.3.5.
124 The definition of investment stages varies in the literature and is not always clear-cut. The definition
presented in Table 2-8 attempts to give an integrated view of different stage definitions. Other investment
stages that are not considered as VC according to the defmition in 2.2.1 include acquisition financing,
management/leveraged buy-out fmancing, management buy-in financing or turnaround financing.
Acquisition financing provides funds for the acquisition of another company. Management/leveraged buy-
out financing enables an operating management group to acquire a product line or business from either a
public or private company. Management buy-in fmancing enables managers from outside the company to
acquire a product line or business. Turnaround financing is provided to companies at a time of operational
or fmancial difficulty with the intention ofthe "turning around" or improving a company's performance.
52 Chapter 2: Theoreticalfoundation

Table 2-8: VC investment stages


Stage Description
Early stage financing
Seed financing Relatively small amount of capital provided to an inventor or entrepreneur to
prove a concept and to quality for start-up capital. This may involve product
development and market research as well as building a management team and
developing a business plan. 125
Start-up financing Financing to companies for product development and initial marketing.
Companies may be in the process of organizing or they may have been in
business for one year or less, but have yet not sold their products
commercially. Usually such firms will have done market studies, assembled
key management, developed a business plan and are ready to conduct
business.
Other early stage Financing to companies that have completed the product development stage
financing (first stage and require further funds to initiate commercial manufacturing and to finance
financing) marketing and sales. Most likely, these companies will be generating
revenues but generally they are not profitable. Often called first stage
financing.
Expansion stage Financing for the growth and expansion of a company that is producing and
financing 126 (second shipping. It mayor may not be showing a profit. Capital may be used to
stage financing) finance increased production capacity, market or product development and/or
to provide additional workin2 capital. Also called second sta2e financing.
Later stage financing 127 Financing to companies that have reached a fairly stable growth rate and are
(third stage) not growing as fast as in the expansion stages. These companies are more
likely to be profitable and to have positive cash flows. Also called third stage
fmancing.
Bridge financing 128 Financing made available to a company in the period of transition from being
privately owned to being publicly quoted. A company like this plans to go
public within about a year. The IPO, however, may not be appropriate yet
due to market timing or the size and performance of the company. Bridge
fmancing can involve restructuring of major stockholder positions through
secondafy transactions, e.2., investors who want to liquidate their stake.
Sources: Based on European Venture Capital ASSOCiatIOn, 2000b; Lipman 1998: 10-13;
National Venture Capital Association Yearbook, 2000: 107-108.

A successful start-up evolves through different investment stages, receiving additional capital
in new rounds of fmancing. The focus on certain investment stages is often linked to an
amount that a VC typically wants to invest per deal. This amount is lower for early
investment Stages and higher for later ones. On an aggregated level, more than half of the US
VC disbursements in 1999 were invested in companies in the expansion stage (54%). Less

125 Zider (1998: 132) claims that most VC in all development stages is used for commercialization and little is
used for R&D.
126 The term expansion stage financing is sometimes also used to describe all non-early stage VC including
second stage, third stage and bridge financing.
127 Just like expansion stage financing, later stage fmancing is also sometimes used to describe all non-eariy
stage VC including second stage, third stage and bridge financing.
128 Can also be regarded as a subgroup of later stage financing.
Chapter 2: Theoreticalfoundation 53

than a quarter was invested in early stage (23%) and later stage companies (20%, including
bridge financing), according to the NYCA Yearbook (2001a: 28).129

Besides focusing on certain investment stages, venture capitalists may also focus on specific
sectors e.g., biotech, Internet, communication technology etc. See 2.2.2, especially Figure
2-6 for a breakdown of US VC disbursements by industry.

Venture funds also often focus on certain geographical regions. On the one hand, this is a
practical move to limit travel time since venture capitalists may have to or want to attend the
board meetings of their portfolio companies. On the other hand, certain regions may offer
better opportunities than other regions. What is important is that the region chosen offers
adequate investment opportunities and exit mechanisms. How strong the differences between
regions are is reflected in the US figures. According to NY CA (2001 a: 31) California
attracted 40.5% and therefore the highest share of VC disbursements in 2000. Second is
Massachusetts, which attracts 9.1%. Next are New York and Texas with 6.6% and 5.6%,
respectively. The 30 US states with the lowest VC disbursements attracted only 4% of the
capital disbursed in 2000.

Focusing investments on certain groups of start-ups can have advantages and disadvantages.
For example, expertise in a specific industry segment may help a venture capitalist to better
support start-ups and therefore increase the value ofhislher investments. On the other hand,
this may limit the chance of a successful IPO since it increases the exposure of VC funds to
the risk that preferences in the capital markets towards specific industry segments' may
change.l30 No matter what fields a VC firm chooses to focus on, it needs to convince
investors of the merits of such a focus.

Highly qualified venture capitalists with a compelling investment strategy also need to
structure VC funds well in order to raise capital from investors. The structure of the venture
fund is an important resource of venture capitalists. The most important elements of the VC
fund structure are the legal form of the VC fund and the compensation of the VC managers,
which includes the management fee and carried interest. Beyond legal form and
compensation, other elements like fund size, fund term etc. are important parts of the VC
fund structure.

129 Three percent of the disbursed VC was invested in companies in the buy-out/acquisition stage. This does
not count as VC according to the definition in 2.2.1 but is included in these numbers by Venture Economics
(organization preparing NVCA report) because the investments are made by VC and not private equity
funds.
130 Baumgllrtner (1998: 58-59) discusses possible advantages and disadvantages of a VC fund focus based on
the theories of CAPM and asymmetric distribution of infonnation in principal-agent-relationships.
54 Chapter 2: Theoretical foundation

Structure ofVC funds: Legal form

The legal form is an important element of the VC fund structure. Many taxation and legal
issues impact the legal form of a venture fund. One of the most basic issues is to avoid
double taxation, which may occur once when the investments are sold and again when the
capital is returned to investors. The legal form of the VC fund should ensure that returns are
subject to tax payments only once, typically when the capital is returned to the investors. In
many countries the limited partnership is a legal form that prevents double taxation. In
addition, issues like management efficiency are important and need to be weighed against tax
issues.

The prevailing legal form of venture funds is the limited partnership.l3l In these limited
partnerships, the investors are limited partners and venture capitalists are general partners.
The limited partners provide capital for the VC fund, which is just a pool of cash and their
liability is limited to the amount of their investment. Their committed investments are
usually drawn down through capital calls, as capital is needed by the VC fund to make
investments or cover costs. The general partners in the limited partnership (or their
employees) manage the fund by investing the fund's capital and monitoring the funded start-
ups. When the fund managers exit investments, they typically distribute the capital and
income to the limited partners. Therefore limited partnerships are usually self-liquidating and
have a predetermined limited lifetime (see below). In this study the term venture capitalist is
typically used to describe the general partner in a limited partnership.

Besides limited partnerships, other types of legal forms of VC funds exist. VC may be
invested through publicly traded closed-end funds which typically have no limited lifetime
(evergreen ,fund).132 Furthermore captive funds that belong to companies may not be
structured as limited partnerships. Captive funds may be funds of financial companies, like
commercial banks, or funds of industrial companies. These two types of captive funds often
differ in objectives and value proposition (see 2.3). Captive funds

may be managed by employees of the investor and may receive capital for investments when
needed. Another legal form VC investors may use in the US is the small business investment
company (SBIC) that provides federally guaranteed risk capital. SBICs are privately owned

131 Around 80% of VC investments in the US from 1987 to 1994 were made through independent venture
partnerships (Gompers and Lerner, 1999: 8-9). The first venture capital limited partnership, Draper, Gaither
and Anderson was formed in the US in 1958 but this form of structuring VC funds did not account for a
majority ofVC funds until the 1980s.
132 The first venture funds in the US (e.g., American Research and Development (ARD) 1946) were publicly
traded as closed-end funds.
Chapter 2: Theoretical foundation 55

venture funds that can supplement their private capital with debt or equity from the federal
government. 133

As mentioned above, the limited partnership is the most widely used form for structuring VC
funds. As Blake (1999: 93) summarizes, which legal form is best for a VC fund is influenced
by different factors, "... the choice of the legal form will depend partly on the country or
countries in which the investments are to be made, partly on the tax position of the carried
interest holders and partly on the specific backgrounds and requirements of investors in the
fund. In most cases, a limited partnership appears to be the most flexible legal form, but it is
always necessary to take good up-to-date advice." Gompers and Lerner (1999: 24, 95) point
out that the research on the legal form of VC funds has been limited so far. In contrast to
other sources, they question whether the limited partnership model is critical to successful
VC investing (1999: 27).

Structure ofVC funds: Compensation

Besides the legal form of VC funds, the compensation of venture capitalists is a major
element of a VC fund structure. Their compensation usually consists of two components:
first, a management fee and second, a carried interest.

The purpose of the management fee is to cover the basic costs of a venture fund, which range
from salaries to office-related costs. The management fee is calculated as a percentage of the
committed capital, the level depending on the size of the fund and the reputation of the
venture capitalists. In most cases, the management fee is tapered at the end of the fund's life,
which means that from a certain year on, the management fee is reduced to reflect the lower
amount of work for venture capitalists in a fully invested fund. \34 According to a survey by
Asset Alternatives Inc. (1999: 58) in the US, most funds charge a management fee of
between 1.5 to 2.5 percent per annum with an average of 2.2%.135

In addition to the management fee, most funds have agreements about the distribution of
costs that are not covered by the management fee and fees that are collected by the VC fund.
On the one hand, VC funds may cover certain operating costs (e.g., fees for professional
advisors) out of the committed capital and not out of the management fees. On the other

133 SBICs proliferated in the US during the 1960s. According to the NVCA Yearbook (200Ia: 21), SBIC
fundraising reached USD 6.2 billion in 67 funds in 2000. The total capital under management reached USD
17.1 billion in 407 funds. Additional information on SBIC financing can be found at
www.sba.gov/inv/overview.
134 According to a survey of US venture funds by Asset Alternatives Inc. (1999: 62) only 21 % of venture funds
do not use agreements that reduce the management fee towards the end of the fund (called scale-down).
\35 The median is 2.3%. Only 3% charged less than 1.5%, 5% from 1.5% to 1.9%, 34% charged 2%, 51 % from
2.1 % to 2.5%, 2% charged 2.6% to 3% and only 5% charged another percentage of the capital committed.
56 Chapter 2: Theoreticalfoundation

hand, fees that are collected136 may be collected by either the venture capitalists or the fund.
All this is determined in the individual fund conditions and may impact the behavior of the
venture capitalists. For example, when VC fund managers have to cover the costs of abortive
investments, they may become more cautious and miss some potential opportunities. The
carried interest, however, is far more important for impacting VC managers' behavior than
how costs and collected fees are split.

The carried interest is the primary source of incentives for the investment team. Carried
interest is a share of the gains and income the fund generates and typically, the investment
team receives 20% oithe fund profits as a carried interest. 137 Although most funds receive a
20% carried interest; the actual payout to the investment team may differ substantially even
among funds with a similar performance. The reasons for this are variations in the fine print
of the partnership agreement. In some funds, for example, general partners may return
certain expenses to the limited partners before calculating profits whereas in other funds,
general partners may not return such expenses. Further, the timing when general partners
start to participate in fund profits may vary. In some funds general partners start to
participate once a certain portion of the capital that limited partners contributed is returned to
them while in other funds the general partner only starts to participate in fund profits once the
committed capital plus a hurdle rate 138 is returned to the limited partner. 139

Carried interest can substantially impact the income of VC managers and is therefore the
main factor that motivates them.140 Carried interest may be a good way to align the interests
of VC managers and investors, since both benefit from high investment returns. 141
Nevertheless, a lot of agency problems may arise in a venture fund since VC managers and
investors try to maximize their own returns. These agency problems should be addressed in
the conditions of the venture fund. Some of the issues that should be covered are: Who

136 E.g., investment-banking fees paid by the start-up for setting up a deal, syndication fees paid by third-party
investors, consulting fees paid by the start-up for out ofthe ordinary support.
137 See for example a survey by Asset Alternatives Inc. (1999: 71). Exceptions to the 20% agreements are
mostly venture funds that were highly successful with earlier funds and have a strong reputation. These
may get a 25% or 30% carried interest (e.g., Kleiner, Perkins, Caufield & Byers, which receives a 30%
carried interest according to Asset Alternatives Inc. (1999: 73)).
138 The hurdle rate, also called preferred rate, is a minimum return to the limited partner that needs to be paid
before the general partner receives a share of the profits. According to Asset Alternatives Inc. (1999: 79) it
is less common among VC funds and more common among buy-out funds.
139 For a more detailed discussion of some of the possibilities for paying out carried interest see, for example,
Asset Alternatives Inc. (1999: 71-94) or Blake (1999: 87-88).
140 For example a $100 million fund with an IRR of 25 percent with a 20 percent carried interest and a 10
percent hurdle rate can pay a total carried interest of $60 million. (Assumptions: 100 million invested on
day I, payback $62 million per year from year 4 to 10.)
Chapter 2: Theoretical foundation 57

covers what type of costs and fees? What happens when VC managers leave the fund early?
What happens, when investors want to replace VC managers?

Structure of VC fund: Other elements

In addition to legal form and compensation, other elements of VC funds are important: these
include the fund size, the fund term, capital call-, distribution- and reinvestment practices, the
minimum investment per investor as well as other, more specific elements like the right of
venture capitalists to raise new funds. In the following section, these structural elements will
be discussed in more detail.

First, the fund size needs to be determined. Typically, this cannot be increased once the fund
is closed. The fund size also impacts the management fee since the management fee is
usually charged as a percentage ofthe committed fund capital.

Then, the fund term needs to be decided on. The fund term is the time in which the capital
and returns have to be paid back to investors. Single investments by a VC fund have a
limited time focus as discussed in 2.2.1. When investments are sold by limited partnership
VC funds, returns are typically not reinvested but distributed to investors as soon as is
practical thus, most VC funds are self-liquidating as they have a predetermined limited life
span (often 10 years). This forces VC managers not only to exit successful investments but
also less successful investments. 142 The pressure to pay back the invested capital may help
VC managers to terminate less attractive investments with little upside potential. VC firms
typically raise a new fund after two to five years, once a fund is substantially invested.
Besides self-liquidating funds, there are also evergreen funds. In evergreen funds, returns are
reinvested. These funds are often quoted on a stock exchange to enable investors to liquidate
their investments.

Next, the capital call practices need to be agreed on. These determine when committed
capital needs to be paid in. Typically capital is called in several installments (takedowns)
when needed over the first two or three years. Then, the distribution practices need to be
decided on. These determine when realized returns are paid out to investors, typically as
soon as possible. Next, the reinvestment practices need to be decided on. These determine in
which cases capital from sold investments can be reinvested. Most funds do not reinvest
capital from sold investments but have a predetermined limited lifetime as discussed above.
Further, the minimum investment from a single investor needs to be set.

141 Little empirical evidence, however, seems to exist to prove, that the level of carried interest is positively
related to performance. Gompers and Lerner (1999: 57-94), for example, analyze VC incentives and do not
fmd any relationship between the incentive compensation and performance.
142 Sometimes called "living dead" or "zombies".
58 Chapter 2: Theoreticalfoundation

In addition to the structural elements discussed above, other more specific elements or
conditions are usually included in venture fund (partnership) agreements since such
conditions are the only way limited investors can influence the behavior of general partners.
Limited partners can take legal action when the general partner violates contractual
agreements. Such additional conditions may be investment restrictions that limit, for
example, what percentage of the fund's capital can be invested in a single investment. Other
restrictions may keep general partners from investing personal funds or limit their ability to
do fundraising for new funds. This is done to ensure the general partners' full attention
towards the venture capital fund. Gompers and Lerner (1999: 38-42) identify a list of 14
covenants that are often included in limited partnership agreements. 143

Besides formal structural elements, investor relations are important to convince investors of
the venture capitalists' qualifications as well as the quality of the investment strategy and VC
fund structure. For a more comprehensive discussion of investor relations as well as terms
and conditions see Brooks (1999:107-111,114-117).

2.2.3.2. Generation of deal flow

In order to invest in business ideas/start-ups, venture capitalists need to identify investment


opportunities (called deals) that can be assessed for their potential to generate value. Early
stage investment opportunities are typically described in business plans whereas deals may
either be in the idea stage or businesses that already exist. Deal flow is the term venture
capitalists use to describe their access to potential investment opportunities. The number of
investment opportunities per unit of time is called deal flow. Getting access to a high number
of deals per unit of time is important to venture capitalists since only a small fraction of all
investment ?pportunities that are reviewed get funding. At the same time the high quality of
the deal flow is a prerequisite for the success of venture capitalists since it predetermines
whether a venture capitalist can invest in a high potential business or idea. Therefore, the
skill to generate a high quality deal flow is an important resource that impacts the competitive
advantage of venture capitalists, as indicated above.

Three different approaches exist for venture capitalists to generate deal flow. 144 Figure 2-9
lists these approaches.

143 Gompers and Lerner (1999: 29-55) analyze the relationship between the number of covenants and the
supply and demand conditions for venture capital. Among other things, they observe that fewer restrictions
are found in funds established during years with greater inflows of new capital.
Chapter 2: Theoreticalfoundation 59

Figure 2-9: Approaches to generate deal flow

Do marketing Reputation
Public relations
Etc.

Actively search VC conferences


Re$earch on the Internet, in press clippings, annual reports
and trade directories
Incubators
Etc.

Network OtherVCs
Funded entrepreneurs
'1Boards of funded start-ups/advisory committees
Lawyers
Headhunters
Consultants
, Bankers
Technology transfer centers
Incubators
Early stage funds
'Etc.

Source: Based on Baumgltrtner. 1998: 59-61 and Peeters. 1999: 121, 129-132

The first approach to generating deal flow is to do marketing and to wait for entrepreneurs to
send in business plans or walk in to describe their ideas. The better a venture capitalist's
reputation, the more so-called unsolicited contacts s/he gets even without doing any
marketing. The challenge is to screen a high number of potential deals without prior quality
control to identify the few that may be promising.

Second, ventur~ capitalists may actively search for business opportunities themselves. This
can be done by attending VC conferences, doing research on the Internet, in press clippings,
annual reports and trade directories or by contacting incubators etc.

Finally, venture capitalists can build a network of individuals and organizations that will
direct entrepreneurs in their direction. Such a network most likely includes other venture
capitalists possibly from former cooperation in syndicated deals (see 2.2.3.4). Venture
capitalists may also be looking for partners that coinvest in a current deal. A network like
this may also include funded entrepreneurs, fellow members of boards or advisory
committees, lawyers, headhunters, consultants, bankers, technology transfer centers,

144 These approaches are mentioned or described, for example, by Baumgartner (1998: 59-61) or Peeters (1999:
121,129-132).
60 Chapter 2: Theoretical foundation

incubators, early stage funds etc. Referrals are typically a source of higher quality deals l45
but usually require that the individuals or organizations referring entrepreneurs get something
back from the VC e.g., referrals for their own services. Most venture capitalists will use a
mixture of the three approaches described above.

It is not only venture capitalists who look for high quality, start-ups also do. Venture
capitalists need to offer something to start-ups that goes beyond plain capital in order to get
access to the high quality deals. It is therefore important for venture capitalists to understand
what start-ups are lool?ng for.

At least three characteristics of venture capitalists and their services are important to start-
ups.146 As shown in Figure 2-10, these are: the investment focus, the reputation and the
value-added support offered.

Figure 2-10: Venture capitalists' characteristics important to start-ups

Investment strategy The investment strategy of the venture capitalist needs to


meet startup characteristics

Reputation The high reputation of the venture capitalist adds to the


credibility of the start-up

Value-added support The venture capitalist actively helps the start-up to succeed, e.g.,
Offers support in management issues and strategic decisions
Helps to find additional management team members
Provides access to networks of people and information

145 Peeters (1999: 129-132, 135) describes the importance of the deal flow sources based on numbers presented
by different venture capitalists. According to one ve, only 25% percent of the deal flow are referrals but
95% of actual investments are made in companies that are referrals. Another ve claims that only around
10% of the referrals are syndication offers from other venture capitalists but 40% of actual investments
made in companies identified through referrals are done in syndication offers from other venture capitalists.
146 See, for example, Peeters (1999: 123-124).
Chapter 2: Theoreticalfoundation 61

As described in 2.2.3.1, the investment focus of a venture capitalist may be on certain stages,
sectors or geographical regions. The focus of the venture capitalist and the stage, sector and
geography of the start-up need to match. The reputation or image of a venture capitalist is
shaped mainly by hislher track record in helping start-ups to become successful. The
reputation is important to start-ups since a venture capitalist with a proven track record may
be better able to support start-up development. Moreover, simply by receiving funding from
a well-respected venture capitalist, start-ups can increase their credibility in the market,
which can help to access customers, business partners and further financing sources. A
venture capitalist may offer diverse value-added support to start-ups. In addition to support
in management issues and strategic decisions, venture capitalists may help to hire additional
members of the management team and leverage their network to offer access to information
and people. See 2.2.3.5 for a further discussion of the support venture capitalists can give to
start-ups.

Top tier VC firms are often well known and have a positive image and a good reputation
which means that they get a lot of deal flow from entrepreneurs approaching them. Start-ups
will often try to get funded by top tier VC firms since these may be better able to increase the
start-ups' chances of being successful although conditions for them in terms of equity that
needs to be given for capital up may be worse. Top VC firms have experience and a proven
track record of helping start-ups to be successful and they can usually offer a wide range of
contacts and support.

For less well-known VC firms it is harder to create demand for their services. These firms
need to improve their track record, focus on interesting niches and offer high quality value-
added services as well as better conditions.

It is important for less well-known VC firms, but also for those VC firms with a good
reputation, to market their services andlor to improve their image in order to ensure access to
a high quality deal flow. This is becoming ever more important since the supply of VC and
the number of VC firms is growing fast as shown in 2.2.2. Therefore, venture capitalists
need to leverage different ways to communicate their value proposition to entrepreneurs
including participation in events like VC conferences, listings in industry references, an
Internet presence, advertising, press coverage, newsletters etc.

2.2.3.3. Assessment of investment opportunities

When venture capitalists get access to deals, they know much less about start-ups than the
entrepreneurs. As mentioned above, this situation is called information asymmetry and is
discussed by Gompers and Lerner (1999: 127-128) in combination with three other
62 Chapter 2: Theoretical foundation

characteristics of start-up fmns l47 that prevent many investors from funding start-ups.
Information asymmetries may lead to agency problems as start-up managers may use their
superior knowledge of the start-up to create benefits for themselves that are not in the best
interest of the investor. 148 Therefore, venture capitalists try to overcome the information
asymmetries by thoroughly investigating potential investment opportunities, as described in
this subchapter, and by monitoring start-ups intensively once an investment is made, as
described in 2.2.3.5. 149 In addition, venture capitalists try to align the interests of start-up
managers with their own interests to prevent agency problems, as described in 2.2.3.4.

Venture capitalists assess investment opportunities thoroughly for their potential to create
high returns. The term that venture capitalists use to describe the process of thorough
investigation of an investment opportunity is due diligence. 150 The skill to conduct a due
diligence is an important resource that impacts the competitive advantage of venture
capitalists, as indicated above. In the following sections, four topics will be discussed: the
objectives of due diligence, the issues venture capitalists look at in due diligence, the sources
of information and the process of due diligence.

Before venture capitalists start the process of due diligence, they need to decide first which
start-ups or ideas present an investment opportunity they want to analyze. Such a pre-
selection can be based on the criteria that are outlined in the investment strategy. Beyond
this, venture capitalists will use common sense and their experience to decide which start-ups
may offer sufficient potential to justify doing a due diligence.

Objectives of due diligence

After venture capitalists have identified an investment opportunity, they perform a due
diligence in order to determine the attractiveness, risks and issues regarding a transaction. A
due diligence may also be done for an existing investment before a new round of financing.
The primary outcome of the due diligence is an investment decision. The insights gained,
however, do not only impact the investment decision but also the terms of the investment
including possible syndication options. In addition, the insights from the due diligence often
also guide the venture capitalists' interaction with a company after an investment is made.
Through due diligence, venture capitalists may understand the most important areas of risk or
upside potential that need to be addressed as well as other issues that need to be dealt with.

147 Uncertainty, the nature offmn assets and conditions in financial and product markets.
148 Agency costs are costs that occur when an agent (here the start-up manager) does not act in the best interest
of the principal (here the venture capitalist). See Jensen and Meckling (1976) for a discussion of agency
problems.
149 See Gompers and Lerner (1999: 130).
150 Besides venture capitalists, investment bankers and others also use the term due diligence.
Chapter 2: Theoreticalfoundation 63

Finally, the due diligence helps venture capitalists to become familiar with the situation,
dynamics and language in the industry sectors analyzed.

Issues venture capitalists look at

Issues that venture capitalist look at in the due diligence typically include the management,
the product market concept and the potential value generation. These three issues are major
issues l51 , although they certainly do not represent a complete list of issues venture capitalists
look at. 152 The management team is probably the most important factor that venture
capitalists look at (Heyning; 1999: 146; MacMillan, Siegel and SubbaNarasimha, 1985: 119;
Sahlman, 1997: 100-101), since an excellent team with an average idea may be able to
continually adapt a product market concept until it is successful. In contrast to this, less
excellent teams may not be able to manage the iterations that are typically necessary even for
excellent ideas in order to create a market success. Although the optimal team structure may
vary for different start-up opportunities, venture capitalists typically look for management
expertise in all relevant fields, e.g., sales and marketing, finance, operations and certainly
technology in high-tech start-ups. In addition to that an experienced CEO is very important
to guide the new venture. For all members of the management team venture capitalists do not
only look for expertise but also for relevant experience, industry contacts and certainly
motivation. How stable a management team has been in the past, may also provide valuable
insights.

The product market concept summarizes the business idea and includes different aspects:
product and services including the reason for being valuable or unique to customers, targeted
customer group, sales strategy, revenue model, margins etc.

The potential value generation is the overall value a business can achieve within a certain
time frame considering determinants like market potential and possible competition. The
potential value generation needs to be large enough to justify a VC investment. Given the
portfolio character of VC, as described above, an investment opportunity needs to promise
very high returns.

151 For example, George Zachary, partner at Mohr Davidow Ventures, fonnulates these three issues for Internet
start-ups in five questions (Hannon, 1999: 24): Management team: "Are these the guys or gals to pull it off?
What is the proof that they can or are pulling it off?" Product market concept: "Can this [Internet start-up]
be a category leader? Is it in a great category (not just an interesting or a good category)?" Potential value
generation: "Can this category support a $500M-$1 B company?"
152 See, for example, Heyning (1999: 147-155), MacMillan, Siegel and SubbaNarasimha (1985) and Tyebjee
and Bruno (1984) for a more detailed discussion of the issues venture capitalists analyze. Also see
discussion of "rules of thumb" below.
64 Chapter 2: Theoreticalfoundation

"Rules of thumb" exist that describe what start-up profile venture capitalists expect to
consider funding these business opportunities. 153 One "rule of thumb", for example, is that
venture capitalists only invest "... in markets that are big enough for a company's sales to
grow to at least $50 million with pre-tax profit of 20 per cent within five years. Experience
shows that a company like that will be able to go public, or to get bought by a larger
company, and will return five to ten times the venture capitalist's original investment."154
Bygrave (1999: 327-334) tests these "rules of thumb" empirically by analyzing venture-
backed public companies. 155 He states that many criteria that are specified as requirements
for investing in start-ups were not met by VC-funded companies that actually did go public.
For example, the criterion to achieve 20 percent market share by year five is not met, the
actual median market share observed was two percent. The annual sales volume of USD 50
million was also not met, the actual median sales reached USD 24 million. The median IRR
observed, however, was 145 percent and exceeded the required 25 percent by far. Bygrave
(1999: 334) also argues that it depends on the industry to what extent criteria are met. He
states that in the young and especialiy fast growing Internet industry, for example, companies
went public with fewer earnings than in the slower growing semiconductor industry. Internet
companies also went public much faster, within a year after the first investment, while
semiconductor companies took five years.

The final decision of a venture capitalist to invest or not invest in a business idea may be
based on an individual set of diverse criteria, which may not even be explicitly stated. Given
the uncertain nature of the topic, this set of criteria may at least partially depend on personal
experience and subjective assessment by the venture capitalist.

Sources of information

Venture capitalists have different sources of information to analyze the issues discussed
above, one source being the business plan of the entrepreneur(s). According to Sahlman
(1997: 99), the business plan should cover four different factors that are critical to every start-
up: the people, the opportunity, the context and risk and reward. A business plan should
introduce the people that want to start a business and, as stated above, the management team
is probably the most important factor for start-up success. Then, the opportunity needs to be

153 See, for example, Bygrave (1997) and Timmons (1994). MacMillan, Zemann and SubbaNarasimha (1987)
discuss characteristics that separate successful from less successful start-ups.
154 Bygrave (1999: 310).
155 Bygrave et al. (1998) studied 122 VC-funded high-tech companies that went public on the Nasdaq during
the period January 1994 and July 1997. See Bygrave et al. (1998) for a more detailed discussion.
Chapter 2: Theoretical foundation 65

explained, including the product-market-concept I56 : What is sold, to whom and how? What
technologies are involved? What is the competitive advantage? What is the growth
perspective? What are the economics? Next, a business plan should cover the context from
demographic trends to regulatory environment. Finally, a business plan should clarify how
the start-up plans to respond to key risks it may face. The level of sophistication of the
business plan also conveys information about the team in addition to the explicit information
the business plan contains.

Venture capitalists, however, do not only rely on information provided by the start-up but
also do their own research and analysis. They especially look at long-term strategic issues,
analyze different scenarios,and the strengths and weaknesses of a business.

Process of due diligence

The process venture capitalists use to perform a due diligence is typically staged, each stage
going into more depth than the stage before. The next stage of due diligence is only done if
the start-up still looks promising after finishing the previous stage. The advantage of such a
staged due diligence process is that it minimizes the time that is spent on deals that are not
funded. According to Heyning (1999: 156-161), five different stages can be described. In
the first stage, the business plan is analyzed, including the analysis of the effects of different
scenarios on the projected financials. The business plan will give a first impression of the
prospects of the business and remains a valuable resource for the subsequent stages ofthe due
diligence process. In the second stage, the venture capitalist typically meets the management
team for the first time and may visit the facilities, thus enabling the venture capitalist to get a
good impression of the quality of the management team and possibly of the current
operations. Next, often in parallel to the first two steps, the venture capitalist studies the
markets and technologies that are involved based on market studies, databases, press articles
etc. Then, the venture capitalist and the start-up typically start to close the deal by agreeing
on the basic terms of a possible investment, which is still, however, subject to the outcome of
the due diligence. A basic agreement is crucial since continuing with the due diligence by
contacting outside people (see below) involves substantial risks for both parties. The
company may face commercial risks when customers, suppliers and others are approached by
venture capitalists. On the other hand, venture capitalists may face the risk that other
investors become interested in the deal and fund the company. Finally, venture capitalists
may involve outside people/experts for a detailed due diligence. For example, they may
approach customers, suppliers, competitors, former employers or industry/technology experts

156 According to Roberts (1991: 16), entrepreneurs, when fonnulating a business plan, often focus too much on
the technology and focus too little on the market, the competitive advantage and the people.
66 Chapter 2: Theoreticalfoundation

to gain additional infonnation. This is typically the most extensive part of the due diligence
and the one with the most significant impact on the fmancing decision.

2.2.3.4. Investment in start-ups

If the due diligence process convinces the venture capitalist to invest in a start-up, and if it
convinces the start-up to accept an investment from the venture capitalist, the investment
needs to be structured and the price needs to be negotiated. The skill of structuring and
negotiating the price of a deal is an important resource that impacts the competitive
advantage of venture capitalists, as indicated above. The important issues are: valuing the
start-up, detennining the cash requirements, designing an investment agreement (a legal
document) that covers issues like price, control right or representation and finally possibly
syndicating with other venture capitalists. 157 The results from due diligence will help the
venture capitalist in different respects to structure and price a deal, e.g., to determine a fair
value of the start-up or to detennine cash requirements over time.

Start-up valuation

The valuation of the start-up is essential since it typically detennines what equity share
entrepreneurs have to give up to venture capitalists. Given a certain investment amount, a
high valuation leads to a lower equity share for the venture capitalist than a low valuation. A
venture capitalist will, therefore, typically value a company less optimistically than an
entrepreneur. The uncertainty involved creates possibilities to argue over the valuation.
Different factors that impact the valuation and different methods for the valuation exist as
indicated below, however each factor and method still leaves a lot of room for interpretation.

Different (actors impact the valuation of a company. Sherling (1999: 165) lists the following
factors: the company's stage of development, the economic and public stock market
environment, the company's position in its market, the prospects for the market sector in
which the company operates, the likelihood that the company will need further cash to
achieve its'objectives and, not least, the competition among capital providers to invest in the
company. There are several reasons why these factors are important for the valuation. The
company's stage of development, for example, impacts the uncertainty involved. Start-ups in
the seed stage can only offer prospects and carmot show success in the market yet. Next, the
economic and public stock market environment impacts the exit options. Furthennore, the
company's position in its market and the prospects of the market sector impact the sales
growth and return expectation and therefore the overall potential value creation. The

157 Legal considerations will not be discussed in this study although they are important for VC. See, for
example, Cooke (1996) for a discussion ofVC focusing on legal issues.
Chapter 2: Theoretical foundation 67

competition among capital providers, fmally, impacts the bargaining power of venture
capitalists and the start-up.158 In addition to all these rational factors, other factors like the
intuition of the venture capitalist may have a significant impact on the valuation.

Different methods for doing a valuation are discussed in the finance literature (e.g.:
Hawawini and Viallet, 1998: 380-382). These methods are more or less suitable for start-ups.
A valuation based on the price/earnings ratio of comparable competitors, for example, is less
suited since most start-ups do not have any earnings yet. Better suited are, for example,
valuations based on sales multiples or a price per subscriber. Using discounted cash flows is
also a possible valuation method. It is based, however, on projections of cash flows, which
are very uncertain for young start-ups.

Cash requirements

Besides the valuation, determining the cash requirements of the start-up is essential to make
an investment. Two major questions are: how much cash is needed and when is it needed?
To address the first question venture capitalists and start-up managers determine the overall
cash requirements they expect based on the business plan, the due diligence results and
experience. Such an estimate is important since cash is essential for start-ups to survive.
Therefore sensitivity analyses are typically done to understand what impact different
scenarios have on the capital requirements, e.g., when revenue growth assumptions prove to
be wrong.

Second, it is important to understand when the cash is needed or how much cash is needed
for a certain period of time. To reduce their risk, venture capitalists usually stage the
investment over different financing rounds especially for early stage investments I 59. When
venture capitalists are not satisfied with the start-up development, they can abandon the
investment by not providing additional capital when it is needed. Gompers and Lerner (1999:
130) state: "Staged capital infusion keeps the owner/manager on a "tight leash" and reduces
potential losses from bad decisions." Refinancing in a new round of financing depends on
the results of a new evaluation (due diligence) of start-up prospects. Venture capitalists will
often want to tie additional capital commitments to some proof of success in the form of pre-
agreed milestones that start-ups need to reach. These milestones may represent the key risks
or issues that the venture capitalist has identified during due diligence. Examples may be a
working prototype, receiving a patent, winning a certain lead customer or achieving full
production. Projected profit and revenue levels may also be used as milestones. Gompers

158 See Sherling (1999: 165-167) for a deeper discussion of the factors that impact the valuation ofa start-up.
159 The stages described here do not necessarily match the stages described in 2.2.3.1. Venture capitalists, for
example, may provide expansion financing to a start-up several times in different financing rounds.
68 Chapter 2: Theoreticalfoundation

and Lerner (1999: 139-140) argue that: "Venture capitalists weigh potential agency and
monitoring costs when determining how frequently they should reevaluate projects and
supply capital." They find empirical support that the duration of funding is impacted by the
likelihood of agency problems and the nature of firm assets. The more likely agency
problems are and the more intangible firm assets are, the more frequently firms are
refinanced.

Venture capitalists call the first time investment in a company initial financing. Additional
capital that is provided to companies that have been funded with VC before is called follow-
on financing. Table 2-9 shows the role of follow-on financing in the US in recent years. In
spite of the rapid growth in the number of companies funded with VC overall, follow-on
investments accounted for around 60 percent of the capital disbursed and companies funded
in the last five years. In terms of value the percentage of follow-on investments has even
increased in the last few years.

Table 2-9: Follow-on investment orus VC disbursements


Year Capital Percent Companies Percent
disbursed follow-on funded follow-on
(Usn million)
1996 11,211 51% 2,002 58%

1997 17,213 58% 2,697 56%

1998 21,981 58% 3,149 59%

1999 59,372 67% 3,969 56%

2000 103,494 67% 5,412 55%

Source: NVCA Yearbook (2001 a: 32)

Issues of investment agreement

Once a company is valued and its capital requirements are determined, a large number of
issues can be agreed on in the legal document summarizing the investment terms. Such a
legal document may be called investment, shareholder or participation agreement. The key
provisions of the investment are summarized in the term sheet. Some of the more important
issues that are typically covered in the term sheet are the price of the investment, the type of
equity the investor receives and other issues like board seats and investor rights. These issues
are described in the following section.
Chapter 2: Theoreticalfoundation 69

Probably the most important issue that needs to be agreed on is the price of the investment,
which means what share of equity the venture capitalist gets for a certain investment amount.
The venture capitalist will use the outcomes of the valuation and the cash requirement
analysis and will apply a target IRR for the investment to determine the equity share slhe
demands. 160 The targeted IRR of venture capitalists varies according to the stage a company
is in. Table 2-10 shows an example of IRR targets.

Table 2-10: Targeted IRR per stage


Stage Target IRR per annum

Seed -80%
Start-up -60%
Other early stage/expansion 40-60%

Later stage 30-40%


'. (1999: 167) and Bygrave (1999: 312)
Based on Sherhng

The figures given in Table 2-10 are approximate and may differ among venture capitalists,
regions, over time or depending on differing stage definitions. The important notion is that
seed investments are riskier since they have a shorter track record and need to be held longer
until exit and therefore require a higher target IRR. Later stage investments are less risky and
therefore require a lower target IRR. See 2.2.3.6 for IRRs actually achieved.

In addition to the price that determines what percentage of the equity a venture capitalist
receives, which type of equity the venture capitalist receives needs to be determined too.
Different options are: common stock, preferred stock and options or warrants. Besides this,
quasi-equity also exists, e.g., redeemable shares. The basic differences between these equity
types are voting rights, allocation of returns and upside potential and the option to buy
additional equity in specific situations, e.g., when start-up performance is below projection.

In combination With the equity type, additional issues need to be agreed on that determine the
rights of the investors. Four of these are discussed in the following section: board seats,
investor rights, exit planning and management compensation. One issue is which investors
get a seat on the board of directors and what information has to be presented to the board and
when.

The special rights a venture capitalist may receive as a 'preferred' investor are another issue
that is related to board representation and may include veto rights. While the management is

160 The future value of the company at the expected time of exit is estimated and discounted back to its present
70 Chapter 2: Theoreticalfoundation

responsible for running the company, investors may demand certain veto rights to protect
their investments. Veto rights may be granted for situations like a change in the board of
directors, changes in senior management, access to new fmancing etc. 161

A third issue that needs to be agreed on is the exit process. Since VC is a limited time
investment, as described in 2.2.1, investors need to ensure that the company can be sold
within a certain time frame. Besides a general agreement with the management that the
company should be sold within a pre-determined time frame, certain investor rights may be
included in a legal a~eement, e.g., the right of the investor to force the sale of the company
under certain conditions.

At least one more issue needs to be covered in a legal agreement, management compensation.
Management incentives should be linked to shareholder value to limit agency problems. 162
The shares that management owns are certainly one way of focusing the management on
shareholder value. This effect can be even stronger when managers have to pay in significant
amounts of their personal capital for their shares. When a start-up fails to achieve its targets,
venture capitalists are able to significantly dilute the management's share in subsequent
rounds of financing, providing an additional incentive for start-up managers. Apart from this,
annual compensation should also be linked to shareholder value, which can be done through
incentives that are based on key operating figures like the annual budget or the operating cash
flow. Such incentives may be paid in cash or in additional shares.!63

Syndication

In the discussion above, the venture capitalist and the management were described as the two
parties negotiating the price and structure of an investment. In many cases, however, not
only one venture capitalist is involved as venture capitalists often form an investment
syndicate and different venture capitalists invest in a company in a single financing round.
According to de Haan (1999: 284-287), the potential advantages of syndication are risk
sharing among different venture capitalists, possible synergies, better division of tasks and
increased objectivity.

value. The targeted IRR is used as a discount rate.


161 See Bygrave (1999: 3 II) for a list of rights that venture capitalists may be granted.
162 See 2.2.3.3.
163 Two more issues regarding the shares of managers may arise and should be covered in the agreement of
venture capitalists and management. The first is what happens to the shares of managers that leave?
Typically their shares are vested and they can only keep a certain percentage according to the time they
spent with the company. See Sherling (1999: 180-181) for a discussion of this issue.
The second issue is from whom do future managers get shares when they join the company? One
possibility is to get these from all current shareholders in proportion to the number of shares they own.
Chapter 2: Theoreticalfoundation 71

First, syndication may result in less risk for a venture fund since the investment amount per
deal is smaller and therefore the capital of a fund can be spread among a larger number of
deals. A higher number of deals with a smaller capital commitment per deal most likely
result in a more stable return since some of the firm-specific risks are diversified away.
Then, synergies may be created in syndicates through the participation of additional venture
capitalists who have additional expertise and networks in certain fields or industries. Next,
tasks can be better divided among a larger number of venture capitalists. Certain aspects of
assessing, monitoring, challenging and supporting the start-up can be shared among venture
capitalists leading to a smaller workload for each. However, in international syndicates the
venture capitalist closest to the start-up may be responsible for monitoring the start-up.
Finally, objectivity may be added to negotiations when more than one venture capitalist
discusses, for example, future strategies with the management of the funded company.

Other authors discuss similar or additional potential advantages of syndication. Lerner


(1994), for example, empirically tests three advantages of syndication and finds empirical
support for all of these. One of these advantages is that syndicating first-round venture
investments may lead to better decisions about whether to invest in firms.

