INVESTOR DRIVEN INNOVATION

Prof. Bart ClarysseDr. Itxaso del PalacioCharlotte Pauwels 21 February 2012

A Research Note for the Science|Business Innovation Board AISBL

WHAT CAN WE LEARN FROM THE WAY PROFESSIONAL INVESTORS SPOT ‘WINNERS’?

© 2012 Science|Business Innovation Board AISBL

The views expressed here are of the authors, and do not necessarily represent those of the Board or the Board’s members.

This report was commissioned by the Science|Business Innovation Board AISBL. The Board is a Belgian not-for-profit scientific association that performs original policy research, engages with policy-makers and the press, and works generally to improve the climate for innovation in Europe. Its three co-founders are Science|Business, ESADE and INSEAD, with participation and support from Microsoft, BP, SKF and Imperial College London. Further information, including other innovation-policy research, is at www.sciencebusiness.net.

The Board is grateful to Máire Geoghegan-Quinn, EU Commissioner for Research, Innovation and Science, for her encouragement and comments on this research.

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EXECUTIVE SUMMARY

There are many well-known success stories such as Google, Betfair and Facebook in which bright ideas created by bright entrepreneurs were identified, funded and professionally managed by well-performing venture capitalists. The case of Skype is a European example of a high-tech company that received an early venture capital (VC) investment of $18.8 million and grew to an $8.5 billion buy-out through the participation of many VCs, private equity, and corporate investors. There are now 115 million Skype users and the company has a total workforce of 420 employees.

These cases demonstrate the value that private risk capital brings to the development and growth of businesses. It also illustrates the enormous impact that these high-tech start-ups have in the economy.

Goals of the Study

What can we learn from the way professional investors identify potential “winners”? The goal of this study is threefold. First, we aim to define the preliminary criteria that professional investors use to identify innovative SMEs in a specific industry and country. Second, our goal is to analyse the applicability of those preliminary criteria to a sample of large corporate investment units. In so doing, we

will be able to shed light on the factors that characterize high-growth innovative SMEs in their early development. The results can help early-stage investors, as well as private equity or later-stage investors, to identify companies with high-growth potential which should secure funding. Third, we aim to consider whether the criteria could be tailored for public policies on innovation and entrepreneurship in different countries – in short, can public-sector managers use the professional-investor methods to improve the effectiveness of their innovation-support programmes? The results of this analysis will contribute to improve public policies and generate further discussion on this subject, at both EU and national level.

Methods

After an initial review of the existing literature, we conducted interviews with selected well-known and well-performing investors: private venture capitalists, such as Amadeus Capital Partners (UK) and Sofinnova (France), and corporate venture capitalists (CVC), such as LaFarge (France), BP Alternative Energy Ventures (UK) and Microsoft (US). A standardised protocol was used for the in-depth, in-person interviews. Repertory grid technique and verbal protocol analysis were used to increase objectivity.

Introduction

The prosperity of the European economy has recently been greatly stimulated by booming success stories such as Skype, Spotify and last.fm. These rather rare, ‘outlier’ success stories are attracting many investors to put money into technology opportunities with potential high returns. However, getting extraordinary returns has become even more difficult in recent years as the IPO market has slowed down. To get funding, start-ups must have a disruptive technology, target emerging and rapidly growing markets, and acquire strong managerial support. Investors play a key role in identifying high-potential opportunities and accelerating such companies’ success.

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Main findings

There are systematic differences between the way private VCs and corporate VCs operate. However, in general terms, they use similar practices for identifying high-growth opportunities. In terms of the criteria, VCs’ primary goal is to get extraordinary financial returns. Among those investment managers interviewed, they focus their evaluation first on the technology of the opportunity, and then on the market and management of the target company. Unlike VCs, CVCs’ primary goal is to invest in opportunities strategically connected to their main activities; among those interviewed, they look first at the strategic fit with their parent corporation, then they evaluate the technology and finally they assess the management team.

Private investor practices with regard to the screening and investment process provide important insights on how to identify high-potential opportunities. These insights can be summarized in the following six stylized facts:

1. The management team of the portfolio company is no longer the dominant criterion for the professional investors interviewed; other criteria such as a disruptive technology and a growing market have taken the lead.

2. They look for disruptive technologies and they use pattern-matching methods to identify them.

3. Most active and well-performing investors are embedded in an experienced community of professionals, which they use for intelligence and support.

4. VCs and CVCs rarely invest in seed or pre-seed opportunities but rather in early- and later-stage businesses. Investments in seed and pre-seed stages need intensive mentoring and guidance rather than capital.

5. Early-stage investors do not have a global perspective, which makes it difficult for them to syndicate with international well-performing investors.

6. There is a shortage of capital available for VC investors.

Policy Recommendations

Government VC intervention in Europe can learn from these findings, in particular from the distinctions between the private and public investment processes. Currently, public VC programs tend to base their funding decisions on an application form, and on heuristics generated within the bureaucracy. However, private and corporate investors screen the market thoroughly before they make a financing decision. They rely on a broad community of experts and choose the ultimate winners based on a pattern-matching process. These findings illustrate that the screening and investment process of public investors needs

Table 1: Ranking of the criteria use for VCs and CVCs, among interviewees

VC CVC1 Technology Strategic fit

2 Market Technology3 Management Management

Financials will come from: • A good technology• A big market• A good development team

Strategy comes first and then, only sometimes, financials should also be attractive

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to be professionalised. It seems clear that most promising projects cannot be identified based on an application form and on heuristics rather than on pre-seed performance of the entrepreneurs.

Another noteworthy issue for policy makers is the fact that neither VCs nor CVCs spend much time or money on the earliest, seed and pre-seed stages of a company. What these micro-firms need – even more than money, according to the interviewees – is coaching and management support to help them get to the stage of professional investment. In order to fulfil this need, our suggestion is that the EC could promote and organise incubation activities that provide active and professional guidance to starting entrepreneurs. In that way, the EC could help many start-ups to take the first steps needed to become ready for early-stage investment provided by VCs and CVCs. This would close the funding gap for many seed and pre-seed companies.

Based on the finding that start-ups tend to be limited in their mobility, the EC could play a role in bringing these start-ups into contact with well-performing investors by stimulating international mobility of entrepreneurs and start-ups. This will help to broaden the start-ups’ communities and accelerate their growth.

