In his classic book, “The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup,” former Harvard Business School professor and startup researcher Noam Wasserman introduced the idea that most entrepreneurs have to make a deliberate choice between optimizing for financial returns (“Rich”) or optimizing for control of their company (“King”). His research showed that very few get to be both Rich and King — that’s the rare exception. Most founders typically must decide between “bootstrapping,” which maintains equity ownership but limits growth by having to self-fund growth initiatives via cash flow, or raising outside capital, which accelerates growth but risks diluting founder equity and diminishing the founder’s decision rights on the board of directors.
At High Alpha Innovation, we partner with large corporations to innovate via systematically launching new ventures and building corporate venture studios. We are fortunate to interact frequently with forward-looking executives who are looking for novel ways to unlock meaningful growth. No matter which type of executive we speak to — a C-suite member, a business unit GM, an innovation leader, a corporate venture capital investor (“CVC”), or even a corporate development deal-junkie — they all seem to face the same Rich versus King tradeoff decision as the entrepreneurial founder when considering launching new ventures. (Note: we do not consider corporate divestitures of more established businesses to be a “new venture” for the purposes of this post).
On one side are executives that might push the organization to invest in a fast-growing VC-backed early stage startup, arguing that using the balance sheet to make a minority equity investment won’t impact the P&L while delivering both high financial returns via eventual sale or IPO of the company as well as meaningful strategic returns through a commercial relationship with the startup that creates differentiation, accelerates time-to-market, or acquires expertise or talent for the corporation. This can be a compelling and valid argument.
On the other side are executives that might push the organization to build new ventures internally that are fully-owned and controlled, arguing this maximizes both financial returns (“we keep 100%, not just a minority”) as well as strategic returns (“we pick the team and dictate the roadmap, so we can customize the new venture to meet our unique strategic needs”). This is also a compelling and valid argument.
Both CVC investments and internal ventures have the ability to meet or exceed expectations, but it is always harder than corporations expect and never goes exactly to plan. Many senior corporate executives we speak to, off the record, are frustrated with their CVC investments and internal venturing efforts falling short of lofty financial and strategic goals. “So, which is the better approach: CVC investing or internal venturing?!”
We believe this is the wrong question to ask and a false dichotomy. Successful corporate innovation requires a portfolio approach and having many different tools in the toolkit (e.g. M&A, partnerships, etc.). In certain circumstances CVC investing makes sense and in other circumstances internal innovation may be the better path (a likely topic for a future post). Each tool in the corporate innovation toolkit has its own pros and cons.
The better question to ask is why past investments and ventures did not deliver against expectations. At High Alpha Innovation, we believe many corporations are setting themselves up for failure because they do not consider the tradeoff between being “Rich” or being “King,” and do not explicitly make the hard decision to optimize for one and manage to the other (or somewhere in between - more on that later). They want to have their cake and eat it too, but many times it can end up in their face. This difficult tradeoff decision is what we call the Corporate Founders’ Dilemma.
For CVC funds that are structured and operate like standalone VC funds (such as GV, which spun out of Google in 2009), having control or influence over the operations of a portfolio company is usually less of an issue because the CVC has already made the explicit decision to optimize for financial returns. But it’s much more tricky for the majority of corporations whose CVC arms have both a financial and strategic mandate. We believe CVC investments have a higher likelihood of making the corporation “Rich” than internal ventures, as external startups can move faster, tap into private capital markets to accelerate growth, attract top talent, and avoid the typical innovation barriers within corporations. However, the strategic returns promised in the investment memo are often difficult to deliver as corporations are used to calling the shots with vendors and partners. It’s hard for them to NOT act like a “King.” CVCs that buy a minority stake in a company usually understand the corporation will not have control or meaningful influence over the operations of said company, but we often see the internal innovation or business unit leader who owns the commercial relationship with the company NOT understand this dynamic, or simply not accept it. These internal commercial owners are focused (rightly so) on optimizing for internal business unit success and this can lead them to misinterpret or misuse the CVC investment as a right to force the startup to do whatever it takes to make him or her successful. In our experience, this misalignment of incentives between internal commercial owner, CVC and startup management teams can irreparably damage the relationship when not managed closely and lead to missed financial and strategic targets for both the corporation and the startup.
