Discover how the concepts of venture capital portfolio construction can be used to unlock corporate innovation potential.
It was 2016, and a Fortune 500 CIO sat in our offices describing how market changes were threatening the continued existence of his entire company.
“For us, innovation projects mean five years, fifteen million dollars, and nothing to show for it.”
How is it that even in the face of existential threats many organizations are unable to effect significant change?
One common reason is that established organizations tend to lump everything into one or two big swings since it’s what they’re most comfortable with. They’re used to succeeding—for the most part—with all of their major initiatives.
But that’s not how things work in meaningful innovation. And, in most cases you don’t even know if it’s going to work out until significant time has passed.For most big companies that means throwing a lot of resources over an extended period of time to pursue something that, at least according to the odds, isn’t going to work.
Established organizations, particularly large ones, tend to make three key strategic errors in their approach to allocating resources to innovation:
Large organizations are used to taking big swings. After all, it’s much more efficient to put your muscle behind a few key initiatives than focus on lots of small ones.
Imagine going to your boss at GM with ideas for ten new types of jet engines, each more innovative than the next. She’s going to sit you down and tell you to focus—if she doesn’t throw you out of the building first.
“Let’s see how this first one works,” is a common phrase we hear when leaders begin innovation initiatives. They tend to choose a very small number of innovation initiatives they think are good bets and put significant resources behind them.
That logic probably works in the normal course of business, where a thoughtful strategy and sufficient resources on average works well, and failure probably means an error in execution.But that logic breaks down in the context of innovation, where failure is the norm, and only a small set of projects actually work out. Adding more resources, especially early on, quickly runs into diminishing returns territory.
Odds are, most or all of the innovation initiatives executives undertake will fail. But it’s hard for them to see it and even harder for them to admit it.
So, instead of reallocating capital and resources to better potential initiatives, they tend to double down on the few in front of them.
When you’re trying to protect a multi-billion dollar business from, for example, a data breach, it’s natural to implement rather draconian procedures to minimize the risks of a breach.
Most companies end up with a long list of checklists and approvals required for any new initiative. That friction greatly reduces the number of initiatives that can realistically launch in any given time period. And most initiatives are killed before they can even launch.
Resource allocation models at large organizations naturally evolve to accommodate evolutionary change, but tend to break down for more innovative projects. Project budgets tend to be at least annual, and often exist in the context of multi-year arcs. Finance teams employ repeatable tests for ROI (e.g., hurdle rates) to ensure capital is being allocated efficiently.
But real innovation involves significant uncertainty—after all, by definition you’re doing something new. In most cases you have few proxies or benchmarks to apply. It’s extremely difficult to predict how much money you’ll need, and when.
All of that makes it hard to comply with standard financial approval processes.So instead of trying a lot of small things, it becomes easier to go to finance with an ask for a substantial capital allocation based on forceful assertions about how successful an innovation initiative is likely to be.
That naturally throttles the number of initiatives explored, and tends to filter out the riskier initiatives for which it’s harder to prove an ROI. It’s also a root cause for the frequent over-allocation that occurs, as well as the extended denial when things aren’t working out.
Executives at large organizations tend to be very aware of the difficulties inherent in pushing innovation initiatives through internal risk management and resource allocation systems.
That makes executives reluctant to undertake risky endeavors; even if they’re willing to risk their reputations on an initiative, they have to consider the sheer level of effort and political capital required to make them happen.
Furthermore, when executives have committed to an innovation initiative, it’s hard for them to admit defeat given all the trouble they have gone through—and the political capital they’ve deployed.
The most fundamental reason for the development of internal politics derives from distributed organizational structures and disparate reward systems.
Take, for example, the IT department which is castigated when the CRM goes down, but sees the sale team get all the credit when sales beats targets. The IT team’s natural response is to block any changes that might threaten the stability of technology systems.
These structural conflicts of interest result in subtle, but powerful, forces against innovation. That tends to kill initiatives before they even start, and puts stress on the ones that do somehow launch.
The larger an organization, the harder it generally is to explain new initiatives sufficiently well to organize, energize, and coordinate the (often far-flung) teams required to implement innovation initiatives.
There are only so many initiatives that can reasonably be pushed through an existing organization at any given time. This also means that frequent changes can feel like whiplash, followed by the onset of fatigue and confusion.
As a result, larger organizations tend to be cautious about introducing too many innovations at a time, or in fact, over time.
Operating an existing business model at scale requires tight coordination and reliable stability.
That often requires abstracting duties into subsystems governed by carefully prescribed expectations to enable safe interfacing with other subsystems. Six Sigma and other quality management systems are examples of ways organizations attempt to eliminate variance.
But innovation by its very nature involves trying new things that tend to disrupt multiple subsystems, pushing them outside of standard operating norms.
Even innovation that doesn’t trigger the risk mitigation and resource allocation filters mentioned above might fall prey to the constraints imposed by various systems designed to eliminate variance.
For more disruptive innovation, it’s common for corporations to use startup entrepreneurs as a model.