Finally, this research suggests that the EC could contribute to making funds available for professional investors by creating a central, early-stage actor, and potentially a professionally managed fund. This central actor should look after the needs of venture capitalists, differentiating them from the private-equity investors. The idea would be to assist venture capitalists during the screening and investment process, and to help them connect to well-performing international investors. Potentially, and only under a professional and experienced management, this organization could also include a fund that contributes to the high-tech entrepreneurial ecosystem.

In conclusion

This feasibility study has resulted in a set of preliminary recommendations for policymakers to promote the high-tech investment ecosystem. Due to the novelty of the study, including the comparison between venture capitalists and corporate venture capitalists, we recommend further definition, testing, development and implementation of the recommendations. The study provides a starting point for stimulating the discussion about policy intervention in the venture capital and corporate venture capital community.

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Introduction

Getting extraordinary returns from high-technology opportunities has become even more difficult in recent years as the IPO market has slowed down. In 2010 there were only 20 technology IPOs in the US, as opposed to 308 in 1999. Acquisitions are now the most likely liquidity route. It seems that the current deal pattern involves a relatively small set of businesses being acquired by an even smaller number of large corporations. As potential acquirers are generally very large, the value of small companies is often relatively insignificant. Their valuations tend to be low, and thus their only way to make money seems to be by having a disruptive technology, targeting emerging and rapidly growing markets, and getting strong managerial support. Investors play a key role in all of these three areas. This is illustrated by the following examples:

• Founded in 2003 and based in Luxemburg, Skype closed an A round of financing, the same year it was founded, from Bessemer Venture

Partners, the oldest VC firm in the US. In March 2004, they closed a second round of funding of $18.8 million from top VCs including Index Ventures. Only two years after its foundation, Skype received $50 million of debt financing from the American online auction house eBay. Recently, the company has been acquired by Microsoft for $8.5 billion. There are now 115 million Skype users and the company has a total workforce of 420 employees1.

• Google received start-up VC of $100,000 in 1998. In 1999, they received a further $25 million in venture capital. This bolstered their growth. By 2000, over 100 million searches were being conducted on a daily basis. Google went public in 2004 with an IPO in the US, where it raised $1.67 billion. As of today, the company employs more than 20,000 people worldwide2.

• Betfair, the company that operates

1 Source: Credit Suisse, www.crunchbase.com2 Source: www.crunchbase.com

1.1. CONTEXT

The flowering of the European economy has been largely stimulated by some high-technology success stories such as Skype, Spotify and last.fm. These firms are attracting many investors to put their money into technology opportunities which may have high returns. The reality is that only a very small percentage of the investments become big deals. While the average return is low, investors are still looking to find the next Google, Skype or Facebook. These ’outlier’ success stories are the main factors pushing money

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the world’s largest online betting exchange, completed a VC financing process in April 2006 which set the company’s valuation at slightly over $3 billion. This spectacular valuation is justified by great financial performance over the last 4 years. The company grew from $10 million in revenue in 2002 to $280 million in 2006. Betfair employs now about 2,000 people in the UK, Continental Europe, Australia and the US.

• Since its foundation in 2004, Facebook has raised $2.34 billion from VCs. Nowadays Facebook gathers 33 per cent of its returns through display advertising; it has realized an EBITDA of $2 billion and an EV of $70 billion in 7 years. As of April 2011, Facebook has over 2,000 employees and offices in 15 countries3.

These are all examples of bright ideas created by bright entrepreneurs that were identified at an early stage, financed and professionally managed by well-performing VCs. These cases demonstrate the value that VC investments bring to the development and growth of businesses, and at the same time illustrate the enormous impact that these high-tech start-ups have in the economy. The number of people employed by these companies is growing fast and is expanding all over the world. The impact of start-ups backed by the VC community is global. US-based companies like Google and Facebook are financed by American VCs and are contributing to European employment and the economy. Some European start-ups like Skype were also funded by American VCs and have

3 Source: Oxford Capital Partners, www.crunchbase.com

grown extraordinarily, supported by the professional advice of these investors. During the years the VC community has demonstrated its ability to accelerate the development of emerging technology opportunities by adding real value and to contribute to economic growth. These examples illustrate the need for motivating policymakers to better understand the high-tech investors’ ecosystem and to support its development.

1.2. GOALS

The goals of this study are threefold. The first goal is to define the criteria to identify innovative, high-potential SMEs in a specific industry and country. The study investigates the way professional investors pick potential winners in technology companies. How do they recognize a potential Google, Genzyme or Vestas when they are confronted with it in an early stage? These insights result in useful preliminary guidelines for professionals as well as for the public sector. On the one hand, professionals in SMEs can use the criteria to attract public and private funding. On the other hand, the public sector can use these criteria for creating specialised funds focusing on innovative and high-growth SMEs and for identifying innovative opportunities to finance.

The second goal is to analyse the applicability of the identified preliminary criteria to the context of big corporations. This sheds light on the relationship between the indicators of innovative SMEs and the factors that characterize successful innovative corporations. By analyzing the connection between innovation indicators in SMEs versus those in big organizations,

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we may be able to recognize the growth potential of early-stage SMEs. The results can help early-stage investors as well as private equity or later-stage investors to identify companies with high-growth potential.

The third angle of the study comprises the consideration whether the identified preliminary criteria could be used and customized for public policies on innovation and entrepreneurship in different countries. The results of this analysis will contribute to the improvement of public policies by providing useful criteria for programme design. It will enable public bodies to design their own SME-supporting programmes, by helping them to identify what kind of SME is suited to participate in pre-commercial or innovative procurement programs and so on.

This feasibility study results in a set of preliminary recommendations for policymakers to promote the high-tech investment ecosystem. Due to the novelty of this study, including the comparison between venture capitalists and corporate venture capitalists, our guess is that further work will be required to define, test, develop and implement the recommendations. In any case, it will be a good starting point for stimulating the discussion about policy intervention in the venture capital and corporate venture capital community.

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LITERATURE REVIEW

The differences between VC firms and CVC have been analyzed and similarities between VC and CVC models have attracted much attention in recent years (see e.g. Hill et al., 2009). Interest has grown especially within large corporations in the wisdom and utility of adopting the structures and practices of the limited partnership (VC firm) (Birkinshaw and Hill, 2003; Chesbrough, 2000, 2003; Brody and Ehrlich, 1998). Despite the progress that has been made in understanding corporate venturing, several major concerns remain regarding the understanding of CVC activities, processes and units. There is

for example a poor understanding of the strategic objectives of corporate venture units, which refers also to the choices made by a unit about what activities it backs and for what reasons (Hill and Birkinshaw, 2008).