De Haan (1999: 287) also discusses some potential problems that may arise through a large
number of members in a syndicate: decisions may be harder to make because many different
parties with different opinions are involved. At the same time, decisions may not get better
only because more parties are involved, especially when some venture capitalists rely too
much on the judgment of others. Finally, there is always the risk that some member of the
syndicate does not contribute significantly and add value to the start-up.

Typically syndicates have a lead investor and co-investors, each playing different roles in a
deal. The lead investor, for example, is often responsible for a thorough due diligence while
the co-investors do less in-depth analyses of the deal. Further, the lead investor may have a
seat on the board, while the co-investors do not.

2.2.3.5. Interaction with start-ups

A venture capitalist typically stays in close contact with a start-up once slhe has invested as
slhe now has an equity stake in the start-up and therefore wants the start-up to be successful
and appreciate in value. It makes sense for the venture capitalists to help the start-up to
improve its performance since this minimizes their own risks. Unlike other investors, e.g., on
the stock market, venture capitalists cannot sell their stake in a company easily since the VC
investments are illiquid. At the same time they are better able to significantly impact the
progress of their investment. Helping the start-up to improve its performance does not only
72 Chapter 2: Theoretical foundation

minimize risks but also maximizes the returns for the venture capitalist. 164 There are two
ways in which the venture capitalist can help to improve the start-up's performance: monitor
the development of the start-up and offer support. The skill of monitoring and supporting a
start-up is an important resource that impacts the competitive advantage of venture
capitalists, as indicated above.

Monitoring a start-up is a continuous effort that is typically done during a fmancing round or
stage. 165 When a start-up faces serious problems, the monitoring activity may be
increased. 166 Once a funded start-up needs additional financing the process of due diligence
may be repeated more or less thoroughly.167 Venture capitalists monitor how start-ups
perform in general but may focus on special issues, for example, the key risks that were
analyzed in the due diligence process. Monitoring the development of a start-up includes
gathering and analyzing information from inside and outside the start-up. Inside information
includes financial data, especially cash flow projections 168 and management information,
which describes the development of the company and markets, e.g., major new orders or
number of employees. The start-up provides this information, often quarterly, to venture
capitalists. The venture capitalist does not only gather and analyze information; s/he also acts
upon it, if problems arise; what rights s/he has to act is determined in the shareholder or
participation agreement. When severe problems arise, a venture capitalist may, for example,
replace a start-up manager who is not performing well. Apart from this, information gained
from monitoring start-ups is also essential to determine the timing of an exit.

Support of the start-up by the venture capitalist may include all activities that add value to the
start-up. Doing a due diligence or monitoring the start-up may already add a lot of value.
These activities are, however, typically seen as measures that minimize the risks of a venture
capitalist. Other activities, that are called support in the following section, focus on actively
maximizing returns. Activities that support start-ups include the following: first, venture
capitalists may act as sparring partners, giving support in management issues and especially
in discussing strategic decisions. To act as sparring partners, venture capitalists need to be
well informed about the situation of the company and the market. Then, venture capitalists
may help to hire new management team members for the start-up with the help of their

164 Differentiating minimizing risks from maximizing returns is a more or less semantic distinction. Both result
in a positive effect on the IRR, the measure of success that venture capitalists use. Minimizing risks could
be interpreted as preventing a negative IRR, maximizing returns as increasing a positive IRR.
165 See 2.2.3.4.
166 Representation on tbe board of directors is one way in which venture capitalists monitor start-ups.
According to Gompers and Lerner (1999: \83) venture capitalists' representation on tbe board increases at
the time of CEO turnover, which is typically a time when start-ups face serious problems.
167 See 2.2.3.3.
168 These should be prepared monthly since "cash is the name of the game", as some venture capitalists call it.
Chapter 2: Theoretical foundation 73

network in the start-up world and their experience that enables them to know what skills are
needed. Finally, venture capitalist can leverage their network to help start-ups to get access
to information and to get in contact with potential customers, suppliers and other business
partners. As indicated in 2.2.1, Kleiner Perkins Caufield & Byers, a well-respected US
venture capitalist, has successfully funded many start-ups. Kleiner Perkins calls the network
of former portfolio companies a 'keiretsu' that enables extensive communication and the
realization of synergies among companies within the 'keiretsu' (Fortune, 1998: 112).

The level of support frop1 venture capitalists differs among venture capitalists and also
among the single investments of a venture capitalist. Start-ups typically look for support
from venture capitalists that goes beyond guarding the investment and often regard support as
an essential task of a venture capitalist. Support from venture capitalists may help start-ups
to build additional resources and create or strengthen their competitive advantage. Therefore,
the support a venture capitalist seems to be able to give may impact the decision which
venture capitalist a start-up chooses. 169

2.2.3.6. Exit investments

As discussed in 2.2.1, VC is a limited time investment because at some point in time, venture
capitalists need to exit an investment and achieve returns to pay back their investors. Exiting
has a strong influence on all the other steps of the VC process. As discussed above, the
success of exiting investments determines the returns of venture capitalists and therefore
impacts the ability to raise new capital. As a result, potential investment decisions are driven
by potential exit opportunities. The skill of exiting investments is an important resource that
impacts the competitive advantage of venture capitalists, as indicated above.

Investments are not always successful and venture capitalists also need to exit less successful
investments that yield low returns or losses. Gompers and Lerner (1999: 19) call this " ... a
healthy discipline, forcing private equity investors to take the necessary, but painful, step of
terminating under-performing firms in their portfolios." As a result, exits may sometimes be
complete write-offs.

Different options exist for exiting an investment including an initial public offering (lPO),
trade sale, secondary purchase or buyback. These options are described below. As already
described in 2.2.1, returns from different investments are typically highly skewed. According
74 Chapter 2: Theoretical foundation

to practitioners, different exit options differ in profitability for venture capitalists. The IPO is
regarded as the most profitable exit option for venture capitalists and a trade sale as the
second most profitable. In the following sections, some figures concerning exits via an IPO
or trade sale are introduced. In addition, some information on the IRR performance of
venture capitalists is discussed.

Initial public offering (IPO)

An IPO of the funded company is often referred to as the most attractive exit option by
venture capitalists (e.g., Wall and Smith 1999:257, 260-263). According to Wall and Smith,
venture capitalists regard the higher price, which they can achieve through an IPO as the
main advantage of an IPO over other exit options, price being the most important criteria for
venture capitalists, as Wall and Smith indicate. Venture capitalists typically achieve the
highest returns from portfolio companies that do an IPO.\70 This, however, depends heavily
on the public markets conditions at the time of a potentiallPO. Gompers and Lerner (1999:
235) find that a high relative valuation level of publicly traded securities impacts the decision
of venture capitalists to provide additional funding or to take firms public. 171

Another advantage of an IPO preparation is that it may provoke a trade bid 172 and therefore
offer a new additional exit option. In addition, an IPO is typically the preferred exit option of
the start-up management since it enables the start-up to keep its independence. The
disadvantages of an IPO are the high costs and often a continued shareholding in a company
for the venture capitalist because of lock-up periods. After the lock-up period is over,
venture capitalists may sell their shares and then return the proceeds to their investors. More
frequently, however, venture capitalists return their shares directly.

An IPO is,typically not only done to provide liquidity to existing investors but to raise
additional capital for the growth of the company.173 Besides access to a new source of

169 Start-ups do not always seem to get what they expect. The satisfaction of many entrepreneurs with VC
support seems to be low according to a study in the Netherlands that is interpreted by Nagtegaal (1999: 188-
191). Nagtegaal suggests that the negotiation process leads to high expectations from the entrepreneur's
side. These expectations, however, are often not met because venture capitalists do not invest as much time
in understanding the specific situation of a start-up once they have made an investment as they did during
the due diligence.
170 See for example Fineberg (1997), Gompers and Lerner (1999: 23) or Khoylian (1988: 6).
171 In addition, market conditions may differ among countries. In the US, the Nasdaq presents opportunities for
young high-risk companies to IPQ. The recent development of equity markets for young high-risk
companies in Europe offer alternatives to the Nasdaq, e.g., Neuer Markt, EASDAQ, Le Nouveau Marchi!.
See Rutschmann (1999) for an overview of European and US growth markets.
172 A trade bid is an offer by another company to acquire the start-up, see the discussion on trade sale.
173 A public offering that raises new capital for the company is called a primary issue. In contrast, an IPQ that
is purely done to provide liquidity to existing investors is called a secondary issue. An IPQ may have a
primary and secondary component.
Chapter 2: Theoretical foundation 75

capital, there are additional advantages for a company to become publicly listed. For
example, companies may get a lot of publicity, gain prestige and credibility and are able to
use stock options to offer incentives to employees. An IPO, however, does not only have
advantages but also creates risks for the company as it requires a lot of the management's
time, creates short-term performance pressure etc. 174 In the process of an IPO, many issues
need to be addressed which include whether the company is ready for an IPO, what the size
of the offering should be, what the valuation should be, who the advisor should be and which
stock exchange should be chosen. Piccino and Kierski (1999) discuss these issues in more
detail.

Sometimes, venture capitl'llists are said to rush start-ups that are not ready to an IPO.
Furthermore, venture capitalists may take actions that improve the IPO performance of a
start-up but jeopardize long-term prospects, for example, cutting back on R&D in order to
increase earnings. Gompers and Lerner (1999: 210), however, do not find evidence that
venture-backed firms under perform the market after going public.

Trade sale

A trade sale is an alternative to an IPO. In a trade sale, a strategic investor acquires the
company. Many companies that are funded by venture capitalists may not be able to go
public because they may be too small or not offer sufficient growth potential. Even if
companies are able to go public, a trade sale may be an attractive alternative. Strategic
investors may try to realize synergies, gain market share or enter markets through an
acquisition. Therefore they are often willing to pay a significant premium for the shares of
the company they acquire. Further, a trade sale is cheaper and faster than an IPO and
typically requires less effort to convince buyers/investors. Finally, a trade sale is typically an
immediate cash exit without a lock-up period. 175 In contrast to these advantages, a trade sale
also has some disadvantages. For example, management often opposes trade sales because it
loses its independence.

Secondary purchase

An IPO or a trade sale are the most attractive exit routes to venture capitalists. When it is not
possible to exit through an IPO or to fmd a strategic investor, selling the investment in the
company to another financial investor may be an alternative, e.g., to another venture capitalist
or private equity company. Such a secondary purchase probably leads to lower returns since

174 See Piccino and Kierski (1999: 248) for a list of the advantages and disadvantages ofan IPQ.
175 Instead of a lock-up period, however, a trade sale may be subject to warranties, indemnities, escrows
(deposit held by lawyers as security of warranties) etc.
76 Chapter 2: Theoretical foundation

financial investors are not willing to pay a premium for shares in a company since it is rare
for them to realize synergies that would justify a premium. The only objective of a financial
investor is IRR and the purchase price significantly impacts the IRR a future investor can
achieve.

Buyback

A final exit option is the buyback of shares by the entrepreneurs or by management. This
exit option is the least favored by venture capitalists but, nevertheless, is often chosen (Wall
and Smith, 1999: 265-266). A buyback is the last option for a venture capitalist when no
other exit route is feasible, usually because the company does not perform well but the lack
of options for the venture capitalist leads to a poor sales price.

No matter what exit mechanism is used, venture capitalists should manage the investment for
exit from the day they invest. As described in 2.2.3.4 venture capitalists should plan the exit
early and agree with the management on exit plans when the investment is made. 176

Venture capitalists distribute the proceeds of an exit to the investors, typically after the sale
has been completed. After an IPO, venture capitalists may distribute shares in the company
to investors instead of cash.

Numbers of trade sales and IPOs

As discussed above, the most recent information provided covers the year 2000. The recent
developments in the stock and VC markets, especially the bursting of the Internet bubble, are
most likely not reflected to a full extent. These developments may lead to a change in the VC
trends and performance described below.

The number and value of venture-backed 177 trade sales in the US is shown in Table 2-11.
According to Table 2-11 the number of trade sales has grown constantly since 1996 and
reached 275 in 2000.

176 See Wall and Smith (1999: 266-278) for a more detailed discussion of the exit planning and exit process.
177 According to the NVCA Yearbook (200Ia: 76), the term venture-backed describes companies that have
received VC at some point in time. It does not matter whether a company is still funded with VC at the time
of an IPa or acquisition.
Chapter 2: Theoretical foundation 77

Table 2-11: Number and value of venture-backed trade sales in the US


Year Number of Average price
venture-backed (USD million)179
trade sales 178

1996 115 111.4

1997 159 68.1

1998 197 72.3

1999 225 235.2

2000 275 392.3

Source: NVCA Yearbook, 2001a: 79

Table 2-11 also shows that the average price of venture-backed trade sales reached record
levels in 2000. This number, however, is only an indicator for the perfonnance of Vc. 180
The actual measure ofperfonnance is the internal rate of return (IRR), see below. The IRR is
influenced by different factors, not considered here. For example, the price of the investment
and the time from investment to exit are factors that impact the IRR significantly.

The number of IPas of venture-backed companies had a less stable development than the
number of trade sales, as shown in Table 2-12. The number of venture-backed IPas may at
least to some extent depend on the overall capital market conditions as discussed below. In
2000 the number of venture-backed IPas was 231, about 10 percent less than the year before.
56 of these IPas were in the online specific sector, 42 in computer software, 34 in
biotechnology and another 32 in communications. Venture-backed IPas accounted for half
of the IPas in the US compared to only 20 percent two years earlier.

178 In the NVCA Yearbook, the term mergers & acquisitions is used as a synonym for trade sales.
179 The average price is calculated based only on those trade sale prices that are known to Venture Economics
(the authors of the NVCA Yearbook). On average around 60% of prices are disclosed from 1996 to 2000.
In 2000, the number of mergers and acquisitions with a known price was 176 with a total value of US 69
billion. In 1999, two exceptionally large acquisitions skewed the average price (NVCA, 2000: 75). Taking
these out would still result in a high average price ofUSD 148 million.
180 Only a percentage of the average price is paid to venture capitalists depending on the share owned by
venture capitalists.
78 Chapter 2: Theoretical foundation

Table 2-12: Number of venture-backed IPOs in the US


Year Number of Number of Percent of
venture-backed all IPOs venture-
IPOs backed IPOs
1996 279 873 32%

1997 137 636 22%


1998 78 397 20%

1999 258 572 45%


2000 231 453 51%
Source: NVCA Yearbook, 2001a: 75

The valuations of companies going public reached record levels in the year 2000. The sum of
total offering size was USD 21.9 billion, about five times as much as in 1998. The average
offering size was USD 94.9 million about twice as much as two years earlier. 181 The NVCA
Yearbook describes mixed signals in the exit markets in 2000. Although the offering size
reached an all time high, the number of IPOs decreased slowly and the aftermarket
performance for venture-backed IPOs was poor. 182 The performance of venture-backed
companies that went public in 2000, however, was -24.7 percent and still better than the one
year performance of venture-backed stocks from the previous ten years which was -43.8
percent or the NASDAQ with -39.3 percent but worse than the S&P 500 which had a one
year return of -1 0.1 percent in 2000. 183

VC performance

The performance of VC funds is typically not published by venture capitalists. At least one
reason for this, although probably not the most important one, is that measuring VC
performance is difficult. Neither VC-funded companies nor VC funds as a whole typically
have an observable market price. Nevertheless, according to Gompers and Lerner (1997: 5-
7), two approaches are used to determine the performance of VC. The first is to analyze the
change in price of VC-backed companies that have recently gone public and the second is to
calculate the internal rates of return for VC funds. Both approaches have serious drawbacks.
When the first approach is used, VC-backed firms that have recently gone public, for

181 See NVCA Yearbook (200Ia: 75).


182 See NVCA Yearbook (200Ia: 75) for additional information.
183 The performance of venture-backed stocks is measured with the Post Venture Capital Index (PVCI)
calculated by Thomson FinancialNenture Economics and Warburg Pincus Counsellors. For more
information see NVCA Yearbook (200Ia: 77).
Chapter 2: Theoreticalfoundation 79

example, may not represent the portfolio of firms currently funded by VC. When the second
approach is used, the methods venture capitalists use to value companies may vary
significantly because some, for example, may be more conservative than others. 184

Despite the measurement problems mentioned above, the aggregated performance of VC


funds is discussed in publicly available sources. 185 In the US, Venture Economics gathers
inf{)rmation from limited partners and publishes aggregated figures on VC fund performance.
These numbers, however, do not differentiate between different exit routes. The NVCA
(2001a: 83-86) reports the IRR of US venture funds over the last year, three years, five years,
ten years and twenty years, as shown in Table 2-13.1 86 As indicated above, the performance
measurement that is used, has several limitations, for example, the net asset value is an
interim value that is based on is subjectively appraised and unrealized value. For a
discussion of further limitations see NVCA Yearbook (200Ia: 84-85).
Table 2-13: IRR* of US VC funds
Fund type 1 year 3 years 5 years 10 years 20 years
Early/seed focused 187.8 92.2 71.0 34.9 24.5
Balanced focused 170.0 61.1 46.9 26.8 17.9
Later stage focused 65.5 35.4 36.1 25.6 18.9
All venture 142.9 64.7 52.2 29.5 20.3
* Net IRR to Investors after fees and profit splIt for Investment honzon endIng 09130199 for
private equity funds in percent
Source: NVCA Yearbook, 2001a: 83

Table 2-13 shows a spectacular performance of US VC funds, especially for early/seed stage-
focused but also balanced funds in the short term. As target IRRs (see Table 2-10) actual
IRRs also vary for different financing stages. Early/seed-focused funds generated an IRR of
187.8 percent over a one year period ending 09/30/00. Later stage focused funds generated a
65.5 percent return over a one year period and balanced focused funds generated 170.0
percent. The resulting performance of 142.9 percent for all venture funds is much higher

184 See Gompers and Lerner (1997) for a more detailed discussion ofVC performance measurement.
185 For example, Bygrave (1999). Among other issues, Bygrave discusses analyses of historical VC
performance and their shortcomings. Bygrave summarizes the fmdings from these analyses: "I the
compounded return on venture capital seems to have been in the teens - probably mid-teens - from the
inception of the industry to the early 1980s; and 2 there were wide swings in the annual returns from lows
of a few percent to highs exceeding 30 percent."
186 The IRR is calculated by taking the net asset value of funds at the beginning of the period being measured
as a negative cash flow and at the end as a terminal positive cash flow. See NVCA Yearbook (2000: 79-80)
for a more in-depth discussion of the method of measurement.
80 Chapter 2: Theoreticalfoundation

than the returns that were achieved over the last three, five, ten and twenty years, which
ranged from 20.3 to 64.7 percent. The 2000 performance is higher than, for example, the
1997 performance when the one-year return of all ventures was 29.5 percent. 187

According to Venture Economics, the reason for the high one year performance in the US in
2000 is the stellar performance of the public markets in the period prior to March 2000
(NVCA, 2001a: 84). By the end of the third quarter for 2000 the downturn in the public
markets had not yet directly affected VC returns.

Several authors claim that VC performance is linked to stock market performance, especially
IPO market performance. 188 Bygrave (1999: 324-327) shows some empirical support for
such a linkage of stock market and VC performance. Such a linkage seems to be logical
since the most profitable exits of venture capitalists are IPOs (as indicated above). A weak
performance in the IPO market also leads to the weak performance of venture-backed IPOs
and impacts the performance of VC overall. This can have a knock-on effect since trade
sales are also more profitable when stock markets perform well since the valuations of
acquired companies are often based on multiples of comparable publicly traded companies.

In addition, to the linkage of stock market and VC performance, several authors describe the
cyclical nature of the VC performance based on the supply and demand of VC, e.g., Bygrave
(1999: 309) or Gompers and Lerner (1999: 21-24).1 89 According to Gompers and Lerner
(1999: 4), the supply of VC cannot adjust quickly to changes in investment opportunities
since investments in venture funds are long-term and illiquid investments.

The cyclical nature ofVC can be described in four stages: in a first stage, VC returns rise and
lead to a larger inflow of new capital. 190 New and often inexperienced VC firms enter the
VC market. In a second stage, the large inflow of new capital leads to an oversupply of
funds. The scarcity of deals increases deal prices (pre-money valuations of start-ups) and
marginal deals are done especially by less experienced players. In a third stage, the high deal
prices lead to falling returns, which lead to a decreasing supply of new capital. 191 Less

187 See NVCA (1998). In 1997, the one, three, five, ten and twenty year perfonnances were lower than in
2000.
188 See for example Black and Gilson (1998), Jeng and Wells (1997).
189 Gompers and Lerner (1999: 21-24) summarize earlier research on this topic. Among others, they discuss
Poterba {I 987, 1989) who argues that changes in the fundraising of VC may result from changes in either
supply of or demand for VC; Jensen (1991) and Sahlman and Stevenson (1986) explain the cyclical nature
of the VC market througb the tendency of institutional investors to over- or under-invest in speculative
markets.
190 In the early 1980s this effect was intensified in the US througb the change in legislation that enabled
pension funds to invest in VC, which led to a large inflow ofVC.
191 E.g., Gompers and Lerner (1999: 10) describe that returns of US VC funds declined in the late 80s because
of over-investment, and the entry of inexperienced managers, leading to lower capital commitments.
Chapter 2: Theoreticalfoundation 81

successful venture capitalists leave the market. In a fourth stage, an under-supply of funds
leads to less competition for deals and therefore falling prices of deals. This results in a rise
of returns as described in stage one and the cycle starts again.

2.3. Corporate Venture Capital: definition and objectives

After discussing venture capital in 2.2 as a basis of Corporate Venture Capital l92 (CVC),
CVC will be introduced. The remaining subchapters have five objectives: first, CVC is
defmed in 2.3.1. Then, the ,objectives or targeted benefits of CVC from the perspective of the
investing company are introduced (2.3.2). The targeted benefits are considered as resources
that result from CVC (2.3.2.7). Next, theories from the literature are discussed that may
explain benefits derived from CVC (2.3.3). Then, the resources necessary to do CVC are
described in detail with the help of the CVC process (2.4-2.6) and the identified challenges
for building CVC resources are summarized (2.7).

2.3.1. Definition of corporate venture capital

A large variety of venturing and entrepreneurship concepts are discussed in the literature.
Although most of these concepts are related and sometimes similar, many different terms are
used by different authors to describe these concepts, e.g., corporate venturing l93 , corporate
entrepreneurship l94, internal corporate venturing l95 , intrapreneurship l96, new venture
divisions l97 and corporate venture capital. Some efforts are made to distinguish different
venturing and entrepreneurship concepts from each other. 198 In this study different venturing
and entrepreneurship concepts will not be discussed instead, Corporate Venture Capital
(CVC) is introduced directly. One concept that is close to CVC is internal corporate

192 Corporate in the tenn Corporate Venture Capital does not necessarily imply that the investing company is a
publicly traded corporation. Privately held companies may certainly be investing in start-ups just as
corporations do.
193 E.g., MacMillan and George (1985).
194 E.g., Ginsberg and Hay (1994). Covin and Miles (1999) discuss a differentiation between corporate
venturing, intrapreneurship and corporate entrepreneurship.
195 E.g., Burgelman (1984).
196 See Pinchot (1985).
197 E.g., Fast (1978).
198 See, for example, Roberts (1980: 136) for a spectrum of different venture strategies; Schween (1996: 17) for
a differentiation of intrapreneurship, corporate venturing, CVC and venture management; McNally (1997:
33-37) for a distinction between internal corporate venturing and CVC.
82 Chapter 2: Theoreticalfoundation

venturing, also called internal venturing or corporate venturing. 199 Internal corporate
venturing and eve are sometimes incorrectly used interchangeably (McNally, 1997: 33).200
Corporate venturing is an entrepreneurial activity within an existing company that "involves
an activity new to the organization" and "will be managed separately at some time during its
life", Block and MacMillan (1993: 14).201 A recent development is that many companies
have started corporate incubators that are similar to external incubators, e.g., Ford and
Trilogy Software. 202 Mostly these incubators are intended to help company internal ideas to
grow into new businesses and therefore are more similar to internal corporate venturing than
to eve since eve is defined as minority investments in external companies in this study as
described below. On a very generic level, internal corporate venturing activities may be
described as activities targeted at taking advantage of internal ideas and other company
resources. In contrast, eve may be described as an activity that is intended to take
advantage of external ideas and developments.

eve is often simply defined as VC;: provided by industrial companies (e.g., SchUppen and
Ehlermann, 2000: 3). Greenthal and Larson (1983: 70) describe eve in even less detail as
"investment[s] in new externally developed ventures". Sykes (1990: 39) goes more into
depth by defining ve as the " ... purchase of non-publicly traded equity in an independently
managed start-up or growth company", thereby excluding internally developed and managed
ventures. Further, Sykes introduces the notion of 'strategic' investments. He only regards
investments with the primary purpose of assisting corporate new business development as
eve, therefore excluding those investments that are made solely to achieve financial return.
Rind (1994: 101) also emphasizes the 'strategic objective' of eve and speaks of "motivations
beyond strictly financial rewards". Kann (2001: 2-3) defines eve as "... equity investments
in privately held entrepreneurial firms by established corporations, usually motivated by
strategic interest" and differentiates eve from corporate venturing, investments by
independent venture capital firms, investments by financial corporations and equity
investments in publicly held companies and joint ventures.

199 Many authors have discussed different perspectives of internal venturing, for example, Block (1982), Block
and Ornati (1987), Block and MacMillan (1993), BurgeJman (1985), Chesbrough and Socolof (2000),
deSarbo, MacMillan and Day (1987), Dougherty (1995), Gee (1994), Gnyawali and Grant (1997), Hippel
(1977), Kanter (1985), Lerner (1995), Lerner (1997), MacMillan, Block and SubbaNarasimha (1986),
MacMillan and Day (1987), Moss Kanter et al. (1991), Simon, Houghton and Gurney (1999), Sorrentino
and Williams (1995), Sykes and Block (1989).
200 Although, sometimes internal corporate venturing and CVC are done in a single effort. This was true
especially for early venturing activities in the 70s. See, for example, Sykes (l986a and 1986b) or
Chesbrough (2000: 32-33) for a discussion of the Exxon example.
201 See Block and MacMillan (1993: 14) for a detailed definition.
202 See Hansen et al. (2000: 78-79).
Chapter 2: Theoretical foundation 83

A detailed definition of eve is given by Schween (1996: 21). Like Sykes, Schween bases
his definition of eve on the definition of ve. Schween uses nine attributes to defme eve:
(1.) eve is an equity or equity-like investment that is (2.) provided by established industrial
companies (3.) for technologically innovative, (4.) legally independent, (5.) small or medium
sized companies (6.) with a high growth potential. eve investors provide (7.) support
(especially advice) to start-ups. eve has (8.) a long-term perspective and leads to (9.)
financial as well as strategic benefits. Schween (1996: 21-23) highlights several differences
between eve and ve. Four of these are: first, eve investments are made by established
industrial companies. Second, beyond fmancial objectives, eve has strategic objectives.
Third, eve investment targets need to be technologically innovative since one of the most
important strategic objectIves of eve is observing new technology trends. Finally, eve
investments may not be made for a limited time only.

The defmition of eve that is used in this study is introduced in the following. This
definition is based on the definition of ve in 2.2.1 and the definitions of eve in the
literature, especially Schween (1996), as described above. 203

Five of the nine attributes Schween (1996: 21) uses to defme eve are already included in the
definition of ve as introduced in 2.2.1.2 04 In addition, Schween discusses four more
attributes of eve: first, funded companies are legally independent. Sykes (1990: 39) uses a
similar attribute that companies are independently managed. Second, eve investors have
not only financial but also strategic objectives. Third, investments are made by established
industrial companies. Fourth, investments are made in technologically innovative companies.
The first two attributes that are discussed by Schween and that are not a part of the definition
of ve in 2.2.1 are included in the definition of eve in this study, as discussed below. The
latter two are not included in the definition of eve in this study. It is not apparent why the
third attribute needs to be true. Why can only established industrial companies invest eVe?
While this may be the typical case, fmancial institutions may not only have financial
objectives for investing ve. Financial institutions may also use eve to try to get access to
new technologies, markets or sales channels. The second attribute discussed above, that
eve investors may not only have financial but also strategic objectives, is considered to be
sufficient to exclude ve investments by fmancial companies made for purely financial

203 For a discussion of the history of eve in the US see Gompers and Lerner (1997: 6-10) and Schween (1996:
28-33). Schween also describes the emergence of eve in Germany.
204 The following characteristics that Schween uses to define eve are already covered in the definition of ve
in 2.2.1: eve is an equity investment, eve is invested in small or medium sized companies, eve is
invested in companies with a high-growth potential, support for the funded company is provided by eve
investors and eve investments are long-term investments. In contrast to ve investment, however, the
eve investment may not have a limited time focus in some cases when strategic benefits may be realized
from holding an investment (Schween, 1996: 23).
84 Chapter 2: Theoreticalfoundation

reasons. Further, it is not apparent why the fourth attribute needs to be true. Although most
ve funded start-ups are typically technologically innovative, in the sense that they
commercialize new technical solutions205 , this may not always be true. The potential lack of
technological innovativeness of ve funded companies becomes apparent when several e-
commerce start-ups are examined. These often do not have a technologically innovative
product but develop a new sales channel for existing products and still receive ve funding.
Therefore, this attribute is not included in the defInition of eve in this study.

In this study, an investment will be regarded as a eve investment, if it meets four criteria:
fIrst, eve is a ve investment then eve investments are made by companies at least
partially for strategic reasons and not only for fInancial reasons. Next, investments are only
considered eve investments when they are made on a regular basis, this excludes one-time
ve investments. Finally, eve investments are made in external start-ups. Each of these
four criteria has a number of attributes. If these attributes are met for an investment it is
considered as a eve investment in this study. These attributes are introduced below.

eve investments are ve investments and need to meet the attributes of a ve investment.
As summarized in Table 2-5, a ve investment has seven attributes. The second attribute,
however, is adapted for the special objectives of the eve investor. As discussed above,
eve investors may keep their investments in the long run, for example, to strengthen a
strategic partnership. Therefore, eve investments do not necessarily need to have a limited
time focus although most investments have. The seven attributes that determine that an
investment is a ve investment can be adapted to eve investments as following:

1. eve investments are equity investments.


2. eva investments have a long-term but typically limited time focus.
3. eve is invested in privately held companies.
4. eve is invested in high-growth companies.
5. eve is invested in start-up companies for the launch, early development or expansion
of a business.

6. Corporate venture capitalists provide active support to funded start-ups.

7. Corporate venture capitalists exercise signifIcant control over funded start-ups.

205 See Schween (1996: 23).


Chapter 2: Theoreticalfoundation 85

The second criterion that determines eve investments is that the investing company needs to
target strategic objectives. This can be regarded as an attribute of eve investments. eve
investments are at least partially made for strategic reasons and not only to maximize the
value of the investment portfolio. Strategic objectives focus on positively impacting the
value of existing and future lines of business of the investing company. Please see 2.3.2 for
an in-depth discussion of strategic objectives. Investments that are only made to maximize
the value of the investment portfolio are not eve investments. To emphasize this attribute, a
second attribute of eve investments will be included in the definition: the investing
company is pursuing a core business other than providing capital. This explicitly excludes
those companies that primarily focus on the business of providing capital like venture
capitalists. These companies may pursue objectives other than maximizing the value of their
investment portfolio. A venture capitalist may, for example, have the strategic objective of
improving hislher understanding of technology when investing in a start-up. This improved
understanding of technology, however, is acquired to maximize the value of the investment
portfolio, therefore the investment should not be regarded as a eve investment. Together,
both attributes discussed above exclude investments from venture capitalists, pension funds
and banks 206 as well as companies that invest ve without targeting strategic objectives from
being regarded as eve investors.

Whether companies make ve investments on a regular basis is the third criterion that
determines if an investment activity qualifies as eve. Companies certa~~y also make
pragmatic one-off ve investments in single start-ups when faced with opportunities. Such
investments are not considered eve investments in this study. In order to qualify as doing
eve on a regular basis, companies need to have the strategic intent to continuously realize
benefits with the help of eve and they need to build the necessary resources to do so, e.g.,
dedicated people, continuous deal flow etc. 207

Instead of the number of ve investments actually made, a different attribute is considered to


reflect whether. a company makes ve investments on a regular basis. In this study, the
activities that are done in order to create ve investment opportunities are used as attributes
that reflect the intention that ve investments are done on a regular basis. The following
activity is used as an attribute: companies generate a constant deal flow and evaluate it for

206 A bank can certainly be a eve investor as well. For example, when a bank invests in an e-commerce
company in order to understand the potential implication of the Internet for its own operations, then it is a
eve investor according to the definition.
207 A minimum number of ve investments that need to be made within a certain period of time is not an
optimal criterion since the number of ve investments made may vary for different reasons, e.g., the size of
the investing company or the conditions in the ve market.
86 Chapter 2: Theoreticalfoundation

potential investment opportunities. Alternatively, companies may have a third party doing
this activity for them if they do indirect CVC.208

The final criterion that determines whether VC investments qualify as CVC is whether the
investment is made in an external start-up. In this study, VC financing of internal projects is
not regarded as CVC. As indicated above, funding of internal projects is considered internal
venture capital. CVC investments have two attributes that identify them as external
investments. First, external start-ups are legally independent entities. Company spin-offs are
often legally indepen?ent entities as well and companies may fund spin-offs through their
CVC activities. If a company, however, only invests in spin-offs, it is doing internal
venturing. Therefore,. the second attribute is that the majority of CVC investments are made
in start-ups not originating from the investing company.

To summarize, CVC can be defined as follows:

Corporate Venture Capita' (CVC) can be defined as external venture capital


investments on a regular basis by a company at least partially targeting strategic
objectives.

All the attributes ofCVC are summarized in Figure 2-11.

Figure 2-11: Attributes of CVC investments

VC investment:
I. eve investments are equity investments.
2. eve investments have a long-term but typically limited time focus.
3. eve is invested in privately held companies.
4. eve is invested in bigh..growth companies.
S. eve is invested in start-up companies for the launch, early development or expansion of a business.
6. Corporate venture capitalists provide active support to funded start-ups.
7. Corporate venture capitalists exercise significant control over funded start-ups.

Strategic objectives:
8. Investing company bas strategic objectives and does not only focus on maximizing the value of the investment
portfolio.
9. Investing company pursues core business other than providing capital.

vc investments on a replar basis:


10. Investing companies generate a constant deal flow and evaluate it for potential invesbDent opportunities.

External:
11. Start-ups funded with eve are legally independent entities.
12. The majority of eve investments are made in start-ups nol originating from the investing company.

208 See 2.5.2.1.


Chapter 2: Theoreticalfoundation 87

2.3.2. Objectives of Corporate Venture Capital

After defming the tenn eve, why companies invest in independent start-ups will be
discussed. In this subchapter, the potential objectives of the investing company for doing
eve will be discussed. Objectives will be viewed as sets of targeted benefits.209 In the next
subchapter (2.3.3), academic theories and approaches are used to suggest briefly, how the
benefits of eve may be derived and explained theoretically.

The literature generally differentiates between two different sets of objectives for doing
eve: strategic and financial objectives (e.g., Siegel, Siegel and MacMillan 1988: 234; Sykes,
1990: 41,45; Winters and Murfin, 1988: 207-208; Schween, 1996: 78-89: 174). Strategic
objectives are focused on' generating benefits to support the corporate development of the
company by leveraging start-up creativity210 e.g., improving process technologies, enhancing
products or entering new markets. Financial objectives are focused on generating financial
return on investments. Although the distinction between strategic and financial objectives
does not hold in the long run, since strategic benefits should finally result in financial
returns21l , this is still a useful distinction. The following definitions will make the tenns
financial and strategic objectives even more practical by describing a more precise
distinction.

Definition of "financial objective": A company is said to target financial objectives if it


focuses on maximizing the value of the venture capital investment portfolio. The value of the
investment portfolio leads to financial return by selling the investments to other investors.

Definition of "strategic objective": A company is said to target strategic objectives if it tries


to realize benefits that maximize the impact of eve on the value of the existing business of
the investing company. Strategic benefits may impact the value of the existing business, for
example, by improving efficiency or customer value or by enabling the move into new
markets. Overall, strategic benefits are supposed to generate growth in the revenue, income
and (stock market) value of the company. The impact on the value of the existing business
may be complex and difficult to track. Increased revenue from new business relations is an
example of a more direct strategic benefit. The impact from a change in attitude within the

209 In this context, the tenn benefit is used to describe an advantage and not a fmancial benefit net of costs.
210 See, for example, Eglau et at. (2000: 188).
211 In the long run, strategic objectives are financial objectives, since strategic objectives try to generate
benefits that improve current or future operations and that help a company to survive and grow in the future.
The result of strategic benefits therefore ultimately is fmancial success.
88 Chapter 2: Theoreticalfoundation

company towards innovation is an example of a strategic benefit that is much harder to track
and evaluate. 212

Sometimes, a third set of objectives of CVC is mentioned, especially in the European


literature: social responsibility (e.g., McNally, 1997: 43). The reasoning is that the
availability of venture capital may, for example, create employment. 213 This kind of
macroeconomic result of venture capital is not the focus of this study. Therefore, social
responsibility will not be analyzed further as an objective in this study.

Venture capitalists typically have fmancial objectives. As described above214 , they are trying
to maximize the value of the venture capital investment portfolio to generate a financial
return, which can be' paid to their investors. Corporate investors may also have financial
objectives. They may try to leverage their own industry expertise to choose investment
targets and may use their expertise, their contacts and other company resources to support the
development of the start-up and hereby increase their own return. Like the investment of a
venture capitalist, the investment of a corporate investor in a start-up may increase the
reputation of the start-up and through this impact its valuation positively.

Typically, corporate investors also have strategic objectives in addition to or instead of


financial objectives. This is a prerequisite for meeting the definition of CVC as formulated in
this study, see 2.3. J.215 The role of strategic objectives may also impact the success of CVC.
Gompers and Lerner (1998: 4) fmd that the instability of CVC programs is particularly great
in corporate funds whose investments do not have a strong strategic focus.

Financial and strategic objectives certainly do not exclude each other. Although it is not
clear whether fmancial and strategic benefits can be maximized simultaneously, financial and
strategic benefits should correlate with each other to some extent. 216 On the one hand, a lack
of financial success is a consequence of a lack of business success or, in worst case, start-up
failure. If a start-up fails, it is less likely that it is able to create significant strategic benefits
for a corporate investor. Strategic benefits like improving its own value proposition through
cross-selling relationships or creating awareness for the importance of innovation (see below)
are unlikely to be advantageous or successful when a portfolio company goes out of

212 See 2.5.5 for a discussion of measuring strategic success ofCVC.


213 See footnote 119,
214 See 22.1 and 2.2.3.1.
215 This is in line with discussions of CVC in the literature, e.g., Schween (1996: 79) and with CVC as
practiced by most companies, e.g., Sykes (1990: 38).
216 Sykes (1990: 38) shows a correlation of financial and strategic success for indirect CVC investments, Yates
and Roberts (1991: 17) also find a correlation of strategic and financial success. They, however, caution
that this may be partially due to cve managers convincing themselves" ... that financially successful
ventures were, in retrospect, strategic."
Chapter 2: Theoretical foundation 89

business. 217 Based on these arguments, financial success may even be considered as a
prerequisite for strategic success. 218 On the other hand, strategic benefits like successful
business relations with the funded start-up do increase the likelihood that the start-up will be
successful and generate financial return for its investors.

Financial objectives are easily specified as return on investment. In the VC industry return
typically is expressed as an internal rate of return (IRR)219. A company may use alternative
measures like ROCE.

In contrast to financial objectives, strategic objectives may be very diverse. The literature
discusses several CVC objectives and targeted benefits. The CVC objectives of eight studies
that explicitly discuss objectives are summarized in Table 2-14. The table also indicates,
where the benefit mentioned is integrated in the benefit structure introduced below.

All the studies shown in Table 2-14 list financial objectives, i.e., return on investment, as
CVC objectives. Besides financial objectives, strategic objectives are listed containing
various targeted strategic benefits.220 No study, however, suggests a structure of the various
targeted strategic benefits beyond the overall differentiation between strategic and financial
objectives,. The authors ofCVC studies just discuss lists of targeted strategic benefits.

217 In addition to this, a favorable internal rate of return (IRR) is also attractive because it can help to protect
eve activities against internal critics, since IRR is an easy way to measure and communicate success while
strategic success may be harder to measure and communicate and may also take longer before it can be
observed. In addition, it is certainly more difficult to criticize a eve activity if it generates financial
returns and is self-sustaining and does not depend on financial support. See Niederkofler (1989: 48-49) for
a similar reasoning.
218 Financial return is not sufficient to guarantee strategic returns from eve. There is no reason, why
successful start-ups will automatically deliver strategic value. Start-ups may become successful without
any contact with the investing company. Contact, however, is a prerequisite for achieving strategic success,
as further discussed below. Yates and Roberts (1991: 17) warn against inferring that setting [mancial
objectives will yield strategic results. In fact there are a lot of examples of financially successful eve
activities that did not generate strategic benefits. See, for example, Greenthal and Larson (1983: 74). Apple
achieved an internal rate of return of approximately 90% over five years, but had little success in improving
the position of the Macintosh, its strategic objective (Brody and Ehrlich, 1988: 55, Hellmann, Milius and
Risk, \995).
219 A company needs to determine what level ofiRR it targets. Targeted and actually achieved IRR of venture
capitalists may provide a guideline, see 2.2.3.6 for overall fund performance and 2.2.3.4 for targeted IRR
per investment. It seems reasonable to expect an internal rate of return (IRR) on eve investments that does
not drastically differ from the IRR independent venture capitalists achieve since companies do have
advantages over venture capitalists (e.g., company resources like contacts, technology expertise, market
expertise etc.) that should help to level out the disadvantages they face, especially when starting eve
activities (e.g., limited venture capital skills, lack of reputation).
220 As already mentioned at the beginning of this chapter, this study will use the term benefit (or targeted
benefit) to specify an objective. An objective is a set of individual (targeted) benefits.
90 Chapter 2: Theoretical foundation

Table 2-14: eve objectives discussed in the literature


Study eve objectives/targeted benefits Discus-


sed at
Greenthal Acquire new businesses 4;5
and Larson, 5

Gain access to new technologies
1983:71 Obtain an attractive return on invested funds Fin.
Siegel,
Siegel and
MacMillan,
Strategic .benefit objectives:
-Exposure to new technologies and markets I
6
-Potential to manufacture or market new products
1988: 234, -Potential to improve manufacturing processes
235-236 4;5


-Potential to acquire companies
FinanCial obiective: Return on investment Fin.


