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Who's Buying Now?

The stock market downturn is putting corporate investing to the test: If now isn't the time to acquire new technology, when is?

1Jan

It's no secret that the same portfolio investments that once boosted corporate earnings are now starting to have the opposite effect. And no surprise that companies that once boasted of their corporate venture initiatives are now backing away.


Starbucks Corp. is a prime example. The Seattle-based operator of upscale coffee shops developed the venture itch in April 1999, investing in such companies as Living.com, an online furniture retailer, and Kozmo.com, an online delivery service. But since last year's fourth quarter, when charges for such investments nearly wiped out its profit, Starbucks has decided to invest only in "core" opportunities, according to a spokesman. Fellow Seattle-based retailer Nordstrom Inc. has had a similar experience, and is also pulling back.


More companies are likely to retrench or quietly exit from venture programs if the recent stock market downturn persists, simply because too much money has been chasing too few good deals. "The Johnny-come-latelies, they raise a billion, and they have to find something to do with it," says The St. Paul Cos. CFO Paul Liska, who has helped develop St. Paul Ventures, one of the biggest corporate funds dedicated to early-seed investing, with $1 billion in assets under management. "I think a lot of people are going to get killed in this area."


Other observers don't go quite so far. "It's clear there will be a retrenchment," says Josh Lerner, a Harvard Business School professor who specializes in venture activity. "Whether there will be a wholesale bloodbath is another question."


But merely the prospect of retrenchment raises a fundamental question: What has happened to strategic investing; that is, buying not so much for financial returns as for a chance to get a toehold in a promising new technology? With Nasdaq down some 40 percent since its high last March, and many high-tech companies down even more, bargains should abound if, in fact, the technology is all it was cracked up to be. Indeed, this should be an opportune time for CFOs of technology-hungry companies to acquire a stake in emerging and experimental technologies, from software to fiber-optic infrastructure.


"Not to be involved in strategic investing when so much innovation is happening at start-up companies places you at a huge disadvantage," says Peter Gardner, a general partner at Allegis Capital LLC, a San Francisco venture firm that provides a passive venture-investing outlet for corporations. "The concept of innovation shifting into the start-up community is permanent. The engineer has been liberated. It's going to be impossible to put him back in the box."


Of course, Gardner's observation assumes that healthy venture activity and big gains through initial public offerings will continue. Yet the feverish IPO activity that drove so much venture investing before the stock market peak last winter has clearly subsided, at least for now.



Taking Profits

Some of the biggest players in this arena — including Microsoft Corp., Cisco Systems Inc., and Intel Corp. — have avoided the fate of Starbucks and Nordstrom, not only by investing more wisely, but also by pulling in their investing horns soon after the market's peak. Intel, for example, took gains of $2.1 billion on its venture programs in the second quarter of 2000, almost equaling its operating income for the period. The Goliath chipmaker then realized gains of $716 million in the third quarter, more than a quarter of its net income of $2.5 billion. And while Intel still had investments in more than 500 companies at a value of $5.85 billion at the end of its third quarter, it anticipated gains of approximately $950 million for the fourth quarter.


Microsoft would have reported a year-to-year decline in pretax net income for the quarter that ended September 30, had the company not realized $1.1 billion in investment gains during the period. Meanwhile, it hired a high-profile investment banker to take the deal-making load off CFO John Connors, who earlier this year told analysts that investment activities should be run out of CEO Steve Ballmer's office rather than his own. And the gains Cisco has taken — and is expected to continue to realize — have been so significant that some analysts now consider the income an ongoing part of the company's operations.


These giants in corporate venture are not alone in taking profits. With about $275 million under management, software maker Adobe Systems Inc. recently took almost 10 percent of that off the table by realizing gains in its first three quarters of about $21.7 million, also almost 10 percent of its operating profit of $284 million for the same period. Much of the gain reflected the home run it hit with Yahoo Inc. after a $5 million stake ballooned to $240 million in value.


The action isn't limited to high tech. The St. Paul Cos., an insurance company based in St. Paul, Minnesota, realized investment gains of $330 million for its first three quarters of the year. Unlike most corporate venture programs, St. Paul's is strictly a financial play, with investments in companies that have little or nothing to do with its business. Among its big winners was Internet marketing company Flycast Communications, which yielded $130 million on a $7 million investment in the first quarter of last year. However, St. Paul continues to make new investments.


So who else is taking new, bigger stakes in new technology companies? It's hard to tell, since disclosure isn't required unless a stake represents more than 5 percent of a publicly traded company, or the value of an investment has changed so significantly that it has to be marked to market on the investor's balance sheet.