In this study we explore some of these unsolved issues by analyzing the investment process and criteria used by both VCs and CVCs. We believe that, despite the differences in their nature and structure, understanding both of them will be very valuable in contributing to the definition of some policy recommendations. The

2.1. TYPES OF INVESTORS

The standard organization of the investment industry emerged in the US where VCs are typically independent financial intermediaries (Sahlman, 1990; Gompers and Lerner, 2004). However, there are other types of investor and investment structures that differ in their investment goals, strategies and value they add to their portfolio companies. Typically the literature identifies two classes of investors: independent and captive venture capitalists. Independent firms tend to be seen as the more traditional type of venture capitalist1. They are funded through limited-life closed-end funds, raise their capital from a variety of external sources (private investors, financial institutions, insurance companies etc.) and are highly committed to generating a return for investors by realising a capital gain within a specified period of time. Captive VCs, such as corporate-based, bank-based and government-based venture capitalists (CVCs, BVCs and GVCs) do not need to raise funds from third parties (Wright and Robbie 1998), but the amount they allocate for investment purposes reflects the overall strategy of the parent institution.

1 In this study, we refer to this type of investors as venture capitalists (VCs)

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results will also extend the existing literature, as while the investment criteria used by VCs have been widely analyzed, CVCs’ investment criteria have been little researched.

2.2. INDEPENDENT VENTURE CAPITAL

Limited partnership is the most typical organizational structure for VC firms. In this structure, VCs serve as general partners and control the day-to-day activities of the fund; investors serve as limited partners and monitor the fund’s progress and attend annual meetings. The venture capital cycle starts with raising a venture fund; proceeds through the investment in, monitoring of, and adding value to firms; continues as the VC firm exits successful deals and returns capital to its investors; and renews itself with the venture capitalist raising additional funds (Gompers and Lerner, 2001). In the VC cycle, general partners are required to negotiate into two directions, both with the investors and the entrepreneurs. VC firms raise money from investors, look for the best opportunities to invest in, and control the use of the invested capital by getting involved in the management of the companies in their portfolio. These entities are structured as management companies responsible for managing several pools of capital during the finite time previously discussed and agreed by the VCs and limited partners.

Most private equity funds are closed-end funds with a limited lifetime of 10–13 years, which can be extended with the consent of the majority of the shareholders. During this period, the general partners undertake investments of various types (e.g., VC, bridge financing, expansion capital,

leveraged buyouts) with the obligation to liquidate all investments and return the proceeds to the investors by the end of the fund’s life.

The incentives for VCs are based on increasing the value of the young companies in which they invest. When a liquidity event occurs and the portfolio companies’ stocks sell at a premium above their investment cost, the venture fund general partners receive a portion of the capital gain (usually 20 per cent). Additionally, general partners charge limited partners an average of 2 per cent of assets under management (known as a management fee). This fee covers the general partners’ responsibilities for identifying investment opportunities, investing in, monitoring and adding value to firms and ultimately achieving some return on their capital.

In recent years, VC performance has fallen significantly. We are approaching a point where the 10-year return in VC is negative. The VC industry has had many successes over the last three decades and is prominent worldwide for its role in financially catalyzing notable, high-growth companies. More recently, however, venture capital returns have stagnated and declined. Both the US and European venture capital industry are at an inflection point.

The following two figures show the relationship between venture capital commitments and returns. Figure 1 shows that venture capital commitments from limited partners increased fivefold but at the same time led to a collapse in performance from which the sector has never recovered. The situation is similar

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when considering the pace at which venture capitalists continue to invest, despite poor recent returns. Figure 2 shows that the expansion in venture capital has not coincided with improved returns. Inertia probably plays a large role in current VC allocations, with too many venture partnerships continuing to invest in information technology because they always have, not because they credibly anticipate improved returns.

Especially in Europe the realized returns of venture investments have historically been below required returns. Many VC professionals point to this underperformance as the main obstacle to the development of a strong VC industry. The relative lack of venture funding in Europe has been frequently attributed to the absence of attractive and liquid markets for VC exits, in particular for IPOs (e.g. Black and Gilson, 1998). The decline in IPOs prevents venture investors from earning the same returns as they

Figure 1: Venture Capital Performance vs committed capital (1990-2008)

Source: National Venture Capital Association Yearbook 2009

have historically. The IPO window never reopened for early-stage companies after the dot-com collapse, largely eliminating the primary source of profitable exits for venture investors. There is no question that the number of venture-backed IPOs has declined; however some companies did successfully come public over the last decade, including in technology. What has changed is that the market has become less accessible for young, money-losing companies than it was in the late 1990s. Another possible reason for the decline in VC performance could be the fact that too much capital is allocated to ventures, with the effect of higher valuations and lower exit multiples (Hege et al, 2009).

Researchers and professionals agree that raising venture capital creates many positive effects for the companies in which they invest (e.g., Sapienza and Timmons, 1989; Sapienza, 1992; Sapienza, Manigart and Vermeir, 1996; Hellmann and Puri, 2000; Lee, Lee and Pennings, 2001).

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Figure 2: Venture Capital performance vs. investments (1990-2008)

Source: National Venture Capital Association Yearbook 2009

Further, given the positive results of venture capitalists’ guidance and advice, their involvement has increased over time (Ferrari, 2003).

VCs’ involvement varies from one company to another. On the one hand, venture capitalists help start-ups accelerate their development and growth by advising them on how to manage their businesses. They help companies increase the number of employees (Davila, Foster and Gupta, 2003) and to innovate (Kortum and Lerner, 2000); they enable the development of firms in new markets (Von Burg and Kenney, 2000) and accelerate this development (Hellmann and Puri, 2000); and they help start-ups increase their returns (Stein and Bygrave, 1990), among other contributions. On the other hand, venture capitalists’ involvement allows investors to monitor the companies’ performance (Kaplan and Strömberg, 2001).

