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Does Success in Tech Ventures Follow from Better R&D? Think Again
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Venture
vs. Vulture
New Wharton professor ponders the paradox of corporate venture capital.
Inventors and entrepreneurs love to talk about eureka moments — times when an idea strikes them like a bolt from the sky. Gary Dushnitsky, a new Wharton management professor who studies patterns of venture capital investment, can claim kinship. The idea for his dissertation on corporate venture capital — "Limitations to Inter-Organizational Knowledge Acquisition: The Paradox of Corporate Venture Capital" — seized him in an equally surprising way.
Dushnitsky, who joined the Wharton faculty this summer after graduating from the doctoral program at New York University's Stern School, was already pondering the relationship between entrepreneurs and venture capitalists. His interest had begun back in the late '90s when he was earning his master's in finance in his native Tel Aviv, a technology hotbed in Israel. "Back then, every quarter you'd hear about Israeli startups either aquired by a large American corporation or receiving investments of hundreds of millions of dollars," he recalls.
When he arrived in New York in 1999, the city was gripped by a similar entrepreneurial fervor. Remember, this was the height of the Internet bubble. "It seemed like everybody was either an entrepreneur or trying to finance one."
Entrepreneurs and investors frequently held meetings to swap business cards and ideas, and he attended as many as he could. The drill became familiar: Entrepreneurs would boast about their technological smarts. Venture capitalists would prospect for investments. But at one meeting, Dushnitsky found himself chatting with an entrepreneur who told him something he hadn't imagined he'd hear: The entrepreneur was steering clear of corporate venture capitalists attending the meeting.
"He told me, 'I have this amazing idea and this corporation that has all the relevant technology and distribution channels, but I'm not going to talk to them right now because I'd risk more than I'd ever benefit.' That caught my attention. Corporate venture capitalists love to talk about opening a 'window on technology.' And here I am talking to an entrepreneur and hearing that inventions are running away from corporations, not toward them."
The entrepreneur, who'd devised a piece of computer hardware, recognized the benefits associated with the corporate investor--leveraging corporate laboratories, market knowledge and equally important visibility and legitimacy. Nonetheless, the fear that the corporation would swipe his idea if he entered into investment discussions outweighed these benefits. Were other entrepreneurs behaving the same way, Dushnitsky wondered? And if so, what might that mean for the diffusion and commercialization of new technologies? As he puts it in his dissertation, "concerns over imitation may drive attractive partners to forego what would otherwise be a profitable relationship."
In other words, potential partners might find themselves in a courtship that never ends with a kiss. "Many mutually profitable relationships might not materialize because one party is not interested in a relationship with a prospective partner unless the partner demonstrates its quality by disclosing information, and the partner is wary of doing so, fearing imitation," he writes.
Dushnitsky studied relationships and potential relationships between 74 corporate venture capitalists and 258 startup-stage entrepreneurs in the computer, telecom, electronics and semiconductor industries.
His findings might lead corporate VCs to rethink their strategies. "I found that while many of the corporations are looking to invest in startups in their own industries, they end up investing in ventures that aren't in their industry. This surprising pattern seems to hold even after controlling for various factors, including declared investment criteria as listed in the Directory of Corporate Venturing, distance from the venture, etc "
That contradicts the reason that many corporations cite for making venture investments. "If you're investing to gain a window on technology, you'd invest in companies in your own industry," he points out. "But if those entrepreneurs aren't willing to approach you because the R&D person from your lab is going to look at their technology, then maybe there will be very little investment. Compared with what you might expect, I find a much, much lower amount of investment."
Dushnitsky calls his finding "the paradox of corporate venture capital." Companies, he explains, often engage in corporate VC as a sort of early-warning system to alert them to promising new technologies and potential rivals. But if they pursue that strategy too aggressively, they end up discouraging the very sorts of investments that they want to make.
A company with an aggressive strategy might, for example, make its venture arm part of an existing business unit or even embed it in its research-and-development division. That way, it ensures that its scientists get to evaluate all of the technologies in which its venture division considers investing. Trouble is, this setup is likely to scare off potential partners. They'll know that letting a big company's scientists study their technology offers an opportunity for those same scientists to reverse-engineer it.
Dushnitsky points to the experience of a small Israeli company named Saifun Semiconductors that was developing a new generation of FLASH memory chip. He says Saifun presented its technology to Advanced Micro Devices, a California-based computer-device maker, hoping to secure an investment. Instead, AMD released a similar product several months later. Saifun sued, and the two companies settled in 2002.
If big companies want to reassure startups about their intentions, they should think about making their venture-capital arms part of a separate subsidiary or work with outside venture capitalists, Dushnitsky says. "An outside money manager might be less likely to imitate." And that, in turn, might reassure entrepreneurs about approaching a big company.
"Corporations want to see smart ideas and think that their best people for doing that are in R&D. But they're only thinking about their side of the equation. Think about what the early-stage entrepreneurs are concerned about. With corporate venture capital personnel in a dedicated subsidiary, you might not have the R&D people looking at technologies, but you might attract more interesting technologies. They need to recognize that entrepreneurs aren't blind to these considerations."
Another way that a company can ensure that its venture division makes investments in its industry is by earning a reputation as a good partner. If a company steals ideas, entrepreneurs won't want to do business with it. But if it's honorable in its dealings, they may be more willing.
Moreover, Dushnitsky finds that the greater the complementarities between the products or services of the corporation and the venture, the more likely an investment is to occur. Building on his findings, he makes an additional observation, "under such mutually beneficial circumstances, established firms, and especially those that are the leader in their industry, may find themselves attracting ventures in complementary lines of business."
Dushnitsky's findings contain lessons for entrepreneurs, too. Of course, they need to be cautious about potential partners and aware of the danger of showing their technologies to potential competitors. But they should know, too, that not all corporate venture capital groups are structured or operate the same way. One that's run by a separate VC-arm for a company with a reputation for fair dealing might be a valuable partner. Conversely, one where the venture arm is part of the R&D division might not be. And finally, a corporation in a complementary line of business may be an attractive alternative to a corporate investor in the venture's industry. Dushnitsky points out that these sorts of issues are more important than ever because small firms have become a key source of innovative technologies.
"Young firms, unlike established firms, can only signal their quality by revealing their underling innovations," he writes. "In the past, when the main venue for external knowledge acquisition involved partnerships among established firms, pre-formation problems could be easily avoided. Partners were chosen based on their history of achievements or the success of prior linkages. This is not the case when it comes to young firms. In the absence of an established track record or a history of inter-firm relationships, disclosure plays an important role in partner choice and relationship formation."
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Sol C. Snider Entrepreneurial Research Center