Winters and Strategic benefits
Murfin, Acqui~itions 4;5
1988: 207- Technology licenses 5
208 6


Product marketing rights
International opportunities 4;6
Window on technology I
Financial return Fin.
Sykes,

Strategic objectives
1990: 41, 45 Identity new opportunities I


Develop business relationships 4;6
Find potential acquisitions 4;5


Learn how to do venture capital 3
Change corporate culture 2
Assist spin-outs from the corporation 3


Return on investment Fin.
Silver, 1993: To incubate and reduce the cost of acquisition (4)
6-7,59-74


To gain exposure to possible new markets 1
To add new products to existing distribution channels 6
To reduce the cost of research and development through strategic 4;5
partnering
To expose middle management to entrepreneurship 2
(3)
To obtain a management training area for bright young trainees in


need of experience 6
To utilize excess manufacturing capacity, space, or computer time 2


To mesh the activities of several departments injoint efforts Fin.
To generate capital gains I
To "look out of the window" - to develop antennae for break-


through technologies I
To generate income through strategic partnering (if it is


competently managed) 3
To provide excellent group therapy for senior management (I)
To create good public relations by reflecting forward-looking -

management 3
To keep pace with their competition, who are probably doing it 2
The "ITEK" reason (secure returns from internal developments)
To encourage new company formation in the community
Chapter 2: Theoreticalfoundation 91

Study eve obiectives/tars!eted benefits Disc. at


Schween, 0 Strategic overall objectives are: Observe technological trends, 1;*;2
1996: 78-89, support growth and strengthen entrepreneurship
174 0
Specific targeted strategic benefits: I
-IdentifY new markets and technologies *
-Generate product- and process-innovation 4;5
-IdentifY potential acquisition targets 4;6
-Build business relationships 3
-Gather CVC experiences 3
-Support spin-offs 2
--Change corporate culture Fin.
0 Financial objective: Return on investment 2
0 Regional development
McNally Identification of new markets I

.
0

(1997: 87, 0 Exposure to new technologies I


89) Financial return Fin.
0 Develop business relationships 4
0 Identification of new products 1;4
0 Improvement of manufacturing processes 4;5
0 Assess potential acquisition. candidates I
0
Learn about venture capital 3
0 Lower manufacturing costs 4;5
0 Social responsibility -
0 Help suppliers/customers (4)
0 Indirect benefits from enhanced small firm sector 2
0 Publicity for company 3;4
0 Assist spin-outs from company 3
0
Assure continued supply of materials/components (4)
o Change corporate culture/need to become more innovative 2
0 Develop an executive network (4)
0 Diversification *
Berger and 0
Strategic overall objectives are: Observe technological trends, 1;*;2
Dllrdrechter, support growth and strengthen entrepreneurship
1998: 40-43, 0 Specific targeted benefits
77 -Window on technology I
-Generating innovation *
-Learning effects 2;3
-Employee motivation 2
-New business relations 4;6
.-Diversification *
-Spin-offs 3
0 Financial objective: Return on investment Fin.
Kann, 2001: 0
External R&D 5
11-13 0
Accelerated market entry 4;(1 ;2)
0 Demand-enhancement 4
1 - Build technology and market knowledge
2 - Change attitude towards innovation and change
3 - Acquire skills and increase company attractiveness for employees
4 - Build and leverage partner network
5 - Source and leverage technologies
6 - Create additional revenue by leveraging company resources
Fin. - Financial objective; * - General objective that is possibly a result of other benefits;
o - Only covered to a limited extent; - - Not covered
92 Chapter 2: Theoreticalfoundation

This study will introduce a structure of targeted strategic benefits. Although the structured
benefits are not completely mutually exclusive and may not be collectively exhaustive as
discussed, a comprehensive list of targeted benefits is helpful to communicate eve benefits
and to test them. 221
Based on the strategic objectives or benefits that are mentioned in the
literature four groups of benefits are differentiated: eve may help companies to gain
knowledge, to gain motivation, to gain skills or to improve and leverage the network of
business partners. Two additional groups of benefits are differentiated in this study as
specific forms of the four groups of benefits above: leveraging sourced technologies and
creating additional revenue by leveraging company resources. Technologies are a specific
type of skills that may be gained, for example, through leveraging relationships with business
partners (e.g., through co-development agreements). Additional revenues are a specific
benefit that can be generated from building and leveraging a partner network.

The six groups of benefits mentioned above are called targeted strategic benefits of eve and
will be used as a structuring device for a large number of specific benefits called sub-
benefits. A benefit may be generated by achieving one or more of the benefit's sub-benefits.
In the following, the targeted strategic benefits and sub-benefits will be introduced and
discussed. Figure 2-12 shows a summary of the targeted strategic benefits and sub-benefits
that are discussed in the following. The six targeted strategic eve benefits are: build
technology and market knowledge, change attitude towards innovation and change, acquire
skills and increase the company attractiveness for employees, build and leverage a partner
network, source and leverage technologies and create additional revenue by leveraging
company resources.

The benefits listed in Table 2-14 are included in the proposed benefit structure as the benefit
or under the benefit indicated in the column "discussed at". Benefits marked with "*,, (e.g.,
growth) are rather general objectives that may be a result of other benefits and are not
discussed below. Benefits marked with "( )" are only partially reflected in the proposed
structure of benefits. The two benefits marked with "-" are not reflected in the proposed
benefit structure. As discussed above, social responsibility is not included as a strategic eve
objective. In addition, the possible objective of doing eve because competitors may be
doing it is not considered as a sufficient objective for doing eve. In order to justify eve
activities, a company should at least understand some of the reasons why competitors may be
doing eve and then could also target these objectives.