However, many times investors have

also been criticized for slowing down entrepreneurs’ performance. In many countries around the world including in Europe, investors’ have been criticized for disrupting and limiting the performance of high-technology start-ups. Limitations are frequently linked to the geographical scope of their investments and syndicating partners’ investments. Also, entrepreneurs already have encountered many “unprofessional” investors, who have no experience managing high-technology companies, who do not understand what the milestones could be, do not know what the start-ups need, and do not have the network of contacts that could help them to take their technology and business ideas to the market.

In an ideal situation, VCs have both engineering and management skills and have acquired several successful high-technology entrepreneurial experiences. In these cases, venture capitalists contribute specialized know-how and access to

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trustworthy networks within their field (Timmons and Bygrave, 1986; Giudici and Paleari, 2000); they also know how the market is structured and have contacts with potential customers and suppliers (Gorman and Sahlman, 1989; Fried and Hisrich, 1995; Sapienza, Manigart and Vermeir, 1996). Their network includes specialized lawyers and accountants that contribute to the management and strategic development of the firm.

During the screening process, investors mobilize their social networks to collect information (Ferrari, 2003) in order to reduce three main risks (Perez, 1986): market risk (establishing potential customers for the product or service); technological risk (evaluating the degree to which the technologies or concepts are well developed and not threatened by potential competitors) and management risk (evaluating the entrepreneur’s technical and human competencies to develop the new firm). Before closing the investments, VCs offer financial expertise for structuring the deal and installing appropriate incentive and compensation systems (Sahlman, 1990; Kaplan and Strömberg, 2003). Finally, after investing, VCs typically take an active and interventionist role in the firm’s decision making. They can be considered incentivized consultants who guide businesses toward public offerings or mergers (Barry, 1994).

2.3. CORPORATE VENTURE CAPITAL (CVC)

In recent years, a growing body of literature has been published in the area of CVC. Big companies use CVC for finding new opportunities to grow. It is a mechanism

by which big corporations can extract value created by smaller organizations; they acquire advanced technology, get new partners and contacts, and access new customers among others. In other words, they use existing resources to generate organic growth within their organization.

CVC can be described as equity investment by consolidated firms in independent entrepreneurial ventures, i.e., relatively new, not-publicly-traded companies which are seeking capital to continue operation (Chesbrough, 2002; Gompers and Lerner, 1998). In recent years, an array of CVC forms has emerged. As a result, the definition of CVC has also been slightly modified, i.e., including investments attempting to monetize existing assets of the firm such as patents (e.g. Hill and Birkinshaw, 2008). In this study we work from Chesbrough’s (2002) definition of CVC which excludes investments made through an external fund managed by a third party as well as new internal ventures that, while distinct from the company’s core business and granted, remain legally part of the company. This definition does however include investments made in start-ups that a company has already spun off as an independent business.

As with the VC market, the Internet bubble also had a big impact on CVC activity in the EU and the US. Between 1998 and 2000, the number of CVC deals rose from about 500 to more than 2,000. In 2001, however, investment activity dropped precipitously as the market for new public offerings dried up. As a result, many firms, which had established funds only a few years before, were forced to shut down their investment operations. On the contrary, leading

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corporations such as Microsoft, IBM, BP, Merck and others continued investing in new ventures (Chesbrough, 2002-HBR1), which resulted in the development of CVC as an important source of innovations for many big corporations.

According to Chesbrough (2002), CVC investments are characterized by two indicators: their objectives and the degree to which the operations of the investing company and the start-up are linked (Figure 1). Although the objectives of the investing companies are various and vary from one company to another, this type of funding usually pursues one of two fundamental goals: strategic or financial. Strategic goals are primarily set to increase the sales and profits of the corporation’s own business, while financial investments are mainly done to gain attractive returns. The second characteristic is the degree to which companies in the investment portfolio are linked to the investing corporation’s current operations. Corporations either invest in new markets and disruptive technologies, or in start-ups that may enable the investing corporation to use its current manufacturing plants, distribution channels, technology or brand.

Based on these two characteristics, CVC investments can be divided into four groups (Figure 3) (Chesbrough, 2002):

1. The first group covers the driving investments. These are investments that have a strategic rationale and dispose tight links between the start-up and the operations of the investing

1 Chesbrough, H., 2002. Making Sense of Corporate Venture Capital. Harvard Business Review - http://hbswk.hbs.edu/archive/2854.html

company. Although many driving investments can contribute to the competitiveness of the corporation, there are limits to what they can achieve. These investments are unlikely to generate a disruptive impact and strategies beyond the current capabilities of the corporation2.

2. The second group is for enabling investments, in which case the investments are also primarily made for strategic reasons but are not tightly linked with the company’s own operations. This type of investment may cover, for example, investments in complementary products, or funds which companies may use to stimulate the development of the ecosystem in which they operate3.

3. The third group are the emergent investments and refer to the investments that are done in start-ups with tight links to the operating capabilities of the investing firm, but that contribute little to the enhancement of the current strategy. Some companies for example may sense an opportunity in a new market with a new set of customers. While the immediate benefits of such investments are financial, the ultimate return may result from exercising a strategic option4.

2 Microsoft’s driving investments of over $1 billion have helped advance its “.Net” architecture that enabled its Windows platform to provide a variety of Internet services.3 Enabling investments were used by Intel to spur the demand of products that required their microprocessors to work, such as video, audio and graphic hardware.4 Lucent’s New Ventures Group identifies underutilized but promising technologies within the company’s Bell Labs and spins them of as independent start-up companies. Afterwards

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Figure 3: CVC characteristics

Source: Chesbrough, 2002

4. Finally, the fourth group covers the passive investments that are not connected to the corporation’s own strategy and are only loosely linked to the corporation’s operational capabilities. Corporations lack the means actively to advance their own businesses through these investments and thus sometimes receive criticism for misusing shareholders’ funds5.

Lucent invests in them by its own, in the first round and with other investors later on.5 Dell Ventures invested into firms that had only tangential connections with Dell’s own strategy hoping that the demand of Dell computers would increase if they succeeded.

2.4. INVESTMENT SELECTION CRITERIA

By their very nature, new ventures carry high levels of risk for those involved. In their search for adequate funding, especially high-technology start-ups face severe adverse selection and moral hazard problems. This is mainly caused by their high level of information asymmetry, the uncertain nature of R&D investments and skewed and highly uncertain returns. Their technology-intensive activity, lack of a track record and absence of tangible assets further restrain them in attracting sufficient external capital (Amit et al., 1998; Gompers, 1995; Storey and Tether, 1998; Tyebjee and Bruno, 1984; Himmelberg and Petersen, 1994; Carpenter and Petersen 2002a; Ascioglu et al., 2008; Hubbard, R.G., 1998).