In regards to internal ventures, if a corporation owns 100% of the new venture, staffs it with salaried and bonused employees without equity ownership, and shares centralized services (e.g. finance, accounting, etc.) with the core business, we see that as just a new business unit no matter what the corporation might want to call it. We hear about many of these “new ventures” (or business units) struggling to gain internal or external traction. We believe this is because most internal ventures are “bootstrapping” without even realizing it. Established public corporations, just like bootstrapped startups, typically self-fund internal growth initiatives through operating cash flows. This means new internal ventures, if “successful,” eventually run into a brick wall as the new venture requires additional internal capital to scale but leadership is unwilling to provide the required capital because it would force them to reallocate funds from the core business initiatives (which are usually more profitable and have nearer term impact). Many innovation leaders we speak with find it incredibly hard to raise sufficient internal capital, especially within public companies that face short-term pressures from Wall Street, because new ventures usually lose money in the near-term and have uncertain payoffs in the longer-term. Even if a new internal venture does have access to sufficient internal capital to scale over time, allocation is often constrained to specific times of year (e.g. annual budgeting) rather than released as appropriate based on performance-based milestones. To boot, these internal ventures also face most, if not all, of the other typical corporate innovation challenges: fighting for scarce resources and internal talent, spending significant time building internal consensus and overcoming bureaucracy, struggling to land exceptional entrepreneurial leaders who dream big and don’t want to work on a salary, and so on. When combined, these barriers often create “zombie” ventures that are marketed externally as successful innovation (see Innovation Theater), but don’t ever scale to a point where senior corporate leaders acknowledge the venture as a meaningful contributor to corporate growth. In our experience, internal ventures may allow the corporation to act like a “King” and call all the shots, but are much less likely to make the corporation “Rich” than CVC investments.
At High Alpha Innovation, we believe the best outcomes come when a corporation explicitly and thoughtfully makes the hard tradeoff between being Rich and being King. Not making a decision, or trying to maximize both, is counterintuitively why many CVC investments and internal ventures fail. Acknowledging this tradeoff and setting the right expectations within the corporation is half the battle.
CVCs who prefer to get “Rich” must ensure internal commercial owners understand and accept that they will be giving up a significant level of control and train these owners to treat CVC-backed startups more as strategic partners and less as vendors that they can push around. Innovation leaders who prefer to be “King” with full control must ensure corporate leaders understand and appreciate the level of capital and type of talent that will be required to scale the new venture over time into a financially meaningful business unit or subsidiary. This might involve convincing the corporation to set aside multi-year funding that the new venture can “unlock” when it hits predetermined milestones regardless of when the milestones are hit. This also might involve getting sign off for new financial incentive structures tied to performance of the new venture that enable key employees to share in the upside (e.g. Stock Appreciation Rights/Phantom Equity, or corporate grants/options tied to specific metrics). Regardless of the tool (CVC investing or internal ventures), we think it’s vitally important for corporations to optimize for one and manage to the other.
However, another good option has emerged recently that lies somewhere in between internal ventures and CVC investments: the corporate-founded startup.
We believe this novel approach, when executed well, can deliver financial returns closer to that of CVC investments while also giving corporations more influence over the startup’s strategic direction and product roadmap. This is not about striving to be both Rich and King, it is about sharing some of the returns and some of the control. It’s an effective compromise in our opinion. The key is understanding that equity is an incredibly strong incentive mechanism (as fully understood in the VC world). Most corporations do not utilize or under-utilize this mechanism. When executed well, “giving up” equity to top entrepreneurs, outside investors, and strategic partners or advisors is not value-destroying but rather value-creating to the corporation because it creates and aligns incentives to build a fast-growing business.
Startup founders inherently understand the power of equity when they manage their employee equity pools. Founders can’t hire top executive talent without giving up some equity. The best founders manage the entire cap table like their employee equity pool, carefully raising capital from a complementary set of investors and advisors that can each add unique value to the startup, such as deep subject matter expertise, industry connections, or access to additional capital.