221 See 3.2.2 for testing eve benefits.


Chapter 2: Theoretical foundation 93

Figure 2-12: Potential benefits of CVC222

~~~~:~SUb~~~~e~~:~~~~~ig"-hu~7.LI"~"~'M~'----~'A"-,~".~a~.oo~~'~I~m=p,~~7'=im~~='~'~I~mp~"~~=i~"'="~.~'~L'-i~=ru~,~w=,-'
company into new sensitivity to the retain talent among potential nal processes technologies
expertise. developments need to ~nnovale Generate business panners Improve the Leverage sales
contacts and early on Increase open-- insights jnto Identify and de- customer value channels
reputation to Identify spccific ness to outside role and velop alternative of own Rent out R&D
achieve developments and management of suppliers products facilities
financial opportunities foster willingness alliances Identify and Enable move Leverage
returns from Support to cooperate with Leverage develop new into new fields manufacturing
invenment decisions to ext~ partners venture capital customers Enhance capabilities
ponfoiio move or not to Improve ability to skills for Improve own technological
move into new dccl \!lith change management of value proposition capabilities that
fields Ge.lerate internal projects Access new may be
Scan for and innovative ideas and for spin-offs markets important in
assess potential Start innovative Stimulate demand the future
acquisition projects for own products
targets Develop region to indirectly
Slfategic benefits
'mprove inno- Participate in
are to some degree
vative atmosphere ' standard design
interdependent
and overlapping
-
Source Panially based on Berger et al., 1998; Greenthal et al., 1983; Schween, 1996, Siegel et al., 1988, Sykes, 1990, Winters el ai, 1988

Table 2-15 shows that all six benefits or their sub-benefits have been mentioned by the author
introduced in Table 2-14.

As indicated above, the targeted strategic benefits are sometimes interdependent and not
without overlap. Generating one benefit may also assist in reaching another. For example,
building technology and market knowledge may lead to sourcing a technology, or acquiring
skills in allianc,e building may support building and leveraging the partner network. At the
same time, similar sub-benefits may be elements of different benefits. An 'improved value
proposition', for example, through a cross-selling relationship is an element of 'building and
leveraging a partner network'. 'Improved customer value' may also result from 'sourcing a
technology'.223

222 The benefits listed above may help to reduce the risk of doing business. Examples are: technology and
market knowledge may reduce the risk of entering new fields. Partner networks may help to share risks of
market development, capital investments etc. among different players. Sourcing technologies may limit the
exposure to development risks.
223 Like all activities, eve may also create some negative results for a company. An example of this may be
that top management spends too much time on eve issues and thereby focuses too little on the core
business. Negative effects from eve are not further discussed in this study.
94 Chapter 2: Theoreticalfoundation

Table 2-15: Coverage of benefits in the CVC literature


Study Build Change Acquire Build Source and Create
technology attitude skills and and leverage additional
and market towards increase leverage technologies revenue by
knowledge innovation company partner leveraging
and attractiveness network company
change for resources
employees
Greenthal and


Larson, 1983
Siegel, Siegel and
MacMillan, 1988

Winters and Murfin,


1988
Sykes, 1990

Silver, 1993

Schween, 1996

McNally, 1997

Berger and
Dordrechter, 1998

Kann,2001

- Benefit or sub-benefit mentioned

As also indicated above, the proposed structure of eve benefits may not be complete. Three
measures, however, have been taken to increase the likelihood that the proposed structure
includes all relevant benefits and sub-benefits of eve: first, as discussed above, the eve
literature has been screened to determine the benefits and sub-benefits of eve that were
discussed and to identify a possible structure for these benefits. Second, benefits are
structured into six groups of sub-benefits. This helps to check the proposed benefits and sub-
benefits for completeness. Third, discussions with practitioners have been used to challenge
the proposed structure for practicability and completeness. In addition, this study will try to
identify additional eve benefits and sub-benefits with the help of case studies, as discussed
in 3.2.2.

2.3.2.1. Build technology and market knowledge

eve is often done in order to identify future trends in technology and markets (e.g., Rind,
1994: 101). This is often referred to as 'a window on technology' (e.g. Hardymon, DeNino
Chapter 2: Theoreticalfoundation 95

and Salter, 1983: 115; Roberts 1980: 135; Winters and Murfin, 1988: 207-208).224 Siegel,
Siegel and MacMillan (1988: 234, 235-236), call it 'exposure to new technologies and
markets' and identify it as the most important strategic CVC benefit. Schween (1996: 78-89,
174) introduces the ability to 'identify new technologies and markets' as a CVC benefit. 225
Sykes (1990: 41) states that CVC managers ranked 'identifying new opportunities' as a top
priority objective. 'Identifying specific new opportunities' is regarded as a sub-benefit of
'building technology and market knowledge' in this study, as discussed below.

At least three sub-benefits, may be achieved: Companies may 'gain valuable insights into
new developments early on'. They may be able to observe and understand the implications
of new developments by, observing trends in the start-up community. A company may
become aware of previously unknown technologies, products or markets that may be or
become relevant for the company, e.g., pose a threat to the current core business. 226 The
knowledge that is gained may lead to the 'identification of specific new market or product
opportunities' that can be pursued by the company.227 Besides identifying new
opportunities, companies may also use knowledge about markets and technologies to support
decisions like entering new markets or leveraging new technologies. Therefore technology
and market knowledge gained from start-ups may 'support decisions to move or not to
move into new fields'. Finally, companies may also gain information about interesting
acquisition opportunities. They may be able to 'scan for and to assess potential acquisition
targets'.

CVC may help a company to build technology and market knowledge because start-ups are a
major source of innovation in different sectors especially in newly developing, often high-
tech, industry segments. Continuously screening potential investment targets and observing
and cooperating with funded start-ups may allow a company the observation and
understanding of new technological and market developments. Certainly many new
industries have been shaped by large companies, e.g., jet engines, television sets, plastics,

224 The concept of the window on technology is at least partially based on the idea of strategic windows
discussed by Abell (1978). According to Abell (1978: 21) a strategic window describes " ... the fact that
there are only limited periods during which the 'fit' between the key requirements of a market and the
particular competencies of a firm competing in that market is at an optimum."
225 On a general level, Schween (1996: 78-89) and Berger and Dordrechter (1998: 40-43) also call this benefit
'observe technological trends', Berger and Dordrechter also mention the benefit diversification. Building
technology and market knowledge can be seen as the first step towards diversification.
226 Observing start-ups serving new markets may also provide insights into the marketing of technologies, For
example, different types of customers, e.g., innovators, early adopters and the early majority in new markets
may be identified. In addition, an understanding of how to market products to these groups could be gained,
a challenge that is discussed by Moore (1991: 17-25).
96 Chapter 2: Theoreticalfoundation

pharmaceuticals and mainframe computers. 228 Other industries, however, have been strongly
influenced if not shaped by start-ups. E.g., Apple, Compaq and Dell in the PC industry;
Microsoft in PC software; Intel and AMD in microprocessors; Cisco in Internet infrastructure
technology; Yahoo as an Internet portal and Amazon in Internet retailing. Start-ups were and
are a major source of innovation, partially creating new industries. Start-ups are at least one
reason why 40% of Fortune 500 companies were replaced between 1990 and 1995 (Kim and
Mauborgne 1999). Sykes (1990: 38) states, "". history demonstrates that major new
business growth areas have evolved from new products originally developed by innovative
small companies." . Observing start-ups closely early on may give companies a lead in
building valuable technology and market knowledge. Working with a start-up in a new
market can yield an understanding of the economics and trends in the new market and an
overview of the most relevant players. This information may provide an option to enter a
certain market, when it starts to grow significantly. Overall, technology and market
knowledge may reduce the risk of new activities in fields that are less known to the company.

2.3.2.2. Change attitude towards innovation and change

CVC may not only lead to information and knowledge as described above. Getting a stimulus
from the outside world may also impact the culture and attitudes within an organization and
motivate people to foster innovation and change. Observing how start-ups do business and
move successfully into new markets may help to instill entrepreneurial spirit and motivate
people by breaking bureaucratic thinking patterns and changing corporate culture (see Sykes,
1990: 41). Berger and Dordrechter (1998: 40-43, 77) and Schween (1996: 78-89, 174)
discuss a 'change in corporate culture' as well as 'strengthening entrepreneurship' as benefits
of CVC. Berger and Dordrechter also describe 'employee motivation' and 'learning effects' as
potential benefits ofCVC.

Specifically, CVC may 'increase the sensitivity to the need to innovate'. It may 'increase
the organization's openness to outside developments and foster willingness to cooperate
with external partners' and react to market and technology trends. Employees may become
more willing to accept and 'improve their ability to deal with change' and actively shape
the future, by 'generating innovative ideas'. A consequence of such changes in attitude may
be that 'innovative projects are started'. A company may also be able to change the
attitude towards innovation and change within the organization by 'developing the region'
around itself. Supporting innovative start-ups that are located geographically near itself may

227 Roberts and Berry (1985: 7-8, 11-12) discuss eve as one alternative to becoming familiar with unfamiliar
markets, unfamiliar technologies or services or completely unfamiliar sectors. This familiarity then helps a
company to decide whether it should enter a new field or not.
228 See Bhide (2000: X).
Chapter 2: Theoretical foundation 97

create an innovative atmosphere that positively impacts the company.229 All the sub-benefits
introduced above are valuable for increasing the ability of an organization to adapt flexibly to
new developments and to shape the future.

The benefit and sub-benefits may result from eve through the exposure of employees to
start-ups. The broad overview of start-up activities as well as close contact to potential or
actual portfolio companies may lead to a change in attitude among employees. 23o Corporate
employees may get exposed to technological innovations as well as the entrepreneurial spirit
within start-ups. Since creativity, flexibility and speed as well as the potential outcomes from
these potential start-up characteristics are demonstrated, eve investors may experience a
kind of wake-up call.231 Just seeing what start-ups are able to do may inspire and motivate
corporate employees to come up with new ideas to improve existing or design new products
(see Greenthal, 1983: 74). Working with start-ups may also help to decrease the impact of
the Not-Invented-Here syndrome.

2.3.2.3. Acquire skills and increase company attractiveness for employees

eve may not only lead to knowledge and a change in attitude, it may also help to acquire
specific skills either by attracting or retaining people or by building skills directly through
eve. eve may increase the attractiveness of a company for potential employees. eve
may help companies to attract or retain people if people want to work for a company that has
an innovative image, which may at least be partially created through eve, or if they are
interested in being in touch with the start-up environment although they do not want to work
for start-ups directly. eve may also offer an opportunity to potentially retain people through
spin-offs. When start-ups fail, former employees, for example, researchers or experienced
managers, may be more likely to return to their previous employers if they kept ties with
them because they were spun off from or funded by their previous employer. In addition to
attracting and retaining people, skills may be built through eve especially in alliance-
making and venture capital. Different authors discuss acquiring ve skills as a benefit of
eve. vcr as a benefit companies may
Sykes (1990: 41, 45) considers 'learning how to do
generate from eve. 'eve experience' as a benefit of
Schween (1996: 78-89, 174) discusses
eve. At least two positive results may result from better ve or eve skills. On the one

229 This issue is discussed in the literature, e.g., Stuchtey (2000), as the impact of clusters on companies within
these clusters.
230 According to Leonard-Barton (1995: 30) even very innovative companies need a stimulus to adapt their
capabilities to a changing environment since core capabilities are also core rigidities. Core capabilities help
companies to flourish in a stable environment but hinder adaptation when the environment is changing.
CVC may be able to provide the stimulus that makes people see that their current capabilities may hinder
innovation in the future. See 2.3.3 for a more detailed discussion of the idea of core rigidities.
231 See 2.3.3 for a more detailed discussion of differences between start-ups and established companies.
98 Chapter 2: Theoretical foundation

hand, improving eve skills may have a positive impact on all types of benefits that can be
generated from eve. On the other hand, ve or eve skills may also help companies to 'spin
off internal ideas into independent ventures' more successfully (see Berger and Dordrechter,
1998: 40-43, 77; Rind, 1994: 101; Schween, 1996: 86; Sykes, 1990: 41, 45). Apart from ve
skills, alliance-making skills may be gained through the eve activity. Alliance-making
skills may help to realize other eve benefits like building and leveraging a partner network
or creating additional sources of revenues. Alliance-making skills may also be valuable for
cooperation with companies other than funded start-ups.

The sub-benefits that may lead to the 'acquisition of skills in alliance building and venture
management' include: 'attracting and retaining talent' , as discussed above. Then
companies may 'generate insights into the role and management of alliances' which may
include information about who does alliances, for what purposes, what the design elements
are, how they are managed and how successful they are. Since a company may be able to
understand better the potential positive results of alliances and their success factors, it may
also extend or leverage its partner network as discussed in 2.3.2.4. This ability may even be
enhanced if the company network in the external community232 is extended and its own
reputation as an alliance partner improved through eve. Finally, a company may 'leverage
its VC skills for the management of internal projects for the support of spin-offs' of
internal ideas into ventures, as mentioned above. 233

As already said above, alliance-making and ve skills may be acquired when doing eve
through observation and practice. On the one hand, processes, economics and management
principles may be studied (Sykes, 1990: 41). On the other hand, skills may be tested and
enhanced through experience.

2.3.2.4. Build and leverage a partner network

eve may help to grow the network of the investing company in the outside world, especially
in the start-up community and may lead to actual business relationships. Berger and
Dordrechter (1998: 40-43, 77) and Schween (1996: 78-89, 174) discuss the general benefit of
developing or 'building new business relationships'. Sykes (1990: 41) even sees business
relationships as among the top priorities of eve programs and suggests that they are an
important way of gaining information. Probably business relationships lead to other eve
benefits as well, for example, a change in attitude.

232 As venture capitalists playa role in referring partners, see for example the 'keiretsu' leveraged by Kleiner
Perkins see 2.2.1, corporate venture capitalists may become partners for start-ups themselves.
233 Spin-offs may present verY specific challenges and assisting spin-offs from the corporation is not typically
regarded as a top priority of eve programs (Sykes, 1990: 41).
Chapter 2.' Theoretical foundation 99

Different types of possible business relationships exist including traditional customer


relationships, supplier relationships or cross-selling relationships. A special way of building
and leveraging a partner network are acquisitions. Acquisitions may be viewed as an extreme
form of a partnership. At the same time, however, they may provide access to new potential
partners. Greenthal and Larson (1983: 71), Schween (1996: 78-89, 174), Siegel, Siegel and
MacMillan (1988: 234, 235-236), Sykes (1990: 41,45) and Winters and Murfin (1988: 207-
208) mention the acquisition of start-ups (or identification of acquisition targets) as a benefit
of eve. An acquisition may enable access to a technology, as discussed in the next section.
An acquisition may also allow access to the business partners of the acquired company,
especially the customers. 234 In some cases, start-ups from abroad may be used to support the
company's own efforts to sell its products internationally (see Winters and Murfin, 1988:
207-208).

The outcome of all the different types of possible business relationships discussed above can
be described as several sub-benefits. eve overall and especially successful business
relationships with start-ups may 'improve the image of the investing company among
potential business partners' and therefore result in additional or more beneficial business
relationships. On the supplier side, eve may help a company to 'identify and develop
alternative suppliers'.235 On the customer side, several sub-benefits may be realized. Start-
ups especially 'may be identified and developed as new customers'. This may not only
create additional revenue (and profit) and extend the company's market penetration or market
reach but the special needs of start-ups may enable the company to modify its own products
early to 'improve its own value proposition' for existing customers and to better meet
possibly growing future demand. 236 Selling to a start-up early on may also result in a
preferred relationship that may become even more valuable when the start-up grows
successfully. As already mentioned above, an acquisition237 that is prepared through eve

234 An acquisition may lead to all kinds of benefits. Besides access to technology and new business partners,
an acquisition may also lead to increased technology and market knowledge, a change in attitude within the
acquiring company and to additional alliance-making skills. In this study, however, access to technology
and markets (new business partners) are regarded as the most important benefits that a CVC-based
acquisition may lead to and these are discussed in this and the next subchapter.
235 McNally (1997: 87) and Rind (1994: 101) also mention two more defensive benefits a corporate strategic
investor may realize by taking an equity share in a company: assure a source of supply or assist a customer.
236 Also see the discussion of disruptive technologies in 2.3.3.
237 While acquisitions of start-ups may offer several advantages, there are also critical opinions regarding the
role and impact of acquisitions. Some authors discuss the merits of acquisitions critically, e.g., Greenthal
and Larson (1983: 71), Hardymon, DeNino and Salter (1983: 117), Porter (1987: 45-46), Sykes (1990: 41).
Acquisitions may not lead to the promised positive effects for several reasons. For example, the acquiring
company's objectives may be in conflict with those of other investors or the entrepreneurs. Key personnel
may leave a company after an acquisition. Acquisition as a stated goal may keep investors out of the most
attractive deals because start-ups may fear such an objective. Overall, investors should be aware that
acquisitions may offer great opportunities but also present a considerable amount of risk.
100 Chapter 2: Theoretical foundation

may help to 'access new markets'. An acquisition originating out of a eve investment may
not necessarily target the funded start-up. The information gained through eve may very
well lead to the acquisition of another player in the field the start-up is active in. 238 Further,
cooperation with start-ups may indirectly lead to a 'stimulation of demand for its own
product'. The basic idea behind this sub-benefit is that a start-up technology may remove
technology "roadblocks" or create new applications for products from the investing
company.239 A company may also improve its potential to win customers and generate sales
in the future by 'participating in the design of industry standards early on'.240 Kann
(2001: 111) finds that corporations in industries in which products are characterized by
standards and technology platforms, including the communications, computing and software
sectors, tend to invest in entrepreneurial firms with the goal of enhancing demand.

In order to build and leverage the partner network and realize the sub-benefits described
above, a company needs to actively screen start-ups for potential partners (customers,
suppliers, distribution partners etc.) .and seek cooperation with them. In order to do that and
realize this benefit, or any other strategic benefits, operating units probably need to be
involved in the ve process since the operating units need to generate the major part of the
benefits.241

The 'skills in alliance-making and venture management' that are discussed above may very
well be helpful to build and leverage a company's partner network. The skills may help, for
example, when potential opportunities are evaluated or when terms are negotiated.

238 This is likely to create tensions with the funded start-up if a competitor is acquired and will probably result
in the company exiting its investment.
239 The sub-benefit of indirect stimulation of demand is certainly related to the sub-benefit of improving its
own value proposition. The latter, however, is likely to be more direct and requires some form of
cooperation, e.g., in a cross-selling relationship or by bundling its own product with a start-up product. In
contrast, the former does not require any direct cooperation, e.g., the development of Internet applications
that require high bandwidth potentially increases the demand for Internet infrastructure and high-speed
Internet access.
240 There are at least two ways in which a company can benefit when start-ups are involved in setting
technology standards. First, start-ups have to decide whether they want to make their new technology
compatible with existing technologies, e.g., which operating system a new software should run on. This
offers companies the opportunity to promote their own standard to be used. This may even happen
indirectly by delivering specific components to start-ups, which are designed on company standards.
Second, when start-ups do set new standards, e.g. communication protocols, it can give a company an
advantage to be involved early, either by influencing the standard or adapting to it very early. Both ways of
being involved in standard setting increases the chance of benefiting from new standards (e.g., through
barriers to entry for other competitors).
241 See 2.5.3.1 and 2.6.4 for a more detailed discussion.
Chapter 2: Theoretical foundation 101

2.3.2.5. Source and leverage technologies

Apart from gaining knowledge of technological trends, eve may help companies to access
technologies from start-ups. Technologies sourced this way may help to improve products or
processes. 'Gaining access to technologies' is mentioned by Greenthal and Larson (1983: 71)
as a benefit of eve. Winters and Murfin (1988: 207-208) describe 'licensing technologies'
as a benefit of eve. As discussed above, acqnisitions may also help to access technologies.
Acquisitions are mentioned by Greenthal and Larson (1983: 71), Schween (1996: 78-89,
174), Siegel, Siegel and MacMillan (1988: 234, 235-236), Sykes (1990: 41, 45) and Winters
and Murfin (1988: 207-208) as potential benefits of eve.

Technologies may be sourced in different ways: first, companies may sign licensing
agreements then, companies may purchase patents from start-ups. Next, companies may
outsource R&D or co-develop technologies in cooperation with start-ups to leverage external
research capacities and expertise. Finally, technologies may be accessed by acquiring start-
ups and such acquisitions may be prepared for with the help of eve.

Sourced technologies may help companies to 'improve internal processes'. Further,


sourced technologies may help companies to 'improve the customer value of its own
products'. This may go as far as strengthening a technological leadership position in specific
fields. Sourced technologies may also 'enable a company to move into fields that are new
to the company'. Finally, sourced technologies may provide access to or 'enhance
technological capabilities that may be important in the future'.242

Sourcing technology from start-ups is a potential benefit of eve not only for the investing
company but possibly also for the start-up. As mentioned above, the investing company may
improve products or processes with the help of new technologies or even be able to enter new
fields with potential future opportunities. Start-ups on the other hand may not only be able to
generate funds but also realize strategic benefits like leveraging the investors' R&D skills in
co-development agreements or increasing the use of its own technology which may
potentially lead to setting an industry standard. Finally, selling off their own start-up to the
investor is a potential exit option for entrepreneurs. All this may not only be possible for
funded start-ups but also for other players that are identified through eve.

2.3.2.6. Create additional revenue by leveraging company resources

Large companies may help start-ups with their sophisticated skills and assets and, at the same
time, generate sales for themselves. Sales channels, marketing, manufacturing, handling of

242 This may be regarded as a real option.


102 Chapter 2: Theoreticalfoundation

regulatory requirements, technologies or research may be leveraged and used to support start-
ups. Siegel, Siegel and MacMillan (1988: 236) mention the potential to 'manufacture or
market new products' as a eve benefit.

Various specific sub-benefits may represent new sources of revenue: A company may
'license out technologies' to start-ups or 'leverage its sophisticated sales channels' by
selling start-up products, e.g., a large pharmaceutical company selling a drug for a small
biotech company. Further a company may 'rent out R&D facilities and expertise'243 to
start-ups, or manufac~e products for them, 'leveraging the company's manufacturing
capabilities' .

A cooperation between start-ups and established companies may lead to a mutually beneficial
match between start-up needs and company skills. In addition to generating revenues, a
company may realize additional benefits through cooperation with start-ups. For example,
benefits like 'building technology and market knowledge' or 'changing attitudes', as described
above, may result. Further, 'selling products to start-ups' or 'licensing technologies' may offer
the opportunity to 'set or impact standards in new markets'.

As with all other types of eve benefits, the sub-benefits described in this section require
active efforts by the investing company to be realized. How eve is done and how benefits
may be realized will be described in 2.4-2.6. First, however, theories will briefly be
introduced in 2.3.3 that may explain why eve creates the benefits and sub-benefits discussed
above and why these may be important to a company.

2.3.2.7. Benefits as resources

According ,to the definition used in this study (see 2.1.3), resources include firm assets,
capabilities, organizational processes, information, knowledge etc. 244 When a company
leverages its resources through activities it may create new resources that may be regarded as
eve benefits may be regarded as resources just like the
input for other activities. Therefore,
eve activity and the resources leveraged in the eve activity.
Figure 2-13 shows an example of this. A company may leverage its capabilities, like
employee skills or networks, to make eve investments. These eve investments are a result
of the company's resources/capabilities. At the same time, eve can be regarded as a
resource since it may lead to benefits like insights into new developments. These insights

243 In the pharmaceutical industry, for example, companies can help start-ups a lot with clinical development
experience and regulatory expertise since many start-ups have limited resources for development.
244 For example, see Barney (1991: 101) who defmes resources as "... all assets, capabilities, organizational
processes, firm attributes, information, knowledge etc. controlled by a firm that enable the firm to conceive
of and implement strategies that improve its efficiency."
Chapter 2: Theoretical foundation 103

into new developments can also be regarded as company resources. They may lead to the
development of new products or markets, which in tum may lead to sales.

Figure 2-13: Benefits of CVC as resources

Output

Sales

2.3.3. Theoretical reasoning for Corporate Venture Capital

Different theories from the literature may be used to explain strategic benefits from eve. 245
Four concepts will be discussed that may explain, why eve could be valuable to companies.
First, the diffetent resource position of start-ups and established companies may lead to
synergies through cooperation. Then, based on transaction costs it can be cheaper for
companies to acquire innovation from external sources than to create it internally. Next,
eve can help. companies to deal with disruptive technologies and as a consequence to
prosper in the long run. Finally, eve may help to prevent core rigidities, a notion introduced
by Leonard-Barton (1995).

Schween (1996: 71-76) 246 identifies different resource positions of start-ups and established
companies that impact the innovativeness of companies. 247 He argues that these different

245 As pure venture capitalists, companies may be able to achieve financial return from investments in a
portfolio of start-ups, see 2.2. As for venture capitalists the basis for these returns is the market value of the
funded start-ups (based on an IPO or acquisition). While some funded start-ups may fail, others may be
very successful. The overall result may be a positive financial return, potentially in addition to strategic
returns.
246 Schween partially bases his work on Nathusius (1979: 508-514).
104 Chapter 2: Theoreticalfoundation

resource posltlOns may lead to synergies through cooperation. Start-ups' strengths, for
example, are a high level of motivation and creativity, a high degree of flexibility and fast
and low cost R&D. Start-ups' weaknesses, for example, are limited fmancial and people
resources and a limited reputation. 248 Established companies have to some extent
complementary strengths and weaknesses. In contrast to start-ups, established companies
have access to financial and people resources and already have an established market position
and reputation. 249 Established companies, however, often lack a high level of employee
motivation and creativity, organizational flexibility as well as efficient research and
especially development processes. 250 Schween (1996: 75-76) argues that these different
resource positions may lead to synergies when start-up and established companies
cooperate. 251

eve may be a way to benefit or leam from start-ups and venture capitalists how to deal with
smaller investments involving high uncertainty. Schween, however, also cautions that the
theoretical synergy potentials may not be realized in practice. 252

The potential advantages of eve may also be explained based on the theory of transaction
costs developed by Williamson. It may be cheaper for a large company to access a resource

247 Schumpeter already emphasizes the role of innovation by identifYing innovation as the basis for economic
development (1934: 65-74) and by discussing the process of creative destruction (1942: 82-84). The
importance of innovation is stressed by many other authors, e.g., Foster (1986: 30) or Porter (1990:45) who
regard innovation as the source of competitive advantage. Brockhoff(1999: 1-3) stresses the role of R&D
as a basis for competitive advantage.
248 These cltaracteristics may be the reasons why start-ups are better at innovations, see Roberts (1980: 137).
249 Niederkofler (1989: 52) lists seven areas where established companies may provide valuable resources to
start-ups: reputation, customer related information and contacts, supplier related information and superior
access to supply sources, distribution system and service network, management skills (in procedures such as
accounting, building up a customer information system etc.), complementary technical know-how and
sophisticated testing facilities and efficient production facilities.
250 Dougherty and Hardy (1996: 1120) fmd an inability of large, mature organizations n to connect new
products with organizational resources, processes, and strategy thwarted innovation ... n Pfeffer and
Stalancik (1978) argue that organizations are not able to generate internally all the resources and functions
required to maintain themselves. Therefore, they must interact with their environment to access the
resources they lack. Bhide (2000: 114) states that, based on their resource position, large companies would
typically rather invest in less uncertain new opportunities but are willing to invest large amounts.
251 According to Brockhoff (1995: 29), for example, synergies based on the exchange of complementary
knowledge are the most important reason for large companies to cooperate with smaller companies in
research and development.
252 Moss Kanter, North, Bernstein, Williamson (1990: 426), for example, state that eve is more successful
when the distance between start-up and corporate is significant. One reason why such synergies may be
hard to realize through eve may be that ve funded start-ups differ in terms of resources from non-Ve
funded start-ups. According to Bhide (2000: XV) ve funded start-ups are similar to established
corporations in many ways, e.g., in terms of the experience and expertise of entrepreneurs, decision-making
procedures etc. In addition, ve funded start-ups often receive sufficient funding.
Chapter 2: Theoreticalfoundation 105

(especially an innovation) from a start-up than to develop it on its own if it is easier or


cheaper for the start-up to develop the resource. 253

Williamson (1975: 205-206) suggest alternatives to hierarchical solutions to overcome the


problems of large companies with innovation. Williamson proposes as one of two
alternatives a market process he calls "classical specialization". Williamson suggests the
following, "An efficient procedure by which to introduce new products is for the initial
development and market testing to be performed by independent inventors and small firms
(perhaps new entrants) in, an industry, the successful developments then to be acquired,
possibly through licensing or merger, for subsequent marketing by a large multidivision
enterprise." This process ,is reflected in several eve benefits/sub-benefits discussed above,
e.g., leverage sourced technologies or leverage existing sales channels to sell start-up
products.

The second alternative Williamson (1975: 206-207) proposes is for a company to try to
"debureaucratize itself' by replicating some characteristics of small firms, e.g., reducing
hierarchical communication and creating more significant incentives. 254 Williamson cautions
that this approach may be difficult and expensive. He argues (1975: 206) as follows: "If,
naturally, organizations experience certain (mainly irreversible) life-cycle changes, it may be
more economical simply to acknowledge these and permit specialization by stages to occur
rather than force innovation through the internal development route." Given the differences
between large and small companies discussed above, it may be more feasible (or a ,large
company not to try to debureaucatize itself especially when resources like motivation or
existing employment contracts are considered. If a company does choose to "debureaucratize
itself', eve m~y actually help in the process if the company is able to realize eve benefits
or sub-benefits such as, for example, change the attitude towards innovation and change.

The existence of disruptive technologies is another possible explanation why eve may be
valuable to companies. According to Christensen (1997), established companies often fail
when faced with disruptive technologies. Christensen (1997: XV) describes disruptive
technologies as technologies that" ... bring to a market a very different value proposition than
had been available previously." Disruptive technologies "... under-perform established
products in mainstream markets. But they have other features that a few fringe (and

253 See Williamson (1975) or (1985) for a detailed discussion of the transaction cost theory,
254 While transactions aod not governaoce is typically the key focus of transaction cost theory Williamson
analyzes the governance issue with the help of the transaction cost theory (Williamson, 1991: 18),
Williamson suggests that in addition to the two fundamental forms of governance, market aod hierarchy, a
hybrid form may be used that creates larger incentives than a purely hierarchical governance aod a higher
degree of administrative control thao market governance (Williamson, 1991: 20-25), eve may be such a
hybrid form of governance.
106 Chapter 2: Theoreticalfoundation

generally new) customers value." In contrast to disruptive technologies, sustaining


technologies "... improve the performance of established products, along the dimensions of
performance that mainstream customers in major markets have historically valued."255
Christensen claims that even radical changes in sustaining technologies did not lead to the
failure ofleading firms, while disruptive technologies did. 256 In contrast, start-ups often take
advantage of disruptive technologies.

Christensen calls the problems companies have in dealing with disruptive technologies the
"innovator's dilemma:' and discusses seven reasons for it (1997: 208-210). First, new
technologies do not seem to be useful, at least, to current customers. Second, the allocation
of resources to innovations may starve low priority projects. Third, the company may not
own the capabilities to develop new markets. Fourth, the capabilities of companies may be
specialized to deal with the current situation, e.g., margins, production volumes, order
processes. Therefore companies may not be able to be successful in situations that differ
from their current way of doing business. Fifth, a company may not be able to acquire
sufficient information on a disruptive technology to make decisive moves. Acquiring such
information depends on iterative leaming from trying out new concepts and failing and this
may not be easy for companies. Sixth, disruptive technologies present significant first-mover
advantages and therefore may require a different strategy than sustaining technologies.
Seventh, companies potentially need to overcome powerful barriers to entry and mobility to
move into disruptive technologies which differ significantly from the types of barriers
defined and historically focused on by economists, e.g., the business models used for
disruptive technologies may not make sense to established leaders.

CVC may potentially help established companies to deal with several of these problems.
First, by observing and working with start-ups established companies may be able to
understand in what way disruptive technologies are useful to customers. Second, such an
understanding may lead to different resource allocations for innovation projects. Third and
fourth, established companies may be able to acquire capabilities or at least understand
capability gaps through working with start-ups. Fifth, established companies may be able to
gather information on new technologies and markets directly through CVC or understand
how start-ups acquire such information. Sixth, CVC may give established companies an
early lead in new developments. Seventh, established companies may be able to limit the
effects of barriers to entry and mobility by building knowledge on start-up business models,
management, governance and development.

255 A similar idea of discontinuities is discussed by Foster (1986). Foster introduces the S-curve concept to
describe such discontinuities. Other authors also discuss discontinuities, e.g., Kaplan (1999).
256 Christensen uses the example of the disk drive industry to show the impact of disruptive technologies.
Chapter 2: Theoretical foundation 107

eve may also help in dealing with core rigidities. Leonard-Barton (1995: 30) introduces the
notion of core rigidities claiming that core capabilities may also function as core rigidities.
She says (1995: XN): "The very system that conveys competitive advantage can also
disadvantage the company, either when it is carried to an extreme or when the competitive
environment changes." Core rigidities may keep companies from doing different things or
from doing things differently. If new technologies emerge, for example, core rigidities may
keep companies from adopting them. 257

Leonard-Barton (1995: 4IY) considers core capabilities as "interlocked systems of


knowledge bases and flows" and argues that these must be constantly developed by tapping
and renewing knowledge ,wellsprings. According to Leonard-Barton (1995: 8), four key
new-product and new-process development-related activities allow companies to
continuously develop core technological capabilities and prevent negative effects from core
rigidities. These activities are integrated problem solving across different cognitive and
functional barriers, implementation of new methodologies and process tools, experimentation
and importing know-how from outside technological and market sources.

eve may help in the last key activity of importing know-how from outside technological or
market sources. 258 Leonard-Barton (1995: 175) states: "Even companies with extensive
internal research capabilities need to tap into complementary external sources of technology."
Mechanisms for sourcing technologies include the following (Leonard-Barton, 1995: 153):
observation, licensing, co-development and acquisitions. eve may be a tool for observing
and finding licensing or co-development partners or identifying potential acquisitions.

As discussed above, eve may create many benefits. eve, however, is probably not the
only way in which many of the benefits can be generated. Internal venturing, supporting
internal ideas with the help of (VC) market-like processes, may also change the attitude of
employees towards innovation and change. 259 M&A may enable companies to buy new
players in markets or with technologies that may be advantageous. 26o Alliances and joint
ventures may be started with start-up companies without taking equity stakes. 261 All these
tools most likely also have advantages that go beyond the eve benefits described above,

257 This case is similar to the problem of disruptive technologies discussed by Christensen (1997).
258 Other sources may be: cooperating with universities or research labs, benchmarking, working closely with
suppliers and customers, forming alliances with competitors or other companies etc.
259 See footnote 199 for a list of references.
260 Cisco is a key example for using acquisitions to access innovations. "Cisco swallows innovative start-up
firms to enhance its hi-tech arsenal." (Corporate Finance, June 1998: 21) Farrokh Billimoria, senior
technology analyst at Hambrecht & Quist, states: "Cisco was the first to identify opportunities in entering
new markets via acquisitions." (Corporate Finance, June 1998: 21)
108 Chapter 2: Theoreticalfoundation

e.g., generating returns from internal business ideas or technologies, creating economies of
scale or expanding geographically. Each tool offers specific advantages and faces specific
challenges. There is probably not a single best tool for every situation, instead all tools can
be used in parallel. 262 When a company is viewed as a portfolio of projects, eve can be
regarded as an activity that helps a company to start additional projects and therefore may
help to improve the return of the overall company based on the portfolio theory.263

2.4. Corporate Venture Capital process

The resources necessary to do eve are explained in detail in the following subchapters. By
leveraging eve resources, the ability to perform the activities of the eve process,
companies can generate the benefits of eve that are discussed in 2.3.2. eompanies may face
challenges when trying to build eve resources that lead to eve benefits. These challenges
are discussed in 2.7.

The eve process is introduced for two reasons: first, the eve process helps to improve the
understanding of eve by providing information in addition to the definition of eve and by
showing the differences between eve and ve. Second, the eve process illustrates the
challenges for generating benefits with eve. These challenges may be reasons why
companies do not generate benefits or sustainable competitive advantage with eve. The
focus of the discussion of the eve process will be on the description of eve. Although, the
results from earlier studies analyzing the success factors of eve will be discussed as well in
the relevant sections, the following subchapters do not intend to describe a comprehensive set
of recommendations on how to do eve.

Since eve is a special form ofve, as discussed in 2.3.1, the design elements and activities
of eve are
similar to those of ve, therefore, the process of eve will be based on the
process ofve introduced in 2.2.3.

The process of eve is also discussed separately in the eve literature. Yates and Roberts
(1991: 31) 'describe four major steps of the eve process, each step having several sub-
processes. Their major process steps are: "[d]eveloping the venture program, initiating
investments, managing the investment portfolio and assimilating investments into business".
Developing the venture program is similar to the ve process step of raising capital.

261 Freidheim (1998) and Harbison and Pekar (1998), for example, discuss the role and management of
strategic alliances.
262 For a differentiation between different tools see, for example, Roberts (1980).
263 The portfolio theory is based on increased returns of an investment portfolio vs. individual investments that
is introduced by Markowitz (1952), see footnote 103. Too many projects or too many low priority projects,
however, may also create problems, see Cooper, Edgett and Kleinschmidt (2000).
Chapter 2: Theoretical foundation 109

Initiating investments includes the ve process steps generate deal flow, assess investment
opportunities and invest. Managing the investment portfolio and assimilating the investments
into the business are similar to the ve process steps ofinteracting with start-ups and to some
extent to exiting. 264

Schween (1996: 116) also describes a four-step eve process. The first step is setting
objectives and providing resources for the eve activity, the second step includes deal flow
generation and due diligence and the third step covers investing and interaction. In contrast
to the ve process, Schween does not only discuss support for the start-up but also benefits
for the investing company. The fourth step covers additional rounds of investment and/or the
exit.

Berger and Dordrechter (1998: 39) also design a eve process but focus more on the
development of the eve activity. Besides setting objectives, determining the organizational
form, designing the eve program and running eve they add controlling as an activity to be
done throughout the eve process. All three approaches discuss the set-up of eve activities
and running eve operations in a single process. While Yates and Roberts and Schween put
emphasis on running the activities, Berger and Dordrechter focus on the set-up.

In order to be able to cover all relevant steps for setting up and running eve, this study uses
two separate sub-processes. Figure 2-14 shows the eve process consisting of the two sub-
processes, 'setting up a eve activity' and 'running a eve activity - investing in start-ups'.

Setting up a eve activity is similar to the ve process step of raising capital. It includes five
steps: setting eve objectives, defining the eve investment approach, determining
organizational linkages, staffing and designing compensation and setting up monitoring.
These five steps cover the first step of the processes introduced by Yates and Roberts and
Schween and the first three steps and partially the step of controlling the process introduced
by Berger and Dordrechter. See 2.5, for a more detailed discussion of setting up a eve
activity.

264 Yates and Roberts, however, emphasize the integration of eve investments rather than an exit as is
typically done by venture capitalists.
110 Chapter 2: Theoretical foundation

Figure 2-14: Processes of setting up and running eve

Setting up eve activity

Set objectives

Running eve activity -Investing in start-ups*

Generate deal
Dow

.. Activities are dooe in the order indicated for a single start-up investment but are done in parallel by the investing company making
several invesunents
Source: Partially based on BaurngAnner(1998). Bergeret al (1998:39), Gompers el at (1999), Schween (1996- 116), Yates et al (1991
31), Zemke(I998)

Running a eve activity includes all the remaining five steps of the ve process: generating
deal flow, assessing investment opportunities, investing, interacting with start-ups and exiting
investments. Monitoring the success of eve is added as an additional sixth process step and
partially reflects the step of controlling introduced by Berger and Dordrechter. The first five
process steps cover the process steps two to four introduced by Yates and Roberts and
Schween as well as the fourth step introduced by Berger and Dordrechter. See 2.6 for a more
detailed discussion of the process.

In the following section, two sub-processes of are described in detail, giving an eve
overview of the critical design elements and activities of eve and their potential effects on
eve success. 265 The infrastructure set-up and the abilities acquired to do eve are resources
the company builds and uses.

2.5. Process of setting up Corporate Venture Capital activities


Setting up a eve activity is similar to the ve process step of raising capital. Like ve
investors, eve investors need to determine their objectives for investing ve, as discussed in
Chapter 2: Theoretical foundation 111

2.5.1. Furthermore, just like venture capitalists, corporate venture capitalists need to build
the necessary resources to successfully fund start-ups, for example, designing the
compensation of eve managers. Unlike venture capitalists, corporate venture capitalists
also face some additional issues when setting up a eve activity since they are not only
venture capitalists and ve investors at the same time but also have strategic objectives that
go beyond the objectives of ve investors and venture capitalists. An example for an issue
that only corporate venture capitalists face is linking the ve activity to the existing
organization.

In the following section, five steps of setting up eve activities are discussed. Figure 2-15
shows an overview of the activities that need to be done in each of the process steps.

Figure 2-15: Activities of setting up eve

Set objectives

Choose financial Choose direct Determine role of Determine required Design monitoring
and strategic andlor indirect organization in skill profile and process to
objectives inveshnent supporting eve staff eve detennine eve
Detennine which approach activity and start-ups managers progress and
specific eve Fonnulate as well as for Design success
benefits are investment strategy realizing strategic compensation
targeted including benefits system
Specify which management Set up mechanisms
parts of the approaches and that ensure
organization need investment focus participation of the
to realize the Detennine organization in eve
benefits of eve commitment to Position eve
eve including activities within
fund size and fund organization
teo.

In a fust step, a company that wants to do eve needs to determine the objectives it wants to
achieve with eve (2.5.1). In a second step, the company needs to define the eve
investment approach (2.5.2). An important decision regarding the investment approach is
whether eve investments are made directly into start-ups or indirectly through the funds of
independent venture capitalists. In a third step, corporate venture capitalists need to
determine the necessary internal and external organizational linkages, especially the linkages

265 The eve process introduced just presents one possible way of organizing eve. Other processes may be
used to do eve. In addition, the process introduced describes eve in a systematic and detailed fashion. In
practice, eve may be done in a less structured way. Companies may set up eve less systematically and
run it more intuitively and still be successful in generating benefits.
Jl2 Chapter 2: Theoreticalfoundation

of the organization to start-ups (2.5.3). In a fourth step, eve management positions need to
be filled. In addition to staffing, the compensation of eve managers needs to be determined
(2.5.4). Finally, a system for monitoring eve progress and success needs to be designed
(2.5.5).

The results of the process of setting up eve activities are valuable company resources.
Building these resources, however, may represent major challenges for companies that want
to do eve. These challenges are discussed in the following subchapters and are summarized
in 2.7.

2.5.1. Setting Corporate Venture Capital objectives

Like venture capitalists, corporate venture capitalists need to decide on the targeted financial
return. In addition, corporate venture capitalists need to decide on the strategic objectives of
eve. While venture capitalists typically focus solely on financial objectives, corporate
venture capitalists have strategic objectives in addition or instead of financial objectives. 266

eve objectives may vary to a significant extent. As discussed in 2.3.2, the eve objective
may include a mix of targeted strategic benefits most likely in addition to targeted financial
benefits. A company doing eve needs to be clear which specific benefits it wants to achieve
with the help of eve. Determining specific targeted (strategic) benefits of eve is a
challenge that eve investors face. Determining the strategic benefits a company wants to
target should be based on an analysis of the company situation. A company should identify
which strengths and weaknesses it has (Rutschi, 1989: 49-50), which opportunities and
threats it faces and how eve may help to improve or take advantage of the situation by
impacting company resources. Companies that do not specify targeted benefits explicitly
may not organize their eve activities in a way that enables them to attain these objectives.
In addition to determining specific targeted benefits, companies should also specify where
within the organization they need to realize these benefits. Determining a specific set of
targeted be!1efits and specifying where these should be realized can guide further decisions on
which resources need to be built in order to do eve, for example, the linkages of eve to the
organization as discussed in 2.5.3. Specifying targeted benefits and where exactly these
benefits should be realized can also help to set up appropriate monitoring processes to
determine the success of eve, see 2.5.5.

While a company needs to target strategic benefits in order to do eve according to the
definition in 2.3.1 the role of financial objectives may also be substantial. Financial
objectives may even be necessary to achieve strategic eve benefits, as discussed in 2.3.2. A

266 According to the definition ofCVC in 2.3.1, CVC investors have strategic objectives.
Chapter 2: Theoretical foundation 113

company needs to set an IRR target for CV C investments. As discussed in footnote 219, the
IRR performance of venture capitalists may provide guidance on the level of IRR targeted.
Certain resources that venture capitalists do not have may help companies to achieve
financial returns from VC investments like technology expertise or certain company
networks. Others factors may limit the ability of CVC investors to generate fmancial returns,
for example, incentive systems, the limited independence of VC activities or the culture of
the company. These issues will be discussed further in the next subchapters.

Whatever the objectives are, they need to be specified and communicated in detail. Although
it may not be possible to determine the exact outcomes of CVC up front, the types of
outcome targeted, expressed in targeted CVC benefits as discussed above, need to be
specified. While less specified objectives may be advantageous in some situations, especially
when the outcome cannot completely be envisioned up front, for example in research, this
seems to be less true for CVC. Gompers and Lerner (1998: 9) state that unclear objectives
lead to dissatisfaction with evc programs. Corporate management's lack of clear mission
regarding venture activity is identified as the number one obstacle for CVC by Siegel, Siegel
and MacMillan (1988: 238).

2.5.2. Corporate Venture Capital investment approach

Once a company decides on the objectives it wants to attain with the help of eve, it needs to
determine the investment approach. There are several issues regarding the investment
approach. One significant decision that needs to be made is whether investments are made
directly in start-ups or indirectly through independent, external VC funds (2.5.2.1). Apart
from this, evc investors need to build similar resources to venture capitalists: they need to
formulate an investment strategy (2.5.2.2) and decide on issues like fund term and fund size
(2.5.2.3).

Another issue regarding the investment approach is the legal structure, which is not discussed
in this study. The tax implications of the legal structure are particularly important. 267

2.5.2.1. Direct vs. indirect investment approach

Two fundamental options exist to invest in eve: companies can invest in start-ups directly
or indirectly. The differentiation between direct and indirect investment approaches is
discussed in most studies on eve (e.g., Greenthal, 1983; Sykes, 1990). Figure 2-16 shows
the different direct and indirect investment approaches.

267 See Schiippen and Ehlermann (2000) for a discussion of legal issues concerning CVC.
114 Chapter 2: Theoreticalfoundation

Indirect investment means that the company invests in an external ve fund that is managed
by an independent venture capitalist who uses the capital to invest in start-ups. A company
can be one of many investors in a pooled ve fund or it can be the sole investor in a dedicated
fund. While a dedicated fund usually has a strong focus that is defined by the investing
company, a pooled fund may (focused fund) or may not (general fund) have such a focus. A
focused fund typically targets certain industries or technologies, e.g., Internet technologies or
even more specifically Internet security.

.
Figure 2-16: eve investment approach options

~:~~~;::::::
a l..cn rclc'"at11 opIlORS ror
IU'alCIlClft\UUM'S

Direct investment means that the company invests directly in the start-up. The company may
either invest in a syndicate with other investors268 or it may invest alone as a sole investor. In
a syndicate a company can either play the role of lead investor or co-investor. A lead
investor initiates an investment and usually puts more effort into due diligence, deal
structuring 'and start-up nurturing, whereas the co-investors simply join the lead investor
investing much less effort in these issues.

The roles, which venture capitalists and companies play in indirect investments, differ from
their roles in direct investments. Table 2-16 gives a short overview of these roles.

Overall, direct investment demands much more sophistication from the eve investor than
indirect investments (see also 2.6). eve investors have a limited responsibility in indirect
investments but share a lot of responsibility in a direct investment.

268 See 2.2.3.4.


Chapter 2: Theoretical foundation 115

Direct and indirect investments have different advantages and face different challenges since
the roles between these approaches differ, as shown above. This is also true for the different
specific options described: indirect investments in general funds, focused, pooled funds or
dedicated funds and direct investments as co- or lead investors, or as a sole investor. The
advantages and challenges of these six approaches are summarized in Table 2-17.

Table 2-16: Roles of venture capitalists and eve investors in direct and indirect
investments
Activity Indirect investment Direct investment (in
syndicate)269
Venture Corporate Participa- Corporate
capitalist venture ting venture
capitalist venture capitalist
capitalist
Generate deal flow

Overall due diligence

Technology/market due diligence
0

Decide on investment
0

Monitor start-up development
Nurture start-up and offer management support

Build strategic relationship with start-up

Help to find appropriate alliance partners
0

Exit investments
.. .. ,

.: Mam responslblhty; 0 Partial responslblhty

Several authors'see indirect investments in limited partnerships, either in pooled or dedicated


funds, as a good alternative if companies simply want to generate financial returns (e.g.,