VCs operate in environments where their relative efficiency in selecting good

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investments gives them a comparative advantage over other investors (Amit et al., 1998). VC investors deal with the information asymmetry by performing an elaborate due diligence before the investment and by monitoring their investments (Berger and Udell 1998). As VC firms differ from each other in their capacity to reduce information asymmetries, they exhibit different selection behaviours. Often VCs invest in a specific stage and a specific investment sector to decrease potential agency costs. The strategy the fund follows and whether or not specific investment sectors are considered may have a clear impact on selection behaviour (Knockaert et al., 2010). Differences in the selection behaviour of funds may also be associated with the size of the VC fund (Engel, 2004) and variations in the human capital of the investment executives. Human capital enables a VC more effectively to screen, monitor and add value to technology investments (Lockett et al., 2002). As human capital theory states, greater human capital is associated with better performance at particular tasks (Becker, 1975).

The identification of VC investment criteria is a well-researched and documented domain in traditional financial literature. Several studies concerning the criteria used by VC investors to evaluate their investments have been already conducted (e.g. Knockaert et al, 2010; Dimov and De Clercq, 2006; Sapienza, 1992). These studies provide a general ranking of the criteria used by VCs. Most of the studies agree that the human factor is of utmost importance (Leleux et al., 1996). There is a frequently iterated position taken by the VC community that above all, it is the quality of the entrepreneur

that ultimately determines the funding decision (MacMillan et al., 1985). The product-market criteria appear to be only moderately important while the overall fund and deal requirements are considered to be of least importance (Leleux, 1996).

Despite the extensive research developed about the investors’ criteria, most of the research on this area has treated the industry homogeneously (Fried and Hisrich, 1988). Early studies are focused on VC in general, with no difference between VCs and CVCs. There is still little research about corporate venturing and the existing one is focused on analyzing the strategic objectives compared to the financial focus of VCs (see e.g. Birkinshaw, 1997; Block and MacMillan, 1993). There does not yet exist any listing of specific criteria used by CVCs and their parent firms for the evaluation of new business opportunities.

Previous literature has also shown that, in terms of performance, VCs and CVCs are similar when their business sectors are similar (Gompers and Lerner, 1998). Since the learning from the VC industry has been extremely valuable for corporate venturing and a lot of corporate venture units draw explicitly from the VC model, we can assume that the criteria used by VCs will also apply to some extent to CVCs, although there may be a difference in order of importance.

For this study, we use the criteria analyzed in VC literature to explain independent investors’ preferences (see Muzyka et al., 1996 for the 35 individual criteria)6.

6 These criteria were gathered from previous research and validated by seven venture capitalists through open-ended interviews.

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We extended this preliminary list with additional criteria extracted from the CVC literature, and use it as a guideline for the interviews. The final list includes 35 individual criteria used by Muzyka et al. (1996)7 for the VC industry as well as 15 additional criteria extracted from the CVC literature8. The final list (see www.sciencebusiness.net for full report) consists of 50 individual criteria grouped for convenience and following the Muzyka et al. (1996) study, into seven general categories.

7 These criteria were gathered from previous research and validated by seven venture capitalists through open-ended interviews.8 The numbers between brackets refer to the articles where the criterion was extracted from.

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METHODOLOGY

In this study we chose to conduct a smaller number of qualitative, in-depth interviews with leading investors instead of focusing on a large sample to perform a quantitative analysis. We believe that face-to-face, in-depth interviews are more suitable considering the objectives of the study. A degree of standardization is obtained by using the same interview protocol for each interviewee (See full report at www.sciencebusines.net for interview protocol.)

The repertory grid technique is an interviewing method that can be used to structure an interview. The technique of repertory grids arose from Kelly’s clinical work in 1955 based on the suggestion that people’s minds construct maps of what they see and that these maps guide their behaviour. The maps are called ‘personal constructs’. There is little quantitative

evidence to support this assumption but qualitative evidence abounds. The repertory grid technique uses a relatively simple approach to relate the interviewee’s constructs directly with elements, or objects to which the interviewee relates his own concepts and values. In practice this means that the elements represent objects related to the subject being investigated (e.g. CVC units or VC units the interviewee often syndicates or is familiar with). First, the elements are listed. Then the interviewee is asked to come up with a range of qualities that may be used to describe the elements. This process can be facilitated by identifying aspects, which make two of the three elements different from the third. These qualities are then rated over the range of elements.

The third part of the interview makes

The methodology used in the literature for identifying the investment criteria of VCs and CVCs has evolved over time. The earliest studies make use of descriptive methods (Wells, 1974). Subsequent studies traditionally use Likert-scaled survey methods (see e.g. Tyebjee and Bruno, 1984; MacMillan et al. 1985). These methods, however, all have the inherent limitations of scaling in that there are inevitable differences in discrimination between what is considered important (Leleux, 1996). As a reaction to this shortcoming other methods such as conjoint analysis and grid techniques have also been used recently (see e.g. Leleux, 1996). Apparently, these methodologies provide more accurate and reliable results. While the results of this methodology are highly reliable, our sample has not enough observations for developing a quantitative analysis. In this study we will start from the results of previous conjoint analysis developed on big samples of VC and CVC investors.

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use of a verbal protocol analysis. Verbal protocol analysis is a theory on verbal thinking-aloud protocols as data. The term is used to describe the methodology where verbal reports, generated by individuals under a range of circumstances, are used as data (Alison, 1995). Verbal reports refer to human subjects’ verbalizations of their thoughts and successive behaviours while they are performing cognitive tasks. Verbal report analysis is used as a means for inferring cognitive processes from behaviour (Ericsson & Simon, 1981).

The sample of the study consists of the most active and well-performing investors. (See appendix at www.sciencebusiness.net for lists of influential CVC and VC firms.)

The final sample consists of 8 investment firms: four VCs and four CVCs (See Table). All the investment firms in the sample have some general characteristics:

Table 2: Sample of VCs and CVCs in the study Location of the investment team interviewed between brackets

• They have performed positively in the last years;

• They have an influential presence in high-tech;

• They invest in early stage opportunities;• They focus in high-growth, high-

potential companies;• The firm is actively investing at present;• The firm is globally present.

