When investing in new growth businesses, corporate leaders are commonly advised to behave more like venture capitalists. VCs, they’re told, take more of a long-term approach, have a greater degree of risk tolerance, and parcel out their funds in stages to mitigate risk.
All of this is right, as far as it goes. But having spent the past five years straddling between our consulting business (which advises large companies) and our venture investment arm (which provides seed investment to entrepreneurs), I now believe there is a more fundamental philosophical difference that corporate leaders need to adopt as well, if they’re serious about creating dynamic new growth businesses that stretch the boundaries of their current business models.
The philosophical divide is this: When VCs invest in an early-stage start-up, they recognize that odds are, the company will fail. When large companies invest in a nascent idea, they will only do so if they see convincing proof that they will generate an appropriate return on their investment. But that seemingly safer approach actually pretty much guarantees corporate investors poor returns on their new growth investments.
It’s not that VCs invest in businesses they think are bad. They just know the odds are stacked against any particular start-up. So when they invest, they look for a business with the potential to hit it big (to cover the inevitable losses), and they take steps to learn quickly whether that possibility is remote or realistic. The operative question for them is, not “How confident am I that this investment will yield a positive return?” but “How much can we afford to lose on a given investment?”
So, a VC might spread her $100 of investment capital across 10 companies in the following way:
Every company starts with $5. Six – which show their lack of promise early on — never receive any follow-on funds. One – possibly more promising — receives one more round of funding. Three companies end up taking 60% of all investment dollars.
By contrast, for corporate innovators each idea needs to carry its own weight. Ideas with positive discounted cash flows get investment. Those that don’t, don’t. Big bets don’t make it through the every-idea-has-to-be-a-winner screen because it’s very hard to create reliable, detailed financial projections for the types of uncertain ideas that have the promise of big returns. So, the corporate investor might spread his investment as follows:
This looks like a safe, prudent portfolio. But how do the investments actually pan out? Results might look like this:
Every idea the corporate investor backed produced something. Five produced positive returns, two broke even, and three lost a little, but not a catastrophic, amount of money.
Trying to make everything a winner led to two hidden traps. First, as in this example, it’s rare that every corporate bet pays off, even when betting conservatively. And yet no provision was made to cover the cost of the inevitable failures. It’s probably true that corporate investors suffer fewer strike-outs than VCs. It’s hard to get good data on innovation success rates, but most corporate leaders will report that even close-to-the-core efforts fail to deliver on their promise at least a third of the time. And of course the more the company pushes the edges of today’s business, the lower those odds sink.
Second, what happens if there is an idea in the portfolio with breakthrough potential? Since the venture capitalist made her investment in smaller increments, she was eventually able to double down on the ideas with substantial potential. The every-idea-must-be-a-winner investor locked all of his resources into smaller projects, none of which was ever going to yield a substantial payback.
The lesson here is clear. If you’re investing in new growth businesses inside a company and want to adopt a VC mind-set, start by assuming any given investment is not going to pan out. Invest a little to test that assumption. Measure the progress of the teams running the projects not by how quickly they can produce commercial results but by how quickly they can provide vital information (evidence of unit profitability, customer interest in the idea, technological feasibility, regulatory clearance, and so on) to figure out if they will eventually produce sizable commercial results. Regard just as valuable evidence that a project won’t pan out as evidence that it will. Expand investment in the winners, and cut off the losers as quickly as possible.
That’s how you invest in growth.