Most corporates choosing to create new business lines and/or test new business models have four choices:
- Build internally
- Make a minority investment into a startup in the wild
- Buy/acquire a proven startup
- 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:
- 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.
- 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.
- 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:
- What new revenues, resources, or capability does this unlock for other areas of the business? [Indirect returns impacting the bottom line]
- 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]
- 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 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!