Company Interviewee

Venture Capital

Sofinnova (France) Jean-Bernard Schmidt

Intel Capital (UK-EU) Marco Battisti

Oxford Capital (UK) Colin Watts

Amadeus Capital (UK) Jason Pinto

Corporate Venture Capital

Microsoft (EU) Stefan Lindeberg

BP Alternative Energy Ventures (UK) John Steedman

Lafarge (France) Pascal Casanova

Cisco (UK) Riccardo Pollastri

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ANALYSIS OF RESULTS

Despite the substantial heterogeneity in this section we present the most relevant results of the study. The Table below summarizes the minimum requirements the opportunities need to comply with in order to be considered valuable and to be further evaluated by investors. We have grouped these basic requirements into six categories: product, market, management team, strategy and financials. In terms of the product, investors evaluate opportunities that have disruptive technologies and are at least “two times more efficient (faster, cheaper, smaller…)”. In terms of market, they look for large markets with rapid and big growth potential; markets which are not concentrated or led by one big player. The management team needs to have a proven track record with previous successful or failed entrepreneurial experience, and

with extensive knowledge of the targeted market. For ensuring the acquisition of the market, the team needs to show a good sense of entry timing; and a fast-moving strategy is recommended. Protected ideas are preferred to a certain extent. Finally, in terms of financials, investors look for opportunities with big margins and high growth opportunities; for IT businesses they expect growing revenues to maximize the acquisition price. For life science businesses they look for an increasing value and an IPO.

The in-depth analysis of the interviews with professional investors resulted in several insights regarding the way they operate to pick winners. These insights can be summarized in the following six stylized facts.

4.1. FINDINGS REGARDING THE INVESTMENT CRITERIA

The exploratory analysis shows that the investment criteria used by investors to identify high-growth opportunities is not unique but varies depending on the location and the specific context of the opportunity. However, despite the lack of a standard “check-list” for identifying high-potential SMEs at an early stage, some general trends and proceedings used by professional investors can be identified. In general the results of the study show that investors use their personal heuristics developed over time, and that they hardly deviate from these personal heuristics. Different criteria are used for different sectors and the criteria depend on external circumstances such as market conditions, the regulatory environment etc.

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Table 3: Criteria and their minimal requirements

SF 1: The management team of the portfolio company is no longer the dominant criterion for the professional investors interviewed; other criteria such as a disruptive technology and a growing market have taken the lead.

While the sample size of interviewees for this feasibility study was not large, it came as a surprise that amog those interviewed the ranking of the criteria resulting from this analysis does not confirm the criteria defined by traditional literature. Previous

research states that the team or the management of the portfolio company is of the utmost importance. In our results the management team only ranks third, for VCs as well as for CVCs. The reasoning behind this finding is that it is more easy to change the management team or to bring in somebody who complements the existing team rather than dealing with intellectual property issues or targeting markets with little growth potential. For traditional VC investors the technology was considered to be the most important

Criteria Venture Capital

PRODUCT • Disruptive technology or explicit improvement• Good cost / efficiency • Do at least 2 times better

MARKET • Existing market: big enough, measurable and reachable• New market: large growth potential• General:- Little concentration (few players) leadership potential- Good knowledge of competitive dynamics- Be able to really change the game

MANAGEMENT TEAM • Proven track record: with previous entrepreneurial experience (even failed opportunities)

• High-energy • Experience in the domain• Cohesive team that can easily be adapted (e.g. new CEO)

STRATEGY • Complementary products

FINANCIALS • Significant potential for fast growing revenues (for an IT idea: M&A) and increasing value (for a Life Science idea: IPO)

• Strong margin prospect

RETURN • 30-40% return

EQUITY • 25-30% is average for £ 1-2M• 20% for £ 2M in later stages

TIME TO EXIT • 3 years (sometimes up to 5 years)

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factor, followed by the market. A cutting-edge technology with a substantially improved effectiveness and a possible big and growing demand would convince most interviewed VCs to invest. With regard to the market, ranked second by VCs, it is required that the technology targets a big market, that it fills an existing gap in that space and that it satisfies customer needs. Not surprisingly CVCs only finance opportunities that strategically fit within the corporation’s strategy. A strategic fit is an essential requirement for corporate investors. One of the most surprising findings is that financials rank last in the list of criteria. In fact, investors claim financials will work as soon as the remaining factors work. A financially healthy deal results from a good technology, a big market and a good development team.

SF 2: Disruptive technologies are key and are discovered through a pattern matching process.

Investors search for disruptive technologies rather than for incremental innovations. In other words, investors look for emerging technologies that operate in new and growing markets rather than for incremental innovations in existing markets. Evaluating a non-existing opportunity in a non-existing market is somehow difficult. For example, traditional mechanisms based on cash-flow estimations are not reliable in these cases. In this context, investors use “pattern matching” mechanisms to evaluate the novelty and potential of disruptive technologies. This methodology consists of finding analogies between current opportunities and previous successful technology companies such as Facebook, Groupon and LinkedIn. The

analogies are then used for evaluating upcoming opportunities. In this process, the capabilities of investor managers are crucial. Their knowledge and experience play a critical role for identifying potential high-growth markets as well as disruptive technologies.

SF 3: Most active and well-performing investors are embedded in an experienced community of professionals.

All interviewed investors said they are getting support from a community of corporate and venture capital investors, entrepreneurs, scientists, lawyers and other professionals. They are part of a network of individuals and organizations related to the technology and innovation process. The connections between the investors and other individuals in the network facilitate the information flow, reduce information asymmetry, accelerate the due diligence process and, ultimately, reduce the cost of transactions. As part of the community, investors have access to specialized knowledge that eases their decision process. They are also connected to trusted and well-performing syndication partners, who not only give them access to a larger pool of resources –mainly money and knowledge- but at the same time validate their decisions.

Currently, investors are well aware of the benefits that come along with being a member of such a community. Collaborations and partnerships outside the boundaries of the deal are emerging. These new relationships are no longer exclusively based on financial complementarities but profit from knowledge complementarities as well.

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SF 4: There is a shortage of capital available for VC investors.