Greenthal, 1983: 76, Winters and Murfin, 1988: 208). Among others McNally (1997: 133)
finds that direct investment is more appropriate for companies targeting strategic objectives
withCVC.

Strategic investors investing in pooled funds probably should not invest in general funds. As
shown in Table 2-17 indirect investments in general funds offer the least number of
advantages but create a significant challenge, which is the lack of focus on fields relevant to
the company. As long as investors can identify special fields of interest, they may try to find
funds focused on areas of their interest and invest in these. Focused funds may offer a higher

269 The degree to which activities are done by a venture capitalist or a corporate venture capitalist differs
depending on their role as co- or lead investor.
116 Chapter 2: Theoretical foundation

probability of generating strategic benefits in the field of interest. Funds focused on investing
in very specific fields, however, may also be riskier than general funds since these fields may
quickly become unattractive for ve investments.

Table 2-17: Advantages and challenges of direct vs. indirect investments


Advantages Challenges

Indirect No need for own deal flow. o Like indirect investment in focused,
investment in o VC skills not necessary". pooled fund. In addition:
general fund o Limited managerial capacity required. o Potential lack of focus of fund
o Opportunity to learn ve skills and to investments on fields relevant to
build network and reputation. company.
Indirect o Like indirect investment in general fund. o Limited influence on investment
investment in In addition: decisions.
focused, o Focus on most relevant technologies/ o Limited access to start-ups and therefore
pooled fund markets possible. realizing strategic benefits difficult.
o Few venture capitalists may be willing to
work closely with eve program.
Indirect oLike indirect investment in focused, o Like indirect investment in focused,
investment in pooled fund. In addition: pooled fund. In addition:
dedicated o Potential impact on indivIdual investment o Few venture capitalists offer dedicated
fund decisions. funds.
Direct o Better chance than for indirect o Needs basic VC skills.
investment as investments to realize strategic benefits o Needs good reputation among venture
co-investor through better selection of and closer capitalists to be included in deals.
contact to start-ups.
o Ability to leverage venture capitalists, for
example for financial skills or monitoring
tasks.
Direct o Better chance than for indirect o Needs own deal flow.
investment as investments to realize strategic benefits Requires extensive VC skills*.
lead investor through better selection of and closer o Requires sufficient management capacity.
contact to start-ups. o Needs good reputation among venture
o Still limited risk through second opinion capitalists to motivate participation in
managing support from venture deals.
capitalists.
Direct o Better chance than for indirect o Needs own deal flow.
investment as investments to realize strategic benefits o Requires extensive ve skills'.
sole investor through better selection of and closer o Requires sufficient management capacity.
contact to start-ups. o No sharing of risk with other investors.
o No potential conflicts of interests with
other investors.
o Potentially higher financial reward.
" ve skills mclude financial skills and managenal skills as discussed m 2.5.4.1.
In addition, indirect eve investments may enable a company to build the necessary
resources for direct eve investments. Yates and Roberts (1991: 1) find that successful
corporate venture capitalists frequently first invest indirectly and then switch to direct (co-)
investment. 270 Since eve activities are "... difficult to do internally ... ", indirect investments
are proposed as an "alternative first step or supplement" to direct investments by Rind (1981:

270 Also see Winters and Murfin (1988: 208).


Chapter 2: Theoretical foundation 117

169). Sykes (1990: 37) frods indirect investments "provide contacts with the venture capital
community and deal flow". This may be especially helpful in industries and geographic
markets where the company has had no prior experience. Besides immediate deal flow and
the opportunity to build a network, indirect investments can also enable a company to acquire
ve skills and a reputation in the ve and start-up community. Nevertheless, working closely
with venture capitalists and learning from them is a challenge, since venture capitalists are
typically very busy and regard strategic support and educating eve managers as not their
major task. Furthermore, eve managers need to actively work on acquiring eve skills to
make use of the learning opportunity.

Companies can also make both direct and indirect investments at the same time, since they
" ... can serve somewhat different purposes and be complementary to one another ... ", as
Sykes (1990: 38) concludes. For example, the investment in indirect eve can provide deal
flow for direct investing activity.

When companies are trying to achieve strategic objectives, direct investments generally seem
to be more appropriate than indirect investments since generating strategic benefits requires a
much closer relationship with the start-up. Only a close relationship between company and
start-up enables participants to realize cooperation opportunities and gets employees close
enough to start-ups to impact corporate culture. 271 Sykes (1990: 37) finds that " ... direct
investments enhance specific business relationships such as marketing or research
agreements."

Schween (1996: 133-137) argues that based on the transaction cost theory, strategic investors
should choose a direct investment approach as long as the number of investments justifies
building up a separate eve activity.272 Schween bases his reasoning on the high specificity
and the strategic importance of the 'transaction', ve investment, which he qualifies as a
knowledge transaction. 273 Kann (2001: 145) proposes that companies should decide on the
investment approach based on the type of strategic objective. She claims that companies
intending to enhance demand (exploiting existing resource base) should do indirect
investments since this offers lower transaction costs but finds that most companies targeting
demand enhancement also do direct investments (Kann, 2001: 103).

271 See 2.5.3.1 and 2.6.4 for a detailed discussion of the role of the organization in realizing strategic benefits.
272 Schween bases his argumentation on work by Picot (1982).
273 Deciding on the investment approach also has a principal-agent-problem component that should be
considered. For the indirect investment approach, superior information available to venture capitalists may
lead to adverse selection and moral hazard. This is discussed by Berger and Dordrechter (1998: 46-48).
When choosing the direct investment approach, corporate venture capitalists face similar challenges to
venture capitalists, see 2.2.3.3. For a detailed discussion of these issues see Schween (1996: 137-164).
118 Chapter 2: Theoretical foundation

Choosing a direct investment approach may increase the likelihood that strategic benefits are
realized. Just choosing a direct investment approach, however, is not sufficient to ensure the
realization of strategic benefits. Other structural elements and skills to run eve activities are
also essential as discussed in the remainder of this subchapter and the next subchapter.

When investing directly, companies may choose not to start with ve investments as a sole
investor since they may lack the necessary ve skills and experience to invest successfully.
Just as independent venture capitalists often share risk by investing in syndicates, corporate
venture capitalists m~y try to find other investors that can offer a second opinion on the
investment target and help nurture the start-up. Companies should probably stick to a co-
investing role while ~hey are not very experienced with eve. In making co-investments,
companies may build resources that enable them to be the lead investor in investment
syndicates or to make investments without partners.

As indicated above, corporate venture capitalists can have both disadvantages and advantages
for making equity investments in start-ups. Disadvantages can include limited experience in
making ve investments and supporting start-ups, less attractive compensation schemes
leading to less motivation or a lower quality of eve managers. On the other hand, industry
expertise, technological skills or contacts to a large pool of companies worldwide may help
companies to successfully do eve. 274 Designing and managing the linkages of the
organization to the eve activity and to start-ups well, however, is essential in order to
leverage organizational resources for eve, see 2.5.3.1.

A prerequisite for doing direct investments, which are typically syndicated, is that companies
are accepted as partners by venture capitalists. Different qualities are required by venture
capitalists. , Acce!, a well-known ve firm for example, looks for a Ve-like conduct of
corporate partners, e.g., fast decision making especially as regards follow-on investments, the
highest standards of professionalism, especially around sensitive information, portfolio
company interests considered more important than parent company interests and a
cooperative reputation in the ve community (Asset Alternatives Inc., 2000: 38). In addition,
the professional set-up of eve activities is important, e.g., continuous executive support or
top talent as eve managers. Finally eve investors need a convincing eve value
proposition to help start-ups, e.g., the use of ve principles such as focusing on a top team
and corporate support.

274 Maula and Murray (2000), for example, find that enterprises co-fmanced by multiple Global Fortune 500
InfoCom corporations receive higher valuations than comparable firms supported by venture capitalists
alone.
Chapter 2: Theoretical foundation 119

2.5.2.2. Investment strategy

Like other venture capitalists, see 2.2.3.1, corporate venture capitalists need to determine an
investment strategy. The investment strategy may at least include the following elements:
management approaches for accessing deal flow, performing due diligence and
monitoring/supporting start-ups as well as a specific investment focus.

A company needs to be clear on the management approaches it uses. It has to know what it
does to generate deal flow, how it assesses investment opportunities, how it structures
investments, how it monitors and supports start-ups and how it exits investments. The ability
to carry out these different eve process activities reflects to what degree a company has
built the resources that' are critical for investing eve. These different elements of
management approaches have been discussed in the subchapters on the ve process above
and will be further discussed in the context of the eve process below. A company needs to
decide to what extent investment approaches are formally written down as policies.

Besides the management approaches, the investment focus is a major part of the investment
strategy. As for other venture capitalists the investment focus can be specified in at least
three dimensions: the industry, technologies and the development stage of the funded start-
ups. The eve investor faces the challenge of defining a specific investment focus that
enables a company to generate the targeted benefits.

Many criteria may influence the decision which industries and/or technologies a company
wants to focus its investments on. One essential criterion for deciding on the
industry/technology focus may be the relevance of certain industries or technologies for
generating strategic benefits. Depending on the targeted strategic benefits, the
industry/technology focus may be rather wide or narrow. If, for example, the targeted
strategic benefit is to 'gain insights into new developments early on' the investment focus
chosen may be rather wide. For other targeted strategic benefits, for example, 'identify and
develop new customers', the investment focus may be more narrow, for example, on
industries that sell to similar customers as the investing company. Both the wide and the
narrow focus may have some disadvantages. On the one hand, a wide focus may, for
example, result in funding many start-ups that are not relevant to the investing company. On
the other hand, a narrow focus may, for example, limit the number of potential investment
opportunities and prevent access to interesting developments that may potentially be related
to the company's core business.

When determining the investment focus, eve investors should also consider the level of
start-up activity. Fields with little start-up activity will offer few attractive investment targets
and therefore may be less attractive for eve investments. Trying to generate start-up
120 Chapter 2: Theoreticalfoundation

activity in a field with currently little start-up activity may be possible, but may be a lot more
difficult than investing in fields with a strong existing start-up activity. Further, ve support
may be hard to fmd in fields with little start-up activity, which is important at least for less
experienced eve investors. 275

An investment focus may also differ regarding to how close the targeted industries or
technologies are to the investing company's own field of activity. Kann (2001: 107) analyzes
accelerated market entry as a benefit of eve and finds that only 2% of evc programs that
invest with the strategic goal of accelerated market entry place their investments in the same
industry sector as the investor. Diversification is sometimes discussed as a strategic benefit
of evc as indicated in 2.3.2. Monsanto's move into biotechnology is an example of cve
activities supporting the move into a new field (Fischer, 1988: 441).

Companies that choose to invest in fields that are unrelated to their current business should be
aware of the difficulties of diversification. 276 Value creation through diversification, is
generally regarded as a difficult strategy. Moving into a new market with a new technology
unrelated to the company's own core competencies often does not create much value
(prahalad and Hamel, 1990). The most successful companies generally "stick to the knitting"
(Peters and Waterman, 1982: 292-305). Diversification may actually lead to lower risk
adjusted performance (Biihner, 1983). Whatever the merits of diversification are, eve does
not seem to be sufficient to enable diversification (Hardymon, DeNino and Salter 1983: 115).
Sykes (1990: 47) argues that the "use of venture capital to explore entirely new, unrelated
business areas also may be of value, but development of effective communication channels
and implementation of follow-on strategies will be more difficult because it will be more
difficult to find areas for mutually beneficial business relationships." Roberts and Berry
(1985: 11) regard the role of eve to be limited to building "corporate familiarity with the
new area." As a second step, other tools may help companies to actively move into a new
field that they have become familiar with through eve. 277

The investment stage the start-up is in determines the trade-off between opportunity, cost and
risk. Investments in relatively developed start-ups offer a higher probability that the start-up
will be successful, more certainty regarding the technologies they are using and the markets
they are serving. Therefore, investments in relatively developed start-ups offer a higher

275 See 2.2.2 for industry breakdown ofVe activity.


276 It is definitely hard to distinguish relevant from less relevant fields, especially when the dynamic
development of technology which impacts the lines between industries is considered. Silverman (1999)
analyzes the impact of technological resources on diversification and finds that a firm's technological
resource base significantly impacts diversification decisions.
277 The investment focus of a eve activity may also be viewed from a portfolio perspective, which is briefly
mentioned in 2.3.3.
Chapter 2: Theoretical foundation 121

probability that they can deliver strategic impact. On the other hand, early stage investments
are less expensive to get into and potential moves from competitive corporate investors may
be preempted. According to Yates and Roberts (1991: 15), a company "... can place more
bets for its investment dollar and learn sooner about emerging technologies and markets."
Early stage investments, however, may also need a higher level of monitoring and support,
which requires resources from the company investing. The investment stage also has an
agency cost dimension as discussed by Kann (2001: 74-76). The strengths of intellectual
property rights impacts the investment stage. Kann (2001: 104-105) finds that corporate
investors with the investment goal of external R&D that invest directly in start-ups target
investments in later stage start-ups in cases when intellectual property rights of start-ups are
weak.

2.5.2.3. Additional issues regarding the investment approach

In addition to choosing a direct or indirect investment approach and defining an investment


strategy, other structural elements of a eve fund need to be determined. Two important
structural elements of a eve fund are the fund term and the fund size. These issues are
similar to the issues other ve funds face as described in 2.2.3.1.278

Almost all ve funds have a predetermined fund term and fund size. These are based on
contractual agreements between the investor and the venture capitalists. Since the company
typically plays both roles, at least when it does direct eve investments, a predetermined
fund term and fund size may not be specified. Even if commitments are made initially when
a eve fund is set up, the company may always take back decisions since it does not have
binding contracts. The fund term and fund size of eve funds are therefore usually subjects
that are up to the discretion of top management279 and reflect the current commitment to
eve from top management. 280
Corporate commitment is typically considered as essential for success (e.g., Bleicher and
Paul, 1987: 67), and insufficient corporate commitment is often discussed as a cause of eve
failure in the literature (e.g., Gompers and Lerner, 1998: 9, Rind, 1994: 103; Winters and

278 Additional structural issues are discussed in other sections, e.g., compensation in subchapter 2.5.4.2.
279 A single dedicated top manager may provide the commitment needed to run a eve activity. At Johnson
and Johnson, for example, it was CEO and chairman Jim Burke (CEO 1971-1989) who believed in the idea
of eve. Today Johnson and Johnson's eve unit (Johnson and Johnson Development Corporation), which
was founded in 1973, is most likely the longest existing eve unit and is still very active today. Johnson
and Johnson's eve unit invested about USD 100 million in 1996 alone in 29 companies worldwide.
280 Certainly top management commitment is reflected in additional resource commitments, for example,
human resources that are discussed separately. In addition top management commitment is also reflected in
a lot of support that is difficult to quantify, for example, advice, time spent on eve issues, internal
promotion of eve, publicly communicated support etc.
122 Chapter 2: Theoreticalfoundation

Murfin, 1988: 208; Yates and Roberts, 1991: 3) Siegel, Siegel and MacMillan (1988: 239)
identify inadequate corporate financial commitment and a lack of patience of corporate
managers as some of tbe most relevant obstacles for CVC management. Inadequate
corporate financial commitment may be expressed in a small fund size and a lack of patience
of corporate managers may be expressed in tbe fund term.

Financial commitment is necessary for at least two reasons: Sufficient capital to build a
portfolio of different investments in start-ups is crucial in order to reduce risk since
statistically only a few start-ups offer significant returns. Capital is also needed in tbe long
term to be able to pr~vide follow-on financing for successful start-ups. Failing to provide
follow-on financing can seriously hamper a company's reputation among venture capitalists
and start-ups and tberefore its access to future deal flow (see 2.6.1). Companies may fail to
provide long-term financial commitment for evc. Greentbal and Larson (1983: 76) find that
when funds are scarce in an organization, cve activities are likely to be discontinued, since
they do not deliver immediate returns.

The patience of corporate managers is not only necessary because start-ups need some time
to become successful (and generate strategic and financial benefits) but also because CVC
managers need to learn their business. Siegel, Siegel and MacMillan (1988: 243) fmd
experience affects CVC investments. According to tbeir study, experienced evc managers
face fewer obstacles, perform better and have more decision-making authority than
inexperienced CV C managers. Rind (1994: 103) states that "... unless a corporation's
commitment is at least seven to ten years, its activities will generally be terminated before
any pearls can be harvested."

Commitment of top management is an important resource of CVC and may present a


challenge in the long run. Top management commitment is not only limited to capital and
time available for CVC activities but also includes other forms of top management support,
for example, tbe marketing ofCVC activities inside and outside the organization. In addition
to top management support, support from other parts of tbe organization is an essential
resource to generate strategic benefit from CVC, as discussed in the next subchapter and top
management needs to encourage cooperation from other parts of the organization (Winters
and Murfin 1988: 208).

2.5.3. Organizational linkages

Three types of linkages are relevant for CVC investments as shown in Figure 2-17 and
discussed in 2.5.3.1 and 2.5.3.2. First, the CVC management needs to be in touch witb the
external world in order to generate deal flow, interact with start-ups etc. These linkages are
discussed in 2.6. Second, the CVC activity needs to be integrated into tbe existing
Chapter 2: Theoretical foundation 123

organization. eve activities depend on support from the organization for setting up and
running eve. For example, the organization needs to determine objectives and support the
due diligence process. In addition, eve needs to be positioned inside the organization.
Finally, the organization needs to be in touch with start-ups directly since strategic benefits
need to be realized within the existing organization and this requires direct interaction with
start-ups. In addition, the organization also needs to provide support to start-ups. The
support of eve activities by the organization and the linkages of the organization to the
outside world are discussed in 2.5.3.1. The positioning of eve inside the organization is
discussed separately in 2.53.2. 281

All types of linkages are based on company resources and present significant challenges for
eve investors.282 In the following section, the role of these linkages to the organization is
discussed further and some approaches are suggested as to how linkages may be designed
and managed. 283

Figure 2-17: Linkages of eve, the organization and the external world

,/~::ernal ~:;i~\
! . Start-ups \
'''Venture /
I capitaJists ,/
Universities ,:
l;..:::=::::;;;;::::=::::......l Etc. \

3. Linkage:
Realize strategic
benefits and provide
resources for start-up

281 Apparently, neither the second nor the third linkage are relevant for venture capitalists. A venture capitalist
typically has neither strategic objectives nor is s/he part of a larger organization with business activities
outside VC investing. Further, the relationship of venture capitalists with their investors is determined
through a contractual relationship.
282 One reason for this is the cultural gap that may exist between start-ups and established companies, for
example, see Niederkofler (1989: 101-102).
124 Chapter 2: Theoreticalfoundation

2.5.3.1. Role ofthe organization in the Corporate Venture Capital process

Although the role of the organization in eve has not received a lot of recognition in the
literature so far, it is essential as explained in the following section. 284 Strategic benefits of
eve need to be realized within the organization to create strategic advantages for the
investing company. Depending on the targeted benefits, different parts of the organization
including business units, top management and R&D may need to build resources like
knowledge, skills or business relationships.285 Most strategic benefits, e.g., extending market
reach through cross-selling relationships, cannot be realized by the eve unit. Even the few
strategic benefits that ~ay be realized by the eve unit, e.g., building market knowledge,
need to be leveraged by other parts of the organization in order to be strategically valuable.
Therefore, a company that targets strategic eve benefits needs to ensure that the
organization is able to realize these benefits.

At the same time, the organization is critical in running eve as different parts of the
organization need to actively support the eve activity. They need to provide resources that
enable investments in start-ups. A business unit, for example, may specify what fields it is
interested in. R&D may need to support the due diligence by assessing a technology. In
addition, the organization also needs to provide resources to support start-ups such as, for
example, sales support. Figure 2-18 describes these relationships in a little more detail.

Companies that want to start and run eve activities need to be aware of these roles of the
organization in running eve and realizing strategic benefits. Companies face a major
challenge when trying to involve the organization in the eve process. It is challenging to
organize eve activities in a way that the organization provides support to eve activities or
start-ups, and realizes strategic benefits. This becomes apparent when potential sources of
conflict for involving the organization in eve are considered, as indicated in Figure 2-19.

283 The linkages described may be designed differently for indirect and direct eve investments. Especially the
first linkage of the eve management to the external world will require less effort for indirect investments.
In both cases, however, managing the linkages is necessary and presents an important challenge for
companies.
284 One exception is Hundertmark, Fahlbusch and Brunner (2000) who analyze how the relationship of
corporates and portfolio companies impacts the strategic benefits from eve based on network theory.
285 See 2.3.2 for a detailed discussion of eve benefits.
Chapter 2: Theoretical foundation 125

Figure 2-18: eve benefits for and support requirements from the organization

eve provides Gain insights into new Gain insights into new Get insights into new
benefits ... technologies and technologies and market technologies and market
market developments developments developments
Introduce potential ' Support continuous wake- Provide contacts to
partners up call potential research
partners
Identify licensing
opportunities
.. , but needs Identify areas of interest Provide direction and Identify areas of interest
support to Support due diligence on support eve activities for Support due diligence by
capture stra- market and technology the long term assessing technologies
tegic value Realize alliance Ensure appropriate Support startups with
opportunities involvement of the information on
Provide channell organization technological
technical suppcrt to start- Manage potential developments
up conflicts and e,ipectations
between business units
and with eve

Figure 2-19: Sources of potential conflicts about eve activities

Inadequate internal visibility,


reputation or network
High attrition rate

t__...J~tisfactOryWOrk
Limited trust in R&D or BU skills
/ L __

Business uni's II L _T_o_p_m_a_na_g_em_e_n_'---.J


R&D/Business
Development

Notinvented~here Changes in top Not~invented-here


syndrome management syndrome
Timing of deals does not Near-tenn P&L Competition for
fit business needs pressure budgets
Weak understanding of
financial implications of
deals
Lacking incentives
High risk but low
revenue in cooperation
with start-ups

The cooperation of the eve unit with the rest of the organization may be difficult and
conflicts may arise. A lack of communication, a limited understanding of eve, competition
126 Chapter 2: Theoreticalfoundation

for budgets or the Not-Invented-Here syndrome286 can be reasons for these conflicts as
shown in Figure 2-19. Companies that want to start eve activities need to analyze what
organizational linkages are necessary in order to reach the targeted eve benefits. If a
company is not certain that the necessary organizational linkages can be built, it should
reconsider whether it wants to do eve at all.

Sykes (1990: 37) identifies the type and frequency of communication with start-ups as a main
factor influencing strategic value. "Modes of communication that involve direct and frequent
contact between the c~rporation and the venture regarding areas of special or mutual interest
produce the highest strategic value." Sykes (1990: 44) further states that " ... the most
valuable communication was at direct working relationship meetings with individuals in the
ventures, rather than at board meetings." Routine contacts and communication, such as
periodic reports by the ventures on their activities and attendance at board meetings, were not
found to deliver significant value. (Sykes, 1990: 42) The cooperation that Sykes proposes
requires not just the regular involvem,.ent of business units and other parts of the organization
but also needs to include actual working relationships between start-ups and relevant parts of
the organization.

A company should consider the necessary linkages to the organization when it starts eve
activities. Processes should be installed that lead to cooperation between the organization
and the start-ups. A possible process to involve the existing organization in eve activities is
shown in Figure 2-20.

As indicated in Figure 2-20, the eve management needs to ensure that the different parts of
the organization, especially individual business units, are involved in eve and keep close
contact witJ1 the funded start-ups and work on building potential business relationships.287
This may be done with the help of a four-step process: in a first step, the eve management
should identify the interests of the organization and discuss the deal flow. eve objective
setting should be included in this first step as well as a discussion on which specific benefits
should be realized by what part of the organization in order to meet the objectives. In a
second step, the eve management may involve the organization in due diligence. In a third
step, the eve management should involve relevant parts of the organization in the
interaction with start-ups and then update these on the development of the start-ups in a
fourth step.

286 See, for example, Mehrwald {I 998) for a discussion of the Not-Invented-Here syndrome.
Chapter 2: Theoreticalfoundation 127

Figure 2-20: Involving the organization in eve

What fields and


How does the startup technologies are the
perfonn? business units
What implication does interested in?
the experience from What start-ups!
interacting with start- technologies exist in
ups have for the the relevant fields?
organization?

How can the


organization benefit
strategically from
interacting with the promising?
start-ups? Which start-ups are
How can business most interesting
relationships be strategically for the
implemented organization?
successfully?

Some other design elements of eve may help strengthen organizational linkages and
therefore increase the likelihood of success and limit the probability that conflicts will arise.
First, the compensation of eve managers may be partially based on an evaluation by
business units and R&D. This evaluation may include the strategic value that eve is able to
deliver to the business unitslR&D or how responsive eve managers are to business
unitIR&D needs. (See 2.5.4.2) Such a compensation element could give eve managers
incentives to organize eve in a way that increases the likelihood of realizing strategic
benefits. As further discussed in 2.5.4.2, such a compensation element may not be
compatible with an existing corporate culture and therefore may not be feasible for all eve
players.

Another way to use compensation to strengthen organizational linkages is to provide personal


incentives to those people from the organization that support the eve activity. For example,
a part of the bonus payments to employees who were directly involved in eve activities
could be based directly on their support of the eve activity or start-ups. Furthermore, key
executives from those parts of the organization that are supposed to support the eve activity

287 When dealing with start-ups, especially when putting them in touch with the organization, eve managers
should always be aware of the differences in culture that may exist between large companies and start-ups.
This difference in culture was identified as one key obstacle for eve management by Siegel, Siegel and
MacMillan (1988: 239).
128 Chapter 2: Theoretical foundation

may receive a share of the fmancial returns from eve. Business unit managers, for example,
may be awarded a carried interest in the eve fund or may have the opportunity to invest in a
side-fund that co-invests with the eve fund. Such a share of the financial returns from start-
up investments may also be paid to the relevant business unit, positively impacting the profit
and loss statement of the business unit.

In addition, an organization may be able to strengthen the linkages to the eve fund by giving
responsibility for linking eve and business unit activities to dedicated people within the
business unit. A manager within a business unit may be responsible for exchanging
information between the eve unit and the business unit, for arranging contacts from the
business unit to s~-ups and for coordinating cooperation. In addition or instead of a
business unit specific employee, the company may also have a start-up specific primary
contact person to coordinate the interaction with one or several start-up.288

Besides compensation and people-based ways to strengthen linkages between the


organization and the eve activities, a company may also create a dependency between the
two. Top management may allow business unit investments into start-ups only through the
eve program, which could help to ensure the cooperation of eve managers with business
unit personnel based on a give and take relationship.

Finally, eve may be promoted internally. Top management may need to ensure the
visibility of and support for the eve activities (see 2.5.2.3). Employees need to know that
eve is not one of many projects but a major issue for the organization.
The design elements discussed above neither lead necessarily to the intended results nor do
they represent a complete list of potential design elements to support the organizational
linkages necessary for doing eve. 289

Additional design elements for making eve successful are discussed in the following
subchapter. The possible interaction of start-ups and the organization is further discussed in
2.6.4.

2.5.3.2. Positioning of Corporate Venture Capital inside the organization

The positioning of a eve activity inside an organization defines the formal linkage of the
eve activity to the organization. The formal positioning, however, may have significant

288 Sykes (1990: 46) does not fmd any correlation of where the primary contact person is located within the
organization and strategic success. According to Sykes, a spokesman for one of the most successful
programs, however, suggests that the primary contact person should be "a high-level person with broad
contacts throughout the corporation and credibility with both top and operating management."
Chapter 2: Theoretical foundation 129

impact on the infonnal linkages of eve to the organization that are discussed above and
therefore impact the success of eve activities to a large extent.

A eve activity has several components that may be located in different parts of the
organization. Three major components of a eve activity are: first, technical ve tasks, e.g.,
generating deal flow or designing investment contracts, then decision processes for
detennining which start-ups are funded, finally internal coordination of objective setting,
support and benefit realization. In the following section, when the position of eve activities
eve activity. Some of the
is discussed, all these comppnents are considered as a part of the
eve components, however, may be separated from the other eve components leading to a
differing level of indepeJ,ldence of eve activities. The funding decision process, in
particular, may be to some degree separated from other components of the eve activity.290

A company needs to decide where eve activities should be located inside the organization.
Four possible positions of eve inside the organization are: as a part of a single business unit,
as a part of corporate business development, as a separate unit beside business units or as a
legally independent entity.

Several issues may influence the decision where eve is positioned within an organization.
Five issues are discussed in the following section. The first issue concerns which part of the
organization is supposed to realize benefits from eve. If a single business unit is supposed
to realize the benefits of eve then it makes sense to position the eve activity within this
business unit. If several business units are supposed to benefit from eve, then eve may be
better positioned outside a single business unit.

The second issue is the Willingness of the organization to support eve depending on its
position inside the organization. As discussed in 2.5.3.1 and further discussed in 2.6.2 and
2.6.4, the organization plays a significant role in supporting eve activities. The willingness

289 The literature on knowledge management may also provide valuable insights on how to ensure
organizationalleaming, e.g., Leonard-Barton (1995: 155-175).
290 The independence of eve managers to make funding decisions may be limited for different reasons. One
reason may be to ensure a strategic focus of eve investments. A decision on strategic relevance may be
partially or completely based on the assessment of people outside the eve management. When the
independence of ve managers is limited, this should not negatively impact the ability to respond quickly to
opportunities. Fast decision making is a challenge for eve investors. Venture capitalists and start-ups
demand fast responses from their co-investors and investors. For example, follow-on financing rounds are
expected to be supported if a start-up meets its milestones. This may require that eve managers are able to
make funding decisions independently. (Greenthal and Larson, 1983: 77) A lack of authority to make
independent decisions was identified as one of the key obstacles to eve management by Siegel, Siegel and
MacMillan (1988: 239). They find that 51 % of all eve managers need to get approval for every single
deal, which is based on thorough evaluation. Another 15% need to get such approval for all deals above a
designated size. For only 26% of all eve managers is getting approval not required or required but
typically a formality. (2% did not respond; Siegel, Siegel and MacMillan (1988: 241 ).)
130 Chapter 2: Theoreticalfoundation

of certain parts of the organization to provide such support may vary according to the
position of the eve activity within the organization. A positioning within a single business
unit may spur the support from this particular business unit but may limit support from other
business units. The other extreme, positioning eve in a legally independent entity may limit
the willingness of all business units to support the eve activity.

The third issue that impacts the position of eve within the organization is the ability to build
ve skills and act as a venture capitalist. The ability to hire ve experts and to motivate eve
managers, for example through ve like compensation models291 , may be greater when eve
activities are organized in an independent legal entity since the current culture of the
organization may not be compatible with the culture of venture capital companies.
Furthermore, an independent legal entity may increase the likelihood of financial success by
putting more emphasis on financial issues when funding start-ups. Business units may put,
for example, more emphasis on technology issues than on potential financial success. 292 In
addition, the limited experience of business units with managing start-ups may lead to a
reduced probability of success (Greenthal and Larson, 1983: 76). Different authors favor the
independent legal entity, e.g., Winters and Murfin (1988: 218). Siegel, Siegel and MacMillan
(1988: 233) argue that "[t]he corporate venture fund should be established as an independent
entity and should have access to a committed, separate pool of funds. This will enable
corporate venture capitalists to respond aggressively to, and manage, investment
opportunities with minimal corporate interference."

The fourth issue that may impact the position of eve within an organization is the potential
acceptance of eve outside the organization. A better acceptance of eve activities outside
the organization may help to increase the number of attractive investment opportunities. A
separate legal entity may increase the acceptance by external venture capitalists and start-ups
since an independent legal entity, for example, may be able to decide faster on funding start-
ups and may be focused on financial results to a larger extent than eve activities inside a
company. As discussed above, however, a separate legal entity may lead to less acceptance
of eve within the organization.

The fifth issue that may impact the position of eve within an organization are legal and tax
considerations. 293 A legally independent entity may for example limit the exposure of the
company to financial risk. Based on the five issues above, a company needs to decide which
position of eve within the organization best fits its own objectives and situation.

291 See 2.5.4.2 for a discussion ofCVC compensation.


292 Financial success, however, may be a prerequisite for strategic success as indicated in 2.3.2.
293 See, for example, Cooke (1996) or Schilppen (2000) for further discussions of legal and tax issues.
Chapter 2: Theoreticalfoundation 131

Related to the position of eve within an organization is the reporting relationship. A


company that does eve needs to decide, to whom the eve management reports. This
depends to some degree on the position of eve within the organization. If eve, for
example, is a part of the business unit, the eve management will most likely report to the
business unit management. If eve is organized in a separate unit or as an independent entity
reporting may be done to an executive committee with members from different parts of the
organization or to the board of directors, possibly also depending on the type of information
that is reported. Greenthal and Larson, (1983: 76) regard the eve management's position
and reporting reiationshipZ94 as a key factor of success of corporate venturing. Whomever
the eve management reports to should be able to defend eve activities against potential
internal critics and to support these in the long run since eve benefits may not be realized
quickly based on the natute ofVe investments and how experience affects doing eve.

2.5.4. Corporate Venture Capital staffing and compensation

People are an essential resource for doing eve and the same is true for the compensating
systems that help to attract and retain these people. While all the people involved in a eve
activity are important, the leader or leaders of the eve activity should have a very diverse set
of skills and experience as discussed below. 295 These leaders of a eve activity are called
eve managers in this study. Finding eve managers (2.5.4.1) and compensating them
(2.5.4.2) represent two major challenges for companies active in eve.

2.5.4.1. Staffing Corporate Venture Capital managers

As indicated above, the eve manager is an important resource for a company that wants to
do eve activities. eve managers need to coordinate activities in two different
environments the ve and start-up world as well as the corporate world. Staffing eve
managers is an important but difficult task. Greenthal and Larson (1983: 76) call staffing
critical for success. Siegel, Siegel and MacMillan (1988: 239) identify the inability to attract
qualified eve .managers as one of the key obstacles to eve management. Winters and
Murfin (1988: 208) identify the use of outstanding people as an essential factor of success. A
eve manager should have a mix of at least three sets of skills/background: first, ve skills
and experience, second, corporate experience and a network inside the company and third,

294 Greenthal and Larson, (1983: 76) fmd that establishing a direct reporting relationship between the eve
management and a powerful senior corporate executive helps to ensure the commitment of the corporation
to eve.
295 Other people that are involved in a eve activity may also need very specific skills and experience. In
contrast to the leaders of a eve activity, they may be specialists with a strong background in certain skill
areas and a less strong background in others.
132 Chapter 2: Theoretical foundation

relevant technology andlor market expertise and a suitable personality. These three sets of
skills are described in Table 2-18. 296

Table 2-18: eve managers' ideal skill sets


Financial and managerial VC skills and experience and a network among venture
capitalists and start-ups are needed in order to be able to do the VC tasks involved e.g.:

Monitor and nurture start-ups: be able to recognize patterns to determine probability


of success, use milestone-based funding approach etc.
Have access to deal flow and entrepreneurs through a network in the VC and start-up
community.
Do financial structuring and transactions: determine appropriate pricing, conduct
negotiations, leverage relationships with investment bankers for initial public
offerings. ~IPO) and develop term sheets.
Corporate experience and a network inside the company are essential to be able to
leverage the organization and to deliver strategic value, e.g.:

Understand business unit needs.

Present relevant deal flow to business units.

Mobilize business unit support for due diligence.

Encourage the development of business relationships and technological support
between the company and funded start-ups.
Keep the organization updated on new trends.
Ensure long-term top management support.
Relevant technology andlor market expertise and a personality that permits a high
standing internally and externally are necessary to become a part of the VC and start-up
network e.g.:

Have deep understanding of technologies and markets in own field of activity to


become accepted partner for venture capitalists and start-ups.
Network externally to be part of VC deal flow and to be approached by start-ups
directly.
Gain support for CVC activity internally and foster cooperation among parties
involved in CVC.

The combination of corporate network and experience as well as VC skills and experience is
rare. Few company employees will have any significant VC experience from prior jobs. On
the other hand it is almost impossible to hire back employees that have left the company to
join venture capitalists if these employees have been successful. Figure 2-21 shows the
combination of corporate and VC skills that potential CVC managers may have.

"Champions" have an ideal skill set for making CVC investments since they have corporate
experience and a corporate network as well as VC skills and experience. As explained above,
however, "Champions" are either very rare or very difficult to hire. Corporate employees

296 The information in Table 2-18 was gathered from preliminary interviews with practitioners.
Chapter 2: Theoretical foundation 133

may grow to become "Champions" over time if they acquire relevant VC skills and
experience.

Figure 2-21: Different skill sets of eve managers

Inside! Champion
Lacks VC skills Ideal skill set
Possible to find Almost impossible to find
Available
Re{Juires significant Requires significant
compensation and compensation and
independence to retain independence to retain
Corporate after acquiring VC skills
experience
and network No Match VC Specialist
.. Not an option Lacks understanding of
strategic requirements
Hard to find
Not Requires significant
available
compensation and
independence to retain

Not available Available

VC skills and experience

"vc Specialists" are suggested as the appropriate staff for CVC management by several
authors (e.g., Greenthal and Larson, 1983: 78; Siegel, Siegel and MacMillan, 1988: 233).
Sykes (1990: 46), on the other hand, does not find a correlation between the years of venture
capital experience of the corporate program managers and strategic value. 297 One reason for
this may be that external venture capitalists lack the understanding of the strategic
requirements the company has which are necessary to realize strategic benefits. The lack of
understanding might also limit the acceptance of the CVC manager internally. This
understanding is hard to acquire since it can only be built through a network to key personnel
in the business units. It is questionable if an external ex-venture capitalist will be able to
build such a network, and, moreover, it is difficult to hire an external VC into the
corporation. This would probably require at least the same compensation as venture
capitalists get externally plus a similar degree of independence.

The "No Match" is not an option.

Therefore the "Insider" remains as the most feasible person to become a CVC manager.
Even an "Insider" may be hard to attract, since good people often want to stay in the

297 Based on 31 survey responses. Strategic value was determined through a five-level rating (-I, 0, + I, +2,
+3) by corporate respondents measuring their perception of the overall strategic value of the eve program.
134 Chapter 2: Theoreticalfoundation

mainstream corporate track (Rind, 1994: 103). The organization must offer a potential eve
manager from inside sufficient incentives to make him join. Since s/he lacks the fundamental
ve skills, it will be necessary to leverage external venture capitalists to a large extent to
make up for this deficit, at least in the beginning until the "Insider" picks up ve skills over
time. Hiring a "ve Specialist" to support the "Insider" with ve skills may be a second
option to compensate for the ve skills the "Insider" lacks. While this may cause problems
for the reasons stated above, it may be possible to hire a somewhat experienced associate
from a ve firm to help compensate for the ve skill deficit.

Over time, the "Insider" will acquire ve skills from observing how venture capitalists do
deals and through learning from participating in deals more or less actively. This may take
some time and may l~ad to less advantageous conditions in some deals. When an "Insider"
ve skills, this is positive for the eve operations but presents a challenge to retain
acquires
him/her within theeve unit. If a eve manager has the intrinsic motivation to stay with the
company, retention is less of a problem. If eve managers do not have such intrinsic
motivation, two options exist for how a company can deal with the retention problem. First,
a company may accept a certain attrition rate and keeps building up internal personnel to
continue to do the eve management job when eve managers leave. This has the
disadvantage that the company loses a highly skilled and networked employee. In addition,
this employee might not act in the best interest of the company but rather maximizes his/her
personal reputation or experience when s/he knows in advance that s/he wants to leave at
some point. As a second option, a company may choose to compensate the eve manager in
a similar way to an independent ve and give himlher a similar degree of freedom (see
2.5.4.2).

As mentioned above, the third required set of skills for eve managers is expertise and a
personality that enables himlher to gain a high standing internally and externally. Although
this advantageous skill set may make it even harder to find the right eve managers, it can
probably be found among corporate staff and venture capitalists.

2.5.4.2. Compensating Corporate Venture Capital managers

It is not only difficult to identify potential eve managers, as discussed above, it is also
difficult to compensate them in a way that helps to attract and retain them in a eve activity.
The compensation systems that help to attract and retain people are a critical resource of
eve. Two basic options exist to compensate eve managers: compensation with or without
a significant, performance based bonus in cash or equity.

Many authors regard compensation as critical for success and suggest compensating eve
managers with a significant, vested, performance based bonus. This rewards them like
Chapter 2: Theoretical foundation 135

independent venture capitalists and serves to attract top quality people. (E.g., Greenthal and
Larson, 1983: 79; Siegel, Siegel and MacMillan 1988: 233) As discussed in 2.2.3.1, venture
capitalists usually receive an equity stake, a carried interest of about 20% of the realized
financial returns which is distributed to partners and managers involved in the fund. Other
authors do not find that compensation influences success (e.g., Block and Omati, 1987: 41).

In the past, the number of eve managers compensated for performance has been limited.
Siegel, Siegel and MacMillan (1988: 241) find that more than one third of all eve managers
receive a fixed base salary only (34.1%). Almost another third (29.4%) get an additional
bonus that is based on eve performance over the short term. 13.7% receive a bonus that is
based on eve long-term performance (over 5 years) and only 9.8% are given a direct equity
participation. 298 This shows that only about a quarter of all eve managers get compensated
for long-term performance. In addition, it is not clear how significant the variable,
performance-based share ofthe compensation is in relation to the fixed salary.

Table 2-19 shows the advantages and disadvantages of Ve-like compensation of eve
managers by comparing it to compensation that is in line with the peer group, meaning
managers on the same hierarchical level as eve managers.

Table 2-19: Comparison of compensation options


Compensation of CVC VC-Iike compensation of CVC
managers in line with peer managers
group
Advantages Easy to set up Retention of top people
No internal conflicts on Motivation to create financial
compensation success
Challenges Retention of top people Potential internal conflict
Lack of motivation to achieve top Trust and cooperation from BUs
financial performance
Possible Hire people who don't have Separate eve activities from rest
solution aspirations to become venture of organization
capitalists and who are not solely Strategic value delivered to BUs
motivated through high should influence a visible part of
compensation the overall compensation
Prepare for a certain level of May work well as long as BU
attrition heads get compensated
May work well if people involved comparably with eve managers
already get compensated very well
with stock options of corporation

298 15.7% did not respond.


136 Chapter 2: Theoreticalfoundation

The major advantage ofVe-like eve manager compensation is that it may help to retain top
talent. 299 The main disadvantage is that it may create internal conflict. If a company
decides, however, to pay performance-based compensation it should decide carefully on what
type of performance. A company that tries to achieve strategic benefits should not only use
financial returns as a basis of performance-based compensation even if financial performance
is easily calculated. See 2.5.5 for a further discussion of how strategic benefits may be
measured.

Both models described above may attract and retain excellent eve managers. Which model
works better for a specific company depends to a large extent on the existing corporate
culture and compensation schemes in other parts of the organization. A significant
performance bonus may fit well in a dynamic high risk and high reward culture. In such an
organization the peer group of eve managers might very well get similar compensation to
venture capitalists. A culture that is based on fun in the job, cooperation, low risk and limited
personal rewards might not need a ~gnificant performance bonus. There is, however, a lack
of empirical research that can support these hypotheses on the effects of different
compensation systems. 300

2.5.5. Corporate Venture Capital monitoring

Monitoring eve activities is critical in determining whether objectives are met and how
eve activities may be improved. A monitoring system that allows the determination of
eve success and the improvement of eve activities is a valuable resource. Developing this
resource may present a major challenge to companies. Little research has been done on
measuring the strategic success of eve, therefore more general discussions on measuring
success wiJI be referred to.3 1

A monitoring system may measure two types of resources: the resource input - the eve
process - and the resource output - the eve benefits. While success can only be determined
by measuring the results and therefore the benefits generated through eve, measuring the
resource input - the eve process - may also provide valuable insights. Monitoring the eve
process could provide three advantages: first, by monitoring the eve process, a company
may be able to find out whether the process is actually run as intended. This includes issues

299 For example, GEVENCO, GE's cve arm, did not offer performance rewards. Between 1979 and 1983 the
principal VC specialist, the president and three vice presidents left GEVENCO to join venture capitalists.
(Hardymon, DeNino and Salter, 1983: 120)
300 The principal-agent problem discussed by Jensen and Meckling (1976) as well as the literature on incentives
in general may provide additional insights into the problems discussed. Sykes (1992) discusses the
compensation of internal ventures, contrasting the two options equality vs. equity.
301 Also see 2.8 for a summary of the discussions on success measures in the literature on CVC.
Chapter 2: Theoreticalfoundation 137

like the following: is the investment activity as high as planned in terms of number of
investment and capital invested; do the funded companies match the defined investment
focus; does the organization provide the intended level of support to the eve activity. If a
company realizes that the eve activity does not meet the targeted levels, it will be able to
react to this. The second advantage of monitoring the eve process is that a company may
not be able to realize eve benefits for a certain period of time since generating benefits takes
some time. As long as benefits cannot be determined, monitoring the process at least
provides some guidance on the progress of the eve activity. Finally, knowing the eve
process well may provide insights into why benefits are generated or not as soon as a
company finds out about which targeted benefits actually have been realized or not. Given
these advantages of monitoring the eve process, a company should invest in designing a
monitoring system that allows the monitoring of resource inputs in the eve activity.

A company doing eve should monitor the success of its eve activities. This will enable it
to judge whether the eve activity needs to be adapted and whether eve is worthwhile at all.
Measuring the success of eve includes measuring financial and strategic results. Measuring
fmancial results can be done in the same way venture capitalists measure success, by
calculating the internal rate of return (IRR) or other measures.3 02 Measuring strategic results
is more difficult (e.g., Berger and Dordrechter, 1998: 90; Siegel, Siegel and MacMillan,
1988: 241). The literature offers little specific suggestions on how to measure the strategic
success of eve. 303 Greenthal and Larson (1983: 77), for example, only state that controlling
mechanisms should be tailored to the eve programs unique operating needs. Neverthdess,
some authors stress the importance of eve monitoring, e.g., Berger and Dordrechter (1998:
43) or Schween (1996: 104).304

The literature on performance measurement may help to develop a comprehensive


monitoring system for measuring eve success. Like the outcomes of eve, the outcomes of
innovations are very uncertain and often difficult to quantify. Therefore, the discussions on
the measurement of innovation success may be helpful in determining the success of eve.
Hauschildt (1997: 381-420) or Gerpott (1999: 69-98), for example, discuss ways of
measuring the success of innovations. Hauschildt defines five basic questions that need to be
answered as the basis for designing an approach to measure the success of innovation. What
is the object that should be measured? What are the characteristics of the object that
determine success? When should the success (of the innovation) be measured? What will be

302 See 2.2.2 and 2.2.3.6.


303 Also see 2.8.
138 Chapter 2: Theoreticalfoundation

used as a reference to compare (innovation) success to? Who should determine (innovation)
success? In the strategy literature, Kaplan and Norton (1992: 71-79) introduce the concept of
the balanced scorecard as a planning and to some degree controlling approach.3 05 The
balanced scorecard translates abstract missions and strategies into specific goals and
measures. Such an approach may also help to operationalize the abstract objectives of
eve. 306
A prerequisite for measuring the strategic success of eve is that the targeted strategic
benefits are formulated, see 2.5.1. In addition, it needs to be determined up front in what
parts of the organization the benefits of eve are supposed to be realized, see 2.5.3.1. These
basic decisions will at least help to determine what needs to be measured and where it should
be measured. Beyond this, however, there are many open issues regarding the development
of a monitoring system. For example, it needs to be determined whether eve success can be
measured based on objective quantitative figures. The generation of several eve benefits
can possibly only be measured based on subjective evaluations. 307

2.6. Process of running Corporate Venture Capital activities

Once a eve program is set up, the eve management has to run the eve activities and
