Print
E-MailSong Ma is Assistant Professor of Finance at the Yale University School of Management. This post is based on his recent article, forthcoming in The Review of Financial Studies.
Recent decades have witnessed non-financial firms’ forays into venture capital by creating Corporate Venture Capital (CVC) divisions. Specifically, firms create corporate-affiliated VC divisions to make systematic minority equity investments in innovative startups. CVC has become a common form of corporate investment adopted by hundreds of firms and has emerged as an important source of entrepreneurial capital. CVC’s nature as corporate investment distinguishes it from the traditional intermediary VC model that seeks pure financial return. A firm that wants to maximize shareholder value should focus not only on financial return but also on the strategic value that CVC investments may add to the parent firm. Survey evidence shows that parent firms view CVCs primarily as strategic investments, with the goal of benefiting internal corporate innovation.
The question naturally arises: What is the strategic role of CVCs in incumbent firms’ innovation efforts? My article, The Life Cycle of Corporate Venture Capital, aims to empirically investigate two different views. On the one hand, firms can make CVC investments with the intention to “fix the weaknesses.” That is, CVCs are used by firms experiencing deteriorating internal innovation to expose themselves to new technologies and regain their innovation edge. This view arises from theories on information acquisition and innovation. These theories argue that firms dedicate resources to external knowledge acquisition, in this case using CVCs to learn from startups, when internal innovation. These information acquisition efforts strengthen internal innovation in later periods.
On the other hand, firms can make CVC investments to “build on strengths.” That is, leading technological firms use their advantageous information to identify promising startup innovation, and these new technologies complement their strong internal innovation and strengthen their market power. This view is rooted in the literature on mergers and acquisitions and innovation. Previous research show that firms with stronger internal R&D are more willing to expand firm boundaries because they are better at harvesting innovation synergies.
In my article, I test these different strategic views of CVC, “fixing the weaknesses” versus “building on strength,” by examining activities at each stage of the CVC life cycle—from when a firm enters CVC, to how a CVC invests in and interacts with portfolio companies, to the decision to terminate a CVC. The analysis begins with the CVC entry decision. I explore the determinants of CVC entry in a firm-year panel. The main finding is that CVCs are started by firms that have experienced recent deteriorations in internal innovation, reflected in decreases in innovation quantity (measured using the annual number of new patents) and innovation quality (measured using new patents’ lifetime citations). To sharpen the interpretation of the result, I isolate variations to innovation that are plausibly unrelated to contemporaneous unobserved firm characteristics. Specifically, I make use of detailed patent citation patterns to construct a Knowledge Obsolescence variable to track the usefulness of a firm’s predetermined knowledge accumulations. I find that knowledge obsolescence predicts an individual firm’s innovation quantity and quality declines, and the relation between these deteriorations and CVC launches is unaffected when exploiting these plausibly exogenous variations to innovation ability.
Putting this entry evidence together, CVC entries appear to be causally motivated by innovation deteriorations, consistent with the interpretation that parent firms initiate CVCs strategically with the intention to fix weaknesses in internal innovation. I further characterize those weaknesses that motivate CVCs. Only deteriorations in the firm’s key innovation areas, but not in peripheral areas, explain the decision to enter CVC. This is in line with the prior literature that shows firms attempting to regain innovation mostly focus on key areas. The pre-CVC deteriorations in innovation quantity and quality are commonly accompanied by declines in integrating new technologies in corporate innovation, as captured by a lower “explorativeness” measure of their patents.
Next, the article explores the investment phase of the CVC life cycle. Consistent with the view that CVCs are strategically adopted to fix weaknesses, CVCs are more likely to invest in entrepreneurial companies that innovate in parent firms’ weakening technological classes. A detailed comparison between the patent portfolios of CVC parent firms and startups helps depict a more complete picture of CVCs’ strategic considerations. Technological proximity between the CVC and startup portfolios has a positive effect on the probability that a venture relation will be formed. But more importantly, conditional on working in proximate technological areas, CVCs are more likely to invest in startups that can provide more complementary innovation knowledge in areas where they are lagging.
I also document strategic value creation subsequent to CVC investments. First, CVC parent firms become more likely to cite patents generated by their portfolio startups after making the investment. This citation pattern only happens after investments are made, and never before. This pattern suggests that CVC parents actively incorporate CVC-led technological knowledge diffusion into corporate operations. Second, subsequent to CVC investments, there are statistically significant and economically sizable increases of internal innovation and overall firm value. Last but not least, I find that strategic acquisitions are an important source of strategic value creation. The knowledge diffusion from portfolio companies is especially strong when there is a follow-up acquisition of the startup. Interestingly, CVC investments are followed by an overall increase in acquisition efficiencies made by parent firms, including those targeting non-portfolio companies.
The final analysis concerns the termination stage of CVCs. In principle, CVCs are not constrained by the typical independent VC fund life of 10 to 12 years. Surprisingly, CVCs appear to be temporary divisions that have shorter and non-uniform life cycles. When defining CVC termination as stopping the search for new startups, the median duration of the CVC life cycle is about four years, with a mean of six. I show that a CVC’s staying power is closely related to the innovation dynamic of the parent firm, and it is terminated when internal innovation weaknesses begin to recover. In contrast and interestingly, the staying power and termination decision are explained neither by initial public offering (IPO) or acquisition exit rates that are used to judge financial return-driven IVCs nor by governance changes.
All told, this article investigates different views of CVCs using life-cycle evidence across the entry, investment, and termination stages. CVCs differ from traditional VCs that are seeking pure financial returns. Instead, CVCs are in general strategic corporate divisions for incumbent firms to respond to negative innovation shocks, and CVCs help those firms to expose themselves to new technologies in order to fix their weaknesses and regain their innovation edge. These findings have implications for understanding entrepreneurial financing and corporate innovation policies.
The complete article is available here.
