Posted by On one of the many Boards I served on during twenty years as a venture capitalist, another member was a seasoned corporate executive. He had retired from being the CEO of a $3.5 billion (in revenue) company, and “in a moment of weakness”, as he described it, was recruited by a partner with a VC firm as the CEO of a startup company. In three years he led the startup on a growth path and successfully sold it.
When we met shortly after that, I congratulated him and asked whether the experience was good enough to start a second career. He looked at me and said “Absolutely never. Startups are so small. They may present great innovation, but it is impossible to grow them into significant companies in terms of income”.
“So”, I asked, “will you go back to running a $3-5 billion company?” “No”, he said, “These are too big to manoeuvre, certainly to grow through innovation and internal entrepreneurship”. He then pondered for a while and said: “The sweet spot is a $1 billion company; it’s big enough to create a critical mass in every department but small and nimble to come up with great, transformative ideas.”
The truth, of course, is in the eyes of the beholder. I would guess that had my friend been the CEO of a $50 billion company, he would have viewed a $5 billion one as nimble and innovative.
R&D investment worldwide continues to grow and will likely hit this year the $2 trillion mark. Of this, the US will spend close to $500 billion, spread across government, academia, and large corporations – the latter capturing about $330 billion. In comparison, as described bellow, the spending on R&D by small and startup firms has declined in recent years. For large corporations, given that R&D is the main source of growth-through-innovation for corporations, that amount has to be directed effectively towards high-yield efforts, averting risks of “casino like” probabilities for success.
Compared with this amount, the $120 billion globally, and $50-60 billion in the US, invested by venture capital firms in startup companies, is not minuscule. It used to be that these amounts were invested primarily in technology-based startups, fostering the type of innovation that large companies could absorb into their traditional processes and turn into growth. That would add another $30-40 billion to the total R&D spending, and directed into high-risk projects.
This has changed in significant ways in recent years, as an increasing portion of venture capital money has been directed at startups betting not on technological innovation, but on business model innovation. When one examines most “unicorns” (startups that reached a private valuation of $1 billion) – It can clearly be seen that the vast majority of them employ an innovative or transformative business model, not necessarily highly innovative technology. Still, even the smaller R&D expense by small, venture-backed companies, plays a crucial role in the economy. What is that?
In corporations, the health of the balance sheet puts a pressure on the type of innovation they can experiment with. With all the talk about the importance of innovation and internal entrepreneurship in large companies, one cannot ignore the risk-reward equation they must employ. The reasons are beyond the typical “two-quarters outlook” that many blame. Corporations are machines or living creatures optimized to run smoothly large, methodical processes. Management, employees, consumers, and governments depend on that to hold the economy as steady as possible and minimally erratic. Therefore, innovation in large corporations tends to be evolutionary, not transformative. Even with islands of more aggressive innovation – a product here, a business line there – on the whole corporations do, and arguably should emphasize stability, controlled growth, and financial certainty.
While increasingly emphasizing the need for innovation and “intrapreneurship”, management must focus on financial visibility and controlled volatility in spending on R&D-based business expansion. In other words – corporate management cannot bet the store on transformative ideas long before they’re proven. Casino-like statistics are unacceptable.
Yet, true transformative growth typically occurs thanks to wild ideas hatched by “wild entrepreneurs.” Eventually, big corporations need these in order to stay competitive, break a slow-growth mold, and at times, simply to survive.
This is where the role of the “casino economy” comes into play. For large corporations, the entrepreneurial, venture-backed universe is a perfect playground:
- let the entrepreneurs and their backers predict or bet on transformative technological change, as well as innovative business models;
- rely on talent not available in-house, which is difficult to recruit;
- treat all this as an off-balance-sheet activity;
- decide when to adopt;
- and – most importantly – let society as a whole fund this entire casino!
And casino it is indeed. Of approximately 3,800 venture-backed companies each year in the US, less than 500 are acquired in following years, and a handful more survive as independents through an IPO. Very few end up generating over $1 billion in revenue. These companies have raised a total of approximately $8 billion (out of $50 billion invested each year). And while the investment return for the VCs might be positive (it rarely is) – this is certainly a very poor yield on R&D and business model innovation investment.
So, VCs and entrepreneurs bet huge amounts of money and time on innovation, within an economic environment that not only allows for it but actually encourages it. And when the time is right, and the winners have emerged, large corporations step in and integrate those winners, turning their attention on an accretive effort to grow their business – not only for the benefit of their shareholders but for the benefit of society as a whole.
In return, it is society itself that funds that great casino. The vast majority of money that venture capitalists raise comes from public sources: pension funds, insurance companies, endowments, and foundations – money earned by employees and entrepreneurs and put to use back in the economic system – a portion of it in fostering the “startup economy”. It is the invisible hand of public, societal money that stirs the stew out of which, eventually, large corporations continue to grow and prosper and return the value to society. It is not governments brute-force mechanisms, commissions, and regulations to try and foster that growth and innovation – but quiet, invisible public money that lets a natural selection process set the pace and direction of the economy.
Governments should focus on allowing this ecosystem to thrive, fostering educational, cultural, and legal frameworks encouraging the participants in the startup economy to take part in it. How they should apply this “light touch” approach is a matter for a separate discussion (and my talk at the conference).
About the author:
Eyal Kaplan was a managing partner with and Israeli venture firm for almost 20 years. In recent years he has focused on working with companies and investment firms on growth-through-innovation strategies.