invest in start-ups just like any other venture capitalist. As already discussed in 2.2.3,
investing in start-ups includes five major tasks: generate deal flow (2.6.1), assess investment
opportunities (2.6.2), invest (2.6.3), interact with start-ups (2,6.4) and exit the investment
when appropriate (2.6.5). In addition, all these activities need to be monitored (2.6.6).
Running these activities by building and leveraging ve abilities are important eve
resources. Both, building ve abilities and leveraging them represent significant challenges
for companies, as discussed further below.

Figure 2-22 gives an overview of the activities in each process step. The following
discussion will focus on issues that are specific to corporate venture capital. In particular, the
challenges that corporate venture capitalists face will be emphasized. For a detailed
discussion of the process steps of running eve see 2.2.3.2 to 2.2.3.6.

304 There is little infonnation on how many companies have made an effort to design success measures for
eve. Schween (1996: 174) finds that 11 of 12 Gennan companies doing eve have no criteria defined to
measure the success of eve.
305 The concept of the balanced scorecard is further developed by Kaplan and Norton (1993), (l996a) and
{I 996b). It is also discussed by other authors, e.g., Epstein and Manzoni (1998).
306 In addition to the literature discussed, other authors also discuss success measurement from a practical
perspective, e.g., Simons, DavviJa and Kaplan (2000), Smith (1999).
307 Subjective evaluations are typically used to detennine the success of eve in eve surveys, e.g., Siegel,
Siegel and MacMillan (1988), Yates (l991).
Chapter 2: Theoreticalfoundation 139

Figure 2-22: Activities of running eve - Investing in start-ups

Generate deal
now

Identify potential Due diligence: Price and negotiate Monitor and Regularly check
deals, e.g., through Assess tenus support start-up financial and
networking, active management team, Design contract development strategic success of
searching or product-market based on legal Realize strategic investment
building reputation concept, potential considerations benefits (build Of Make exit decision
value generatio~, Find co-investment impact resources) based on financial
etc. partnersl1ead by ensuring and strategic
Assess strategic investors interaction of start- considerations
relevance, up with relevant
especially whIch business units and
strategic benefits building business
may be realized relationships
(which re;;ources
built or impacted)
Leverage
organization for
due diligence

If a company uses indirect investments through an independent ve fund, the activities


described in detail below need to be done to a much lesser extent by the company (see also
2.5.2.1). Instead, the venture capitalists will do a major part of these activities. While a
company can still try to generate its own deal flow when doing indirect eve, the ve is
primarily responsible for this. The company may still support the assessment of investment
opportunities to some extent, mostly by evaluating the start-up technology or market.
Depending on the agreement with the ve, the company may have the right to reject investing
in deals. More likely, however, the ve will make investment decisions. The interaction with
the investee should be as extensive as for direct ve investments since the strategic value of
eve investments are primarily realized in these interactions. The ve typically takes
responsibility for exiting indirect eve investments and the company is not heavily involved.
Although the ve may be responsible for most of the eve investment activities, the company
should try to participate actively in all parts of the investment process if it wants to acquire
ve skills.
As indicated above, the abilities that are necessary to run the eve investment process are
valuable company resources. Building and leveraging these resources may represent major
challenges to companies that want to do eve. These challenges are discussed in the
following subchapters and are summarized in 2.7.
140 Chapter 2: Theoreticalfoundation

2.6.1. Generation of deal flow

Deal flow is the term venture capitalists use to describe their access to potential investment
opportunities as discussed in 2.2.3.2.308 Like other venture capitalists, corporate venture
capitalists need to generate deal flow. The ability to generate deal flow is an essential
resource since deal flow is the basis for any investment. An investor that does not have
access to the best investment opportunities will not be able to perform as well as investors
who can choose from among the best deals. Winters and Murfin (1988: 208) identify a high
quality deal flow as the most important success factor ofCVC. Companies face challenges to
build the ability to generate deal flow. This includes the challenges other venture capitalists
face as well as CVC specific challenges.

In 2.2.3.2, three ways are described in which venture capitalists can generate deal flow: First,
venture capitalists may do some basic marketing or rely on their image and reputation and
wait for start-ups to contact them. Then, venture capitalists may actively search for deals
themselves, for example, at conferences. Finally, venture capitalists may network with
professionals, incubators or other people and institutions that have access to deals. An
additional source of deal flow for CVC investors may be their own organization. Employees
may know of investment opportunities and business units may already work with potentially
interesting start-ups.

Just to do marketing and wait for deals is not an option even for well-known and highly
respected venture capitalists and it is not sufficient for corporate venture capitalists either.
Therefore corporate venture capitalists also need to actively search and network in order to
generate sufficient high quality deal flow.

Corporate venture capitalists may have advantages over other investors when generating deal
flow since they can probably offer access to resources that are valuable to start-ups like
industry contacts, sales channels or technological competencies. 309 Corporate venture
capitalists, however, also face potentially significant challenges when they try to generate
deal flow, especially when a company has little experience and reputation in the VC and
start-up world. The corporate venture capitalist's attractiveness to start-ups and to other
venture capitalists as an investor or co-investor may be limited for the following reasons.
First, corporate venture capitalists may not be as attractive to start-ups as other venture
capitalists. Start-ups may not trust in the corporate venture capitalist's ability to provide

308 As for other venture capitalists, deal flow does not only consist of business concepts. A lot of identified
deals may be later stage deals that have already received funding and are up for a new round of financing.
Chapter 2: Theoreticalfoundation 141

necessary business-building support. They may also fear a conflict of interest since
companies providing venture capital have their own business interests that may conflict with
start-up interests. As a specific case of conflicting interests, start-ups may also fear that
corporate venture capitalists may try to acquire the start-up. This however, may also
represent an attractive exit option for start-ups. Understanding start-up needs may help
companies to design eve activities in a way that is attractive to start-ups. Rind (1994: 103)
discusses what start-ups shOUld expect from corporate investors, e.g., longevity, experienced
people running eve, adequate funds available, a long investment time horizon and
flexible/fast decision making.

In addition to the potentially low attractiveness of corporate venture capitalists to start-ups,


corporate venture capitalists may also not be attractive partners for other venture capitalists
for similar reasons)10 Just like start-ups, venture capitalists may fear that corporate venture
capitalists may not have the right skills and objectives to support start-ups. Moreover,
venture capitalists may fear that corporate venture capital operations will shut down early and
therefore they cannot be relied on as partners. 311 The lack of attractiveness of corporate
venture capitalists to start-ups and venture capitalists may be a major challenge for generating
deal flow since start-ups and venture capitalists represent the major source of deal flow for
corporate venture capitalists as discussed in the following section.

Siegel, Siegel and MacMillan (1988: 242) identify three significant sources of deal flow for
eve investors: venture capitalists (34.6%), direct contact with entrepreneurs (28.8%) and
departments of the company (25%). There are different opinions in the literature whether the
utilized sources of deal flow correlate with the success of the eve activity. Sykes (1990: 46)
finds that different deal flow sources do not seem to deliver a different quality of deal flow.
Yates and Roberts (1991: 33) on the other hand determine venture capitalists as the primary
deal flow source of top performers (48%). Bottom performers generate their primary deal
flow in-house with venture capitalists only being the second most important source of deal
flow (24%).

Venture capitalists can either deliver deal flow in the context of a limited fund the company
has invested in or as part of a potential syndication, where the company co-invests with other
investors. Sykes (1990: 45) finds that the importance of venture capitalists as a source of

309 As already indicated in footnote 274, Maula and Murray (2000) find that enterprises co-financed by
multiple Global Fortune 500 InfoCom corporations receive higher valuations than comparable firms
supported by venture capitalists alone.
310 See 2.5.2.1 for a discussion on the corporate venture capitalists' characteristics that venture capitalists are
looking for.
311 See 2.5.2.3 for a discussion on the lack of corporate commitment as a source of failure ofCVC activities.
142 Chapter 2: Theoretical foundation

deal flow in fact increases commensurate with the longevity of CVC programs. Programs
that were in operation for more than five years generated 42% of their deal flow from venture
capitalists compared to 22% for programs younger than five years. This may be a result of
the company building a VC network and gaining a reputation among venture capitalists.

Company departments may be a good source of deal flow, especially when CVC investments
focus on investments in the company's own field of activity. Researchers and developers
often have extensive personal networks that can be leveraged to get access to entrepreneurs.
Furthermore, departn,Ients often already work or try to work with start-ups that may be
potentially interesting investment targets. Equity ties to these start-ups may help to build or
improve a working rylationship with the organization. An advantage of the deal flow that is
generated by the business units may be the potential relatedness of the deals to the business
activities of the own organization. A potential disadvantage may be the limited business
focus of employees from the organization when jUdging the potential of start-ups. Company
employees may focus on technological issues more heavily than on the potential of the start-
up to become a successful market player. 312

Corporate venture capitalists should try to leverage all the different sources of deal flow since
a high quality deal flow is essential for CVC activities. In order to leverage potentially
significant sources of deal flow, corporate venture capitalists should design CVC and act in a
way that is attractive to partners, especially start-ups and venture capitalists.

2.6.2. Assessment of investment opportunities

As discussed in 2.2.3.3, venture capitalists assess investment opportunities in a due diligence


process in order to understand the potential upsides and risks of an investment in a start-
up.313 Tlie ability to assess investment opportunities is a significant resource for corporate
venture capitalists since it determines which start-ups are funded and under what conditions.
Creating and leveraging this ability to assess investment opportunities is a major challenge
for corporate venture capitalists. 314

Four issues regarding the due diligence by venture capitalists are discussed in 2.2.3.3: the
objectives of due diligence, the issues venture capitalists look at in due diligence, the sources
of information and the process of due diligence. There is one significant difference between

312 In addition, potential deals may also develop out of the organization. Employees may have ideas that may
be spun out of the company. This, however, in not considered eve according to the definition in 2.3.1.
313 As discussed in 2.2.3.3, this is done to minimize the infonnation asymmetry between venture capitalists and
start-ups.
314 One of the major problems for assessing investment opportunities is the high level of uncertainty start-ups
face. In addition, Yates and Roberts (1991: 13) say, "selecting which investments to make is challenging
because, even after an exhaustive search many investment opportunities are not worth pursuing."
Chapter 2: Theoretical foundation 143

venture capitalists and corporate venture capitalists. Corporate venture capitalists need to
consider an additional issue when assessing investment opportunities. In addition to the
issues or investment criteria venture capitalists look at, e.g., the management team, the
product market concept, the potential value generation etc., corporate venture capitalists
should also look for a strategic fit. The company needs to evaluate the strategic relevance of
the start-up's business concept, technologies etc. for its own organization. In particular it
needs to assess if the investment potentially meets the strategic objectives by generating
strategic benefits. In order to do that assessment the eve management should leverage their
own organization. Internal' expertise can be used to evaluate the business concept, as long as
there is expertise in-house regarding the technology or market the business concept is based
on. This has two major benefits. It can give very valuable insights into the potential
financial success of the stint-up. Second, such an involvement of the organization is already
the first step to realizing strategic benefits. The organization may, for example, gain an
insight into technology trends, may promote internal change by facing its own employees
with the dynamic start-up environment or may build contacts with potential future business
partners. 315

Siegel, Siegel and MacMillan (1988: 235) survey the issues or investment criteria of eve
funds. They differentiate between five different groups of criteria: the entrepreneur's
personality, the entrepreneur's experience, the characteristics of the product, the
characteristics of the market and financial considerations. The most important investment
criteria of eve managers as identified by Siegel, Siegel and MacMillan are shown in Table
2-20. They are compared to the investment criteria of independent venture capitalists.

315 This certainly requires cooperation from the organization. In order to stimulate such support and to
potentially also involve parts of the organization that suffer from a Not-Invented-Here syndrome at least
two issues are important: top management commitment to eve and intensive management of
organizational linkages. Both issues are discussed in the text.
144 Chapter 2: Theoretical foundation

Table 2-20: Investment criteria most frequently rated as essential by corporate venture
capitalists vs. independent venture capitalists
Criterion Group of CVC Independent
criterion (percent) VC
(Percent)

[Entrepreneurs1capable of s!lstained effort E. Personality 67 64

[Entrepreneurs1familiar with market E. Experience 67 62

[Entrepreneurs1able to evaluate and react well to risk E. Personality 48 NA


Market/industIy attractive to corporation Market 39 NA
Product fits with corporation's long-term strategy Product 37 NA
Target market enjoys significant growth rate Market 35 43

Product can be protected Product 31 29

Entrepreneur has demonstrated leadership ability E. Experience 31 50

Return 10 times investment in 5 to 10 years, Financial 28 50

Source: Siegel, Siegel and MacMillan, 1988: 238

Two of the investment criteria listed can be considered as an indicator of strategic fit:
market/industry attractive to corporation and product fits with corporation's long-term
strategy. These are the fourth and fifth most important criteria for an investment decision for
corporate venture capitalists. 316 Like venture capitalists, corporate venture capitalists value
the experience and personality of entrepreneurs most. In contrast, potential financial returns
are much more important for venture capitalists than for corporate venture capitalists. 317

To what level corporate venture capitalists need to get involved in due diligence depends on
their role in the investment. Lead investors need to do the due diligence much more
stringently than co-investors. 318 The intensity of the due diligence also depends on the stage
the start-up is in. If a start-up has already received funding and is up for a new round of
financing it may be easier to evaluate its chances of succeeding based on past success. Even

316 The sample of corporate venture capitalists may also include the venture capital activities of companies that
only focus on financial return, which are not considered as corporate venture capitalists in this study.
Therefore the importance of criteria that reflect strategic fit may actually be larger for corporate venture
capitalists.
317 This becomes even more apparent when taking into consideration that independent venture capitalists also
include the criterion that the investment can easily be liquidated (44%) in their top ten list of investment
criteria. Based on the argument in 2.3.2, that financially successful investments are more likely to create
strategic returns, this may present a challenge for corporate venture capitalist to create strategic benefits.
318 When making indirect investments, the involvement in the due diligence process is probably limited.
Learning how to perform a due diligence, however, is an important skill to learn from venture capitalists.
This can be leveraged for future direct investments.
Chapter 2: Theoreticalfoundation 145

if a corporate venture capitalist is not deeply involved in the due diligence, s/he should at
least assess the strategic fit.

At the end of the assessment the CVC management needs to come to a conclusion whether it
wants to fund the assessed business concept or not. If the CVC management does want to
fund a start-up, it needs to decide under what terms and conditions it is willing to invest and
what amount of capital it wants to invest. These decisions are the basis for the negotiations
described in the next subchapter.

2.6.3. Investment in start-ups

Once the due diligence is ,completed, the investment needs to be structured if the corporate
venture capitalist decides to invest in a start-up and the start-up wants to receive an
investment from the corporate venture capitalist. As discussed in 2.2.3.4, structuring the
investment includes at least four tasks: valuing the start-up, determining the cash
requirements, designing an investment agreement (a legal document) that covers issues like
price, control rights or representation and finally, possibly syndicating with other venture
capitalists.

Being able to structure an investment is a valuable resource. Corporate venture capitalists


may face the challenge of building the expertise that is necessary to do this. Especially if
venture capital activities have just recently started and no experienced VC managers have
been hired, structuring investments may be difficult. A sub-optimal investment structure,
however, may limit the opportunity to generate financial and strategic benefits.

For indirect CVC investments, structuring investments is not an issue since the venture
capitalist takes eare of it. Companies investing venture capital directly should try to acquire
the necessary skills quickly either by hiring external experts or by building the skill in-house
through learning by doing as discussed in 2.5.4.1. As long as a corporate venture capitalist
does not have investment skills in-house, co-investments may be a way to get around the
investment structuring challenge.3 19 Participating in co-investment has an additional
advantage as corporate venture capitalists can learn from the investment negotiations and
agreements they participate in as co-investors.

A significant challenge that corporate venture capitalists face is pricing a deal based on a
start-up valuation and negotiating terms. This may be even harder if the investment target
has already received funding in earlier rounds of financing since the current value of the start-
up needs to be determined as a basis for the price new investors need to pay for equity.

319 As discussed in 2.2.3.4, many venture capitalists syndicate investments to reduce the risk of single
investments and their investment portfolio overall.
146 Chapter 2: Theoreticalfoundation

Existing investors have an incentive to value the start-up as highly as possible to increase the
value of their equity stake, while new investors will want to pay as little as possible. No
matter which round corporate investors participate in, Gompers and Lerner (1998: 28) fmd
that eve investments are typically made at a premium, meaning that eve investors pay
more than other investors for the same share of equity. In order to limit the premium they
pay, companies may demand that they invest on the same terms as other investors in the same
financing round. Leveraging the skills of lead- and other co-investors like that to negotiate a
fair price may especially help less experienced investors.

Like the negotiation of terms, the legal contract design requires some experience. A
challenge that especially corporate venture capitalists face is protecting proprietary
knowledge and assets of the start-up as well as preventing negative interference with the
start-up development. Especially when a corporate investor tries to obtain information from
external start-ups, s/he should be aware that start-ups might be afraid of the investor
"stealing" its ideas. The investing company needs to make sure that this will not happen
otherwise it might encounter serious litigation. (Greenthal and Larson, 1983: 73) For the
company the most important issue is to protect itself from litigation for infringing on
proprietary knowledge or hindering start-up development. (E.g., Rind, 1994: 103) The
company should state as explicitly as possible what it may and may not do. Even legal
agreements, however, will never offer complete protection from conflicts. The best insurance
against legal claims is building a fair and trust-based relationship.

2.6.4. Interaction with start-ups

Venture capitalists need to interact with portfolio companies for two reasons: to monitor and
to support. the development, see 2.2.3.5. For corporate venture capitalists there is an
additional reason to interact with start-ups, which is to realize strategic benefits. The ability
to interact with start-ups, especially to realize strategic benefits, is a major resource of eve.
Building up this ability and interacting with start-ups represents a major challenge for
corporate venture capitalists. While companies may start to realize strategic benefits through
deal flow screening and in the due diligence process, a significant share of strategic benefits
need to be realized in the interaction with the start-ups. This includes benefits like leveraging
partnerships, accessing technologies, acquiring alliance-making skills as well as changing the
attitude of employees towards innovation.

In the following section, the monitoring and support role of venture capitalists will be
summarized (2.6.4.1). Then, the challenge of realizing strategic benefits through interaction
with start-ups will be discussed (2.6.4.2).
Chapter 2: Theoreticalfoundation 147

2.6.4.1. Monitoring and supporting start-up development

Venture capitalists support start-ups not only with capital but are also likely to offer
substantial managerial support, as discussed in 2.2.3.5. Based on their experience venture
capitalists help to make strategic business decisions. With their networks of managers and
entrepreneurs they help to staff key positions in start-ups. Their networks in the start-up
community and among larger corporations help starts-ups to get access to potential
customers. Their experience and networks enable them to help start-ups to build up a
network of business partners that enables the start-up to focus on its own core strength.

Corporate investors can also offer such managerial support to start-ups. A company may be
less able to provide certam elements of this support such as, for example, support for staffing
key positions. On the other hand, there are areas in which the company may even provide
more extensive support than venture capitalists, for example, with its network that can
include many established companies. 320 Among these established companies may, for
example, be potential customers or business partners.

An even more important type of support to the start-up may be if the investing company itself
becomes a customer, supplier or any other type of business partner of the start-up. There are
a large variety of roles the investing company can play for the start-up. Some of these
supportive roles are listed as follows: the investing company may use its sales organization to
sell start-up products. This access to sales channels can enable start-ups to reach a large
number of customers quickly in various geographic locations. Corporate marketing expertise
may enable start-ups to reach and mobilize potential customers efficiently. The investing
company may produce components for start-ups or provide manufacturing support that can
help start-ups to set up and scale up production in a short period of time. R&D support may
provide start-ups with access to expensive and powerful research facilities or enable parallel
research on different projects. Regulatory support may help start-ups in the pharmaceutical
business to master approval processes, possibly in different regional areas. 321

The different ways in which venture capitalists and corporate venture capitalists support start-
ups may be complementary. Therefore, corporate investors may not need to provide the

320 Potentially valuable resources ofthe eve investors are also discussed in 2.3.3, 2.5.2.1 and 2.5.3.1.
32\ Rind (1994: 104) discusses additional ways in which investing companies can help start-ups, e.g.,
credibility with customers, banks and other investors, immediate income from an R&D or consulting
contract and a customer interface with an interested party.
148 Chapter 2: Theoretical foundation

same type of support to start-ups that venture capitalists do if they provide other types of
meaningful support to start-ups when they co-invest. 322

Providing corporate support beyond the typical ve support also has three major advantages
for the investing company: first, the likelihood of the start-up becoming successful and
therefore increasing the potential financial return from the investment. Then, corporate
support makes a corporate investor attractive to start-ups and therefore enables companies to
get into financially promising and strategically interesting deals since the resources of a
company may provide, a lot of value to start-ups. Finally, corporate support usually leads to a
close interaction of the company with the start-up and to actual business relationships and
this is how a compan~ can realize many strategic benefits.

Since support beyond the typical ve support can provide advantages to the investing
company and to the start-up, supporting start-ups can be mutually beneficial for both.
Essential for a beneficial close interaction with the start-up are organizational links that
ensure the participation of all parts of the organization. These organizational links and the
generation of strategic benefits are further discussed in the next subchapter.

2.6.4.2. Realizing strategic benefits through interaction with start-ups

Realizing strategic benefits, which may also be called building resources, is the major
objective of corporate venture capitalists according to the definition of eve in 2.3.1. As
indicated above, strategic benefits may be realized in steps of the eve process other than
interacting with start-ups once they are funded. A company may already be able to obtain
information, build skills and networks through its access to deal flow, its role in the due
diligence process and its presence in the ve and start-up world overall. The interaction with
start-ups orrce they are funded, however, is essential for realizing strategic benefits.

Many strategic benefits of eve can only be realized through intensive interaction with start-
ups. Any type of building business relationships or partnering, e.g., supplier, customer or
cross-selling relationships, can only be designed, evaluated and executed in close cooperation
with start-ups. Access to start-up technologies requires close cooperation and so does
acquiring skills in alliance-making. Other eve benefits may be realized without a close
interaction with start-ups, nevertheless, close cooperation helps to realize these benefits as
well. For example, many corporate employees may get in touch and possibly feel inspired
and motivated through cooperation with start-ups.

322 The complementary roles of venture capitalists and corporate investors may also offer opportunities for
closer cooperation beyond deal based co-investments.
Chapter 2: Theoreticalfoundation 149

As discussed in 2.5.3.1, not only the eve management needs to interact with start-ups. To
realize strategic benefits it is essential that those parts of the organization that are supposed to
realize strategic benefits are in close interaction with start-ups. The same is true for
providing support to start-ups, which is discussed in 2.6.4.1. A lot of support needs to be
provided by parts of the organization other than the eve management. The parts of the
organization that need to provide support and realize benefits are typically the operating
units, R&D or business development. In 2.5.3.1 what an organization may do to strengthen
the linkages of the organization to start-ups is also discussed.

Well-designed and managed organizational links enable potentially fruitful interaction


between the investing company and funded start-ups and may lead to mutually beneficial
relationships.

2.6.5. Exit investments

As discussed in 2.2.3.6, independent venture capitalists need to exit investments at some


point in time and realize financial benefits to return these to their investors. Like ve, eve is
typically a limited time investment. In some cases it may be beneficial for a company to
keep an equity stake in a start-up, for example, to support building a long-term business
relationship. In some cases, the company may even acquire a start-up completely. Most of
the time, however, the company should exit an investment once venture capital is not needed
any longer by the start-up, for example, because the start-up goes public. Another reason for
exiting an investment is when the start-up is not likely to create any financial or strategic
returns for the investor in the future. Admitting this and potentially making a loss, however,
may be difficult for the investor. 323 The ability to determine the exit point and exiting
investments in start-ups is a valuable resource for corporate venture capitalists that is difficult
to build.

In addition to the often purely financial considerations of venture capitalists in deciding on


the exit, corporilte venture capitalists need to include strategic issues in their decisions.
Figure 2-23 structures the different situations a corporate venture capitalist may face and
includes a suggestion on how companies may act in these situations. In order to make exit

323 Like independent venture capitalists, eve investors need to be willing to divest under-perfonning start-ups
at some point. They need to keep in mind that the failure of the individual start-up is part of the portfolio
character of venture capital investments, discussed in 2.2, and not necessarily a sign of bad eve
management.
150 Chapter 2: Theoreticalfoundation

decisions, the financial and strategic success of investments needs to be determined on a


regular basis, or at least whenever a start-up requires additional financing.3 24

Figure 2-23: Exit decision matrix of eve

Exit and/or keep


Continue 10
Slop flmding and equity position if
Successful support start~up
try to secure beneficial for
strategic benefits- and realize
strategic
strategic benefits
relalioDship
Continue to sup-
port start-up and
Strategic consider possibi- Exit and possibly
su..... Pending Exit lities of increasing continue working
with start-up
probability of
success

Consider ways to Exit and realize


Unsuccessful Exit exit, maximizing fmancial benefits
fmancial returns

Unsuccessful Pending Potentially


successful
Financial succ..s

Situation unlikely since financially unsuccessful start-up will rarely deliver strategic value.
Since financial suecess is realized through an exit, investments can only be potentially successful before an
exit.

The eve management should regularly check where investments fall inside the exit decision
matrix.3 2S The matrix offers recommendations on how to act in different situations. These
recommendations are rough guidelines based on logical reasoning and remain to be proved.
Whenever a start-up is financially unsuccessful, it should no longer be supported. It seems
difficult to 'imagine that such a start-up could be strategically successful (see 2.3.2). If this
happens anyway, the company should stop funding to limit the financial loss and try to secure
strategic benefits. If financial success is pending, but the start-up is strategically
unsuccessfuJ, there is no need for a company focusing on strategic benefits to keep investing.
The company should consider ways of exiting the investment, maximizing the financial
return. If both, financial and strategic success, are pending the company should continue to
support the start-up, at least as long a strategic or fmancial success is likely in the future. At
the same time, the company should consider possibilities of improving the probability of

324 In order to use the exit decision matrix the eve management needs to decide on strategic and financial
success. This is definitely not a simple task, at least for strategic success. It is also difficult for financial
success to draw a line between still "pending" and "unsuccessful". One possible way of detennining the
success of an investment is to check whether a start-up has reached the milestones all parties agreed on.
325 Since financial success is achieved through an exit, financial investments can only be potentially successful
before an exit.
Chapter 2: Theoretical foundation 151

success. If the start-up already delivers strategic benefits, while financial success is still
pending, the company should continue supporting the start-up and realize strategic benefits.
If the start-up is potentially successful fmancially but unsuccessful strategically, the company
should exit and focus on maximizing financial benefits. If in such a situation, strategic
success is still pending, the company should consider carrying on working with the start-up
after an exit. The company may also retain its investment if this ensures the realization of
strategic benefits. If the start-up is successful in both dimensions, the company should exit
and/or keep an equity position in the start-up depending on what is the best way to maximize
strategic return.

2.6.6. Monitoring Corporate Venture Capital activities

As discussed in 2.5.5 a monitoring system that measures the input and success of eve
investments is an essential resource, although it is a challenge to set up such a system. The
monitoring system designed should be applied once eve activities have started, this means
that input and success should be measured. In addition, the results from monitoring eve
should be acted upon. If the results of monitoring eve are not satisfactory, the list of
challenges discussed in 2.7 may be helpful to determine the reasons.

2.7. Challenges for generating benefits through Corporate Venture capital

As discussed in 2.4 the ability to set up and leverage eve resources is necessary for
generating eve benefits. When trying to build and leverage eve resources, companies may
face challenges that can prevent them from realizing the benefits from eve. The challenges
for setting up and running eve were discussed in chapters 2.5 and 2.6 and are summarized
in Table 2-21.

The challenges summarized in Table 2-21 may keep companies from realizing benefits
through eve. Although the list of challenges does not represent a tested set of key factors of
success, the challenges still highlight issues that are potentially most important for realizing
eve benefits. These challenges were tested in this study for their role as critical factors for
impacting sustainable competitive advantage as discussed in 3.3.
152 Chapter 2: Theoreticalfoundation

Table 2-21: Challenges of setting up and running CVC activities


Activ~ Challene:e
Set objectives
I Determine specific targeted strategic benefits of eve.
Define evc investment approach
Decide on either using a direct or an indirect investment approach.
Determine l)1anagement approaches for eve activities (generating deal flow,
due diligence, investing, interacting with start-ups, exiting, monitoring).
Defme an investment focus that enables a company to generate targeted
benefits.
Ensure corporate commitment in the long run. (Partially reflected in fund term
and fund 'size.)
Determine organizational linkages
Design organizational linkages to realize benefits within the organization.
Design organizational linkages to support eve activity.
Design organizational linkages to support start-ups.
Position eve within the organization in terms of responsibility and reporting.
Staff and design compensation
Find eve managers with an adequate mix of corporate experience and
networks, ve skills and networks and technological and market expertise.
Design compensation system that attracts and retains eve personnel and also is
compatible with company culture.

.r
Set up monitoring
Set up monitoring system that allows the measurement of strategic success and
the adaption of eve activity.
Generate deal flow
I Generate sufficient high quality deal flow.
Assess investment opportunities
Perform due diligence to assess potential of investment opportunity and to
determine strategic relevance.


Leverage organization to support due diligence.
Achieve strategic objectives through due diligence support by organization.
Invest
Build investment and negotiation skills for pricing deals and designing


investment agreements.
Structure investments to protect proprietary start-up assets and also enable

r
strategic benefits for the investing company.
Interact with start-ups
0 Monitor start-ups and provide "classic" ve support to them.
Leverage the organization to provide corporate support to start-ups.
Realize strategic benefits by interacting with start-ups.

T
Exit investments
Determine when to exit investments.
Manage exit process.

I
Monitor success
Monitor eve activities.
Adapt eve activities based on results of monitoring.
Chapter 2: Theoretical foundation 153

2.8. Overview of previous research on Corporate Venture Capital


Several studies have analyzed eve empirically since the first eve activities were started in
the 1960s in the US.326 Table 2-22 gives an overview of different empirical studies on eve
by describing their objectives, design and results and by looking at the strategic objectives,
specific benefits and success measures that are discussed in these studies.3 27 The main focus
of previous studies has been on determining the eve activity level, eve success and factors
determining success. 328

Table 2-22: Summary of empirical eve studies


Author; Study Study results Strategic eve Specific strategic eve
objectives; objectives benefits/success measures
Study design mentioned mentioned

Kann (2001) Proposition that selection of program Three categories of Proposes a valuation
Determines structure should be based on strategic investment goals: framework for CVC that is
how to investment goal and strength oOP I. External R&D based on different factors. The
structure CVC rights. Some ofthe specific (acquire resources) total value of the CVC program
to best achieve propositions were met and some 2. Accelerated is derived from the financial
strategic were not, e.g.: market entry and strategic value of
investment In spite of higher transaction costs, (acquire resources) individual investments, the
goals.3 29 even those investors that try to 3. Demand- synergistic value of the CVC
Looks at 120 exploit existing re-sources mostly enhancement program in form of strategic
companies invest directly (exploit existing options and network effects
doingCVC; Based on agency problems, resources) and the management costs.
field companies investing directly target In addition, These values and costs are
interviews with later stage investments when IP creating options on based on the program structure,
seven CVC rights weaken when they target future strategic environmental factors and
players. external R&D but not when they moves is a possible venture as well as program
target accelerated market entry. objective. uncertainties related to these.
Design of valuation framework, see
last column.

326 For a more detailed discussion of eve history see Gompers and Lerner (1998: 6), who state: "First
corporate venture funds began in the mid-I 960s, ( ... ) spurred by the successes of the first organized venture
capital fund ... " Companies such as Dow, DuPont, Exxon, Ford, General Electric, Singer or Union Carbide
typically invested directly, see Sykes, (1990: 38).
327 Different empirical studies are not listed in Table 2-2: The National Economic Development Office (1986)
studies the UK eve activity. Bannock Consulting (1999) analyze the cve activity in Europe. Other
studies analyze cve partially based on case studies: Grimbergen and Wolleswinkel (2000), Hagleitner
(2000), Niederkofler (1989), Winters and Murfin (1988).
328 It should be noted that there are also studies that focus on the impact of CVC on start-up success. Maula
and Murray (2000), for example, analyze a sample of 325 venture capital backed IT IPOs. They find that
enterprises co-financed by multiple Global Fortune 500 InfoCom corporations receive higher valuations
than comparable firms supported by venture capitalists alone. This is likely to have a positive impact on the
investing company as well.
329 Research builds on the assumption that motivation for eve can be explained by strategic reasons, while the
structure is additionally affected by agency and transaction costs associated with different program
structures.
154 Chapter 2: Theoretical foundation

Author; Study Study results Strategic eve Specific strategic eve


objectives; objectives benefits/success measures
Study design mentioned mentioned

Kurzand Companies are able to support Financial: ROI Specific strategic benefits:
Wehmeyer competitive strategies and to a Strategic: I. Technology observation
(1999) smaller extent growth strategies with I. Technology -Antenna for new technologies
Analysis of the help of eve. observation -Taking advantage of strategic
eve Largest impact of eve on strategy is 2. Growth support windows
impact on the ability of a company to 3. Entrepreneurial -Access to know-how
strategy; differentiate itself through access to spirit 2. Growth support
interviews product innovations and to a smaller 4. Increased -Access to new technologies
with eve extent through strengthening efficiency -Preparation of acquisitions
experts entrepreheurial spirit and the ability Other: -Strengthening demand for core
from to respond to change. Positive image products
fifteen Overall, role of eve in realizing effects, creating -Securing supply of attractive
German company strategies limited compared jobs, regional components
companies. to other activities like R&D. development -Extension of product portfolio
-Market observation
3. Entrepreneurial spirit
-Increased entrepreneurial spirit
through spin-offs
-Training and networks
4. Increased efficiency
-Access to more efficient R&D
-Limiting techno!. dev. risk
-Synergies from combining
capabilities
Berger and Description of eve success factors I. Window on Success measures: Mention
Dlirdrechter along eve process. technology one example of a success
(1998). Overview and evaluation of German 2. Generating measure for the objective
Analysis of eve programs. innovation window on technology:
German eve Prediction of increasing role of eve 3. Leaming effects Number of identified new
programs for in ve industry 4. Employee technologies
potential motivation
success. 5. New business
Interviews relationships
with twelve 6. Diversification
eve program 7. Spin-offs
managers and
additional
experts
Chapter 2: Theoreticalfoundation 155

Author; Study Study results Strategic eve Specific strategic eve


objectives; objectives benefits/success measures
Study design mentioned mentioned

Gompers and Key fmdings are: "Corporate Direct (financial) Benefits:


Lerner (1998) venture investments appear to be at return Some examples mentioned,
Compare least as successful [ ... J as those Indirect (strategic) e.g., insight that leads to a
success of backed by independent venture return e.g., redirected research program in
evc organizations, particularly when strategic alliances a corporate laboratory, or
investments there is a strategic overlap between and better funding internal ideas that
with that of the corporate parent and the portfolio understanding of would have otherwise received
independent firm. While corporate venture industry trends no funding
venture capitalists tend to invest at a Success measures:
organizations. premium to other firms, this premium Indirect benefits that corporate
An appears to be no higher in venture investors receive are
examination of investments with a strong strategic difficult to identify and
over 30.000 fit. Finally, corporate programs quantify. A less satisfactory
venture capital without a strong strategic focus but more tractable measure is
transactions in appear to be much less stable ... " the success of the firm
about 8500 receiving funds, for example,
financing the probability of the venture
rounds. going public or beinK acquired.
McNally Relative importance of CVC Lists 16 different In addition to the four listed in
(1997) objectives to UK companies. Most potential and more the study results column:
Analyzes CVC important objectives are: or less specific Improvement of manufacturing
activity in the Identification of new markets, evC benefits as processes, assess potential
UK by exposure to new technologies, shown in Table acquisition candidates, learn
surveying large financial return, development of 2-14. See next about venture capital, lower
companies business relationships and column manufacturing costs, help
(73), venture identification of new products. suppliers/customers, indirect
capitalists (39) Analysis ofCVC investment process. benefits from enhanced small
and small firms Focus ofCVC on high-tech and early firm sector, publicity for
(48). stage deals. company, assist spin-outs from
Analysis of experiences of venture company, assure continued
capitalists with corporate investors. supply of
Relative importance of CVC to start- materials/components, change
ups. corporate culture/need to
become more innovative,
develop an executive network,
diversification
156 Chapter 2: Theoretical foundation

Author; Study results Strategic eve Specific strategic eve


Study objectives benefits/success measures
objectives; mentioned mentioned
Study design

Schween CVC potentially beneficial for Overall objectives Benefits:


(1996) investing and funded company. are: Observe -Know-how transfer through
Survey and Detailed CVC description and technological multiple contacts with different
evaluation of summary of evc options and trends, support parts of the organization to the
GennanCVC success factors. growth and venture in due diligence or
activities. Limited use ofCVC in Gennany. strengthen management support.
Identification Unsatisfactory success of existing entrepreneurship. -Supplier relationships,
and analysis of CVC in G,ennany for several reasons. The specific licenses, joint ventures and
twelve Gennan E.g., unclear and inappropriate objectives are: research contracts.
CVC programs objectives, choice of wrong -IdentifY new Success measures:
in 136 Gennan instrumeqts (mainly indirect CVC) to markets and Increase in sales due to CVC
companies. achieve strategic objectives, limited technologies. activities. Number of new
top management support and -Generate product- products/technologies from
commitment and limited quality of and process- CVC activities.
CVC management. innovation.
Proposes five ways to improve the -IdentifY potential
useofCVC. acquisition targets.
-Build business
relationships.
-GatherCVC
experiences.
-Support spin-offs.
-Change corporate
culture.
Hurry, Miller Hurry, Miller and Bowman claim Two alternatives Benefits:
and Bowman that Japanese CVC investments have for strategic Business relationship:
(1992) more of an option character seeking objectives: -Joint resellrch program.
A comparison new technology while US CVC -Implicit call -Licensing agreement for the
of US and investments are more regarded as option ("shadow venture's new technology.
Japanese CVC individual projects seeking direct option") on new -Product technology
programs venture gains. technology. development arrangements.
investing in the -Direct venture -Manufacture of the venture's
USA. gains. products.
Looks at 20 -Distribution of the venture's
US and 20 products (in Japan).
Japanese CVC -Marketing and after sales
programs. service ofthe venture's exports
(to Japan).
"Implicit right" to acquire a new
technology from the start-up at a
future point in time.
Success measures:
Number of business
relationships and acquisitions.
Chapter 2: Theoreticalfoundation 157

Author; Study results Strategic eve Specific strategic eve


Study objectives benefits/success measures
objectives; mentioned mentioned
Study design

Yates and Venture capitalists are the key deal Summary of


Roberts source of the more successful CVC objectives
(1991) activities. described by other
Determine Successful corporate venture authors.
success criteria capitalists frequently first invest
forCVC, indirectly and then switch to direct
focusing on the investments.
step of Corporate familiarity with the
initiating venture's market is more important
investments. in determining strategic success than
Yates and familiarity with the venture's
Roberts study technology.
49 large u.s. Strategically successful corporate
corporations venture capitalists make more
that make CVC investments in later rounds, foster
investments. business relationships and exercise
less control over the portfolio firm.
Financial and strategic success are
positively correlated.
Sykes (1990) Four of eight tested factors are found -IdentifY new Success measures:
Determining to have a significant influence on opportunities Frequency of interaction with
CVC success strategic value ofCVC activity: Type -Develop business start-up (different types of
factors for and frequency of communication relationships meetings, reports, requests and
strategic with the ventures, return on portfolio -Find potential advice).
success and investment, mode of investment acquisitions Business relationships formed,
performance of (direct vs. indirect through VC fund) -Learn how to do e.g., marketing or research
existing and the choice of the primary venture capital agreements.
programs. strategic objective. --Change corporate
Analysis of Sykes tests six strategic objectives culture
thirty-one US for their influence on success. -Assist spin-outs
corporations Objectives that produce a mutually from the
involved in supportive environment, such as corporation
strategic CVC f6rmation of corporatelventure
activities, to business relationships, are more
"assist likely to lead to success. In contrast
corporate new objectives that are likely to induce a
business potential conflict of interest, such as
development" v~nture acquisition, may lead to the
failure of the relationship.
158 Chapter 2: Theoretical foundation

Author; Study results Strategic eve Specific strategic eve


Study objectives benefits/success measures
objectives; mentioned mentioned
Study design

Siegel, Siegel eve fund should be an -Exposure to new


and MacMillan independent entity with access to technologies and
(1988) separate, committed pool of funds. markets
An analysis Skilled venture professionals with -Potential to
trying to ve experience should manage manufacture or
determine which eVCfund. market new
approach to Fund managers should be products
CVC is most compensated VC-like. -Potential to
likely to produce CVC funds should primarily focus improve
successful on financial objectives. manufacturing
(fmancial) Financially unattractive venture processes
results. proposals might be referred to other -Potential to
Survey of 52 US parts of the organization to explore acquire companies
cve programs. potential alternative relationships.
The corporation should be willing
to acceot a limited role.
Hardymon, eve not a good tool to diversifY Diversification Benefits:
DeNinoand for four main reasons, e.g., . through In-depth look at potential
Salter (1983) -The restricted universe of acquisitions and acquisition targets.
Determine role investment opportunities, i.e., insights into new Access to potential acquisition
ofcve as a among other things an em-phasis on products, markets targets before the acquirer has to
diversification high-tech businesses. and technologies. pay a premium for success.
tool. -A conflict of interest with other Window on Opportunity to acquire a well-
Analysis of syndicate members or the start-up. technology known (amicable) company and
three eve -Difficulty in transferring Limitation of risk therefore reducing the risk of
programs. technology from investees. of being active in a integration.
-A conflict between diver-sifYing new field Success measures:
and building a healthy venture Number of businesses acquired
caoital portfolio. as main success measure.
Greenthal and Greenthal and Larson question the Greenthal and Benefits:
Larson (1983) potential success of an acquisition Larson identifY two They see three ways in which
Describe objective for eve. Financial strategic objectives corporations can gain benefits
objectives of returns, however, are likely to be of CVC: Acquiring from technology transfer:
eve and key achieved but are unlikely to new businesses and Licensing agreements, joint
design elements contribute significantly to overall gaining access to R&D efforts and help to discern
for success. corporate growth. Further they new technologies. new market opportunities for its
A survey of observe mixed results for gaining existing corporate product lines
twelve corporate access to new technologies. early.
venture groups Four success factors for internal Success measures:
in the USA plus venture group: Short-term: Number of
several -its position and reporting investments, fmancial stability
companies that relationship within the organization of individual ventures.
had withdrawn -management systems, designed to
from venture control it
capital -the way it is staffed
involvement and -the way staff are compensated
six private
venture
capitalists.
Chapter 2: Theoretical foundation 159

Different aspects of the studies described in Table 2-22 have already been discussed in
different parts of this chapter. The factors of success that are presented by various authors
are discussed in subchapters 2.5 and 2.6 to a large extent. The potential objectives of eve,
which are mentioned by different authors, are discussed in subchapter 2.3.2. In addition,
high-level objectives are broken down into specific benefits. The list of specific benefits
discussed in 2.3.2 incorporates the few specific benefits discussed by the authors listed
above.

Little work has been done,on developing measures for the strategic success of eve. Few
specific strategic success measures are proposed in the studies discussed above. In these
studies, the strategic SUCCess of eve activities is measured by subjective assessments by
eve managers whether expected results have been achieved, as discussed below. An
exception to this is the study by Gompers and Lerner (1998). Gompers and Lerner use the
economic success of the funded start-ups as a success measure for the investing company.

Yates and Roberts (1991: 10) classify a firm as " .. .'strategically successful' based on self-
assessment by the respondent that the firm's eve program was producing a rate of new
business development that was superior to that from internal development efforts, given the
same level of resources." Sykes (1990: 37) asks corporations to " ... rate, on a five-level
scale, the overall contribution (added value) of their programs in meeting their strategic
objectives." Siegel, Siegel and MacMillan (1988: 241) ask the participants in their survey to
rate their general levels of satisfaction relative to their various objectives on a scale from 1
(unsatisfactory) to 4 (outstanding). Different sources agree that the measurement of strategic
eve benefits is difficult, e.g., Niederkofler (1989: 113-115). Siegel, Siegel and MacMillan
(1988: 241) say, " ... performance is not easily quantified, particularly when associated with
strategic benefit~ ... ". Besides the quoted subjective measures, financial success is often cited
as an indicator whether eve is strategically successful. Little effort is made to develop
strategic success measures that reflect actual performance. McNally (1997) states that no
objective measures exist to prove benefits. Measuring strategic performance however is
regarded as essential. Berger and Dordrechter (1998) stress the importance of eve
controlling with the help of operational success measures even though they are difficult to
develop. As the only exception Kann (2001: 113-141) proposes a framework for eve
valuation as briefly introduced in Table 2-22. This valuation framework, however, needs to
be operationalized further before it can be applied in practice. In addition the proposed
valuation framework is only based on three strategic benefits of eve and may need to be
extended to cover additional potential eve benefits.

An issue that has not been discussed in the literature so far is the impact eve actually has on
the investing company. While the benefits of eve are discussed to some degree, whether
160 Chapter 2: Theoretical foundation

these benefits may have a lasting impact on the overall company situation is not discussed.
Kurz and Wehmeyer (1999) represent to some extent an exception. They analyze the
potential impact of eve on company strategy. They do not, however, try to evaluate the
impact of eve on competitive advantage or even on actual success.

This study may contribute to the analysis of eve in three ways. First, as discussed in 2.3.2,
this study specifies the potential benefits of eve. Second, the generated specific benefits of
eve may be leveraged to determine the success of eve. Finally, and most importantly, this
study will analyze the potential impact of eve on the investing company. In the next
chapter, a conceptual model is introduced that helps to determine the impact of eve on
sustainable competitive advantage of the investing company.
Chapter 3: CVC-impact-Model 161

3. eVe-Impact-Model

In the last two chapters the research question was introduced and sustainable competitive
advantage as well as eve, the key constructs used in this study, were defined.

In this chapter, a conceptual model is developed that describes how eve


may impact
sustainable competitive advantage. As discussed in chapter 1, the objective of this
conceptual model is to understand whether eve may impact sustainable competitive
advantage and to start a di'scussion on what companies can do to increase the likelihood of
impacting sustainable competitive advantage through eve.

First, the overall idea of the conceptual model is introduced (3.1). In the model, two
hypotheses link eve with sustainable competitive advantage. Then, the model is
operationalized by introducing indicators for three distinct variables that are derived from the
hypotheses (3.2). Finally, how eve activities can be tested for their role in impacting
sustainable competitive advantage from eve is discussed (3.3).

3.1. eVe-Impact-Model: linking eve to sustainable competitive


advantage

The objective of this study, as discussed in chapter 1, is to develop an approach to detennine


the impact of eve on sustainable competitive advantage of a company. As described in
2.1.1, the resource-based view of the finn is one of two major approaches that discuss the
sources of sustainable competitive advantage. This view considers a finn as a bundle of
resources (2.1.3). Resources can be sources of sustainable competitive advantage when they
meet certain attributes (2.1.3.2). Using this approach, eve is analyzed for its potential to
impact sustainable competitive advantage. A resource needs to meet the six attributes
summarized in 2.1.3.3 to have the potential to be a source of sustainable competitive
advantage. eve needs to be valuable, rare, appropriable, imperfectly imitable, imperfectly
substitutable and durable.

It is difficult, however, to operationalize this analysis of the potential of eve to impact


sustainable competitive advantage since eve is a rather abstract and complex resource. It is
difficult to apply these six criteria to a eve process. For example, it is hard to detennine the
value of eve for a company. The real source of value is not the generic process of eve but
the benefits that are created with it.
162 Chapter 3: CVC-Impact-Model

In order to discuss the potential of eve to impact sustainable competitive advantage it is


helpful to separate eve into two different resources: eve activities and eve benefits.3 3o
When this is done, two hypotheses can be used to link the eve activity with eve benefits
and sustainable competitive advantage. The first hypothesis determines whether benefits are
generated from eve activities.

Hypothesis 1: If companies engage in eve according to the definition in 2.3.1, then they
generate benefits.

The eve benefits are then linked to sustainable competitive advantage in hypothesis 2.

Hypothesis 2: If companies generate benefits from eve, then these benefits have the
potential to positively impact the companies' sustainable competitive advantage.