But anecdotal evidence suggests companies are still buying aggressively. In July, Sun Microsystems Inc. invested $3 million in Cygent Inc., a San Francisco­based, privately held developer of software designed to help telecom operators cut billing costs and market services more effectively. Cygent's CFO and chief operating officer, Eric Saltzman, says an IPO in the near term may be out of the question in the current environment. But he contends that Cygent's total financing of $51 million is enough to enable the company to turn cash-flow positive, and that Sun has indicated that it is far more interested in the potential strategic benefits of its investment than in a quick return. Cygent's software is based on Java, Sun's Internet programming language, and Cygent's relationships with telecom suppliers will help Sun sell servers. As a result, says Saltzman, "they are much less concerned with the timing of an IPO" than are financial investors.


Saltzman's observation is seconded by Jonathan Schwartz, senior vice president of corporate strategy and planning for Sun. "I could care less when Cygent goes public," says Schwartz, who notes that the value investors place on Sun's operating income is roughly 50 times greater than the value they place on its investment gains. And he notes that although Sun's stock price has fallen, making it a less valuable currency with which to fund investments, those of many potential candidates have fallen further.


What's more, says Schwartz, the sell-off in tech stocks has driven out a lot of what he describes as "dumb money" that had been competing to finance new companies. As a result, he says, Sun is finding more private tech firms amenable to outright acquisition that a year ago might only have been willing to offer small minority stakes. The most recent example, he says, is HighGround Systems Inc., a Marlborough, Massachusetts, maker of storage network software that Sun acquired on December 4 for $400 million, but initially approached merely as a potential minority investor.



More on the Way

Whether strategic or financial in nature, more corporate investments are on the way. Over the past three years, some 250 U.S. companies have launched their own venture activities, according to Corporate Venturing Report, a newsletter dedicated to corporate venture activity. Based on SEC filings, the newsletter figures that those companies committed about $10 billion to start-ups in the first half of 2000 alone, and another $4.3 billion in the third quarter.


Liska, for one, wonders whether corporations have fully examined the downside. Despite Schwartz's assertion to the contrary, Liska says, "There's still a lot of dumb money coming into venture. The fact is you're constrained by deal flow. There's a very small network of people who generate deal flow with [one another], and you've got to be part of the club."


Others aren't so sure. Harvard's Lerner, for one, contends that unlike past waves of venture activity, most notably in the late 1960s and mid-1980s, when corporations dove in because of the financial returns, there is now an overall higher level of sophistication.


Consider the nuanced approach adopted by one relative newcomer, San Francisco­based energy holding company PG&E Corp., which launched Pacific Venture Capital barely a year ago. The firm planned to invest $40 million by the end of 2000, about 75 percent in energy-related ventures and the rest in telecom-related start-ups. While Pacific Venture will not do a deal that's not considered strategic, its deals must have financial promise.


"People use the word 'strategic,' but one needs to be careful," says Peter Darbee, PG&E Corp.'s CFO. "We've already been approached by people saying, 'Why don't you do this project in retail energy, where people have already tried and failed? As big as you are, you should have a nationwide play in energy on a retail basis.' But we will not do deals for some strategic reason where we can't connect to specific [net present values] and internal rates of return that meet our targets."


PG&E isn't the only newcomer advocating caution. While most corporate venture arms claim to adopt a strategic mandate rather than a strict mission of gunning for high returns, many try to have it both ways: they'll dabble in start-ups that could provide useful technology or become a growing customer for the parent while also expecting a healthy rate of return.


But that is a difficult balancing act. Veterans of corporate venture advise setting realistic expectations for top management. That's especially important as more traditional companies break into the venture ranks. In short order, they may see themselves carrying a negative return.


"There's a saying in the venture community: 'The lemons ripen before the other fruit,'" says Steve Kahn, a managing director at Advent International Corp., a Boston-based venture capital firm that has a fund targeting corporate venture programs. "You're going to have losers before your winners. It's not uncommon to have a couple of deals go south before your winner shows up." Corporations are vulnerable not only to making bad investments, but also to lacking the patience to let the good ones mature.



The Uncorporate Approach

Moreover, many corporations have a command-and-control mentality that, while necessary for corporate survival, is anathema to successful venture activity. "Big companies have to deliver quarterly results to Wall Street," notes Don Laurie, who consults with corporations on their venture activities and is the author of the forthcoming book Venture Catalyst: 5 Strategies to Explosive Corporate Growth. "So they have a mindset of 'Give me predictable results, and if I don't control this I'm dead.' Entrepreneurs don't have operational plans; they have a business-building process. There's a fundamental difference. You're dealing with an emerging market, not an existing market. And running a big company is very different from running a small company. I never met an entrepreneur who said he could run GE or Union Carbide or IBM. I've never met a big-company executive who didn't think he could run an early-stage venture for two hours every fourth Thursday."