After all, startups are designed from the ground up to disrupt. Shouldn’t large organizations look and act more like startups, at least when they’re trying to effect significant change?
Well, that’s probably true. But the root of the corporate innovation problems above derives from a very simple oversight.
Startups don’t exist in isolation; they thrive in a symbiotic relationship with venture capitalists.
By injecting the concepts of venture capital into the mix, large organizations can begin to realize the extraordinary potential offered by innovation.
Startups exist in symbiosis with venture capitalists who assess, fund, and guide them towards maximum value creation.It’s a model that has evolved over decades. But it’s very different from operating. Many of the corporate limitations described above derive from executives failing to understand the distinction between being a boss and being an investor.
But mention the words “venture capital” to a corporate executive and you’ll likely get a disdainful roll of the eyes. “That doesn’t work for us,” they’ll say. Or, “those VCs take too much risk.”
That latter part is probably true; as I have written elsewhere, the returns in the venture capital suggest something is broken in the industry.
But the former statement—that VC approaches don’t work for corporations—is probably inaccurate. The challenges in institutional (e.g., non corporate) venture investing are rooted in the “2 and 20” venture compensation structure, and generally don’t implicate the parts of VC that do work well.Venture capital plays a critical role in the startup ecosystem; without it, the system simply wouldn’t work. Similarly for corporate innovation, if you don’t have a team playing the role of investor, things are likely to break down rather quickly.
Venture investing is meaningfully different from traditional investing, meaning that applying a traditional portfolio approach often fails in the context of disruptive innovation.
Taking a traditional approach to pursuing disruptive innovation usually results in:
Disruption projects often fail, but when they do work results can be extraordinary. In other words, outcomes are highly variable and difficult to predict.
Unless you’ve figured out a magic bullet to make your disruption efforts much more reliable, the only way to smooth this volatility is through a portfolio approach. Traditional approaches, as described above, often involve too few projects to smooth volatility.
The traditional approach also leads to poor results on average. But why?
For one thing, small innovation portfolios make it much harder to build an organizational innovation skill. Organizations often do a poor job the first several times—which in many cases are the only tries they make.For another, investing is very different from operating. The skills, attitudes, and priorities are different.
Venture capital skill sets take years to hone, even for highly successful operators and entrepreneurs. Lacking these skills and attitudes usually leads to poor quality decisions that impact the average outcome.
Disruption projects have, as we discussed, very different risk and timing contours relative to traditional projects.
And it’s not just the resource allocation systems that tend to break down. The methodologies and skills employed by corporate innovators tend to result in suboptimal resource allocation.
Measuring success, for example, is often fundamentally different in the context of disruption. And the stages of risk and uncertainty reduction roll out very differently and can feel alien to corporate innovators.
This inefficient resource allocation further exacerbates both the volatility of outcomes and the average results relative to resources utilized.
All of these are reasons why discarding the skills, methodologies, and learning of 60+ years of venture investing would be a mistake.
Venture capital is more than a way of investing in companies. It’s an approach to asset allocation and optimized value creation. And it’s just what corporations need to transform their approach to innovation—with some nuances in application of course.
CVC (Corporate VC) groups invest in startups, often alongside traditional VCs. In today’s increasingly fast-paced markets, corporate venture is an important innovation and value creation strategy. That’s probably why CVC now accounts for 25% of venture capital invested in the US.
But we think corporate venturing should be an additional strategy, not a replacement.For one thing, CVC faces its own set of challenges:
In many cases, corporate venture groups realize only a modest strategic return on their investments; most of the return tends to accrue to the founders and eventual acquirers (or public shareholders).
Successful corporate innovation, meanwhile, is much more likely to lead to significant strategic and financial benefits. That’s why internal innovation is critical, and probably more important than CVC in the larger scheme of things.
Once you move past the misapprehensions about venture in the corporate context, the broad strokes of venture strategy are fairly accessible. Of course venture capital is a nuanced and complex field, and the devil (as usual) resides in the details. But that shouldn’t stop innovation executives from applying the most important parts of venture to their own activities.
So, what can we learn from venture capitalists?
Corporate executives, like entrepreneurs, tend to have a small number of active areas of focus at any given time. As an operator, it’s just not feasible to do a good job of executing on too many things at once.Venture capitalists, by contrast, seek to have a lot of active portfolio companies at any given time.
They know it’s very hard to predict outcomes and resource needs, so they smooth out the volatility with a large portfolio.
Corporate executives participate in execution—hence the name. They run teams and are by their very nature bosses.
The best tend to stay involved in (without micromanaging) their projects—in other words, they are operators.Venture capitalists know better than to try to operate their portfolio companies. When you’re in charge of a team, it is harder to maintain the emotional distance necessary to make tough choices.
Being a venture capitalist is also a lot of work. Especially if you’re dealing with a broad portfolio (which you should), it’s nearly impossible to maintain the level of attention required to operate each company.
And for your innovation project leaders, it’s much harder to report to an executive than a board member. The level and frequency of reporting to a boss tends to be much greater, and often requires getting into the details.That’s why good VCs act like board members instead of bosses.