This approach constitutes a conceptual model, as visualized in Figure 3-1.

Figure 3-1: CVC-Impact-Model: ij:ypotheses

m: If companies generate benefits


from eve. then these benefits have
the potential to positively impact

.
the companies' sustainable
competitive advantage

------.~

eve activities may lead to eve benefits. eve benefits in turn may be the source of
sustainable competitive advantage. It is an open question whether the formulation of the
hypothesis is valid. This is analyzed with the help of case studies in the next chapters. The
second hypothesis may also be formulated differently to reflect doubts about the potential of
eve to impact sustainable competitive advantage positively that may arise from little

330 Like eve activities, benefits from eve can be regarded as resources, e.g., Barney (1991: 101), see 2.3.2.7.
Chapter 3: CVC-Impact-Model 163

success ofCVC activities in the past. 33 ! CVC may not be a source of sustainable competitive
advantage when used as an isolated tool. This study may help to identify specific conditions
when CVC could impact sustainable competitive advantage.

The conceptual model that links CVC activities with sustainable competitive advantage with
the help of two hypotheses needs to be operationalized to be applied. How this could be
achieved is described in the next subchapter.

Before describing how the CVC-Impact-Model is operationalized, it is briefly discussed how


it could be tested. This' study intends to provide the basis for the analysis of a causal
relationship between the three hypothetical constructs - CVC activities, CVC benefits and
sustainable competitive advantage, as formulated in the research question. Hypothetical
constructs, also called latent variables332, are those variables that cannot be observed directly
because they are abstract (Backhaus et aI., 2000: 392-393). It is difficult, for example, to
observe whether a sustainable competitive advantage exists or not. According to Homburg
and Pflesser (2000: 640), the LISREL-Approach333 of causal analysis is the best known
approach to test the causal relationships of latent variables. The LISREL-Approach is a
multivariate statistical technique. LISREL is able to analyze relationships with several
dependent variables, multiple step casual relationships and latent variables (Backhaus et aI.,
2000: XXIV). The LISREL-Approach is based on the analysis of correlation and co-
variances, and it allows the testing of a predetermined system of hypotheses in total
(Backhaus et aI., 2000: 394-395, 397-401). This system of hypotheses consists of two
models, according to Backhaus et aI. (2000: XXIV): first a structural model needs to describe
the causal relationships between the latent variables that need to be tested. The structural
model is based on theoretical reasoning. The CVC-Impact-Model, as shown in Figure 3-1, is
the structural model used in this study. In addition to the structural model, a measurement
model needs to determine the indicators that allow the measurement of the latent variables
indirectly. The measurement model operationalizes latent variables with the help of
indicators (Backhaus et al., 2000: 393) also called items (Homburg and Pflesser, 2000: 637,
641),334 The operationalization of the CVC-Impact-Model, that is discussed in 3.2, can be
used as a basis for operationalizing the LISREL-Approach.

33! As indicated in 1.1.


332 Backhaus et al. (2000: XXIV).
333 LISREL stands for Linear Structural Relationship. LISREL is a computer program that can be used to
analyze complex causal relationships.
334 Latent variables (theoretical terms) and the indicators (observation terms) are linked through
correspondence rules (Bagozzi, 1998: 49, 59-60).
164 Chapter 3: CVC-Impact-Model

LISREL is a dependence technique that intends to support or to reject the causal relationship
described in a model. LISREL cannot be used as an interdependence technique that identifies
a causal relationship (Backhaus et aI., 2000: XXI).335 Therefore it is very important that the
hypotheses of the model are based on intensive theoretical reasoning (Backhaus et al., 2000:
391). The rest of this chapter provides this theoretical reasoning by identifying indicators for
the hypothetical constructs - eve activity, eve benefits and sustainable competitive
advantage. In addition, case studies are used to provide a better understanding of the
relationships between variables and to specify the hypotheses discussed. The theoretical
discussion and the ca~e study analysis together are intended to provide a sound basis for a
future statistical analysis with a large sample.

3.2. Operationalizing the eVe-Impact-Model


In order to operationalize the eVe-Impact-Model, the three hypothetical constructs or latent
variables that are linked by the two hypotheses developed above need to be operationalized:
eve activity, eve benefits and sustainable competitive advantage. The variables are
formulated as follows:

Variable 1: Level of eve activity.

Variable 2: Level of benefits.

Variable 3: Level of potential to create competitive advantage.

Each of the three variables needs to be operationalized to apply the model and determine the
potential impact of eve activities on sustainable competitive advantage. 3.2.1 to 3.2.3
discuss what items and indicators are used in order to operationalize the three variables. 336

3.2.1. Operationalizing variable 1: Level of eve activity

In order to operationalize the first latent variable and to measure the level of the eve
activity, thedefinition of eve in 2.3.1 is used. All the attributes of the definition of eve
derived in 2.3.1 are used as items or indicators to measure the hypothetical construct or latent
variable eve activity. A measurement of these items is summarized in Figure 3-2.

335 Aaker, Kumar and Day (200 I: 437) also differentiate between dependence techniques and interdependence
techniques.
336 The three sets of variables and items constitute the measurement model as discussed in 3.1.
Chapter 3: CVC-impact-Model 165

Figure 3-2: Items for measuring variable 1 - level of eve activity

Always Mostly 50/50 Some- Never


times
1. Investments are equity investments ..... 0 0 0 0 0
2. Investments have a long-teon but typically limited time focus ... "' 0 0 0 0 0
3. Investments are made in privately held compat)ies ... 0 0 0 0 0
4. Investments are made in high-growth companies .... 0 0 0 0 0
S. Investments are made in start-up companies for the launch. early developtnent or
expansion of a business ... 0 0 0 0 0
6. The company provides active support to funded start-ups., .. 0 0 0 0 0
7. The company exercises significant controVover funded start-ups ..... 0 0 0 0 0
8. The company targets strategic objectives and does not only focus on maximizing
the value of investment portfolio ... 0 0 0 0 0
9. The company generates a constant deaHlow and evaluates it for potential
investment opportunities ..... 0 0 0 0 0
)0. Funded start-ups are legally indepenlient entities ... 0 0 0 0 0
II. Investments are made in start-ups not originating from the investing company .... 0 0 0 0 0

y" No

12. The investing company pursues a core business other than providilig capitaL. .. 0 0

The first eleven items in Figure 3-2 are measured on a scale with five different attributes: the
attribute can be met always, mostly, in about half of the cases, sometimes or never)37 The
twelfth item can either be met or not be met. For a company to do eve according to the
defmition in 2.3.1, the twelfth attribute or item should be met and the other eleven should be
met at least most of the time.

Measuring the attributes of the eve definition on a five-point scale provides the opportunity
to potentially identify different ways in which investments are made depending on the level
to which the attributes are met. Such a differentiation may provide the opportunity to derive
hypotheses on how successful different ways of doing (evC) investments are in generating
benefits or in impacting sustainable competitive advantage. The results from the case studies
discussed in chapter 4 may also be used to refine the definition of eve based on
observations or-eve as done by companies in practice. eertain attributes or items that are
used in the definition of eve may not be necessary. Especially one or more of the first
seven attributes that are derived from ve investments338 may not need to be met for
investments in order to qualify as eve investments.

337 When a larger sample of companies is analyzed with statistical tools, it may be more appropriate to ask for
specific percentage ranges. They could at least be given in addition as an explanation. In this study, the
categories chosen were well-suited since they are easily communicated and the critical distinction between
mostly and in about half of the cases is clear.
338 See 2.2.1 and 2.3. I.
166 Chapter 3: CVC-Impact-Model

3.2.2. Operationalizing variable 2: Level of benefits

In order to operationalize variable 2 and to detennine the level of eve benefits, the structure
of evc benefits discussed in 2.3.2 is used. As Figure 2-12 shows, two separate sets of
benefits may be targeted with the help of CVC: financial and strategic benefits. Six specific
strategic benefits have been formulated. Each benefit may be generated by realizing one or
more sub-benefits.

To what degree companies realize the potential benefits of cve needs to be analyzed. The
benefits and sub-benefits are used as the items or indicators of the latent variable cve
benefits in the CVC-Impact-Model. 339 The extent to which a benefit is realized may change
with the number of sub-benefits that are realized and the degree to which they are realized (as
discussed below).

Certain benefits/sub-benefits may not be analyzed because they are not considered in the
discussion of CVC benefits. As discussed in 2.3.2, three measures have been taken in order
to increase the likelihood that all relevant CVC benefits and sub-benefits are covered. In
addition, the case interviews contain open questions asking for CVC benefits that are not
covered in the list.

In this study, both the level of benefits and the level of sub-benefits of CVC are measured.
While measuring the sub-benefits would be sufficient in the context of this study, as
discussed in 3.2.3.3, measuring both levels provides a rough indicator of whether benefits are
actually overarching categories for the corresponding sub-benefits. This, however, is only a
basic indicator since the exact relationships between benefits and sub-benefits are not
considered. Figure 3-3 and Figure 3-4 show how the level to which CVC benefits/sub-
benefits are realized is determined in this study. All benefits and sub-benefits are evaluated
on a four-point scale. Companies may have realized CVC benefits or sub-benefits to the full
extent (3), to a large extent (2), to a lesser extent (1) or not at all (0). An even number of
possible answers is chosen on purpose to force respondents to decide whether benefits have
been realized to a larger or lesser extent. Therefore, omitting the answer "to a medium
extent" allows the generation of more meaningful results.

In addition to determining the extent up which the benefit has been realized, it is helpful to
find out, first, how important a benefit or sub-benefit is for the investing company. This can
Chapter 3: CVC-Impact-Model 167

provide insights into the success of the eve activity by analyzing which targeted benefits are
realized to what extent. The questionnaire asks whether realizing a benefit or sub-benefit is a
major objective, whether it is important, desirable or irrelevant to the company. Again, there
is no possible "medium" answer offered to find out whether benefits are more or less
important to a company.

When assessing the results from the measurement of variable 2 for a specific company, the
results need to be set in the perspective of the investment activity of the company. The level
to which sub-benefits are realized certainly depends on the characteristics of the investment
activity, especially the number of investments, the amount invested and the time that has
elapsed since the start of ~e investment operations and since single investments were made.
This will be important especially if statistical analyses with a larger sample should be
undertaken.

Only benefits or sub-benefits that are relevant to a company are analyzed further in this
study. If a certain benefit or sub-benefit is irrelevant to a company, the level to which this
benefit or sub-benefit has been realized is not checked.

Sub-benefits that are realized only to a lesser extent (l) or not at all (0) are assumed not to
have the potential to positively impact sustainable competitive advantage. 340 Therefore, only
those sub-benefits are analyzed as described in 3.2.3 that have been realized to a large (2) or
full extent (3).

339 Alternatively to regarding eve benefits as a construct or latent variable that can be operationalized with the
help of six groups of items or indicators (sub-benefits), the six groups of benefits may be regarded as
different constructs instead. In this study this distinction is more or less semantic since interpreting the
results from case studies is rather similar for both options. Using six different constructs instead of one,
however, may be advantageous when a statistical test is done, e.g., with the help of the LISREL-Approach.
Therefore, this question should be reconsidered when a statistical test is prepared.
340 As explained in 3.2.3.3 only sub-benefits are analyzed for their potential to create sustainable competitive
advantage.
168 Chapter 3: CVC-Impact-Model

Figure 3-3: Measuring targeted and realized eve benefits (112)

obJCI: ~ ..,. ".


Major JPlpOf-- Ocsi... Im::le. Rcallu:d

="" , , ""'''''
lorull
.'"
N.

Financial benefit
Leverage company expertise, contacts and reputation to achieve "" J 0
financial returns from investment portfolio .. 0 0 0 0 0 0 0 0
Strategi'i benefits
Build technology and market knowledge.................. 0 0 0 0 0 0 0 0
Gain insights into new developments early on .. 0 0 0 0 0 0 0 0
Identify specific new opportunities ... 0 0 0 0 0 0 0 0
Support decisions to move or not to move into new fields ... 0 0 0 0 0 0 0 0
Scan for and assess potential acquisition targets .... 0 0 0 0 0 0 0 0
Other: _ _ _ _ _ _ _ __ 0 0 0 0 0 0 0 0
Cbange attitude towards innovation and change ................ 0 0 0 0 0 0 0 0
Increase sensitivity to the need to Innovate .... 0 0 0 0 0 0 0 0
Increase openness to outside developments and foster willingness
to cooperate with external partners .. . 0 0 0 0 0 0 0 0
Improve ability to deal with change.. . 0 0 0 0 0 0 0 0
Generate innovative ideas... ' ... . 0 0 0 0 0 0 0 0
Start innovative projects ..... 0 0 0 0 0 0 0 0
Develop region to improve innovative atmosphere .. 0 0 0 0 0 0 0 0
Other: _ _ _ _ _ _ _ __ 0 0 0 0 0 0 0 0
Acquire skills& increase company attractiveness for employees 0 0 0 0 0 0 0 0
Attract and retain talent.. 0 0 0 0 0 0 0 0
Generate insights into role and management of alliances .... 0 0 0 0 0 0 0 0
Leverage venture capital skills for management of intemaJ
projects and for spin-offs .. 0 0 0 0 0 0 0 0
Otber: _ _ _ _ _ _ _ __ 0 0 0 0 0 0 0 0

Figure 3-4: Measuring targeted and realized eve benefits (2/2)

..""',""'" ,
Major JIIIp(If- Desir. Irrde.

, ""',"'"
N~

Strategic benefits
objCl:- !alii
,~
able
"'" .fuU
alall
J 0
Build & leverage partner network (cross-selling, acquisitions) 0 0 0 0 0 0 0 0
Improve image among potential business partners .. 0 0 0 0 0 0 0 0
Identify and develop alternative suppliers .. 0 0 0 0 0 0 0 0
Identify and develop new customers ... 0 0 0 0 0 0 0 0
Improve own value proposition with help of partner network ..... 0 0 0 0 0 0 0 0
Access new markets through partnering ..... 0 0 0 0 0 0 0 0
Stimulate dematW for own products indirectly .. 0 0 0 0 0 0 0 0
Participate in standard design .... 0 0 0 0 0 0 0 0
Other: _ _ _ _ _ _ _ __ 0 0 0 0 0 0 0 0
Source & leverage technologies {licensing, co-development) 0 0 0 0 0 0 0 0
Improve internal processes through sourced technologies .... 0 0 0 0 0 0 0 0
Improve the customer va1ue of own products through s. techn ..... 0 0 0 0 0 0 0 0
Enable move into new fields through sourced technologies... . 0 0 0 0 0 0 0 0
Enhance technolo.gical capabilities that may be important in the
future by sourcing technologies .. 0 0 0 0 0 0 0 0
Other: _ _ _ _ _ _ _ __ 0 0 0 0 0 0 0 0
Create additional revenue by leveraging company resourte:s.... 0 0 0 0 0 0 0 0
Create revenue by licensing out technologies .. 0 0 0 0 0 0 0 0
Create revenue by leveraging sales channels .... 0 0 0 0 0 0 0 0
Create revenue by renting out R&D facilities .. 0 0 0 0 0 0 0 0
Create revenue by leveraging manufacturing capabilities ... 0 0 0 0 0 0 0 0
Other: _ _ _ _ _ _ _ __ 0 0 0 0 0 0 0 0
Additional benefits: _ _ _ _ __ 0 0 0 0 0 0 0 0
Chapter 3: CVC-Impact-Model 169

3.2.3. Operationalizing variable 3: Level of potential to create competitive advantage

In this section, an approach is described that allows the operationalization of variable 3,


which measures the potential of eve to create competitive advantage. As discussed below,
eve benefits/sub-benefits are analyzed for their potential to impact a company's sustainable
competitive advantage. By considering eve benefits and sub-benefits as resources, as
discussed in 2.3.2.7, their potential to impact sustainable competitive advantage is analyzed
with the help of attributes of sustainable competitive advantage341 . These attributes are used
as items or indicators. In the following subchapters, several issues are discussed that need to
be specified in order to operationalize variable 3.

First, the attributes that determine a resource's potential to impact sustainable competitive
advantage are described (see 3.2.3.1). Then, in 3.2.3.2, the extent to which eve activities
and eve benefits need to be checked for the attributes of sustainable competitive advantage
is discussed. Next, in 3.2.3.3, why sub-benefits from eve rather then benefits will be
analyzed for their potential to impact sustainable competitive advantage is explained. In the
next section, 3.2.3.4, different ways are introduced as to how a benefit may impact
sustainable competitive advantage. Based on that, limitations of the approach introduced to
identify resources that potentially impact sustainable competitive advantage will be discussed
(see 3.2.3.5). Then, it is argued that variable 3 should be measured by analyzing the results
of the eve activity of a company overall rather than by analyzing individual eve
investment case examples (see 3.2.3.6). In 3.2.3.7, how the attributes of sustainable
competitive advantage can be measured empirically is shown.

3.2.3.1. Attributes determining sustainable competitive advantage

Resources can be tested for their potential to impact sustainable competitive advantage by
analyzing the six attributes discussed in 2.1.3.2. Table 3-1 summarizes the resource attributes
that are necessary to potentially impact sustainable competitive advantage. These are to be
valuable, rare, -appropriable, imperfectly imitable, imperfectly substitutable and durable. In a
causal analysis the attributes would be the items or indicators of the theoretical construct or
latent variable sustainable competitive advantage.

341 These were discussed in 2.1.3.2 and 2.1.3.3.


170 Chapter 3: CVC-impact-Model

Table 3-1: Description of attributes of sustainable competitive advantage


Attribute Description

Valuable Resource needs to be valuable in the specific business context, e.g.:


Increases efficiency or effectiveness
Helps to implement strategy to exploit opportunities andlor to neutralize threats in a
firm's environment
Possible examples are: higher returns or barriers to en1l1' for other comjJetitors
Rare Resource is not possessed by a large number of competing firms. When several firms in
an industry own a valuable and rare resource it can still be a source of competitive
advantage as long as the number of firms is less than the number needed to generate
almost perfect competition dynamics in an industry.
Appropriable Resources are appropriable if potential returns from resources, especially intangible
resources, can be appropriated by the firm. A challenge for appropriability is that
employees may bargain to appropriate major parts of the returns from resources.
Factors that decrease appropriability are if the contribution of the resource (especially
individual employees) to productivity is clearly identifiable, the resource is mobile and
may be contribute to other firms' productivity in the same way.
Ways to increase appropriability may be to embed the resource (especially employees)
deeply into organizational routines so that the value of the resource depends on the
interaction with the rest of the organization.
Imperfectly Competitors cannot imitate' a resource (or only at costs that exceed the returns from the
imitable resource) when its role is not transparent, when the resource is not transferable or not
replicable:
A resource is not transparent when neither competitors nor the company itself may be
able to determine how the sub-benefit (or the bundle of sub-benefits) will help to create
competitive advantage. The reason for this can be tacit knowledge: the company or
individual employees are able to do something but it is not articulated how it is done
because this is not possible, people do not want to or are not aware of the role of the
knowledge. A resource that is not transparent is also said to be causal ambiguous.
A resource is not transferable or replicable when competitors cannot acquire the
resource externally or build it internally. Reasons for this may be that a resource is
historically dependent or socially complex. A resource is historically dependent (or
path dependent) if only a certain path through history enables the company to acquire
the resource. A resource is socially complex if it is a mix of many human andlor
organizational capabilities that is so complex that this mix cannot be imitated, e.g.,
interpersonal relations, culture or reputation.
Other barriers to imitation, also called isolating mechanisms in the Iiterature 342 , are
listed in Table 2-4.
Once a resource is neither transparent nor transferable nor replicable, imperfect imitability
is ensured. If the resources responsible for superior returns are unknown they cannot be
imitated. If resources cannot be transferred or replicated they cannot be imitated even if
their effect on sustainable competitive advantage is known.
Imperfectly No substitute resources exist that can be exploited to implement the same strategy and
substitutable generate the same results. (Or substitutes only can be accessed at costs that exceed the
returns from the resource.) Substitutes should not only be currently non-existent. Future
substitutes need to be unlikely in order to ensure sustainability.
Durable The value of the resource depreciates slowly. Reinvestment in resources may slow down
their erosion.3 43

342 See 2.1.3.3.


Chapter 3: CVC-Impact-Model 171

If a resource (eVe benefit) meets the first three attributes (valuable, rare and appropriable) it
is said to have the potential to impact competitive advantage. If the other three attributes are
met as well (imperfectly imitable, imperfectly substitutable and durable) the resource is said
to have the potential to impact sustainable competitive advantage. 344

3.2.3.2. Testing eve activities vs. eve benefits

As discussed above, the resource eve is separated into two elements in this study: eve
activities and eve benefits345 . In order to determine the potential of eve to be a source of
sustainable competitive advantage, whether both constructs, eve activities and eve
benefits, or only one construct have to meet the six attributes of sustainable competitive
advantage needs to be determined. In the following sections, it is demonstrated that it
depends on the attributes whether eve benefits, eve activities or both need to be analyzed
for meeting the attributes of sustainable competitive advantage.

The first attribute of sustainable competitive advantage is value. The value of activities is
difficult to assess without considering their outcomes. Therefore, activities are only valuable
if their outcomes are valuable. This means that eve activities are only valuable if their
outcomes, eve benefits, are valuable. As a consequence, eve benefits need to be analyzed
for their value.

The second attribute of sustainable competitive advantage is rareness. Since eve benefits
and not eve activities are potentially valuable, eve benefits also need to be rare. Rareness
of eve benefits, however, is independent of rareness of eve activities, as visualized in
Table 3-2. Even if eve activities are rare, eve benefits may not be rare (for example, even
if eve is only done by few players, many players may have a high sensitivity to the need to
innovate, which is one possible eve benefit). Vice versa, when eve activities are not rare
the benefits from eve activities may still be rare. Therefore, in order to impact sustainable

343 This idea is discussed by Reed and OeFilIippi (1990: 97-99). According to Reed and OeFillippi
reinvestments should be made to increase causal ambiguity. Specifically this would mean "... providing
support for the people with tacit knowledge and to utilize that knowledge in other activities [... J, improving
security to protect complex procedures, [... ] and increasing levels of human, site, physical asset, and
dedicated asset specificity." (Specificity is used to describe assets that are built in order to support
particular transactions. See Williamson (1985: 55).) eve may be one possible investment in causal
ambiguity.
344 Resources that do not meet the six attributes may stiIl be valuable to a company. They may create a
competitive advantage for a limited time or they may terminate an existing competitive advantage of
another player. Resources that do not meet the six criteria, however, do not contribute to sustainable
competitive advantage. For a discussion of limitations of the approach to identiJY sources of sustainable
competitive advantage used in this study see 3.2.3.5.
345 In this subchapter the term benefits is used to describe both benefits and sub-benefits.
172 Chapter 3: CVC-Impact-Model

competitive advantage with eve, eve benefits need to be rare. It is not relevant whether
eve activities are rare.
Table 3-2: Possibilities for meeting the attribute rareness
Benefits rare rare not rare not rare

Activities rare not rare rare not rare

Attribute rareness met? yes yes no no

The third attribute of sustainable competitive advantage is appropriability. Resources are


appropriable by a c9mpany if the value generated from them can be appropriated by the
company. Since the value of eve activities depends on the value of eve benefits, as
discussed above, eve benefits need to be analyzed for appropriability.

The fourth attribute of sustainable competitive advantage is imperfect imitability. Two cases
need to be considered: first, eve benefits may be imitated and, second, eve activities may
be imitated. The imitation of eve benefits, that does not require an imitation of eve
activities, is considered substitution of eve and is discussed in the next paragraph. The
imitation of eve activities will present a problem for the potential of eve to be a source of
sustainable competitive advantage if the eve activities imitated lead to eve benefits.
Therefore, if specific elements of a eve activity are necessary to create eve benefits and if
these elements are hard to imitate, then eve may have the potential to impact sustainable
competitive advantage. As a consequence, whether eve activities that lead to eve benefits
are imitable needs to be analyzed.

Elements that prevent imitation of resources are discussed as isolating mechanisms in the
literature. 346 In 3.3, challenges to set up and run eve activities are discussed as potential
isolating mechanisms that may prevent imitation.

The fifth attribute of sustainable competitive advantage is imperfect substitutability. Two


cases of substitution may limit the potential of eve to impact sustainable competitive
advantage. As discussed above, it may limit the potential of eve to impact sustainable
competitive advantage if eve activities can be substituted with other activities that create
benefits that are similar to eve benefits (e.g., using internal venturing to increase the
innovativeness of the organization). In the second case, eve benefits may be substituted by
other resources that create a similar value to companies (e.g., acquisition of technologies

346 See 2.1.3.3.


Chapter 3: CVC-Impact-Model 173

through M&A may limit the necessity to increase the innovativeness of the organization).
Both cases need to be analyzed.

The sixth attribute of sustainable competitive advantage is durability. Durability of eve can
be interpreted in two ways. First, a eve activity may lead to valuable eve benefits on a
regular basis. In this case the eve activity is durable. Even if the eve activity is not
durable, a realized eve benefit may be durable if its value to the company depreciates
slowly over time. Only if neither the eve activity nor the eve benefit created with the
eve activity are durable, will eve not be a durable resource.
The results of the discussion above are summarized in Figure 3-5. The questions that will be
asked to identify whether eve benefits meet the attributes of sustainable competitive
advantage are further specified in 3.2.3.7.

Figure 3-5: Attributes of SeA applied to eve activities and benefits

Attribute: Questions to be asked for each benefit of eve:

Value -Is the eve benefit valuable to the organization?

Rareness Is the eve benefit rare?

Appropriability Is the value from the eve benefit appropriable?

Imperfect Can the eve activities that enable the realization ofthe eve benefit be imitated
imitability by other companies, enabling the realization of the same benefit?

Imperfect ean the eve activities that lead to the eve benefit be substituted by other (non-
substitutability eVe) activities that lead to the same benefit?

Can the eve benefit be substituted by another resource of similar value?

Durability Is eve likely to create this benefit continuously in the future?

Does the value of a single realized benefit depreciate slowly?

3.2.3.3. Testing benefits vs. sub-benefits

As discussed above, the benefits and sub-benefits of eve are resources. These resources
need to be tested for their potential to impact sustainable competitive advantage. Whether
eve benefits or the corresponding sub-benefits according to the distinction in 2.3.2 should
be tested needs to be determined. For at least three reasons it is better to test sub-benefits
rather than benefits for their potential to impact sustainable competitive advantage:

First, it is easier to assess whether sub-benefits meet certain attributes because they are more
specific than benefits by definition. This is especially true for the attribute of value. For
174 Chapter 3: CVC-Impact-Model

example, it is relatively difficult to determine the value of the benefit: "Change in attitude
towards innovation and change". It is easier to assess whether a sub-benefit is valuable:
"Foster willingness to cooperate with external partners." The change in the intensity of
cooperation and the results from cooperation with external partners may be evaluated more
easily than a general change in attitude. Although, it may still be hard to determine CVC as a
cause for such changes.

Second, for some benefits it may not even be possible to determine the sustainable
competitive advanta~e potential since the benefit may be a result of various distinct and
rather different sub-benefits. While the sub-benefits of some benefits are rather similar
(benefits I, 5 and 6), the sub-benefits of other benefits are diverse (benefits 2, 3, 4). For
example, the benefit (4) "build and leverage partner network". The sub-benefit "develop
start-ups as new customers" may meet the attributes of sustainable competitive advantage,
but the sub-benefit "stimulate demand for own products indirectly" may not at the same time.
Still, the benefit has the potential to impact sustainable competitive advantage when at least
one sub-benefit has this potential since a benefit is the sum of all corresponding sub-benefits
(see 2.3.2). This potential of a benefit could hardly be determined by just analyzing at the
level of the benefit.

Finally, it is not only easier to assess sub-benefits for their potential to impact sustainable
competitive advantage but it also provides deeper insights than merely analyzing benefits.
The potential impact on sustainable competitive advantage can be pinpointed more exactly by
analyzing sub-benefits since these are more specific than benefits by definition.

For these reasons, this study analyzes sub-benefits, not benefits, for their potential to impact
sustainabl~ competitive advantage. When a single sub-benefit is found to meet all attributes
of sustainable competitive advantage, the sub-benefit and the corresponding benefit are said
to have the potential to impact sustainable competitive advantage.

3.2.3.4. Ways to impact sustainable competitive advantage

Resources, benefits or sub-benefits, from CVC may impact sustainable competitive


advantage in two ways. Resources from CVC may be new to the company and therefore be a
new source of sustainable competitive advantage. Another option is that a resource is already
owned by a company and possibly a source of sustainable competitive advantage and that
Chapter 3: CVC-impact-Model 175

eve strengthens this resource.347 Not only single resources may be the source of sustainable
competitive advantage. As discussed in 3.2.3.5, bundles of resources may also be the source
of sustainable competitive advantage. Resources gained through eve may be a part of
existing or new bundles of existing or new resources.

An example for accessing a resource that is new to the company may be the 'willingness to
cooperate with external partners'. 'Gaining additional insights into technology and market
trends' could be an example of a resource that is strengthened through eve. When a new
resource, e.g., 'increase sensitivity to innovation' is combined with a strengthened existing
resource, e.g., 'insights into technology and market trends', and an existing technology
competence this bundle of resources may lead to an early entry into new markets. This could
be an example of how a bundle of existing and new resources is the source of sustainable
competitive advantage.

Resources that contribute to a bundle of resources that is a source of sustainable competitive


advantage need to meet the six attributes of sustainable competitive advantage individually.
While meeting some attributes may require other resources to be in place as well, only those
resources are considered to be a potential source of sustainable competitive advantage that
meet all the attributes of sustainable competitive advantage. If a resource is not valuable, it
does not contribute to sustainable competitive advantage even if it seems to be a part of a
bundle of resources. If such a resource is not rare, others can use it in the same way. If such
a resource is not appropriable, the returns from it will not be realized by the company. If
such a resource is imitable, others can imitate it and take advantage of it. If such a resource is
substitutable, others can get similar results without the resource. And if such a resource is
not durable, it will not contribute to a competitive advantage in a sustainable way. As a
result, all the resources in a bundle of resources that do not meet the six criteria do not
contribute to sustainable competitive advantage. 348 Therefore it is always individual
resources that constitute the basis of sustainable competitive advantage, although it may be

347 This study analyzes whether resources from eve (sub-benefits) potentially impact sustainable competitive
advantage positively. This does not include determining a company's existing sustainable competitive
advantage. The potential of a resource to impact sustainable competitive advantage can be assessed without
knowing existing sources of sustainable competitive advantage. As discussed in 2.1.3.2 and above, a
resource needs to meet six attributes in order to have the potential to impact sustainable competitive
advantage. Whether the resource actually does impact sustainable competitive advantage or not is not
analyzed in this study.
348 There is an exception to this as discussed in the next subchapter.
176 Chapter 3: CVC-Impact-Model

necessary for other resources to exist as well for a single resource to meet the attributes of
sustainable competitive advantage especially the attribute ofvalue.3 49

If a resource does not meet the attributes of sustainable competitive advantage the resource
may still have a positive impact on the company. It may even be the source of competitive
advantage for a while. Such a resource, however, will not be the basis for a sustainable
competitive advantage.

3.2.3.5. Limitation to identifying resources that may impact sustainable competitive


advantage'

For two reasons some resources that impact sustainable competitive advantage may not be
identified in this study: first, a resource that is a potential source of sustainable competitive
advantage may not be tested because it was not identified as a benefit or sub-benefit from
eve. Second, it may be not understood that a certain resource meets or does not meet the
attributes of sustainable competitive advantage. In addition to these possibilities, a company
might have argued that a resource met a certain attribute of sustainable competitive advantage
but it actually did not. These limitations to the approach are described in more detail below.

If a sub-benefit of eve is not considered, it cannot be tested and therefore not be identified
as a potential source of sustainable competitive advantage. Even though several measures
have been taken to ensure that a comprehensive list of eve sub-benefits (resources) is tested
(see 3.2.2), some resources may still not be considered. One possible reason why a resource
is not considered is that the company does not know that it creates a certain benefit or sub-
benefit with eve. This is similar to the notions of causal ambiguity or tacit knowledge that
are discussed in 2.1.3.2.350 A company may not know or not be able to pinpoint the exact
benefits or sub-benefits of eve. When benefits are not considered they cannot be tested for
their potential to impact sustainable competitive advantage.

The second reason, why potential sources of sustainable competitive advantage are not
identified, . is that it may not be understood that a certain resource meets attributes of

349 For example, it may be necessary to have certain technological skills in order to take advantage of insights
into new developments and create a sustainable competitive advantage. If a company has these
technological skills, the insights into new developments may be a source of sustainable competitive
advantage. The technological skills, however, also need to meet the attributes of sustainable competitive
advantage to potentially be a source of sustainable competitive advantage.
350 As discussed in 2.1.3.2, Barney introduces the term causal ambiguity to describe the situation that
sustainable competitive advantage is imperfectly imitable because its sources cannot be identified either by
the company or by external players. The link between sustainable competitive advantage and the resources
that create it is said to be causal ambiguous. Grant talks about complex resource bundles that make it hard
to determine the exact sources of sustainable competitive advantage. A similar issue is discussed beyond
the resource literature as the tacit knowledge phenomenon (see 2.1.3.2).
Chapter 3: CVC-Impact-Model 177

sustainable competitive advantage. A test of the resource attributes may result in diagnosing
that the resource does not meet specific attributes. Actually, the resource may still meet the
attribute but it is not understood how. Examples why this may happen are: first, the resource
may be valuable in a context or in combination with other resources that is not considered.
Then, the resource may have a tacit dimension that makes it imperfectly imitable and this
tacit dimension is not considered. Next, even if resources are imitable individually, they may
be difficult to identify in bundles of resources and therefore potentially impact sustainable
competitive advantage. Finally, there may be reasons why a resource is more valuable to one
company than to another which are not understood. When resources are diagnosed as not
meeting certain attributes they actually still may do but it is not understood how.

Vice versa, resources that are diagnosed to meet certain attributes of sustainable competitive
advantage may actually not meet these attributes. While a company may consider a eve
sub-benefit, for example, to meet the attribute of imperfect imitability, this assessment may
be wrong and the resource actually is imitable.

The bottom line is: the proposed approach to determine the impact of eve on sustainable
competitive advantage may miss some resources that have the potential to impact sustainable
competitive advantage. 351 At the same time, some resources that are considered to meet the
attributes of sustainable competitive advantage may actually not meet them.

3.2.3.6. Testing benefits from single cases vs. eve results overall

Two possibilities exist to test eve resources (sub-benefits) for their potential to impact
sustainable competitive advantage. First, specific case examples of investments in start-ups
can be analyzed for the sub-benefits that were generated. Second, the eve activity overall
can be analyzed for the sub-benefits that were generated. In both cases, the sub-benefits may
be analyzed for their potential to impact sustainable competitive advantage.

This study uses the second alternative to measure variable 3. Sub-benefits from the overall
eve activity are analyzed for their potential to impact sustainable competitive advantage.

351 The approach of testing a list of resources may still result in identifYing more potential sources of
sustainable competitive advantage than searching for sources, through starting by looking at existing
sustainable competitive advantage. It is probably easier to come up with a rather complete list of eve
benefits than trying to derive resources that create sustainable competitive advantage, starting at the existing
sustainable competitive advantage. First, it is hard to completely identifY the existing sustainable
competitive advantage of a company, further it is difficult to determine which resources contribute to
sustainable competitive advantage. Finally no potential only actual sources of sustainable competitive
advantage wiIl be identified with the approach of starting with identifYing sustainable competitive
advantage. Potential sources may still be valuable to identifY because they offer opportunities to create new
sustainable competitive advantage.
178 Chapter 3: CVC-Impact-Model

Analyzing the sub-benefits from the overall eve activity has a major advantage over
analyzing sub-benefits from individual case examples. Many sub-benefits are not derived
from single investments in start-ups but from continuous eve investments. Awareness for
the need to innovate or openness to outside developments, for example, most likely are not
derived from a single investment in a start-up. Therefore sub-benefits from the overall eve
activity are analyzed. This has an additional advantage: an analysis of all eve investments
already reflects how the company assesses the results of eve overall building on a large base
of experiences and information. An aggregation of the results from looking at single cases is
not likely to reflect the same depth of synthesis.

3.2.3.7. Measuring attributes

As discussed above, the potential impact of eve on sustainable competitive advantage is


measured with the help of the six items. The measurement is done by checking each single
sub-benefit of eve that has been realized by a company352 for all six attributes as discussed
in 3.2.3.2. Sub-benefits that are notrealized by a company are not checked for their potential
to impact sustainable competitive advantage.

Some of the questions to identify which eve sub-benefits meet the attributes of sustainable
competitive advantage that are summarized in Figure 3-5 are formulated on a rather abstract
level. In addition, these questions are based on the resource theory that is not widely used by
practitioners. Therefore, some of these questions have been reformulated less abstractly and
more specifically as discussed in the following sections.

Specifying the attribute of value

In the cont,ext of the resource-based view of the firm, a resource is considered valuable if it
leads to increased efficiency or effectiveness or helps to exploit opportunities andlor to
neutralize threats as discussed in 2.1.3.2 and Table 3-1. Therefore, the value of a eve sub-
benefit is checked by asking the following question:

Is this eve sub-benefit valuable in the way that it leads to increased efficiency or
effectiveness or helps to exploit opportunities andlor neutralize threats?

This question is still rather abstract and answers are based on subjective assessments and not
on objective measures. The value of eve sub-benefits, however, is difficult to measure
using objective figures. While eve sub-benefits may directly lead to measurable effects like
increased revenues, other effects can only be measured with difficulty. For example, it is
very hard to express the value of early insights into new developments using numbers. Still,

352 To a large or to a full extent as discussed in 3.2.2.


Chapter 3: CVC-Impact-Model 179

most people will agree that such insights may be very valuable, although this assessment is
based on subjective evaluations. Even if a eve sub-benefit leads to measurable effects such
as increased revenues, it may still be difficult to quantify the increase of revenues resulting
from eve. In addition, revenues do not reflect value when costs are not considered and
therefore a quantification of eve sub-benefits would also require considering the costs
incurred.

In this study, the decision whether a eve sub-benefit is valuable is based on the subjective
assessments of people who,are closely in touch with eve and the investing organization.

Specifying the attribute of rareness

In order for a resource to be rare, it can only be owned by a number of firms that is less than
the number of firms needed to generate almost perfect competition. 353 This statement,
however, represents a theoretical concept that is hard to measure objectively.

In this study, rareness is measured based on a subjective assessment. Interviewees were


asked whether the eve sub-benefit is rare enough among competitors to potentially lead to
advantages for those players that realize the sub-benefit through eve or in any other way.

Specifying the attribute of appropriability

As described in 2.1.3.2 and Table 3-1, a resource is appropriable if a company is able to


realize the returns from the resource. In this study, whether a company is able to appropriate
the returns from eve sub-benefits needs to be measured. Appropriability of eve sub-
benefits is measured by a subjective assessment by the interviewees.

In addition to this, the appropriability of human resources is discussed since it represents a


major challenge for companies.3 54 If individual employees can bargain for a significant share
of the returns from a eve sub-benefit, the eve sub-benefit is not appropriable. According
to Grant (1991: 129) at least three reasons may prevent employees from bargaining for a
significant share of the returns from eve sub-benefits: first, a significant impact by
individual employees on realizing a eve sub-benefit cannot be identified. Second,
employees with significant impact on realizing a eve sub-benefit cannot easily start to work
for competitors. Finally, employees with significant impact on realizing a eve sub-benefit
cannot easily realize the same eve sub-benefit for competitors. See Figure 3-6 how these
issues are discussed in the interviews.

353 See 2.1.3.2 and Table 3-\.


i80 Chapter 3: CVC-impact-Model

Specifying the attribute of imperfect imitability

Whether eve sub-benefits can be imitated by competitors needs to be checked. Two


possible cases exist: first, eve activities may be imitated in order to realize eve sub-
benefits. Second, eve sub-benefits may be imitated directly. As discussed in 3.2.3.2, the
second case is regarded as substitution of eve and is discussed below. Therefore, only the
first case is considered in this section: can the eve activities that enable the realization of a
eve sub-benefit be imitated by other companies, enabling them to realize the same sub-
benefit?
As discussed in 2.1.3.2 and Table 3-1, Grant (125-128) suggests two fundamental reasons
why a resource may not be imitated: first, the resource or the role of the resource is not
transparent. Second; the resource is not transferable or not replicable. When applying these
reasons to the question formulated above, three possible situations needed to be considered
that may keep competitors from imitating eve sub-benefits. First, it is not transparent that a
certain eve sub-benefit is valuable (or may impact sustainable competitive advantage).
Second, it is not transparent that a certain sub-benefit is realized through eve. Finally,
competitors are not able to transfer or replicate the ability to generate a certain sub-benefit
through eve. The role of these three possible reasons for preventing imitation is analyzed in
this study.

Many reasons may exist why a resource is not transparent, transferable or replicable. As
discussed in 2.1.3.3, such reasons are called isolating mechanisms or barriers to imitation in
the literature. In 3.3, challenges to set up and run eve activities are discussed as potential
isolating mechanisms that may prevent imitation.

Specifying the attribute of imperfect substitutability

As described in 2.1.3.2 and Table 3-1, resources may not be easily substitutable in order to
impact sustainable competitive advantage. Two questions that test eve sub-benefits for
meeting the attribute of imperfect substitutability are derived in 3.2.3.2. First, can the eve
activities that lead to the eve sub-benefit be substituted by other (non-eVe) activities that
lead to the same sub-benefit? Second, can the eve sub-benefit be substituted by another
resource of similar value?

As discussed in Table 3-1, two more specifications are included. A resource that is
theoretically substitutable but only at costs that exceed the returns from the resource is
considered as imperfectly substitutable. A resource, however, that currently has no substitute

354 See 2.1.3.2 and Table3-1.


Chapter 3: CVC-Impact-Model 181

but is likely to have a substitute in the future is not considered as imperfectly substitutable. 355
These additional specifications were considered in the measurement of eve sub-benefits, see
Figure 3-6.

Figure 3-6: Example for measuring variable 3

eve BENEFIT: GAIN INSIGHTS INTO NEW DEVELOPMENTS EARLY ON


True De- Not Explanabon (Whylhow/undcr
pendsuuc wllalcordlllons1)

Value This eve benefit is valuable in the way that it leads to increased efficiency or 0 0 0
effectiveness or helps to exploit opportunities and/or neutralize threats?
Why/how?
Rare- The eve benefit is rare enough among c.?mpetilotS to potentially lead to 0 0 0
advanlages r~ those players that realize the benefit through eve or any other
way.
Appro.- Tbe value from theCVC benefit is appropriable by the company. 0 0 0
priability No individual employees can bargain fot a significant share of the rewrns from 0 0 0
eve benefits. (Why? Significant impact by individual employees on realizing a
eve benefit cannot be identified? Employees with significant impact on
realizing a eve benefit are notmobdc'orcannOl easily rea1ize the same cve
benefit for competilOr5?)
Imper. It is not transparent to competitors thaI the eve benefit is valuable 0 0 0
feci imi- It is not transparent to competitors that the benefit is generated through evc 0 0 0
lability Competitors are not able to transfer or replicate the ability to generate the benefit
through eve 0 0 0
Imper- No activities other than eve activities exist that lead to the eve benefit. It is 0 0 0
fect unlikely that such activities will exist in the future If activities other than eve
substi- activities lead to the eve benefit then only at costs that exceed the returns from
ulability the eve benefit
The eve benefit can currently not be sub~tituted through anOlher resource of 0 0 0
similar value. This is also unlikely in the furure. IfeVe benefits can be
substiruted then only al costs that exceed the returns from the eve benefil

Dura- eve activities are likely to create this benefit continuously in the future. 000
bility The value of a single realized benefit depreciates slowly 000

Specifying the attribute of durability

Two questions are derived in 3.2.3.2 that test whether eve sub-benefits are durable. These
are formulated as two statements that need to be true: first, eve activities are likely to create
this sub-benefit continuously in the future. Second, the value of a single realized sub-benefit
depreciates slowly. If one of these two statements is true, the eve sub-benefit is considered
to be durable. As for the other attributes, the assessment whether a eve sub-benefit meets
the attribute of durability is based on subjective assessments of interviewees.

Summarizing the results from the discussion above, Figure 3-6 demonstrates how eve sub-
benefits are tested for meeting the attributes of sustainable competitive advantage.3 56 Instead

355 Whether a resource is likely to have a substitute in the future cannot be detennined simply by definition.
Such a possibility may be expressed as a probability that is unlikely to be 100% or 0%. It may be argued
that every resource may be substituted at some time in the future. Little and only unreliable infonnation can
usually be gathered about the potential development of substitutes, therefore this study uses a personal
assessment by the interviewee to assess the likelihood of future substitutes although this does not provide
perfect results.
356 Instead of the tenn sub-benefit, the tenn benefit is used in all parts of the questionnaire.
182 Chapter 3: CVC-Impact-Model

of questions, statements are used to measure whether a CVC sub-benefit meets the attributes
of sustainable competitive advantage. These statements may either be true or not be true for
a specific sub-benefit. The statement may also be true depending on certain conditions that
need to be explained by the interviewee.

It should be noted that the measurement of variable 3 used several indistinct terms, e.g.,
slowly, continuously in the future etc. This may negatively affect the accuracy of results and
the comparability between different companies. The indistinct terms, however, are a
consequence of the a,bstract attributes of sustainable competitive advantage. Increasing the
accuracy of the language may not only be difficult in some cases but it would be less
practical in terms o~ empirical applicability in this study. Future research that is focused
more narrowly on analyzing the potential of resources to impact sustainable competitive
advantage may use more specific items than this study. In this study, the interviewer needed
to make sure in the case interviews that the underlying ideas were clearly understood by the
interviewees.

A CVC sub-benefit was said to have the potential to impact sustainable competitive
advantage in the case that the following statements were true: the statements of value and
rareness needed to be true. Both statements of appropriability needed to be true. At least one
of the three statements of imperfect imitability needed to be true. Both statements of
imperfect substitutability needed to be true. Finally, at least one of the statements of
durability needed to be true.

Challenges exist for impacting sustainable competitive advantage with CVC. Some of these
challenges were identified by testing CVC sub-benefits for meeting the attributes of
sustainable competitive advantage as discussed above. Challenges to set up and run CVC
activities and their implication for impacting sustainable competitive advantage are discussed
in more detail in the next subchapter.

3.3. Critical activities for impacting sustainable competitive advantage

The CVC-Impact-Model was introduced in 3.1 and operationalized with the help of three
variables in 3.2. Whether CVC has the potential to impact sustainable competitive advantage
or not can be analyzed with the help of the CVC-Impact-Model. An additional analysis is
discussed in this subchapter to identify the CVC activities that are potentially critical to
impact sustainable competitive advantage through CVC. This analysis is a first step towards
Chapter 3: CVC-Impact-Model 183

determining what eve activities companies should focus on to increase the likelihood of
impacting sustainable competitive advantage with eve. 357

A eve activity needs to meet at least two criteria to be critical to impact sustainable
competitive advantage from eve. First, it needs to be relevant for realizing eve benefits
and second, one or a few players must be able to do it better than others. If an activity is not
relevant for realizing eve benefits or sub-benefits, it is not relevant for creating competitive
advantage. If some players are not better at doing an activity than the majority of players,
many can do the activity ip. the same way and prevent somebody from creating sustainable
competitive advantage by doing this activity better. These two criteria are tested as described
below.

In addition, a third criterion is tested, the difficulty of performing specific eve activities.
The underlying idea for this criterion is to find out whether a certain activity offers the
potential to be done better by some players than by others. This is more likely when an
activity that is relevant for realizing eve benefits is difficult to do. Ifa eve activity is
difficult to do, this increases the likelihood that the benefits realized from it cannot be
imitated easily and therefore increases the likelihood that the eve activity is critical to
impact sustainable competitive advantage from eve. A difficult eve activity therefore
represents a potential isolating mechanism for sustainable competitive advantage created with
eve.3 58
The eve activities that are tested are the challenges for setting up and running eve
identified in 2.5 and 2.6 and summarized in 2.7.359 These eve challenges are tested because
dealing with them well is a key prerequisite for doing eve successfully. Since dealing with
the eve challenges is likely to be difficult, they offer an opportunity for companies to
differentiate themselves from other players and potentially impact sustainable competitive
advantage. The eve challenges are also likely to cover the whole spectrum of eve
activities that are likely to be relevant for realizing eve benefits.

357 The analysis of this challenge to generate eve benefits is similar to an analysis of the key factors of
success. It focuses on analyzing how eve needs to be done in order to generate eve benefits.
358 The reasons why a company is better able to handle eve challenges than others are also isolating
mechanisms if they prevent imitation in the long run. See 2.1.3.3 for a discussion of isolating mechanisms.
359 See Table 2-21.
184 Chapter 3: CVC-Impact-Model

The eve challenges need to be tested for the three criteria introduced above. The specific
questions that are asked are: 360

Is the eve challenge relevant for realizing eve benefits?

Is it difficult to deal with the eve challenge?

Is the company interviewed better able to handle the eve challenge than other
players?

All three questions are answered on a five-point scale. Relevance is measured on a scale with
the attributes essential, relevant to a large extent, relevant to some extent, relevant to a small
extent and not relevant. Difficulty in dealing with a challenge is measured on a scale with the
attributes very difficult, difficult to a large extent, difficult to some extent, difficult to a small
extent and not difficult. The ability to be better able to handle eve challenges is measured
on a scale with the attributes most likely, likely to a large extent, likely to some extent, likely
to a small extent and not likely. FigUre 3-7 and Figure 3-8 show how the eve challenges are
tested in this study.

Five different types of conclusions can be drawn from the analysis of eve challenges.
These possible conclusions are visualized in Figure 3-9 and explained in the following
paragraphs.

A eve challenge that is not essentially relevant or to a large extent relevant for realizing
eve benefits is considered not to be critical for impacting sustainable competitive advantage
(conclusion I).

When a e~e challenge that is essential or relevant to a large extent but is not very difficult to
deal with or difficult to deal with to a large extent and when the company interviewed is not
most likely or likely to a large extent to be better able to handle the challenge, the challenge
is not considered to be critical for impacting sustainable competitive advantage (conclusion
II). Such a' challenge may need to be dealt with well but does not offer any opportunity to
create an isolating mechanism.

360 The order in which the three criteria are tested has been changed so that the interviewees can answer the
questions more easily,
Chapter 3: CVC-Impact-Model 185

Figure 3-7: Testing role of eve activities for impacting sustainable competitive
advantage (112)

.....
RclevantfoTr=b DiffiroJllode:llwllh 6dtcrabletohandle
eve proc.ess step/eve challenge ZII\llCVCbeIlc:fits?
N~
dIaIlcllle?
V.~ N~ ..,.
itlhanotherCVCs1
NOiat
Set objectives ti>I oda'" difficult diDkull Iikcly oI'
Determine specific targeted strategic benefits of eve. .. 00000 00000 00000
Define eve investment approach
Decide on either using a direct or an indirect investtnent approach... ,.. .00000 00000 00000
Detennine management approaches for eve activities (generating deal
flow. due diligence. investing, interacting with start-ups, exiting,
monitoring) ....................... 00000 00000 00000
Derme an investment focus that enables a company to generate targeted
benefits... ) 00000 00000 00000
Ensure corporate commitment in the long run. (Partially reflected in fund
leon and fund size.) ..... 00000 00000 00000
Determine organizational linkages
Design organizational linkages to reaJi:te be,,"efits within the organization. 00000 00000 00000
Design organizational linkages to support eve activity ... .. 00000 00000 00000
Design organizationa11inkages to support stan-ups..... .00000 00000 00000
