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 always 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 and internal venture investments 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 right question to ask is why a particular investment 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 Founder's 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 as the CVC has already made the explicit decision to optimize for financial returns. But it’s much more tricky for most 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 the private capital markets to accelerate growth, attract top talent, and avoid the typical innovation barriers within corporations. Strategic returns are harder to deliver, though, as it is hard for many corporations to NOT act like a “King” as they may be used to calling all the shots with vendors and partners. Most CVC investors understand that the corporation is giving up control or influence, but we’ve seen many of the commercial relationship owners between the corporation and startup not understand this, or simply do not accept it. These internal commercial leaders 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 the internal leader and business unit 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 wholly-owned 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 cashflows meaning the growth capital available to new ventures is inherently quite limited. 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, for new ventures that typically lose money in the near-term and have uncertain payoffs in the longer-term. Even if a new internal venture can land some internal seed capital and begin to show traction that might warrant additional funding to accelerate growth, allocation of this scarce growth capital is 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. These barriers and the lack of access to sufficient capital and talent often creates “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, wholly-owned ventures allow the corporation to act like a “King” and call 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 must ensure internal commercial owners understand and accept that they will be giving up a significant level of control and train them to treat CVC-backed startups more as strategic partners and less as vendors that they can push around. Innovation leaders who decide they’d prefer to be “King” and fully control a new internal venture must ensure corporate leaders understand and appreciate the capital, talent, and new incentive structures 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 or new 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 majority-owned 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 a bit 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) and we see most corporations not or under-utilizing this mechanism when launching new ventures. When done right, corporate venture builders “giving up” equity in a new standalone startup to top entrepreneurs, investors, and advisors is not value-destroying but actually value-creating to the corporation because it creates and aligns incentives to build a fast-growing venture-backable company.
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 actually manage their 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 percent 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 don’t want base hits, they want home runs and (ideally) grand slams.
In order to attract the best entrepreneurial talent and top-tier investors to a majority-owned corporate-founded startup, corporate venture builders must act like the best founders and carefully build a complementary cap table that will involve giving up some level of equity and control. But just giving up equity and control is not enough to convince entrepreneurs and investors. The corporate venture builder must prove to potential CEOs and initial investors why the corporation deserves such high initial ownership and how it will deliver on the immense strategic value it promises to create. The encouraging news is that this can be done.
A recent example: High Alpha Innovation 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 was the unique assets and capabilities of SVB that could create immense value for Bolster. With more than 50% of venture-backed startups choosing to bank with SVB, access to SVB’s rich network was an incredibly valuable asset for Bolster in that it could help Bolster efficiently build both supply and demand for its marketplace. Partly due to this unique strategic value, SVB and High Alpha were able to bring on 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. Without clear strategic value from SVB and sharing of equity with the founding team and outside investors, it’s unlikely this corporate-founded startup could have landed this complementary “A team.”
Building “A Teams” from the start can increase the odds of success. Why? “A Teams” can kick off a virtuous cycle that occurs frequently in the venture capital world. They make hiring more “A” player employees easier, which makes the product better, which lands more customers and partners, which drives revenue growth, which improves the odds of landing top 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.”
Corporate venture builders must first 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” often leads to failure. Corporations must optimize for one, manage to the other, and set appropriate internal expectations with corporate leaders.
In this post we described an emerging third option, corporate-founded startups, that lies between CVC investing and internal venturing in the toolkit, but requires corporations to get more comfortable with the idea of sharing equity in a new separate entity with outside entrepreneurs, investors, and advisors. Sharing equity is the best means to land an “A Team,” as SVB demonstrated with Bolster, which is what meaningfully increases the odds and magnitude of a new venture’s success. We believe corporations getting a slightly smaller slice of a bigger pie, and the strategic value derived from ventures that are actually able to reach scale, will nearly always outweigh the returns (or losses) from wholly-owned internal ventures or CVC investments that tried to make the corporation both “Rich” and “King.”
The Corporate Founder's Dilemma dictates that corporate venture builders must deliberately choose to optimize for returns OR for control. In this article, we proposed a third option: corporate-founded startups that give up some return and control to increase the probability of success for a new venture. Please choose wisely.
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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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