In which form of collaboration does a partner make an investment in an existing business

Most corporates choosing to create new business lines and/or test new business models have four choices:

1. Build internally
2. Make a minority investment into a startup in the wild
3. Buy/acquire a proven startup
4. Partner to build new ventures

This article will compare the four options outlining the chance of success, costs, timeframes, common challenges, and the type of business idea each is best suited to.

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1. Build Internally

What is it? Building new businesses in-house, either using internal talent (current employees) or hiring in external talent.

Chance of Success: Less than 8% of ventures launched internally reach scale. That's worse even than the average 90% who die in the wild.

Time to Success: For those that do succeed, it typically takes at least twice as long as a startup in the wild to build a new company within a large corporate. As an analogue, a standard startup accelerator is 3 months; a corporate accelerator is 6–12 months. Typically, this means 6–12 years to £50m+ in profit.

Cost: I've yet to see a corporate build an internal venture which didn't cost at a minimum two times (more often 4–5 times) what it would take to build it in the wild. Including talent, internal ventures usually cost £50-100m+ to reach scale.

Control: The corporate enjoys 100% ownership, and the new venture typically operates within existing business structures and management.

Best For: New products within the core business. You already have a significant share of the market, so have time to play. There's also inherently less uncertainty, increasing the chance of success and the ability to repurpose experts from within the organisation.

You could also invest here to build long-term capability in-house (if you can retain the founder talent you train), but you will need a parallel approach for the short- to mid-term while you're getting up to speed.

Common Pitfalls/Challenges for Building Internally:

1. Talent: Using in-house talent slows execution, as teams are learning entrepreneurial skills from scratch. However, attracting proven founder talent is often more challenging than anticipated; entrepreneurs are cautious of corporate bureaucracy stifling the freedom to build something they're passionate about.
2. Governance: Corporates typically try to fit new ideas into existing reporting and funding structures. This leads to delays and often results in teams increasing the investment ask, giving them enough capital to make it to the next budgeting cycle. The total investment will be spent, even if the idea has already been disproven. Meanwhile, day-to-day governance is too heavy for a new business to have space to pivot and learn in the market.
3. Incentivisation: New ventures need real founders, who have skin-in-the-game through equity, and are incentivised to grow enterprise value or to kill the business early, so they can make their money and find success elsewhere. If the salary is too comfortable (lacking personal opportunity cost), initiatives take longer to die, often requiring a steering committee to kill the idea.

Ultimately, these challenges slow the time to market and dramatically increase the risk and cost of failure.

As Anne Boden, founder of Starling Bank, and former RBS employee, put it:

"I came from that world… if I thought I was going to be able to create that, I would have done. But, unfortunately, it's tough to replicate the energy and technology of a startup."

- Anne Boden, Founder and CEO Starling Bank

2. Minority Investment

Minority investments are an increasingly popular way for corporates to innovate. Between 2013 and 2018, corporate VCs increased invested capital 4x, spending $50bn+ in 2018.

Chance of Success: Here, we can think about two measures - whether the investment makes a profitable return and whether it delivers 'strategic' value/learnings.

The metrics we look to for the financial return are Return on Investment (ROI) and the Internal Rate of Return (IRR). Has the portfolio of investments returned a minimum of 3x cash (i.e. a profitable return given the risks) in a suitable timeframe (typically 7–10 years)?

However, the true IRR or ROI is often ignored or not tracked for corporate investments, with investment teams not held accountable for creating profitable returns. Moreover, it's an incredibly tall order in the first place for those teams. If we take the VC world as an analogue for success, 95% of funds fail to make a profitable return on their investment at all. Of those that do, just 4% return 10x the value.

For the strategic value, it can be even harder to quantify the return. However, there are a few measures that can help make this more tangible:

1. What new revenues, resources, or capability does this unlock for other areas of the business? (Indirect returns impacting the bottom line)
2. How many successful commercial pilots are you running with the startups? What is the value unlocked in terms of additional revenue or cost savings? Though you should also ask here whether the investment was a pre-requisite for the pilot (often it's not required)
3. How many minority investments have you acquired? Did your investment increase your chances of becoming the acquirer? How much did you save on the overall cost to acquire? How does this balance across your portfolio of minority investments?

A question corporates need to ask is whether, given their responsibility to shareholders, they should be taking on this VC risk/return profile — especially if the "strategic value" cannot be tangibly measured.

Time to Results: In exiting startup investments, 7-10 years is the target for most venture capital funds. However, the typical time to realise any return on capital is 12–14 years.

Pilots typically require the startup to be series A or above, so if you invest at the Seed stage, it will likely be ca. two years before the startup has the maturity to deliver pilots with you. You can find more on typical acquisition timelines in the next section on "Buy".

Cost: At Seed, the median VC deal size in 2019 was £350k at a pre-money valuation of £8M. At Series A, it was £3.6M invested at a pre-money valuation of £27M.