Position eve within the organization in tenns of responsibility and
reporting..... .. 00000 00000 00000
Staff positions and design compensation
Find eve managers with an adequate mix of corporate experience and
networks. ve skills and networks and technological and market expenise. .00000 00000 00000
Design compensation system that attllets and retains eve personnel and
that is also compatible with company culture... " 00000 00000 00000
Set up monitoring
Set up monitnring system that allows the measurement of strategic success
and the adaptation of eve activity.... '. 00000 00000 00000

Figure 3-8: Testing role of eve activities for impacting sustainable competitive
advantage (2/2)

Rclcvantforllla!i Difficulltodca1witb Bcucr able til handle


eve process step/eve challenge
Generate deal flow
,,-
lingCVCbc~fit5?
Nol
ehaUcngc?
Very
difficult
N.
difficul!
"",
I!lhanothcrCVCs~

hkcly
Notal
,II
"ol
~"".'"
Generate sufficient high quality deal flow ... 00000 00000 00000
Assess investment opportunities
Pel'fonn due diligence to assess potential of investment opportunity and
to determiPe strategic relevance 00000 00000 00000
Leverage organization to support due diligence ... 00000 00000 00000
Achieve strategic objectives through due diligence support by
organization ... 00000 00000 00000
Invest
Build investment and negotiation skills fOf pricing deals and designing
investment agreements..... 00000 00000 00000
Structure investments to protect proprietary start-up assets and also
enable strategic benefits for the investing company.... 00000 00000 00000
Interact with start-ups
Monitof start-ups and provide Qclassic" ve support to them..... 00000 00000 00000
Leverage the organization to provide corporate support to start-ups ....... . 00000 00000 00000
Rea1ize strategic benefits by intemcting with stan-ups ..... 00000 00000 00000
Exit investments
Detennine when to exit investments .... . 00000 00000 00000
Manage exit process {how to exit).... . 00000 00000 00000
Monitor success
Monitor eve activities ...................... . 00000 00000 00000
Adapt eve activities based on results of m<mitoring .... 00000 00000 00000
186 Chapter 3: CVC-Impact-Model

Figure 3-9: Possible conclusions from analysis of eve challenges

Essentially relevant or Very difficult or Most likely or likely to Critical challenges for
relevant to a large difficult to a large a large extent to be impacting sustainable
extent for realizing extent to deal with better able to handle it competitive advantage
CVCbenefits? challenge? than other CVCs? (SCA)?
lIJJoo lIJJoo lIJJoo
. . Not critical for
1. No YesiNo YesiNo impacting SCA
. . Not critical for
II. Yes No No impacting SCA
. . Potentially critical for
III. Yes Yes No impacting SCA but hardly
an opportunity for company
interviewed

.
. . Potentially critical for
IV. Yes Yes Yes impacting SCA and an
opportunity for
company interviewed
Potentially critical for
v. Yes No Yes impacting SCA for
company interviewed

A eve challenge is considered as being a critical factor for impacting sustainable


competitive advantage and therefore offering opportunities for certain companies when it is
essentially relevant or relevant to a large extent for realizing eve benefits and when it is
very difficult or difficult to a large extent to deal with. When the company interviewed is not
at least likely to a large extent to be better able to handle the challenge, the challenge may
have the potential to be a source of sustainable competitive advantage for other companies
(conclusio'l III). When the company interviewed is also most likely or likely to a large extent
to be better able to handle the eve challenge than others, the challenge offers the
opportunity to be a source of sustainable competitive advantage for the company interviewed
and possibly for others (conclusion IV).

A eve challenge is also considered to be potentially a critical factor for impacting


sustainable competitive advantage for the company interviewed when it is essentially relevant
or relevant to a large extent for realizing eve benefits and when a single company is most
likely or likely to a large extent to be better able to handle the challenge even when it is not
considered to be difficult (conclusion V). This is because the level of difficulty of dealing
with a eve challenge is not measured objectively but subjectively using the assessment of
the company interviewed. A company may, however, consider a challenge not to be difficult
and, at the same time, most other companies do consider this challenge to be difficult. If the
company is better able to handle the challenge than others, it may very well impact
sustainable competitive advantage by dealing well with this challenge.
Chapter 4: Case studies 187

4. Case studies

The CVC-Impact-Model that was developed in chapter 3 has been used in case studies to show
its applicability and to improve it. The case study approach is further explained in 4.1. The
results from four individual case studies are discussed in 4.2 to 4.7. The background of CVC
activities is discussed in 4.2. Findings on the level of CVC activity are discussed in 4.3.
Findings on the level ofCVC benefits are presented in 4.4. Findings on the potential impact of
CVC on sustainable comp<;titive advantage are discussed in 4.5. Findings on CVC challenges
are presented in 4.6. Finally, the overall applicability of the CVC-Impact-Model is discussed
in 4.7.

4.1. Research approach

The objective of this study is to determine the impact of CVC on sustainable competitive
advantage. For this purpose a conceptual model was developed in chapter 3. Before the CV C-
Impact-Model can be applied to test hypotheses, the applicability of the model needs to be
demonstrated. Therefore, the model and the way in which it is operationalized has been
applied in case studies. The results from the application of the model in case studies are
intended to be used to optimize the operationalization of the model and to develop and refine
hypotheses. 361

The case study objectives are explained in more detail in 4.1.1. The interview design is
described in 4.1.2. The quality of the research design is discussed in 4.1.3. Finally, the choice
of case study targets is explained in 4.1.4.

4.1.1. Objectives of case studies

The objective of the case studies performed in this study is primarily to apply the theoretically
discussed CVC-Impact-Model to some examples to show its applicability. The application of
the model in these examples is intended to allow the optimization of its operationalization in
some respects. In addition, the application of the model is intended to develop and refine
hypotheses especially regarding the likelihood of CVC benefits impacting sustainable
competitive advantage and to develop initial hypotheses on which CVC activities are
potentially critical to impact sustainable competitive advantage.

361 Sound hypotheses are a necessary requirement for doing a statistical analysis based, for example, on the
LISREL approach, since LISREL can only support or not support a described causal relationship, as
discussed in 3. l.
188 Chapter 4: Case studies

It is not intended to try to generalize findings from case studies instead the preparation of such
a generalization is targeted. By looking at a small number of specific cases intensively, the
applicability of the developed conceptual model is demonstrated and the adaptation of
hypotheses and the way in which the model is operationalized is allowed for. These findings
may be used as a basis for examining a statistically significant sample regarding the potential
impact of eve on sustainable competitive advantage.

The following specific findings are targeted regarding the ability to measure variables and how
the measurement can be optimized. A specific issue regarding variable I is whether the list of
attributes or single attributes determining the level to which companies do eve are too
restrictive. A specific issue regarding variable 2 is whether the list of eve benefits is
complete. 362 A specific issue regarding variable 3 is whether it is possible to communicate the
attributes of sustainable competitive advantage and whether meaningful answers can be
generated. This was especially important since the resource-based view has not been applied
in the way suggested in this study b~fore. Finally, a practical issue is analyzed, namely, how
time-consuming it is to fill out the questionnaire prepared for this study, and how much
support is needed in the process.

The second outcome targeted from the case studies is to generate additional insights into eve
as well as to develop and refine hypotheses from applying the model. A core area in which the
aspiration is to generate findings and to develop hypotheses concerns questions regarding if
and when the attributes of sustainable competitive advantage for eve benefits are met. The
overall findings from applying the model are discussed in subchapters 4.3.5, 4.4.5, 4.5.5 and
4.6.5.

Given the 9bjectives described above, the case studies are to a large degree descriptive and to
some degree exploratory.363

4.1.2. Case study interview design

In the discussion of interview design, several questions are covered. First, it is argued that
face-to-face interviews and telephone interviews are suited to collect data in this study. Then,
it is explained why the use of mostly closed questions in a structured questionnaire is

362 This is a final test whether the list of eve benefits and sub-benefits that have been derived from the literature
and from discussions with practitioners is complete.
Chapter 4: Case studies 189

appropriate. Next, it is discussed why mainly subjective data is used. Finally, it is explained
why only a single person per company is interviewed.

Interviews are used as the main source of information in this study. In addition, some
documentation is analyzed as specified for the individual cases in 4.2. Interviews can be done
face-to-face, over the phone, in written form or computer-based. 364 In this study face-to-face
and telephone interviews were most advantageous as discussed below.

Face-to-face or telephone interviews have some strengths.365 The interviewer can introduce
the underlying concept ~ore easily and more comprehensively than when surveys are
answered by interviewees independently without contact with the interviewer. When
necessary the interviewer 'can explain the questions to the interviewee. This is especially
important in this study since the theory underlying the CVC-Impact-Model is not widely used
in practice. Therefore, the concept needs additional explanation and filling out the
questionnaire requires support.

Face-to-face interviews and telephone interviews to some extent also allow the gathering of
information that goes beyond the written answers. This information may be derived, for
example, from reactions and questions that arise. Such information is especially important in
this study since the interviews are intended to show the applicability of the model introduced.

At least one more strength of face-to-face or telephone interviews is that the interviewer can
ask for an explanation when unexpected results occur. This facility is important for this study
to evaluate the applicability of the model.

A weakness of telephone and especially face-to-face interviews is that the interviewer may
potentially influence the interviewee through his/her presence or his/her comments, which may

363 The case studies described in this section are to a lesser degree explanatory when the objective is to try to
frnd out why attributes of sustainable competitive advantage are met or not met. Descriptive, exploratory and
explanatory are the three types of case study described by Yin (1994: 3-6). To a limited degree, the case
studies in this chapter are used for theory building, a major objective for using case studies according to
Eisenbardt (1989: 532). Theory building in the case studies analyzed in this chapter, however, is focused on
testing, refining and extending a proposed conceptual model and not on developing such a model from
scratch.
364 See, for example, Scheffler (2000: 69-72).
365 According to Yin (1994: 80) general strengths of interviews are that they are targeted and insightful.
Interviews are targeted in the sense that they focus directly on the case study topic. Interviews are insightful
because they can provide perceived causal inferences.
190 Chapter 4: Case studies

lead to biased answers.3 66 This possibility has to be accepted in this study since the face-to-
face and telephone interviews are superior given the strengths described above.

This study uses a structured questionnaire containing mostly closed and some open questions
(see appendix). This was identified as the best way to apply the model developed in chapter
3. 367 The information specified in detail in chapter 3 is mostly gathered with the help of
closed questions. In addition, open questions are targeted to allow the optimization of the
operationalized model and the development of hypotheses. The use of a structured
questionnaire increase~ the reliability of the case studies as discussed in the next section and
most parts of the questionnaire can be used in a statistical analysis leveraging the eve-
Impact-Model.

In this study some objective data is collected as well. However, mainly subjective assessments
are called for especially on eve benefits and attributes of sustainable competitive advantage.
Subjective data has some drawbacks and some advantages. A drawback of subjective
assessments is that they are more likely to be biased than objective data. In this study, this
may be true for questions on the level of benefits realized since eve managers are likely to
see and present their own work more positively than it may actually be. For the important
questions on meeting the attributes of sustainable competitive advantage, a bias is less likely.
For the questions on sustainable competitive advantage, it is less apparent what is positive or
negative and the eve managers are less likely to feel responsible for the results since an effect
on sustainable competitive advantage does not only depend on their own work. This limits the
probability of a bias. As already indicated in 1.2, 2.5.5 and 2.8, developing objective success
measures for eve is an open issue.3 68 Objective success measures could at least limit the bias
of the analysis of eve benefits. As long as no specific objective measures of eve are
available, the approach used in this study is feasible to evaluate how successful eve is. An
advantage is definitely that it is relatively easy to use. 369

Subjective assessments have the advantage that they allow the experience and expertise of
eve managers for collecting data to be drawn on. Although subjective data is collected, this

366 According to Yin (1994: 80) weaknesses of interviews in general may be a bias due to poorly constructed
questions, response bias, inaccuracies due to poor recall and reflexivity meaning that an interviewee may
state what the interviewer wants to hear.
367 For open-ended theory building a less structured interview with more open questions would be more
appropriate.
368 It is unlikely that objective measures can be developed for all parts ofthe model.
369 Given the breadth and nature of data necessary to apply the eVe-Impact-Model, valid objective measures
seem to be impractical for this study.
Chapter 4: Case studies 191

is not purely qualitative. The use of scales allows the collection of semi-quantitative data that
enables statistical analysis. 37o

Based on the focus of this study it was considered best to interview eve managers. eve
managers were considered most likely to be competent and potentially the only employees
within the organization to be competent to provide information on the various areas analyzed.
In addition, it was considered sufficient to do only one interview per company, since the
objective is to show the applicability of the model and to develop and refine hypotheses and
not to generalize findings.3~1 Just doing one interview per company also prevents problems
with aggregating results and dealing with potentially conflicting data.

4.1.3. Quality of researeh design

It is important to determine the quality of research design. Yin (1994: 32) states, "[b]ecause a
research design is supposed to represent a logical set of statements, you also can judge the
quality of any given design according to certain logical tests." Different criteria determine the
quality of the research design. Yin (1994: 32-38) focuses on the quality of research for case
studies and differentiates between four tests that are commonly applied in order to determine
the quality of the research design: the tests of reliability, construct validity, internal validity
and external validity. Lienert and Raatz (1998: 7) describe the quality of tests in general.
They regard objectivity besides reliability and validity as essential. In this section, the
different quality criteria are briefly described. First, however, their role in this study is
discussed.

The objective of this study is to develop an approach to determine the impact of eve on
sustainable competitive advantage. Based on theoretical reasoning, a conceptual model has
been developed that describes the relationship of eve and sustainable competitive advantage.
Before the model could be used to test hypotheses, its applicability needed to be tested first
and hypotheses needed to be developed and refined. For this reason mostly descriptive and
partially exploratory case studies were done. In the following paragraphs it is described what
has been done in this study to increase the quality of research.

Objectivity exists when the research results are independent of the researcher. Objectivity has
different aspects: objectivity of research process, objectivity of data analysis and objectivity of

370 For a differentiation between qualitative, quantitative and semi-quantitative measurement see Hauschildt
(1997: 386).
371 Kumar, Stem and Anderson (1993), for example, regard the key informant approach as an appropriate
method to generate research findings. Nevertheless, findings based on information from key informants
should be interpreted with care. Ernst (200 I: 315) finds a significant informant bias in success factor
research on new product development. According to Ernst, hierarchical position as well as functional
background impact the information provided by informants to an extent that limits validity of research.
192 Chapter 4: Case studies

interpretation. 372 The objectivity of the research process is increased with the help of a sound
theoretical basis and, based on this, an unbiased questionnaire. In this study, the CVC-Impact-
Model has been derived as a basis for analysis from theories discussed in the literature. Within
the model, explicit rules are used for interpreting data. This data was gathered with the help of
a comprehensive and written questionnaire that limited the need for the interviewer to explain
concepts and questions (see appendix).

Reliability exists when repeating the measurement of the same attributes with the same
procedures leads to si~ilar results. Different aspects of reliability are discussed, for example,
by Lienert and Raatz (1998: 9-10). Reliability may be increased by checking the consistency
of results, by asking ~fferent people within an organization the same questions or by retesting.
According to Yin (1994: 33, 36-37), reliability for case studies can be increased by providing
detailed documentation of the process followed. This has been done in this study by providing
a detailed questionnaire (see appendix).373 In addition, the data that was gathered is provided
almost completely as raw data in subchapters 4.2 to 4.6 before it is analyzed further and
interpreted.

Reliability is a necessary condition for validity. Validity exists, when the research measures
what was intended to be measured. Therefore, validity varies with the extent of systematic
errors (Ernst, 200 I: 84). Different aspects of validity exist, for example, construct validity or
internal validity.374 As suggested by Ernst (2001: 315) the use of key informants may limit the
validity of the results.3 75 In order to increase validity of the approach which is based on a
sound theoretical basis, as discussed above, interviews with practitioners have been conducted
upfront in particular to confirm the list of CVC benefits that is tested. In addition, it was the
very objective of the case studies in this study to analyze the validity of the proposed approach
by applying' the model in multiple cases and to improve the model based on the findings when
necessary.

4.1.4. Case study targets

In this study, rather different case study targets have been chosen in terms of level of
investment activity, time in operation or industry. Choosing different types of CVC players

372 See Lienert and Raatz (1998: 7-9). The German terms they use are: Durchfithrnngsobjektivitlit,
Auswertungsobjektivitfit und Interpretationsobjektivitlit.
373 In order to improve reliability, explanations of the questions asked are provided. It is, however, not
considered ideal to make explanations so detailed that no support from an interviewer is needed anymore.
Based on the nature of the variables tested, this would require long and complex explanations. This would
make tilling out the questionnaire more difficult and would require more input in terms of time and energy
from the interviewee which, in tum, may limit the response rate.
374 See, for example, Lienert and Raatz (1998: 10-11).
375 See footnote 371.
Chapter 4: Case studies 193

has at least two advantages, given the objective of the case studies, to show the applicability of
the CVC-Impact-Model and to develop hypotheses. Choosing different types of CVC players
is more appropriate to achieve the objective for doing case studies since it provides the
opportunity to show the applicability of the CVC-Impact-Model in different settings. 376

While the intention is to look at small and young CVC activities in addition to those that have
been large and active for a longer period of time, minimum requirements need to be met by
potential case study targets. The activity needs to have been in operation for at least two years.
This is considered to be the minimum amount of time for realizing at least some strategic
benefits from first investments. In addition, the amount invested needs to be at least USD 50
million in at least 10 companies. This investment level is considered to be the minimum level
to prove serious objectives and to be able to realize strategic benefits from a portfolio of
investments.

Four companies have been chosen as case study targets. These are Intel, Media X, Philips and
Novartis. Key facts about their investment activity are summarized in Table 4-1, which is
sorted in the order of the level of investment activities.

Table 4-1: Case study targets


Company Level of CVC activity time Industry
investment activity in operation
(approx. fund size in (approx. years)
2000, USD million)
Intel 2700* 10 Semiconductors

Media X >100 >5 Media

Philips 100** 2 Electronics

Novartis 60 5 Life Science

* No predetermmed fund SIze; Illvestments III 1999 and 2000 only


** No predetermined fund size; investments so far

All four companies are large established players in their respective markets. Intel is a US
semiconductor company and probably the largest CVC investor in the world. Media X is a
large media company that chose not to have its identity disclosed. Philips is a large European
electronics manufacturer that has recently started CVC activities. Novartis is a large European

376 Based on the definition of eve in this study, companies have not been considered as case study targets when
they did not try to achieve strategic objectives.
194 Chapter 4: Case studies

life science company. While Novartis had invested CVC for more than five years, the overall
investment level remained rather small compared to the other case studies.

4.2. Company background

In the following subchapters background information on the CVC activities of the four
companies interviewed is provided: Intel (4.2.1), Media X377 (4.2.2), Philips (4.2.3) and
Novartis (4.2.4).

4.2.1. Intel Capital - Background

The information provided on Intel Capital was gathered from two sources: first, from a face-
to-face interview by the author with two members of Intel Capital Europe. 378 Second, from
the Internet page of Intel Capital (www.intel.comlcapital).

Intel Capital is the CVC arm of InteJ.379 Intel Capital was founded in the early 1990s380 and
had about 350 employees worldwide at the time of the interview. This included about 130
professionals in addition to legal, treasury, marketing and PR people. Intel Capital did not
invest out of a fund with a predetermined fund size. 381 By investing USD 1.2 billion in 1999
and USD 1.5 billion in 2000, Intel Capital was probably the largest corporate venture capital
investor in the world. In 2001, Intel Capital also planned to invest about USD 1.5 billion.
Intel Capital only invested directly in start-ups and not indirectly through external VC funds.
In 1999, Intel Capital made 250 investments, in 2000, 350 investments and the Intel Capital
portfolio at the time of the interview consisted of 550 companies. In 2000, Intel Capital exited
a large number of investments with a value of USD 4 billion. Intel Capital focused on
investments in the IT and telecommunications sectors in both hard- and software and typically
funded private companies in early stages but not at the seed stage. The targeted investment
amount per deal ranged from USD 2 to 10 million. Intel Capital intended to stay below a 20%
equity stake for reporting reasons and 95% of the investments were syndicated. In the US,
Intel Capital was typically a co-investor in investment syndicates but based on the limited

377 Media X chose to remain anonymous.


378 Mr. Torsten Krumm, Strategic Investment Manager and Head of Intel Capital Germany, and Mr. Thomas
Offner, Strategic Investment Manager, on March 26th 200 I in Munich.
379 Intel Capital was also responsible for Intel's M&A activity which was small in terms of number of
investments compared to the CVC activity.
380 Until the late 1990s, Intel's CVC activities were a part of business development without the branding ofintel
Capital.
381 There were two exceptions: Intel Capital managed two funds with a predetermined fund size. First, the Intel
Communication fund which targeted investments in wireless technologies with a fund size of USD 500
million. Second, the Intel 64 fund which tried to support the development of a 64 bit technology ecosystem
with an equal fund size of USD 250 million, with half of the capital being provided by Intel and the other half
by external investors including Compaq, Dell, Hewlett Packard and NEC.
Chapter 4: Case studies 195

number of experienced venture capitalists in Europe, Intel Capital was lead investor in about
half of the deals in Europe. 30% of Intel Capital's deal flow came from venture capitalists and
other corporate venture capitalists, 20% from business units382 and 50% directly from
entrepreneurs. On average Intel Capital had a 1% closing rate. 383

Intel regarded its CVC activities as absolutely essential in the context of its overall strategy.
This was reflected in the leadership of Intel Capital as Leslie L. Vadasz, President of Intel
Capital, was also Executive Vice President of Intel. Intel intended to positively impact its
competitive situation through its CVC activities. The specific objectives of Intel for investing
CVC are discussed below. Intel was satisfied with meeting goals on three dimensions: the
CVC activity level, the financial success of CVC activities measured by IRR and ROI and
with meeting strategic CVC objectives. This was determined with the help of two measures.
First, the number of relevant innovative developments Intel was or was not participating in
and, second, the level at which business agreements between Intel business units and start-ups
were met. These business agreements were formulated for every investment Intel made and
described which type of cooperation the relevant Intel business unit and the start-up intended
to develop and what kind of support the relevant Intel business units agreed to provide. The
business unit agreements with start-ups reflected Intel Capital's effort to provide "value beyond
equity". Among other things, Intel's support to portfolio companies included issues like
technological assistance, insight into future trends or access to the widespread network of
Intel.

4.2.2. Media X Venture Capital - Background

The information provided on Media X Venture Capital was gathered from two sources: first,
from a face-to~face interview by the author with an investment partner of the CVC fund. 384
Second, from the Internet page of Media X Venture Capital. Media X chose to remain
anonymous. Therefore the term Media X is used to identify the company and some
background information has been omitted.

Media X had started its CVC activities more than five years before the time of the interview
and Media X Venture Capital had more than 10 professionals dedicated to CVC activities.
The total fund size was more than USD 100. 90 percent of all investments were made directly
in start-ups; in 2000, Media X Venture Capital had invested in a double digit number of start-
ups at the time of the interview.

382 All the deal flow from business units was external deal flow. Intel did not believe in funding internal
ventures.
383 This means that 1% percent of deals that Intel saw received funding.
384 The interview took place on April 61h 2001.
196 Chapter 4: Case studies

Media X Venture Capital focused on investing in start-ups in all stages. The targeted
investment amount per investment round was about USD 5 million, while this varied
depending on the stage of the funded start-up. The technology focus was in Internet
infrastructure. Media X Venture Capital syndicated all of its deals. The major source of deal
flow was venture capitalists although the network of current and former portfolio companies
was also an important source of deal flow. Some deal flow came from inside Media X itself.

The CVC activities were very important in the context of Media X's overall strategy. One
indication for this could be that the CVC activities were discussed in analyst reports on Media
X. Media X intended to impact its sustainable competitive advantage with CVC and CVC
activities were regarded as Media X's eye on technology and were expected to support Media
X's move into new fields.

At the time of the interview, the CVC investment activity had exceeded the targeted levels and
Media X was very satisfied with the level to which it had met its CVC objectives. Its financial
performance had achieved triple digit return figures since inception.

4.2.3. Philips Corporate Venturing - Background

The information provided on Philips Corporate Venturing was gathered from a telephone
interview. 385

Philips Corporate Venturing was founded at the end of 1998. Ten people were working for the
venturing activity at the time of the interview excluding administrative staff. Philips
Corporate Venturing did not invest out of a predetermined fund but needed approval for every
investment from the management board, which met every two weeks. Philips Corporate
Venturing only invested directly in start-ups and not through other venture capital funds. At
the time of the interview, Philips had invested about USD 100 million in a total of 25
companies, 17 investments were made in 2000.

The targeted investment amount per deal was USD 5 to 6 million. Philips Corporate
Venturing targeted investments in start-ups in the later early stage or in the expansion stage, an
exception being spin-outs from Philips that might receive seed funding. Philips' investment
focus reflected the industries Philips is active in. These are represented by six clusters of
technology: display technologies, storage solutions, connectivity, digital video, personal health
monitoring and value-added services for consumer electronic devices.

385 The interview was conducted by the author with Chey-Hui Chia, Manager Corporate Venturing, on April 10th
2001.
Chapter 4: Case studies 197

All of Philips' investments were syndicated and Philips was co-investor in about 90% of the
deals. 60% to 70% of the deal flow came from external sources like venture capitalists,
investment bankers etc. and the rest came from internal sources like product divisions, M&A,
investor relations or treasury.

CVC was regarded as a key activity in the context of Philips' overall strategy and Philips
intended to impact its sustainable competitive advantage with the help of eve. At the time of
the interview, the investment activity level had met its targets. Philips was also satisfied with
the level to which it had met its objectives, taking into account the short life of the program.
Measures for meeting strategic objectives, however, were a challenge, according to Philips.
The calculated financial performance was positive although there had not been any exits at the
time of the interview.

4.2.4. Novartis Venture Fund - Background

The information provided on Novartis Venture Fund was gathered from three sources: first,
from a telephone interview386 , second, from the Internet page of the Novartis Venture Fund387 ,
and third, from the Activity Reports of the Novartis Venture Fund from 1997 to 2000.

The Novartis Venture Fund was founded in 1996. The total fund size was CHF 100 million
with CHF 96 million already invested in 85 start-ups at the time of the interview. 17
investments were made in 2000. Investments were made in external start-ups as well as in
start-ups developing from inside Novartis as further discussed in 4.3.4. Returns from
investments remained in the fund and could be reinvested. Two people ran the Novartis
Venture Fund. Investments were only made directly into start-ups in the seed and early stage.
Expansion financing was only provided in follow-on financing rounds for existing
investments. The target investment amount per round ranged from CHF 0.1 to 5 million and
the investment focus was on life science and health care. 90% of all investments were
syndicated and the Novartis Venture Fund was usually in the role of a co-investor. Deal flow
was generated. through its own Internet page, publications and networking at events.
Substantial deal flow was generated from the high visibility of Novartis Venture Fund in its
field.

The cve activities had a medium level of importance in the context of the overall strategy of
Novartis. There was no intention of impacting sustainable competitive advantage ofNovartis
solely through the venturing activities. According to Novartis Venture Fund, investments by
other parts of the corporation were necessary as well, in order to impact sustainable

386 The interview was conducted by the author with Dr. Juerg Meier, Executive Director, on April 10" 2001.
387 www.venturefund.novartis.com
198 Chapter 4: Case studies

competitive advantage. So far the level of investment activity had met its targets and the
Novartis Venture Fund was satisfied with the level to which it had met its objectives. The
calculated financial perfonnance was 30% per annum so far.

4.3. eve activity


In the following subchapters, the level of eve activities of the four companies interviewed is
discussed (4.3.1 to 4.3.4). The results from individual interviews are compared and
conclusions are drawn in 4.3.5.

4.3.1. Intel Capital - CVC activity

Of the twelve attributes of eve discussed in 3.2.1, most were always met and Intel certainly
pursued a core business other than providing capital. As shown in Figure 4-1, three attributes
were mostly met: investments were mostly (95%) equity investments, investments were
mostly made in privately held companies and in start-up companies for the launch, early
development or expansion of a business (90%)388.

The only attribute of eve investments that was not always or mostly met was the attribute
concerning control over funded start-ups. Intel only exercised control over funded start-ups to
a limited extent. While Intel tried to help start-ups to solve problems and move in the right
direction especially on questions related to technologies, Intel was not formally involved in
strategic business decisions. This was reflected in the fact that Intel did not take voting board
seats. According to Mr. Krumm, significant control was not an attribute of eve investments
since this might create a conflict of interests and might lead to legal problems especially
antitrust issues. Intel might be accused of acting in its own best interest rather than in the best
interest of the start-up if it attempted to exercise control. This issue is more critical for Intel
and other corporate investors than for financial investors because corporate investors have a
core business other than investing and this core business may be impacted depending on the
success of the start-up. Because of its dominant market position, Intel may be even more
careful regarding these issues than other players.

Strictly speaking, Intel did not do eve according to the definition in 3.2.1 because one
attribute of eve is not met most of the time. It will be reconsidered in 4.3.5, whether the
attribute to exercise significant control over the funded start-ups should be used as an indicator
for eve activity.

388 Some investments were made in publicly traded companies.


Chapter 4: Case studies 199

Figure 4-1: Intel Capital's level of CVC activity

Always Mostly SOISO Some- Never

I. Investments are equity investments ...... 0


0
ti"""
0 0
2. Investments have a long-term but typically limited time focus ... '"
0 0 0 0
3. Investments are made in privately held companies ... 0
0 0 0
4. Investments are made in high-growth companies ....
0 0 0 0


5. Investments are made in start-up companies for the launch, early development or
expansion ofa business ... 0 0 0 0
6. The company provides active support to funded start-ups .... 0 0 0 0
7. The company exercises significant control over funded Slart-ups .... 0 0 0 0


8. The company targets strategic objectives and does not only focus on maximizing
the value of investment portfolio ... 0 0 0 0


9. The company generates a constant deal flow and evaluates it for potential
investment opportunities ... 0 0 0 0
to. Funded start-ups are legally independent entities ...
11. Investments are made in start-ups not originating from the investing company ...
0
0
0
0
0
0
0
0

y" No

12. The investing company pursues a core business other than providing capital ...
0

4.3.2. Media X Venture Capital- CVC activity

Of the twelve attributes ofCVC discussed in 3.2.1, most were always met, three were mostly
met and Media X certainly did pursue a core business other than providing capital. As shown
in Figure 4-2, only three attributes were mostly met: Media X usually exercised significant
control over funded start-ups, funded start-ups were mostly legally independent entities and
investments were mostly made in start-ups not originating from the investing company. Media
X took a board seat in most of its investments and thereby exercised control over the major
personnel and business decisions of the portfolio companies. As far as funding internal ideas
and legally dependent ventures were concerned, Media X had made a few internal investments
in legally dependent entities but did not intend to make any more of these investments in the
future.

Since Media X met all the attributes of CVC at least most of the time, it qualified as doing
CVC according to the definition used in this study.389

389 See 3.2.1.


200 Chapter 4: Case studies

Figure 4-2: Media X's level of eve activity

Always MOldy S0I50 Somo- N....


times
I. Invesbnents are equity invesunents .... ,_ ", ," .... ,_ .. , .. , .. __ ... _, .. _.... ,_ ", ,_, ... _, __ ._ 0 0 0 0
2. Investments have a longterm but typically limited time focus .................. ," .... 0 0 0 0
3. Investments are made in privately held ,companies ... ,..... _....... _, ...................
4. Investments are made in bipgrowth companies .................. , ......................
0
0
0
0
0
0
0
0


S, Investments are made in startup CORlpUes for the lauru:b. early development or
expansion of a business ........... , ," ... , ............... ,__ .. ,_, .................................... 0 0 0 0
6. The company provides active support to funded start-ups ...... _.. ,....... , .............. 0 0 0 0
7. The company exercises significantcORtrol over funded start-ups ........................ 0
0 0 0


8. The company targets strategic objectives and does not only focus on maximizing
the value of invesbnent portfolio .................................... , ............................ 0 0 0 0


9. The company generates a constan\ deal flow and evaluates it for potential
investment opportunities ................ , .................................................. ,. 0 0 0 0
10. Funded start-ups are legally independent entities ......................................... 0 0 0 0
11. Investments are made in starHIps not originating from the investing company ..... 0 0 0 0

Yes No

12. The investing company pursues a core business other than ~roviding capital......... 0

4.3.3. Philips Corporate Venturing - eve activity

Of the twelve attributes of CVC discussed in 3.2.1, most were always met by Philips
Corporate Venturing. As shown in Figure 4-3, two attributes were only met most of the time:
funded start-ups are legally independent entities and investments are made in start-ups not
originating from the investing company. These attributes were not always met because some
of Philips Corporate Venturing investments were made in internal start-ups out of Philips
which might'receive seed capital from Philips Corporate Venturing.
Chapter 4: Case studies 201

Figure 4-3: Philips Corporate Venturing's level of eve activity

Always Mostly 50150 Some- Never


times
I. Investments are equity investments ... 0 0 0 0
2. Investments have a long-teon but typically limited time focus ... ". 0 0 0 0
3. Investments are made in privately held companies ....
0 0 0 0
4. Investments are made in high-growth companies ......
0 0 0 0


5. Investments are made in start-up companies for the launch, early development or
expansion of a business .... 0 0 0 0
6. The company provides active support to fJnded start-ups ...... 0
0 0 0
7. The company ex.ercises significant control over funded start-ups ... 0 0 0
0


8. The company targets strategic objectives and does not only focus on maximizing
the value of investment portfolio .. 0 0 0 0


9. The company generates a constant deal flow and evaluates it for potential
investment opportunities ... 0 0 0 0
to. Funded start-ups are legally independent entities ....
II. Invesbnents are made in start-ups not originating from the investing company .....
0
0
0
0
0
0
0
0

y" No

12. The investing company pursues a core business other than providing capital...
0

One attribute of eve was only sometimes met. Philips only sometimes exercised significant
control over funded start-ups and therefore did not meet this attribute. Although Philips did
take observer board seats and tried to actively support funded start-ups most of the time, for
example, by trying to help with contacts with potential partners within Philips, it did not
exercise significant control over start-ups by taking voting board seats. Strictly speaking,
Philips did not do eve according to the definition in 3.2.1 because one attribute of eve was
not met at least most of the time. As already indicated in 4.3.1, it is reconsidered in 4.3.5,
whether the attribute to exercise significant control over the funded start-ups should be used as
an indicator for eve activity.

4.3.4. Novartis Venture Fund - eve activity

Of the twelve attributes of eve discussed in 3.2.1, four were always met by the Novartis
Venture Fund, four were mostly met and Novartis pursued a core business other than
providing capital. As shown in Figure 4-4, the Novartis Venture Fund always invested in
privately held start-up companies for the launch, early development, and (sometimes)
expansion of a business. The Novartis Venture Fund always generated a constant deal flow
and evaluated it for potential investment opportunities and the Novartis Venture Fund always
funded start-ups that were legally independent entities. The investments made by the Novartis
Venture Fund were mostly equity investments, mostly had a long-term but typically limited
time focus, were mostly made in high-growth companies and the Novartis Venture Fund
202 Chapter 4: Case studies

mostly targeted strategic objectives and did not only focus on maximizing the value of the
investment portfolio.

Figure 4-4: Novartis Venture Fund's level of eve activity

Always Mostly SOISO Some-- Never


times
1. Investments are equity investments ... 0 0 0 0
2. Investments have a long-term but typically limited time focus ... 0 0 0 0
3.lnvestments are made in privately held companies ...
0 0 0 0
4. Investments are made in high-growth companies ... 0
0 0 0
5. Investments are made in start-up companies for the launch, early development or
expansion of a business ..... 0 0 0 0
6. The company provides active support to funded Slart-ups ... 0 0 0
0
7. The company exercises significant control over funded start-ups ... 0 0 0
0


8. The company targets strategic objectives and does not only focus on maximizing
the value of investment portfolio ... 0 0 0 0


9. The company generates a constant deal flow and evaluates it for potential
investment opportunities .... 0 0 0 0
10. Funded start-ups are legally independent entities
11. Investments are made in start-ups not originating from the investing company ....

0
0
0
0

0
0
0
0

No


y"

12. The investing company pursues a core business other than providing capital... 0

Three of the attributes were not met at least most of the time. One attribute of eve was only
met in about half of the cases as investments by the Novartis Venture Fund were made in start-
ups not originating from the investing company only in about 50 percent of cases. At the time
of the interview, only about one third of the investments had been made in companies that
were not Novartis related, while the ratio of recent investments was more like 50%. All the
investments jn Novartis related companies, however, were made in cooperation with other
investors. Another two attributes of eve were only sometimes met as Novartis or the
Novartis Venture Fund provided active support to funded start-ups only in some cases. This
was a direct consequence of the fact that there were only two employees working for the
Novartis Venture Fund. In addition, the Novartis Venture Fund only exercised significant
control over funded start-ups in some cases.

Strictly speaking, Novartis did not do eve according to the definition in 3.2.1 because three
attributes of eve were not met at least most of the time. As discussed in 4.3.1 and 4.3.3, it is
reconsidered in 4.3.5, whether the attribute to exercise significant control over the funded
start-ups should be used as an indicator for eve activity. The role of the remaining two
attributes that were not met by Novartis is also discussed in 4.3.5.
Chapter 4: Case studies 203

4.3.5. Overall findings on the level of eve activity

All companies analyzed met most attributes of evc that were introduced in 3.2.1 always or
most of the time. The exceptions are discussed in the following paragraphs.

Intel, Philips and Novartis did not exercise significant control over funded start-ups most of
the time. These companies did not accept voting rights on the board, and usually refrained
from influencing business decisions directly. At least Intel and Philips, however, tried to
support the funded start-ups, for example, when essential strategic decisions needed to be
made. This behavior was chosen deliberately to prevent a conflict of interest. Such a conflict
of interest may be created when decisions of the portfolio companies have an impact on the
investing company, e.g., a'start-up endorsing a technology that competes with the investing
company's technology or a start-up moving into the investing company's markets. Novartis
also stated they did not have enough management capacity to take voting board seats. Based
on the concerns about conflict of interest, significant control is not considered a necessary
attribute of cve. Therefore the model should be changed in this respect.

Novartis did not meet two other attributes of cve at least most of the time. Investments were
often made in start-ups originating from the investing company and Novartis did not provide
active support most of the time.

Novartis has made most of its investments in companies related to Novartis in the past and still
invested in related companies about half of the time at the time of the interview. Based on its
background and philosophy as a fund that was initially started to support internal start-ups
after the merger of Ciba and Sandoz, Novartis had invested in about equal numbers of internal
and external start-ups at the time of the interview. This was in contrast to the other companies
interviewed. Intel did not believe in internal start-ups. Media X tried some out but regarded
internal start-ups overall as requiring a larger effort than external investments and at the same
time as offering less upside potential. Philips also thought that external and internal start-ups
were quite different in respect to the management approach and was thinking about separating
responsibility for them.

The other attribute that Novartis did not meet was providing active support to portfolio
companies at least most of the time. The reason support was only provided in some cases was
the limited management capacity ofNovartis.

Since Novartis did not meet two attributes of sustainable competItlVe advantage, it was
considered not to do evc according to the definition. When possible differences between
Novartis and other interviewees are apparent for the other attributes analyzed, this is indicated
below.
204 Chapter 4: Case studies

4.4. Targeted and realized benefits


In the following subchapters, the level of targeted and realized benefits of the four companies
interviewed is discussed (4.4.1 to 4.4.4). The results from individual interviews are compared
and conclusions are drawn in 4.4.5.

4.4.1. Intel Capital - Targeted and realized benefits

Intel targeted several benefits with cve and generated all of these to some extent, as
described in the following section. Intel considered financial and strategic objectives as
equally important. It only invested in deals which potentially met both objectives. Investment
opportunities that did, not promise to be financially as well as strategically beneficial did not
receive funding. Based on the discussion in 2.3.2 and 3.2.2 the exact targeted benefits are
highlighted in Figure 4-5.

Figure 4-5: Intel Capital's CVC objectives


Major objective
Important
Desirable
I
\(hll.'\ i.' stl ,lkgH' I I'tUI liS

E"'~"!""~=;:Ch~~g;;ti~~d; -1 Acquire skills &


:towards : increase company
:innovation & : attractiveness for
' -_ _ _....I;!:~_n~: _______ j employees company

Tal1!eted sub-benefits
Leverage Gain insights Increase sensitivit~ Attract and Improve image Improve intet~ License out
company into new to lhe need to relain talent among potential nal processes technologies
expertise, developments innovate Generate business oartners Improve the Leverage sales
contacts and early on r-increase-opcnness: insights into Identify and de- customer value channels
reputation 10
achieve ~ce~~ speci~ r ~::I:~~ent5and i ~~~:;:ment of ;~~':i:~emative ;~:~ ~:~lti:
R&D
financial opportunities l fosler willingness: alliances Identify and Enable move Leverage
retumsfrom Suppon : to cooperate with 1 Leverage develop new into new fields manufacturing
investment decisions to L~~J~rJ1!tp!ln~~~1 venture capital '""''''''_ _ .....,1
Enhance capabilities
portfolio move or not to Improve ability to skills for Improve own technological
move into new deal with char\ge management of value proposition capabilities thai
~ ~c~~s or an :' ~enerat,e. . I :~;;I ;;~-e;; ~~~:Snew :a:o~nt in
i ~::i~i~~ntiaI1~::ovative _I ~!:!~t;r:~:~dl,---th_,_fu_tu_~_...J
L~~~~~~~ _____ j improve
Develop region
inno-
10 indirectly
Participate in
vative atmosphere standard design

Two sets of strategic benefits were major objectives for Intel: build technology and market
knowledge and build and leverage a partner network. Certain sub-benefits of these benefits
were major objectives while other sub-benefits were of less relevance. Regarding building
technology and market knowledge, three sub-benefits were major objectives: gain insights into
new developments early on, identifY specific new opportunities and support decisions to move
or not to move into new fields. The sub-benefit, scan for and assess potential acquisition
targets, was only desirable. Regarding building and leveraging a partner network, four sub-
benefits were major objectives: improving own value proposition to customers, accessing new
Chapter 4: Case studies 205

markets, stimulating demand for own products indirectly and participating in standard design.
A further sub-benefit, identifying and developing alternative suppliers, was important. At least
two of the sub-benefits above were major objectives for Intel based on industry characteristics:
improving own value proposition to customers and stimulating demand for own products
indirectly. Intel only provided a part of a system to customers, a Lego block so to say, that
consisted of different hardware and software components and that was finally sold to end
customers. Intel was, therefbre, interested for other players to continue to provide valuable
components of the system/complementary products, which create additional demand for the
whole system. At the same time, Intel wanted other components of the system to work
optimally with their own product potentially requiring new versions of their products with
higher profit margins.

An important strategic objective of CVC was to source and leverage technologies. This was
true for all sub-benefits tested: improving internal processes, improving the customer value of
own products, enabling the move into new fields and enhancing technological capabilities that
may be important in the future. While Intel tried to develop technologies by itself or acquire
them, once they were proven and identified as important for Intel, CVC might still help to
source and leverage less important technologies. In addition, CVC might be advantageous, for
example, when Intel could not determine the role or feasibility of a technology in an early
stage.

Changing the attitude of the organization towards innovation and change through CVC was
desirable for Intel. The sub-benefit of generating innovative ideas within its own organization
was even a major objective of CVC. The sub-benefit of starting innovative projects was
important and the sub-benefit of increasing openness to outside developments and of fostering
willingness to cooperate with external partners was desirable. The other sub-benefits of
changing the attitude towards innovation and change were irrelevant to Intel.

Finally, the benefit of acquiring skills increasing the company attractiveness for employees as
well as the benefit of creating additional revenue by leveraging company resources including
all sub-benefits were irrelevant to Intel. No benefits or sub-benefits, in addition to those
discussed in 2.3.2, were identified by Intel as targeted benefits.

As shown in Figure 4-6 and Figure 4-7, the targeted financial and all targeted strategic benefits
were realized to some extent by Intel. Two strategic benefits and ten sub-benefits had been
realized to a full extent (3), one strategic benefit and six sub-benefits to a large extent (2) and
one strategic benefit and two sub-benefits to a lesser extent (l). None of the targeted strategic
benefits or sub-benefits had not been realized at all (0).
206 Chapter 4: Case studies

Financial returns, a major objective, had been achieved to a full extent by Intel. The strategic
benefit to build technology and market knowledge, a major objective, had been realized to a
full extent. The same was true for all sub-benefits except scanning for and assessing potential
acquisition targets. This sub-benefit, which was only desirable, as discussed above, had only
been realized to a lesser extent.

The strategic benefit of changing the attitude of the organization towards innovation and
change, which was desirable for Intel, had been realized to a large extent. The sub-benefit of
increasing openness tp outside developments and of fostering willingness to cooperate with
external partners, which was desirable, had been realized to a full extent. The sub-benefit of
generating innovativ~ ideas within Intel, which was a major objective, had been realized to a
large extent. Finally, the sub-benefit of starting innovative projects, which was an important
objective of eve, had been realized to a lesser extent.

The benefit of building and leveraging a partner network, which was a major objective for
Intel, had been realized to a full extent. This was also true for the sub-benefits which were a
major objective, to improve its own value proposition with the help of a partner network, to
access new markets through partnering, to stimulate demand for own products indirectly and
to participate in standard design. The important sub-benefit of identifying and developing
alternative suppliers had been realized to a large extent.

The important benefit of sourcing and leveraging technologies through eve had been realized
to a large extent by Intel. Two sub-benefits also had been realized to a large extent: improving
the customer value of own products through sourced technologies as well as enhancing the
technological capabilities that may be important in the future by sourcing technologies. The
two other flub-benefits had been realized to a full extent: improving internal processes through
sourced technologies and enabling Intel to move into new fields through sourced technologies.
Chapter 4: Case studies 207

Figure 4-6: Intel Capital - Targeted and realized CVC benefits (112)

Financial benefit
~or
obje'-
live
Impor- Desir Incle-
IaI1I
"'" '"'"
....""
10 full
~
, , """" ...
N


Leverage company expertise, contacts and reputation to achieve 3 0
financial returns from investment portfolio. 0 0 0 0 0 0


Strategic benefits
Build technology and market knowledge.............................. . 0 0 0 0 0 0


0 0 0 0


Gain insights into new developments early qn." .. 0 0
Identify specific new opportunities .... 0 0 0 0 0 0
0 0

Support decisions to move or not to move into new fields ... 0 0 0 0
Scan for and assess potentia! acquisition targets .. 0 0 0 0 0 0

Change attitude towards inDovation and change.....................


Increase sensitivity to the need to innovate
0
0
0
0
0
0 0
n.a. 0 0


Increase openness to outside developments and foster willingness


to cooperate with external partners .. 0 0 0 0 0 0
Improve ability to dea1 with change... 0 0 0 n.a.
Generate innovative ideas .... 0 0 0 0 0 0


Start innovative projects .. 0 0 0 0 0 0
Develop region to improve innovative atmosphere ..... . 0 0 0 n.a.

Acquire skills& increase company attractiveness for employees 0 0 0


n.a.


Attract and retain talent .. 0 0 0 n.a.
Generate insights into role and management of alliances .... 0 0 0 n.a.


Leverage venture capital skills for management of internal
projects and for spin-offs ... 0 0 0 n.a.

Figure 4-7: Intel Capital - Targeted and realized CVC benefits (2/2)

"',.
Major Impor- Desir. lmle- Rwlzed
..... No<


"" ,
""" .. 0,
objec- lant 10 full

"'"
StrategiC benefits '''"
0 0 0 6 0
0


Build & leverage partner network (cross-selling, acquisitions)


Improve image among potential business partners .. 0 0 0 n.a.

a
Identify and develop alternative suppliers 0 0 0 0 0 0


Identify and develop new ~tomers 0 0 0 n.a.


Improve own value proposition with help of partner network ..... 0 0 0 0 0
Access new markets through partnering ... 0 0 0 0 0 0


0 0 0

Stimulate demand for own products indirectly .. 0 0 0
Participate in standard design ..... 0 0 0 0 0 0

Source & leverage technologies (licensing, co-development).......... 0


0 0 0 0

0 0 0
0
0
0
0

Improve internal processes ~hrough sourced technologies ...


Improve the customer vaJue of own products through s.techn .... . 0 0 0 0 0 0
Enable move into new fields through sourced technologies ...... . 0 0 0 0 0 0
Enhance technological capabilities that may be important in the
future by sourcing technologies .. 0
0
0 0 0 0

Create additional revenue by leveraging company resources ..... 0


0
0 0
0 0
n.a.


Create revenue by licensing out technologies .. n.a.
Create revenue by leveraging sales channels .. a 0 0 n.a.
Create revenue by renting out R&D facilities .. 0 0 0 n.a.
Create revenue by leveraging manufacturing capabilities ... 0 0 0 n.a.
208 Chapter 4: Case studies

4.4.2. Media X Venture Capital- Targeted and realized benefits

Media X targeted many objectives with eve and achieved all of them at least to some extent
except for one. This is discussed below.

As shown in Figure 4-8, both, financial and strategic returns were targeted. Of the six groups
of strategic benefits, Media X considered three groups as major objectives: build technology
and market knowledge, build and leverage a partner network, as well as source and leverage
technologies. Two groups of strategic benefits were important to Media X: acquire skills and
increase the company' attractiveness for employees as well as create additional revenue by
leveraging company resources. The remaining group of eve benefits, changing the attitude
towards innovation ana change, was desirable.

Building technology and market knowledge was a major objective of eve for Media X. The
most important sub-benefit was to gain insights into new developments early on, which was
also a major objective. It was desirable for Media X that such new insights lead to the
identification of new opportunities, the support of decisions to move or not to move into new
fields and the scanning for and assessment of potential acquisitions targets.

Figure 4-8: Media X's CVC objectives

f-~~~;~~~~itf:iLA'~ctand JImproveiml8.e Improveinter- License out


: Vlty to the need : ---.retain..taleIiL among potential naJ processes technologies

reputation to
1I~~;;.Jr'~t~~~~:~:~::,"::.",,~:1:~~e:~~~~-1.ld~fyandde-
:.. en y speci-: to outside : role and : velop alternative
.:~:~~Iue .~:~5esaJes I
of own Rent out R&D
achieve ! 'fie new : developments an : management of' __!'I..9P!i.er!________ products facilities
financial : opportunities : foster willingness: alliances Identify aDd : Enable move Leverage
returns from :- Support : to cooperate with :. Levenge develop new I into new fields manufacturing
investment : decisions t o : er rs venlure capital -custan.er.s. 0_: Enhance capabilities

--'!
: move or not to ::. mprove I Ily I