The challenge, then, is to create a bona fide venture outfit under the umbrella of the parent. When PG&E started its venture arm, it hired the COO of a Bay Area start-up and moved the unit across the bay to Oakland. The head of the unit reports to CFO Darbee, who says PG&E concluded it needed to add additional "growth legs," and that venture investing stood to provide a better boost to shareholder value than investing in the corporation's utility. After going through a strategic-planning process, "we concluded we wanted to change the makeup of our portfolio with higher P/E and market-to-book [multiple] businesses," says Darbee.


Even with strict discipline in place, Darbee has also been careful about setting expectations for the fund. "We have anticipated three years of moderate losses," he notes. "Historically, VCs have been happy with 20 percent to 25 percent returns. We tried to set expectations at an appropriately sober level and try to do better than that. I certainly don't want to be explaining to our CEO or board why we're missing our numbers."


Indeed, the numbers promise to haunt strategic-oriented venture activity, especially if venture investing goes through a down cycle, as so many anticipate. Returns can easily be measured; strategic benefits cannot.


That helps explain St. Paul Ventures's relentless focus on financial returns. The objective, Liska flatly states, "is to make money." He cites a compounded return of 65 percent for the last three years. St. Paul's financial orientation grew out of an investment program the company started in the late 1980s that evolved into a focus on start-ups in consumer technology, communications, the Internet, and health care.


Today, St. Paul Ventures is dedicated to investing in the seed round, which can maximize returns if a company goes public. Liska takes issue with the conventional wisdom that this a more risky approach. "I would argue it is not higher risk, higher reward," he says. "It allows you to control more of the outcome, and it allows you to capture a larger piece of a deal at smaller prices." In committing $1.3 billion to St. Paul Ventures in October, The St. Paul Cos. sees opportunities for more 10- and 20-fold returns. However, Liska notes, "if we did not have a fund today with a 14-year track record, we would not get into the venture business." He scoffs at the notion of newcomers investing large sums in venture. "Just because they have expertise in business, that doesn't necessarily translate into being a venture capitalist," he says.


Indeed, one can argue that coming early to the party has provided a valuable advantage. Philadelphia-based cable service provider Comcast Corp. got in early on the Internet, thanks to one of the company's founders, Julian Brodsky, who saw its potential and argued to the Comcast board of directors that it needed to invest in the coming revolution. Comcast's first investment, a $2 million stake in VeriSign Inc., an Internet security software provider, yielded a 100-fold return.


Comcast's venture arm, Comcast Interactive Capital, has made 47 investments, 18 of which have been liquidated, most recently Pets.com, the online pet supply retailer that filed for bankruptcy in November. "I went in for all the wrong reasons," says Brodsky. He was a friend of the CFO's, and there was also the pull of Amazon.com's involvement and connections with a VC. Brodsky vows not to repeat the mistake, even if it was a relatively small one at $2.5 million. Comcast Interactive has an internal rate of return of 200 percent since January 1999, having gotten in on such Internet deals as Ticketmaster Online and VerticalNet while there was a robust market for Internet IPOs. Comcast Interactive's return for the third quarter of 2000 was a healthy 15 percent, but, Brodsky admits, "now the low-hanging fruit is higher up."


Some corporate venturers contend that a strategic focus can reduce risk, thanks simply to a company's knowledge of the business. The value of the buyer to a start-up through the buyer's distribution network, its willingness to be a customer, its technological expertise, or some other business function provides a natural advantage.


"[Our portfolio companies] realize the value we bring," says Steven Rolls, CFO of Convergys Corp., a Cincinnati-based billing and customer service outsourcing company with $2 billion (12 months trailing) in sales. "We're not just about money."


While Convergys doesn't have a formal venture arm, it has made several strategic investments, and Rolls hopes to expand the program. A recent investment included VideoGate.com Inc., which develops live video and voice capabilities for customer service. Not only will Convergys become a premiere customer, says Rolls, but also "we can help develop [its] technologies and give feedback." As a large customer with a deep knowledge about its industry's trends, "we meet some of these companies and change the direction of what they're trying to do," he says.


Not that there's no risk of failure. "Are we going to back the wrong horse sometimes? You bet," says Rolls. "But the risk for us is not extreme, because we understand the technology. As much as [traditional] venture firms know, we know more, because the companies we pick up are either enabling technologies for us, or they're, in concept, potential competitors to us. It's technology we would build or want to build internally."


And while PG&E's Darbee resists the label of "strategic," he considers Pacific Venture the holding company's "forward-sweeping radar." One energy trend that's getting a hard look from the company is new fuel cell technology, which, if taken to its technological extreme, he says, will "eliminate the need for power plants, because people would have fuel cells in their garage or their basement." A typical response from a big company would be to create a strategic- planning organization to study the implications of emerging technology, says Darbee, and it would be an academic exercise. "But when you're putting in millions, you're taking these companies pretty seriously," he says.