Seed capital investments are extraordinarily risky and most of the time only profitable in a long-term perspective. The limited profitability of VC firms in the last years is making it very difficult for them to raise follow-on rounds. An additional difficulty for VC investors to raise enough capital is the high concentration of capital in large corporations. This small number of very liquid corporations, unfortunately, is not too keen to invest in risk capital. As an example, Oxford Capital Partners mentioned that $2 trillion in “cash” is available on the corporate balance sheets and $300 billion is located in the top technology companies, but that it is very difficult to get funding from these institutions. The reason for the reluctance of these big corporations to provide capital to VC firms is their short-term view and risk-aversion, which makes them reluctant to invest in early stage companies.

SF 5: VCs and CVCs do not invest in seed or pre-seed opportunities. They invest in early and later-stage businesses. Investments in seed and pre-seed stages need intensive mentoring and guidance rather than capital.

VCs and CVCs invest in early-stage companies rather than in seed opportunities. In order to reduce the risk, investors finance companies that already have customers, are well structured, have some kind of track record and are involved in an already existing network of entrepreneurs and investors. These companies are no longer in a seed or pre-seed stage but rather in an early or even later stage.

Very few VC firms and corporations have seed and pre-seed investment funds. These investments are extremely risky and uncertain, have only long-term returns and require intensive mentoring and advice. Exceptions of funds addressing seed and pre-seed stages are the Amadeus and Angels Seed Fund, the Index Seed fund and the Microsoft Bizspark program. These funds and programs focus on mentoring and incubation activities for a rather large pool of pre-seed opportunities. In this stage, targeting a large number of businesses is important to eventually result in a small percentage of good performing starters.In order to fill the gap of funding for seed and pre-seed companies, accelerator programs such as SeedCamp and Springboard have been constituted. These programs are based on a network of serial entrepreneurs who play the role of mentors and “super angels”1.

SF 6: Early-stage entrepreneurs do not have a global perspective.

One of the challenges that many of the small and early-stage companies in Europe face is related to their local focus. Very few companies in Europe are born global and are willing to be relocated in geographically distant countries. They target local or nearby markets and they often are reluctant to be mobile. Since well-performing investors prefer to finance companies nearby themselves, the local focus of starting entrepreneurs in the EU impedes access to appropriate finance. An

1 The term super angel refers to the angel investors who have experience in starting and exiting small technology firms, and who are willing to provide hands-on support to the entrepreneurs.

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increased international mobility among these starting entrepreneurs could bring them closer to well-performing investor communities.

4.2. DIFFERENCES BETWEEN VCs AND CVCs

There is anecdotal evidence that while independent VC firms are going through difficult times with regard to raising new funds, their corporate counterparts have surged: more corporations have set up early-stage funds; the number of corporate investments is growing; and the way in which CVCs operate is getting more and more effective. The CVC units seem to have a more flexible structure than the VC units. The focus of a CVC fund is reviewed yearly according to the trends of the market and according to the corporation’s strategy. The capital under management depends on the results of the balance sheet. The way they invest is variable: while some CVCs syndicate with VCs or angels to invest in the companies (e.g. BP Alternative Energy Fund), other CVCs invest in pre-seed stages through mentoring programs which help them to identify high potential companies. In general, all CVCs interviewed agreed that investing in early stage opportunities has a positive impact on the long-term strategy of the corporation.

The emergence of corporate venture capitalists at the expense of the traditional venture capitalists suggests that CVC units offer some structural and management differences over independent VC firms. The Table below lists the foundation dates of the investor firms that were interviewed. This table illustrates that the CVC industry can be considered to be relatively new. The average CVC unit age is much lower compared to the age of the independent units. As this is a younger industry, deal flow is still weaker. The focus and goals are also different. The Table following lists some of the other main differentiating characteristics. While strategic fit with the parent company is the most important goal for CVC investors, the VCs’ principal goal is to get extraordinary financial returns on their investments. As a result, many of the interviewed corporate investors admitted that they need the VC investors’ financial perspective and experience to grow the companies to an exit. On the other hand, the VCs’ view on syndication with CVCs is fragmented. While some VCs agree that investing together with CVCs gives them access to expertise, strong branding and an immediate strong market share, other VCs point to the fact that CVCs sometimes limit the exit or acquisition opportunities of the start-ups and thus limit their returns as well.  

Table 4: Foundation dates

VC Year of foundation CVC Year of foundation

Oxford Capital 1999 3TS Cisco Growth Fund

2007

Sofinnova 1972 BP Alternative Ventures

2006

Intel Capital 1991 Microsoft BizSpark 2008

Amadeus Capital Partners

1997 Lafarge NA

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Table 5: Characteristics of VCs versus CVCs

Venture Capital Corporate Venture CapitalNature Independent unit Linked to a corporationFund Structure Limited Partners Agreement Variable and flexible

(e.g. direct investments, incubation/mentoring programs…)

Fund lifetime 10 year fund cycle Yearly – from the balance sheet

Strategy/Goal Financial return 1st Strategic investment2nd Financial return

Compensation Fee + Carried Interest Salary (+ rewards based on performance)

Deal-Flow Hundreds of deals/yearSometimes actively searching: tracking companies and people

Well known CVC: hundreds deals/yearOther CVC: very few deals/yearMost of them: Actively searching

Investments per year

6-10 Well established companies: 3-10Starting companies: 1-2

Involvement in Board position

Full board members Full board membersObserver status

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POLICY RECOMMENDATIONS

5.1. Organise knowledge support in the pre-seed and seed stages

A remarkable finding of this research is that VCs as well as CVCs focus on later-stage companies rather than on early-stage opportunities. Very few funds address seed-stage opportunities because of their high risk, lack of a proven technology and uncertain market acceptance.

Nevertheless, the early discovery and guidance of high-potential opportunities is very important. In this scenario, the EC could address this gap by organising knowledge and mentoring programs in pre-seed and seed stages in order to help starting entrepreneurs transform an idea into a business opportunity. In the earliest stages entrepreneurs need expert knowledge to test their technology and to define a winning business execution. Further on, expert advice on specific areas such as IP, prototyping, and communications is also needed. This knowledge is best provided by professionals, serial entrepreneurs, academics and super angels. By organizing knowledge and mentoring programs, the EC can help a large pool of entrepreneurs accelerate their companies to get ready for raising private investment. In some

cases, the EC can also facilitate the access of promising entrepreneurial projects to get further support in incubators. In the early stages it is very important to reach a large amount of starters rather than to provide equity to just a small percentage of good performing starters.