VC fund managers understand the power of equity when they look at their portfolio of companies. What drives top quartile financial returns for VC funds is not increasing percentage ownership in underperforming portfolio companies, but getting a small but incredibly valuable slice of the next Google or Facebook. This “Power Law” dynamic is very important to understand because it implies the VC must believe every investment has the potential to return the fund. They need the conviction an investment can deliver that 10X return. They don’t want base hits, they want home runs and ideally grand slams.
In order to attract the best entrepreneurial talent and outside investors to a corporate-founded startup, corporate venture builders must act like the best founders and carefully build a complementary cap table that will require the corporation to give up some level of equity and control. But giving up equity and control is usually not enough to convince the best entrepreneurs and investors. The corporate venture builder must justify its initial ownership by proving to potential founding CEOs and initial investors how, specifically, it will provide the startup with an ongoing “unfair advantage” that increases the odds of financial success.
As an example, we recently partnered with Silicon Valley Bank (“SVB”) to run our proven Sprint Week playbook and launch Bolster, a marketplace for fractional executive talent that helps founders more efficiently scale their executive teams. A core component of the pitch at the end of “Sprint Week” was the “unfair advantage” that SVB could provide for Bolster. With more than 50% of venture-backed startups choosing to bank with SVB, access to SVB’s customer network and local relationship managers would help Bolster efficiently build both supply and demand for its marketplace. In part due to this unfair advantage, SVB and High Alpha were able to attract serial entrepreneur Matt Blumberg, former CEO of Return Path, and famed investors Fred Wilson, Founder and Partner at Union Square Ventures, and Greg Sands, Founder and Managing Partner at Costanoa Ventures. SVB’s corporate-founded startup was able to land this complementary “A team” by sharing equity with the founding CEO and outside investors.
For seed and early stage VCs, team is by far the most important factor in investment decision making. Why? “A Teams” kick-start a virtuous cycle. They make hiring more “A player” employees easier, which makes the product better, which lands more customers and partners, which drives growth, which improves the odds of landing more investors, which provides the market signaling, capital and expertise to further accelerate this cycle. Momentum matters in VC and it all starts with the “A team.”
Corporations need to understand that acting like a “King” will rarely make the corporation more “Rich” and getting “Rich” will rarely allow them to act like a “King.” Trying to be both “Rich” and “King” is what leads to failure in most cases. Corporations should optimize for one, manage to the other, and ensure relevant corporate stakeholders accept this tradeoff. In this post we described a relatively newer option, the corporate-founded startup, that lies somewhere in-between CVC and internal venturing in the corporation’s growth toolkit. To use this new tool, senior corporate leaders must get comfortable with the idea of spinning up a new startup that shares some level of equity and control with outside entrepreneurs, investors, and advisors. Sharing equity and control is essential for landing an“A Team,” as SVB demonstrated with Bolster, that can meaningfully increase the odds of growing a new business to a scale where the c-suite takes notice and the corporation can extract indirect strategic benefits.
A corporate-founded startup is like a made-to-order pie baked by a professional - you get to pick the type of pie you want to exist, provide some rare ingredients, and get professionals to bake it. A CVC investment is like buying one slice of a pre-made pie baked by a professional - you are curious to try to see if you like it, you can add your own toppings to improve the taste, but you can’t change the ingredients. An internal venture is like a home-made pie - you can definitely try to make it from scratch, but the quality of the pie will vary widely depending on your pie-making abilities and how many times you’ve baked that particular type of pie. When corporations get the urge for a particular type of pie, they first need to assess their level of appetite and pie-making ability and then decide whether a made-to-order, pre-made pie, or home-made pie is the best option.
The Corporate Founders’ Dilemma dictates that corporations must deliberately and explicitly choose to optimize for returns OR for control when considering new ventures. In this article, we proposed a third option of creating a corporate-founded startup that gives up some level of return and some level of control to land an “A Team” that can meaningfully increase the odds of getting a new business venture to a scale that matters to the corporation.
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High Alpha Innovation partners with the world’s leading organizations to drive innovation through startup creation, leveraging the venture studio model pioneered by High Alpha. As a Director, Mike Joslin partners with corporate leaders to guide them through the startup launch process.
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