Even Chevron Corp. has felt the need to form a venture fund, the first in the oil business, after sensing that much of the important innovations were coming from start-ups. One role of venture at Chevron, says venture executive Cliff Detz, is to complement the company's internal R&D program by gaining access to technology the corporation wouldn't see otherwise. One recent investment was in TenSquare, a San Jose, California, start-up that is building a point-of-sale network that could provide "promotional material to the customer right at the pump," says Detz. "This is an opportunity to offer the customer some other services and generate revenue at the service site."


Illumina not only has promising applications, but it also delivered a 10-fold return on Chevron's investment when it went public in July 2000, providing a win-win that many corporate programs pray for. Like so many corporate programs, Chevron's straddles the line between the strategic and the financial. Detz says strategic programs that don't care about returns are "swept away" when times get tough. "We will not invest in a bad deal just because it's of strategic interest. Our role is to act like a venture investor."



George Donnelly is editor of Boston Business Journal.



Paradigm Lost?


Corporate venture programs racked up big paper gains on IPOs early last year, only to see much less in the following months, according to the newsletter Corporate Venturing Report. Cisco Systems was the big exception, thanks to investments in such firms as Corvis, Nuance Communications, and Quantum Effect Devices. The table below lists results for the 25 companies that had the biggest gains from IPOs beginning last March 17.


Value generated in 2000 through IPOs, in $ millions as of date shown, based on value of shares held by corporations minus original equity investment.
Source: Corporate Venturing Report

Company3/176/159/1511/20
Dell Computer 856455699175
Motorola461292401221
Enron46113700
Singapore Technologies400981480
Microsoft3682491200
Nortel Networks3550661124
Omnicon Group33914100
Staples3298800
Amazon266000
British Telecom2649000
Integrated Device Technology23902620
Intel2373112110
GE210000
CBS182000
Texas Instruments16788069
Adobe Systems164840106
Excite@Home154000
Concentric Network154000
Novartis12401320
Verio117000
Torstar117000
Cisco Systems981741,700667
Ticketmaster Online City Search91000
Comcast74000
Allstate Insurance72000
Total12,5984,4148,6682,724

Venture Partnering

One way to test the venture capital waters is to get involved with traditional venture capitalists, working with a number of venture funds and tapping into their know-how. The natural antagonism between independent, experienced venture executives and new corporate players with heaps of cash has diminished, say observers, as they have realized the benefits of working together.

"Any venture program is much more likely to be successful if it establishes close and long-term relationships with traditional venture businesses," says Peter Gardner, a general partner at Allegis Capital LLC, a venture firm based in San Francisco. "Corporate investors bring big brands, distribution channels, deep pockets, and domain experience. VCs bring a lot of experience and the structure that allows for intensive support of young companies. In an investment area that's highly competitive, having investors around the table that know and trust [one another] and bring complementary skill sets is very much to the benefit of these start-up companies."

Corporations find that an investment in a traditional venture fund can diversify their portfolio and give them a better crack at good deals. "The more narrow [a venture program] is, the more likely they are to find things of strategic value and the less likely they are to get good returns," notes Advent International Corp.'s Steve Kahn, a managing director of the Boston-based venture capital company. "For companies that created dedicated funds, our experience has been [that] the financial returns suffer. There is a balance when it comes to financial returns and strategic value. We've created a pooled-fund approach as a way to find the appropriate balance." Some companies continue their direct investing while putting aside money for passive funds. Others, says Kahn, "came to us because they tried to do it themselves and had a bad experience." Advent's fund, with its focus on telecommunications and IT, "has a broad enough hunting license where we're not going to restrict ourselves."

While a corporate investor's relationship with a VC fund can increase deal flow, some corporations, like The Boeing Co., use passive venture investing to enhance their technology flow. Boeing has about $100 million passively committed to nine different venture funds, including Allegis Capital, and venture capital funds based in the United States, England, Israel, Switzerland, Russia, and Australia. All of these funds delve into technological areas of interest to Boeing, says Miller Adams, director of technology planning and acquisition at the company's Phantom Works, its R&D organization.

"This is a technology strategy for us," says Adams. "We have as much interaction with the portfolios as we desire. We're able to follow all the technological development early in the process." New start-ups are often brought into Boeing, where there is give-and-take on their technology's prospects. Recently, says Adams, a start-up's database management application was adopted in-house. "It's complementary to our in-house R&D," he says.

By going the passive route, corporations sacrifice some of the control that comes from direct investing, but they avoid the pitfalls of growing a program from scratch. "I view it as a make/buy decision," says Kahn. "Setting up your own operation is getting into a new line of business. For a group that doesn't have that experience, taking people from the inside and turning them into VCs is a big mistake." —G.D.

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