The median deal sizes provide a good indication of the costs involved. However, we know that corporates often end up overpaying compared to VC funds. For example, the average Corporate VC deal in 2017 was £16M compared to £12.4M for VCs.

Control: After dilution, corporates typically have a <10% stake in the venture. They often do not have a board seat and are not guaranteed the right to acquire, should the startup be successful.

Common Pitfalls/Challenges for Minority Investments:

1. Delivering strategic wins: If it's close enough to core, you ultimately want to own the startup, but having an early stake doesn't guarantee control or a right to acquire. If it's exploring a new technology or business model, why not create a commercially meaningful partnership instead, without the need to invest/own equity before partnering?
2. Unlocking unfair advantages for a minority investment: Providing scale strengths and domain knowledge from the core business to your portfolio companies can be a real differentiator. However, it is often challenging to move the core to support something you only have a minority stake in and will likely never own.
3. You can read more on the challenges of CVC in my article "Betting Your Innovation Budget: Why risk it on CVC?".

Best redirected to focus on pilots and joint ventures: Honestly, we struggle to recommend the minority investment model for corporates as it stands.

Suppose the startup you want to work with already exists, and you want to test new technology. In that case, we'd recommend corporate-startup collaborations on pilots and joint ventures, where you can learn about the new technology or product and see if it impacts your bottom line. However, you don't need to have invested in the startup to run a pilot, so make sure you're not overpaying for the privilege.

3. Buy

There are two types of M&A: to grow the core or to innovate. This post focuses solely on M&A to innovate.

Chance of Success: According to Harvard Business Review, 70–90% of Mergers and Acquisitions fail.

Time to Results: Depending on the deal complexity, the acquisition process can take months or years, with the post-acquisition integration process often requiring a more extended period. However, the startup needs time to prove itself worthy of acquisition. If we count from idea inception, it's a long slog. In 2018, the average age of a startup at acquisition was 5–10 years old (37% of acquisitions), followed by 10–15 years.

For the few acquisitions that do succeed in creating profitable synergies, it typically takes 2-6 years post integration for these to materialise. 

Source: Statista

Capital Required: In 2018, the global median for M&A was 9.3x EBITDA, but it can easily reach the double digits.

For example, PayPal paid 40x revenues for Honey Science Corporation, for $4bn cash. They also paid 13x revenues and doubled its IPO valuation for iZettle, forking out $2.2bn. Meanwhile, Salesforce paid 22x revenues for MuleSoft in 2018, at $6bn. The list goes on and on, with many examples of 12–25x revenue acquisitions, including Microsoft's purchase of GitHub for $7.5bn (25x revenues).

Control: Technically, you have full control post-acquisition. However, if you want to keep the original founders, you will have to cede some of this control in practice, as they value the autonomy to try new things. To get the inside perspective on this, I recommend this post by Waze's Founder Noam Bardin, who shares why he left Google 7 years after Waze's acquisition. He talks about the rising trend for independence amongst acquired founders but how there will always be a clash in cultures.

Common Pitfalls/Challenges for Innovation M&A:

1. The startup has to exist: It must also be open to acquisition, and you must be able to outbid competitors.
2. Designing for exit: Rarely, if ever, has a startup been designed to exit to a specific acquirer in advance. The startup succeeded because of its independence, and transforming into a new kind of company, as part of another company, brings new risks.
3. Who leads: The existing CEO is likely to struggle to repeat their success while operating in such different conditions as part of a larger organisation. Moreover, do they still have the drive and the hunger post-acquisition? However, changing leadership at the point of acquisition introduces significant unknown risks.

For more reasons why innovation M&A fails, I highly recommend this blog by the inimitable Steve Blank.

Best For: When the idea already exists, and there are enough startups at maturity, rendering it too late to build your own version. If the acquisition is to survive, culture clashes must be managed (often requiring external specialist support).

4. Partner

Typically, this means partnering with a consultancy to build new ventures.

We realised there was a fundamental misalignment of incentives when building ventures as consultants.

We used to build corporate ventures within our innovation consultancy business (Rainmaking Innovation). When doing so, we charged fees and worked from ideation to implementation, bringing in our own talent. Across tens of ventures in multiple industries, we saw that corporate scale strengths and deep domain knowledge could unlock tangible advantages for our ventures, from infrastructure to data, to customers. But we still couldn't get new ideas to market at the pace, cost, or most importantly, the success rate compared to building our own startups in the wild (without any corporate involvement). Despite all our corporate partners' scale strengths and deep domain knowledge, we were achieving worse outcomes (% success rate and ROI). 

Challenges to be surmounted when Partnering:

1. What success are you paying for: As a consultant, if you're paid to ideate 'N' ideas in 'X' months, you'll do just that. If you're paid to test an idea for 6 months, you'll keep testing for 6 months.
2. Cost to outsource: Day rates add up fast, especially for top talent with an agency needing to make their margin on top.
3. Missing the talent altogether: Attracting proven entrepreneurial talent without equity is hard, and at times, simply not possible. So, even if you have the budget for day rates, you may still miss the more experienced founders who can drive your idea forward at the fastest pace.
4. Continued corporate bureaucracy: If the venture is still wholly owned and legally part of the corporate, it's impossible to give it the freedom needed by startups in the wild to make decisions and pivot at pace.

