CVC-backed ventures are more innovative but less profitable than IVC-backed ventures

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This is a practical review of “Corporate Venture Capital, Value Creation, and Innovation” published in The Review of Financial Studies, Issue 27(8) (2014), pp. 2434-2473 — by Thomas J. Chemmanur, Elena Loutskina, and Xuan Tian.

This study examines the differences in performance of firms backed by corporate venture capital (CVC) vs. independent venture capital (IVC). [CVC is the in-house venture capital unit/division of typically established and large firms, e.g. Google Ventures, that primarily invest in in-house entrepreneurial opportunities as well as promising ventures from outside the parent firm. IVC is the venture capital as we know it.]

CVC-backed ventures create more, and more influential patents than IVC-backed ventures

The main finding of the paper is that CVC-backed firms achieve better innovation outputs even though they are younger, riskier, and less profitable than IVC-backed firms. This can be seen in the patent output graphs for CVC and IVC investees, below.

Patent outcomes for CVC- vs. IVC-backed ventures
source: Chemmanur, Loutskina, Tian, (2014), p. 2461

The authors suggest two mechanisms for this effect. First, the technological fit between the parent firm and the CVC investee allows the parent firm to better evaluate and advise the investee, thereby helping improve its innovation output. The implicit assumption here is that IVCs do not possess similar technological know-how, and thus cannot achieve such a good fit.

Second, CVC units’ greater tolerance for failure gives their investees more latitude in the innovation game. This is interesting in that ALL venture capital investments, regardless of the source of funding, is arguably as risky as it gets when investing is concerned. I am not sure the fidelity of the `​tolerance for failure` measure allows us to differentiate meaningfully between CVC and IVC firms in this dimension.

Another related concern is how different CVCs and IVCs are, in general. More specifically, whether a CVC invests internally that much. Many CVC units of prominent firms, particularly in the tech and pharma/biotech domains, invest as much in outside ventures as the internal ones, if not more. Thus, I am not sure if the following assumption holds: that CVCs aim for creation of new knowledge or revenue streams that are related to (and thus extend or expand) those of the parent firms’. For some investments? Sure. For the whole portfolio of investments? Not so sure. Some CVCs spend a lot of time and money on outside ventures, possibly with a goal to diversify . After all, if the technology and targeted product-market space of the venture is very close to those of the parent firms’, it could as well be pursued as an internal (maybe a bit more more independent?) project.

Going back to the paper: the authors suggest that, combined, the technological fit and the greater tolerance for failure (= more freedom to experiment for the investee) lead to CVC investees’ generating more patents than IVC investees. On the profitability front, the authors find that CVC-backed ventures are less profitable at IPO, but quickly catch up with their IVC-backed cousins in terms of operating performance in the few years after the IPO. Their profit margins are not meaningfully different in year five, post-IPO.

A final observation: looking at the number of patents (Panel A) and how influential those patents are (Panel B), CVC- and IVC-backed ventures appear to be similar for very low and very high performing firms (the latter less so). The difference is between ventures with somewhat good performance. An alternative reading of this could be that both CVC and IVC firms can identify losers and cut costs, as well as both being able to push the top performers to produce more. For ventures with good (but not awesome) performance, CVCs seem to extract more innovation while IVCs opt to increase profit/valuation of the investees. This makes sense. Even if the CVC-backed venture’s performance eventually declines, the intellectual property created would stay in-house and likely help create value for the parent firm. On the other hand, IVC-backed firms would rather increase customer adoption, scale, and increase firm valuation for a successful exit (or to mitigate losses), instead of creating more patents — the valuation of which is a highly complicated endeavor with uncertain outcomes.

The main reason that I found this paper to be interesting is that it provides evidence against the common view that large corporations are typically short-sighted, in that their managers focus on short-term results that can improve the market value (= stock price) of their firm, thus increasing the managers’ short-term payoffs. Another common view is that (independent) venture capital firms are relatively longer-term players who eye exit within 5-10 years with multiple X returns. The authors’ findings in this paper is exactly the opposite: impatient VCs push their ventures to `​quick` profitability, at the expense of creating more innovation, while their more `patient` CVC cousins tolerate failure better. Coupled with the technological know-how of the parent firm, CVC-backed ventures create more patents that can provide a more solid footing in the competitive landscape.

I would be interested in comparing CVC and IVC returns, shifting the unit of analysis from investees to investors, and examine if CVC and IVC firms are really that different.

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