Corporate Venture Capital, Value Creation, and Innovation

The following post comes to us from Thomas Chemmanur, Professor of Finance at Boston College; Elena Loutskina of the Finance Area at the University of Virginia; and Xuan Tian of the Finance Department at Indiana University.

There is no doubt that innovation is a critical driver of a nation’s long-term economic growth and competitive advantage. The question lies, however, in identifying the optimal organizational form for nurturing innovation. While corporate research laboratories account for two-thirds of all U.S. research, it is not obvious that these innovation incubators are more efficient than independent investors such as venture capitalists. In our paper, Corporate Venture Capital, Value Creation, and Innovation, forthcoming in the Review of Financial Studies, we explore this question by comparing the innovation productivity of entrepreneurial firms backed by corporate venture capitalists (CVCs) and independent venture capitalists (IVCs).

CVC subsidiaries are an effective way for corporations to conduct research and development (R&D) activities externally while still pursuing corporate parent goals. U.S. corporations started establishing CVC funds as early as the 1960s. By 2011, CVC investments grew to 15% of the total venture disbursements in the U.S. Unlike IVC funds, which are structured as 10-year-life limited partnerships, CVCs have no contractual obligation to dissolve the fund and hence have longer investment horizons. In making investment decisions, IVCs pursue solely high financial returns, whereas CVCs must also serve the strategic objectives of their parent corporations. Last but not least, the performance-based compensation structure (i.e., 2% of management fees and 20% of carried interest) enjoyed by IVC fund managers is normally not found in CVC funds: CVC fund managers are compensated by a fixed salary and corporate bonuses that are tied to their parent company’s financial performance. Overall, these differences between CVCs and IVCs line up with the organizational structure and incentives of traditional corporate financing of internal innovation, and with independent venture capital financing of innovative firms.

Arguably, CVCs could be better than IVCs at nurturing innovation of their portfolio firms. After all, CVCs’ unique organizational and compensation structure may allow them to be more open to the experimentation and occasional failures in their portfolio firms necessary for motivating successful innovation. Further, the superior industry and technology expertise of parent corporations may enhance CVCs’ ability to better evaluate and deploy portfolio firms’ R&D, thus allowing CVCs to better nurture these new ventures’ technologies and products.

At the same time, CVCs’ organizational structure may also adversely affect their ability to foster innovation of portfolio firms. CVCs are structured as subsidiaries of corporations and thus are subject to centralized resource allocation and the associated corporate socialism known to foster mediocrity in R&D activities. Moreover, in pursuit of parents’ strategic objectives, CVCs may be incentivized to exploit, rather than nurture, the entrepreneurial firms they invest in, and hence impede innovation in these firms. In contrast, IVCs may be more efficient in their resource allocation because they have full control over the capital, pursue purely financial returns, and offer financial performance–based compensation to their fund managers. IVCs typically focus their investments in a given industry and thus understand well this industry-specific innovation process. The relative ability of CVCs and IVCs in nurturing innovation is ultimately an empirical question.

To address our research question, we use the National Bureau of Economics Research’s (NBER) patent citation database to examine the innovation output of firms backed by CVCs versus those backed by IVCs. In our core set of tests, we document that CVC-backed IPO firms produce more patents and patents that are of higher quality. Specifically, as compared to IVC-backed firms, CVC-backed IPO firms produce 26.9% more patents in the three years before IPO, and these patents receive 17.6% more citations. In the first four years after IPO including the IPO year, CVC-backed firms produce 44.9% more patents that receive 13.2% more future citations. While our baseline results are based on entrepreneurial firms that eventually go public, we come to similar conclusions based on our analysis of the entire universe of VC-backed entrepreneurial firms, suggesting that our results are not driven by CVCs bringing their most innovative firms public. We present a number of empirical tests suggesting that our results are unlikely to be entirely driven by the better selection ability on the part of CVCs. Instead, the results of our propensity-score matching and difference-in-differences analyses suggest that there is a significant treatment effect of CVC financing on innovation.

Last but not least, our analysis reveals two possible mechanisms through which CVCs are able to better nurture innovation than IVCs. First, we show that entrepreneurial firms that operate close to the industrial expertise of the CVC’s parent company (i.e., have a better “technological fit” with the parent firm) are more innovative. This finding is consistent with the superior technological expertise of CVCs, which allows them to better evaluate the quality of the entrepreneurial firm’s R&D projects and to better advise these entrepreneurial firms. Second, we evaluate the argument that investors’ greater tolerance for failure may motivate greater innovative activity by their portfolio firms. Since innovation is a complex activity, the optimal way to motivate innovation is to show tolerance for failure in the short term and provide rewards for success in the long term. We find that CVCs are more failure tolerant than IVCs, and that VC investors’ failure tolerance positively affects portfolio firms’ innovation output.

One question that arises from our finding is why the majority of entrepreneurial firms continue to be funded predominantly by IVCs. One possible explanation lies in CVCs having an advantage relative to IVCs only in industries with better technological fit between the CVC corporate parent and the entrepreneurial firm or industries where tolerance for failure is crucial. In other industries, the centralized resource allocation problems of CVCs and the potential conflicts of interest between a CVC’s corporate parent and the entrepreneurial firm may dominate, making IVCs the preferred source of financing.

The full paper is available for download here.

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