A Blog by Jonathan Low

 

Jul 25, 2019

The Reason Companies Invest in Startups - To Repair Weaknesses

This is a contemporary variation on the traditional 'make versus buy' decision familiar to generations of MBA students.

But it may also support the contention that large tech firms are investing in or acquiring startups to remove potential competition. A decision that may come back to haunt them in the current anti-tech environment. JL

Jyoti Madhusoodanan reports in Yale Insights:

Industrial firms that back startups invest corporate funds into startups relevant to their interests in order to shore up weakening aspects of their business. A dip in a company’s innovation—as seen in the quality and number of patents—increased its chances of initiating a CVC (corporate venture capitalist) in the same year by 26%. Parent companies were more likely to cite patents from startups they had invested in, suggesting that (it) had resulted in the parent firm incorporating startups’ technology. This “diffusion” of knowledge was especially strong if the initial CVC investment was followed by the larger firm acquiring the startup
Venture capital investments in the right new ventures can provide outsized financial returns. But a large number of industrial firms that back startups aren’t doing it only for the potential profits. Instead, they often invest corporate funds into startups relevant to their interests in order to shore up weakening aspects of their business, according to a recent study by Song Ma, assistant professor of finance at Yale SOM.
Ma began exploring the topic during his doctoral studies. When speaking with friends at startups, he learned that corporate venture capitalists (CVCs) were an important source of their funding—a factor that hadn’t received much attention from academia. Precisely why a large company would choose to invest in an external firm—and the economic implications of such investments—were not well understood.
These companies aren’t in business to nurture startups, Ma says: “Google is a search engine; others manufacture cars or computers. Why are these firms making investments when it’s not their main business? I began to wonder why they choose to invest in startups, and whether the firms they choose are different from those that independent VCs pick.”
For example, it could be that firms choose startups that “build on their existing strengths,” Ma says. Or they could be investing in companies “that offer technology or resources to fix the parent firms’ internal weaknesses.”

Read the study:  “The Life Cycle of Corporate Venture Capital”

To understand their rationale, Ma studied CVCs launched by public firms in the U.S. between 1980 and 2006. He began by compiling data on companies’ financial situations, information on firms’ patents, their history of CVC investments, and the portfolio of startups they chose. The number of patents a firm has are a sign of the quantity of innovation occurring there, Ma explains. And the more frequently those patents are cited, the higher the quality of their innovations.
In his analysis, Ma found that a dip in a company’s innovation—as seen in the quality and number of patents—increased its chances of initiating a CVC in the same year by about 26%, compared to firms that had no changes to their innovation. “We can see very clearly that firms create CVCs at times when they’re doing poorly,” Ma says. “It’s the first clear evidence that this is an effort to fix their weaknesses rather than build on their existing strengths.”
These minority equity investments were typically made in technologies or areas that were faltering in the parent firm, which “shows this active intent of seeking opportunities to complement or fix weaknesses,” he adds.
Parent companies were more likely to cite patents from startups they had invested in after the investment, suggesting that the CVC investment had resulted in the parent firm actively incorporating startups’ technology or knowledge into their own workings. This “diffusion” of knowledge was especially strong if the initial CVC investment was followed up by the larger firm acquiring the startup. The expertise and technology firms gained from their portfolio of startups helped the bottom line: in most cases, companies typically saw an increase in their own firm’s overall value and patents after CVC investments.
“Big firms can be weakened when there’s a disruptive environment because of startups. Investing in the startups is a useful long-term strategy to cope and absorb new technologies.”
It appears that investments through a CVC complement rather than replace other efforts such as investing in internal R&D, Ma says. But because firms can also use knowledge from startups in their portfolios to feed these internal efforts, “overall, the CVC benefits the firm in many different dimensions,” he notes.
Unlike traditional venture capital investors, who typically exit investments in in 10 to 12 years, CVCs don’t necessarily have a clear end date. However, Ma found that most investments were short-lived, with a median lifespan of just four years. CVCs were typically terminated when the parent firm began to recover.
The study also reveals that such investments are not the realm of tech giants alone; small and mid-size firms also use CVCs as a means to remedy their own weaknesses. “My prior view was that these investments were made by large firms such as Google or Intel, so I was surprised to find this is a very popular and prevalent phenomenon among smaller companies as well,” Ma says. “When they’re exposed to technology shocks, they’re using these investments as a way to catch up.”
CVC investments could be particularly valuable to parent firms during times when the startup sector is very active and creative, he adds. “Big firms could potentially be weakened when there’s a disruptive environment because of startups,” he says. “Using CVCs to invest in the startups—who are presumably their competitors—is a useful long-term strategy to cope and absorb new technologies.”

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