Funding innovation from the balance sheet
“Show me your revenue and profit projections for the next year.”
If this isn’t the most dreaded sentence a corporate innovator can hear, it’s certainly high on the list. This is an impossible request of anyone building something new when there are more assumptions than known facts. Any sales or profitability projections at the early stage are guesses--at best. Yet innovation teams inside of corporations are asked to perform this kind of analysis routinely before receiving the funding they need. In some ways, it makes sense: this is how capital allocation decisions are made inside the core business, and executing the analysis--even if wrong--forces the team to think through the details of the opportunity. How else should the company compare any innovation opportunity against competing demands on cash?
The downside of this approach is that it locks teams into projections and assumptions before anyone knows what is going to happen. Financial forecasts don’t provide room for business model pivots. Every model ends up looking like a hockey stick to meet projected return requirements, with a rapid expected climb in sales and profits. When those results fail to materialize later, the venture and its leaders are deemed to have failed.
The problem is that new ventures face learning challenges, not execution challenges. The initial focus for any transformative new venture should be on finding product market fit through rapid experimentation. This is not a capital efficient activity, by design. In the core business, it’s exactly the reverse: in a world of high knowledge and low assumptions, core business teams should be focused on execution, not learning. When execution is the challenge, building the forecast is easy (and imperative). When learning is the challenge, a reliable forecast is impossible. Yet companies often make decisions and fund these two different types of opportunities in the same way.
When a business unit is executing on a new opportunity that is an extension of its core business model (eg a new product extension), it makes sense to divert profit to fund it. The expected Return on Investment can be quantified and measured against the firm’s Weighted Average Cost of Capital and compared against other opportunities to determine if the opportunity is worth pursuing. In these circumstances, new opportunities can and should be run in a capital efficient manner right out of the gates. The capital used to fund these opportunities is impatient, and demands a quick return.
Conversely, when companies are pursuing transformative innovation, known unknowns and “unknown unknowns” prevent a reliable understanding of when a return might come, or how large that return will be. These kinds of opportunities require a different kind of capital, and a different kind of calculus. For core innovations, the frequency of correctness matters more than, or at least as much as, the magnitude of correctness: companies should expect most core innovations to succeed. For transformative innovations--those opportunities that are far beyond a firm’s base of knowledge--the magnitude of correctness matters more than the frequency. There will be many failures, and a lot of learning, but occasional spectacular successes, when done correctly. These kinds of transformative opportunities require patient capital.
The P&L is not patient; the balance sheet can be. Core innovation should be financed as an operating activity; transformative innovation should be financed as a balance sheet investment. How? Corporations can learn much from the approach of venture capitalists, who have refined a fund and investment structure over decades that works well for financing high-assumption/low-knowledge innovation. Venture capitalists count more on being spectacularly right occasionally than being frequently right, and the investment model aligns to this objective.
The standard venture capital fund is set up as a limited partnership, with the venture capital firm as the General Partner, or fund manager, and the investors as Limited Partners. The venture capital firm is responsible for allocating investors’ capital into discrete investments, and is held accountable for the results. When it works well, returns flow back to both Limited Partners and General Partners. At High Alpha Innovation, we have adapted the standard venture fund structure to work for 1) building of new ventures (not just investment) and 2) in a corporate setting, providing a structure for balance sheet investment into transformative innovation.
In this model, High Alpha Innovation acts as the General Partner, and the corporation acts as the sole Limited Partner in a fund structure. There are no management fees, as is traditional in a venture fund. Rather, the capital invested into the partnership funds both the studio operations (a team of full-time venture builders and associated costs of the studio) and pre-seed investment into new companies (for B2B SaaS companies, between $500,000 to $1,000,000 in initial funding per venture). High Alpha Innovation and the corporate partner share in the equity ownership the joint studio fund earns in the new companies it launches, according to a predetermined ratio. This structure enables the corporation to build transformative new ventures with a professional venture builder and possibly other investors who have skin in the game, while funding the effort from the balance sheet. To the extent that a corporation’s accounting rules require a roll up of fund activities to the P&L, the impact is often in the form of “below the line” charges, meaning the corporation can avoid impacting the metrics that drive share price (EPS, EBITDA).
This approach provides many additional benefits:
- Competition with venture-backed startups: Corporations compete with venture-backed, independent startups that play by different rules. These venture-backed companies don’t have to be capital efficient in the near term, and can do things scaled corporations can’t do internally as a result. Launching ventures externally with investment from the balance sheet enables corporations to build ventures that are funded with the same structure as venture-backed startups, enabling them to compete on equal terms--except that when done correctly, the new ventures also benefit from their association with the corporation, which plays the role of initial customer or distribution partner.
- Governance, incentives, and entrepreneurial talent to drive success: Startups are hard. Most fail. Corporations make it even harder for their new ventures when they apply mismatched governance systems or incentives. They have a hard time recruiting world-class entrepreneurial talent as a result. The structure we have designed relies on the same governance and incentive systems venture-backed startups typically use, and enables us to recruit capable and eager co-founders who can move quickly and build scale.
- Optionality for new ventures: While it may seem counterintuitive to build new ventures externally, with outside partners as co-owners, this actually increases the future options for these new ventures and can create more value for the corporation over the long run. The corporation can always choose to take control of the venture later; if a corporation controls a venture from the time of launch, other investors or partners will be hard to recruit later. The structure described in this article provides a way for partners to participate and enables the corporation to keep the options for new ventures open until it becomes clear which structures or paths will create the most value.
- Protection from the core business: Corporations’ attempts at transformative innovation die when the core business loves them too much, or, conversely, views them as a threat. By launching externally, funding from the balance sheet, and--especially--involving outside partners with skin in the game, these new transformative ventures have the distance from the core business they need to increase their chance of success.
There is no reason all of a firm’s transformative innovation efforts couldn’t be executed through a fund structure like this. Instead of a studio partner as the General Partner, the Chief Innovation Officer and his or her team could play that role in an external entity (or, alternatively, an outside partner can also do the job). One of many investments a fund with that structure could participate in could be a venture fund partnership or venture studio partnership with professional fund managers. The corporation could monitor returns against allocated balance sheet capital, and the innovation team would be responsible for the results.
There are many corporations using separate legal entities to fund and manage innovation efforts, but they often don’t go far enough: the team members often remain employees of the corporation instead of the new entity (warping incentives), the corporation’s executives remain heavily involved in investment decisions (applying the same governance and decision models used in the operating business), and capital is allocated on a per-deal basis, sometimes as a tax on operating businesses. These approaches act as limiters on the external launch or investment model and reduce its effectiveness. Executives believe that by applying these approaches they will increase the frequency of correctness and drive more rapid capital efficiency; they do neither. The solution is patient (balance sheet capital, with a focus on the magnitude of correctness, not frequency, and governance and incentive models that are appropriate for learning challenges.
If you’re interested in exploring how an external, balance sheet-funded approach could be customized and used to drive tangible, transformative innovation, along with its strategic and financial returns, at your company, please reach out to us. Let’s talk about your constraints and opportunities, and how we can partner to produce market-beating results.