Some good practices already demonstrate the importance of mentoring entrepreneurs and accelerating pre-seed and seed stage opportunities around Europe. Based on an educational approach, the Imperial College Business School in London teaches and coaches around 150 students with entrepreneurial ideas each year. The program is known as the Innovation, Entrepreneurship and Design (IE&D) program and is partly financed with government money. The students are grouped into multidisciplinary teams including engineers, designers and MBAs. The teams work on real business cases over 6 months in which they are taught the different areas of business planning. During these 6 months, the students are intensively coached by both academic as well as professional experts. IE&D already proved to be very successful in mentoring entrepreneurs in the pre-seed stages. About 40% of the students who followed

In this section, we describe three policy recommendations based on the main findings described in the previous section. We use examples of existing good practices to illustrate the way in which the European Commission can use these recommendations.

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the program in 2009 started their own company or are in a certain way involved in the entrepreneurial community.

There are also examples of good practices promoted by the private sector. Microsoft has installed a program that provides mentoring for a large pool of ICT-related business ideas. The program is known as Microsoft BizSpark. It helps software start-ups succeed by giving them access to Microsoft software development tools, connecting them with key industry players, including investors, and providing them with marketing visibility. Since 2005, Microsoft has been helping partners across Europe to secure public funding. More than $500m has been granted to partner companies in over 20 countries, to invest in R&D and innovation, skills and new jobs.

In recent years many accelerator programs have been started as well. While most of them are privately managed, some of them have also received public funding. Well-known examples in Europe are Seedcamp based in the UK and Startupbootcamp based in Denmark. These programs are seen as ‘the new incubators’ that bring opportunities to entrepreneurs, provide intensive guidance as well as money. They target starting entrepreneurs with or without early revenues who have an Alpha or Beta version of a product, a prototype, videos or screenshots. Through the program, these start-ups get mentoring as well as early-stage micro seed investments. The entrepreneurs receive multiple learning and networking opportunities, which enable them to develop entrepreneurship as well as leadership skills.

5.2. Support knowledge mobility in the pre-seed and seed stages

The study shows that a vibrant entrepreneurial eco-system is essential for the detection and growth of high-potential opportunities. Yet, the European entrepreneurial eco-system is rather weak and highly fragmented. Despite the initial intentions of nascent entrepreneurs in Europe to target global markets, they eventually stay rather local and are hardly mobile. As a result, knowledge networks are only encountered in local communities. This makes it difficult for the entrepreneurs to be approached by active, well-performing international investor communities. Consequently, the access to expert professionals and serial entrepreneurs is often limited as well.

In this context, the EC could stimulate the international mobility of entrepreneurs and investors. In that way, entrepreneurs would have access to expert knowledge in other countries and markets. It would also reduce the difficulties faced by entrepreneurs when approaching the highly fragmented countries in Europe.

The EU’s Framework Programme 7 provides a suitable environment to promote this mobility. FP7 endorses the collaboration of geographically distant actors involved in the entrepreneurial community, including entrepreneurs and investors. Thereby, a few “technology clusters” should first be identified where money, people and ideas come together. Second, FP7 should sponsor the system that facilitates and promotes mobility throughout these few “technology clusters”.

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5.3. Create a central early stage actor and potentially a professionally managed fund (instead of fund of fund schemes)

Finally, the results of this study show that early-stage funds are struggling to get liquidity and to make follow-on investments. Some countries in Europe have tried to cover this gap by investing in early-stage opportunities or by putting their money into funds of funds. Unfortunately, none of these mechanisms have been shown to be successful. On the one hand, it is very unlikely that direct investments from public funds will discover the next Google. As we have shown, the most promising projects financed by professional investors comprise disruptive innovations. Public funds, on the contrary, only tend to finance incremental innovations. Additionally, starting entrepreneurs don’t receive the professional support and advice required to take the businesses further from public entities. On the other hand, fund of funds do not contribute to the liquidity of existing funds. They reinforce the activity of big investors such as Sofinnova but they do not increase the amount of money available. In some countries public investing mechanisms have only been a political and lobbying tool, and are characterised by enduring problems after every election process.

Therefore we suggest that the EC can better contribute to the existing eco-system by creating a professional entity that helps existing funds to increase their liquidity. This requires the involvement of experienced investors and successful serial entrepreneurs. In other words, the EC can create an organization that looks after venture capital funds and contributes to the construction of a healthy entrepreneurial eco-system.

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CONCLUSION

The interviews made clear that there is no standard list of criteria available for the identification of high-potential ideas. Investors use their network to scan the market and to identify high-growth potential opportunities. They are embedded in a professional community of stakeholders that help them during the different stages of the financing process. This professional community is a relatively new phenomenon that distinguishes well-performing investors from their counterparts. Apart from the community, investors tend to track entrepreneurs and only invest in bright founders’ teams with disruptive technology opportunities.

Based on the findings, our recommendations addressed three main issues. First, we found that professional investors focus on early-stage companies rather than on seed and pre-seed opportunities. Because of the high risks involved in pre-seed opportunities, private investors tend to avoid them. In fact, investors pointed out that seed and pre-seed stages require intensive mentoring and advice rather than capital. Our first recommendation addressed this gap. The EC can organise knowledge support in the pre-seed and seed stages to help entrepreneurs getting ready to raise private venture capital. Secondly, the interviews showed that

starting entrepreneurs are rarely willing to move or relocate. As a result, it is very unlikely that well-performing international investors will fund them. In this context, the EC can support knowledge mobility in the pre-seed and seed stages. Some existing programs like FP7 are a suitable platform to promote the cross-country collaboration and mobility of entrepreneurs.

Finally, the third recommendation suggests that the EC could create a Central Early Stage Actor that looks specifically after venture capital investments. This actor should be professionally managed and highly experienced so as to assist VCs during the screening and investment process, and help them become connected to well-performing international investors. Potentially and only under a professional and experienced management, this organization could also include a fund which contributes to the high-tech entrepreneurial ecosystem.

Due to the novelty of the study, including the comparison between venture capitalists and corporate venture capitalists, we recommend a further definition, test, development and implementation of the recommendations. This feasibility study provides the starting point for stimulating the discussion about policy intervention in the venture capital and corporate venture capital community.

This study provides some important insights into how professional investors pick potential winners in the market. Several in-depth interviews with well-performing investors from the VC as well as from the CVC sector resulted in six stylized facts and three important policy recommendations.

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