Ultimately, we realised there was a fundamental misalignment of incentives when building ventures as consultants.

"Over the last seven years, we've done joint projects with BCG Digital Ventures, Creative Dock, FoundersLane… and we've realised that corporations can't buy innovation. Consultancies that charge a fee for ideating and building new ventures rarely succeed because of the fundamental misalignment of incentives. The consultants' motivation is to maximise fee income, not necessarily to produce a successful new venture for the corporate. The Rainmaking model fixes that."

- Uli Huener, Chief Innovation Officer, EnBw

Our new investment-only corporate venture building model:

We've created a hybrid of build, invest and buy; based on years of experiencing doing all three.

We partner with large corporations to build the businesses they ultimately want to own. By partnering with us, they syndicate the early, risky stage of the investment. Then, once proven, they can acquire the startup, with most of the value still to come (in future years post-acquisition).

What's different:

1. We don't charge any fees. Instead, we co-invest millions of our own capital (via our Fund) in new ventures. We make our return on the successful exit of the venture back to our corporate partner. This means we win or lose together with our partners, based on the venture's success. We don't get paid to try. 
2. We find proven, experienced founders for each venture and incentivise them with equity and the freedom to operate as a proper startup in the wild.
3. We identify unfair advantages (specific scale strengths and deep domain knowledge), which we draw from the corporate into the venture.

Our new investment-only Venture Studio approach allows our corporate partners to realise strategic growth as an add-on to traditional pure-play M&A and in-house builds. Our model offers significant advantages for certain types of strategically compelling ventures adjacent to core capabilities and competencies today. We focus 'where you want to be' instead of 'where you are' to fold the new ability (and material profits) into the business once established and scaling. We have a proven record of success and can provide better certainty and improved outcomes (with >40% of every Seed investment reaching scaled $10-50m profitability) through this way of working.

Chance of success: We're turning the typical VC return rate of 1 in 10 into 1 in 3. Ultimately, we de-risk building new businesses; for our corporate partners, Rainmaking and the venture founders. 

We have 13 years of venture building experience with a proven process and track record across 60+ ventures. To date, we have achieved a 5.5x cash multiple and a 112% IRR across our portfolio. Survival rates (as of January 2021) across our ventures are: 33% failed, 27% successfully exited and 40% still active.

Furthermore, venture studios typically outperform startups in the wild by 30%, according to a GSNN Study. And that's without the corporate's unfair advantages, which give our ventures a decisive lead, and faster route to scale.

Time to success: The same GSNN study showed that studio ventures achieve 2x IRR in half the time. In our model, ventures are typically brought back by their corporate parent at the 4–6 year mark, once the business is mature enough to survive reacquisition and integration.

Source: GSNN's Disrupting the Venture Landscape Report

Control: Corporates have 30–40% equity, the highest number of board seats of any party (3 seats out of 7), and guaranteed the option to be the sole buyer of the venture, with minimum performance metrics to protect from buying a business that isn't strategically valuable.

Cost: In our Seed round, we invest £200K while our corporate partners invest £400k. This £600k provides the venture with a 12–15 months runway. If we both decide to invest further (as the venture scales), we put in £2–4m, and our corporate partners invest £2–4m. This gives the venture an additional 2–3 years runway.

When it comes time to taking control and integrating the venture in year 4 or 5, the corporate partner already owns c.40%. By taking full (100%) ownership at this stage, the majority of the venture's value is still to be realised, as the business scales during its remaining lifetime. This translates to an average 90% value still to be realised, which is wholly captured by the corporate partner after Rainmaking's exit.

Best For: Creating new (to the corporate) strategically aligned businesses that leverage the core's scale strengths and domain expertise. They represent adjacent opportunities that cannot be realised through product development alone or as part of day-to-day business.

These are the kinds of ventures the corporate wants to own fully and could become a new business line one day where the corporate wishes to syndicate the risk in the early stages and increase the chance of the venture surviving and scaling. But, typically, the corporate doesn't have the relevant in-house capabilities or is looking to scale up new capabilities without adding to FTE headcount in the core business today.

Example Ventures: Typically, our partners are looking to tap into a new market/ or customer group, test a new business model or develop a new capability. Their ambitions for new ventures are strategic and aligned to the core but ultimately adjacent to business as usual. This means the new idea does not need to live within the core business while it grows.

Summary: Building new businesses - a comparison of methods

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Still, have questions? We'd love to hear them! Just comment below, and I'll look to answer them directly or in more posts!

What is the difference between a strategic alliance and an acquisition?

What is mergers and acquisitions in developing strategic partnership?

Which of the following is NOT feature of strategic alliance?