They engage periodically with their startup teams for updates and to provide guidance, but they don’t try to manage them. They definitely don’t get caught in the weeds. If a VC is operating a portfolio company, that means that something has gone terribly wrong.
Corporate executives are accustomed to modeling each project, and justifying each individually to external parties (typically finance).Venture capitalists know that they make money from the overall success of their portfolio, and act accordingly.
They assemble capital (raise funds) in large chunks based on planned investment and liquidity strategies designed to last 10+ years. They don’t model out 20 individual portfolio companies to their investors. They model out overall expected returns based on well-known proxies—other venture funds.
They also don’t justify each investment individually to their LPs. They have discretion about how to allocate the capital they raise.
So, act like a VC and raise a large pool of capital from your organization designed to be allocated over an extended period of time, and without having to go back each time to explain your needs to the finance department.
Justify it based on a portfolio of returns instead of trying to prove that any particular initiative is likely to be successful.
Corporate innovation executives tend to focus on ensuring that each project performs well. When an initiative struggles, it’s very tempting for people with an operator mindset to jump in and try to fix it.But that’s a great way to waste a bunch of time and resources on something that’s destined to fail, and meanwhile starve more deserving projects.
Investors know that some of their investments are going to fail. Instead of focusing on fixing troubled projects, they focus on doing a good job of allocating resources.
They know that doing a great job of establishing rubrics for evaluating progress will enable them to make the tough decisions about when a project deserves additional resources or not. They know a fast no is better than a slow no.Read here about how to handle failing innovation initiatives.
Corporate innovators tend to focus on the viability of each individual initiative, using normative models derived from their corporate parent. That represents at least two key errors:
Venture capitalists use carefully considered—and startup appropriate—milestones and stage-gate processes to understand the risk, potential, and value of each of their portfolio companies. They use these assessments to efficiently allocate their scarce capital resources.
This is perhaps the most challenging aspect of applying venture paradigms to corporate innovation, because it involves very different skills and approaches than are typically used in corporate environments. That’s why this area tends to be one where our corporate clients request the most assistance.
Corporate innovation leaders, as we mentioned above, tend to act like operators. That’s true for their bosses as well.
Tight organization and integration are the norm, with clear reporting structures and aligned strategies. But it’s really hard to act like a venture capitalist if you’re being managed like an executive.
Venture capital partners are called “General Partners” and their investors are called “Limited Partners.” The “Limited” part refers to the limited control and oversight investors have over the day-to-day operations of the General Partners.
That works, because the VCs need to be allowed to make their informed decisions without constantly having to explain things to investors who aren’t in a good position to understand what’s going on and how to act.
A similar approach works for innovation departments. Separation there is potentially even more important than it is in venture capital.
By keeping innovation teams and systems separate, you can avoid some of the systemic and procedural limitations that might otherwise constrain innovation efforts. This has implications for tracking and reporting systems, organizational design, and operations. It also can make it difficult to integrate successful projects back into the mothership, although there are ways to reduce this risk.
Corporate executives understand how important people are to success.
However, the very nature and reality of modern corporate human capital means that process and role often have to supersede individual contributors. Short job tenures and the nature of job advancement in the modern corporate ecology are major contributors.
Venture capitalists know that the most important ingredient for startup success is the founding team. Even the best idea with a mediocre team is very likely to fail.
VCs also understand that the inherent complexity of innovation means it’s more about learning than execution, at least until the company finds product-market fit and begins sustainably scaling. And they know that small teams are more effective in the early phases requiring adaptability and learning.
That’s why it’s so critical to have an amazing and diverse early team. Unfortunately for most corporate innovators, some of those team members don’t exist in your organization. And the standard organizational human capital practices (e.g., recruiting, compensation, oversight) tend to align poorly with adding them.
Corporate executives are accustomed to working in a context where clear evidence of success or failure is visible within a year or two of launching a project, and often much earlier.Venture capitalists have resigned themselves to the fact that the outcome is rarely clear until several years in to a startup. In some cases it can take a decade for success (or failure) to be a settled fact. That has implications for resource allocation, team organization, and management.
For structural reasons, corporate innovation groups have a strong tendency to focus on a small number of innovation initiatives at a time.
The inherent volatility and risk of meaningful innovation makes this a very risky bet. They often compensate by choosing incremental over disruptive innovations. And even in those circumstances they too often fail.
The result is a combination of a poor average return on investment and a failure to meet key strategic needs in our increasingly fast-paced economy.We believe corporate innovators can dramatically improve results by borrowing from the 60+ years of learning embodied in the venture capital industry. From a high level, this means taking a portfolio approach to innovation, and acting as an investor (resource allocator) instead of an operator.
This has the benefit of enabling a significantly higher volume of innovation projects, which increases expected ROI. It also enables organizational behavior that is much more conducive to success for each initiative, further enhancing anticipated ROI.If you're interested in learning more about how Manifold helps organizations organize like VCs, we'd love to talk.