Big companies have money. Lots of money. In fact, large, publicly traded organizations have the cheapest capital of any company on the planet—by far. Inexpensive capital may be their single most significant comparative advantage over small companies. It’s a shame that they frequently squander it on items that don’t help them grow stronger.

Fortune 500 companies have public stock, public debt, collateralized debt, debt with enhanced credit ratings, supplier financing, and in a few situations, commercial paper (short-term debt issued directly to the investor). This means large companies, in addition to all of their advantages with manufacturing economies of scale, intellectual property, R&D, and specialized management, can put the power of cheap capital to work so as to beat all others. They have the ability to approach the investor directly and can raise billions of dollars in a couple of hours simply by posting an interest rate on a Telerate, Reuters, or Bloomberg terminal. Some companies, such as Ford Credit or GE Credit, do this every day.

Financial giants can bypass the financial intermediaries altogether and save on high transaction fees by placing their money directly with the investor. Major companies have more funding sources, lower interest rates, lower transaction fees, and immediate access compared to small companies. Yet, despite these enormous advantages, large companies frequently fail. It seems that being successful at raising cheap capital is not the same as being successful. Obviously there is more to the equation than just getting money. Large companies need to have good investment opportunities and an efficient structure to manage their investors’ capital. This is where the SEU ventures come in.

Taking the risk capital from large companies and placing it into a few select small companies provides a great equation for future growth. Small companies need to be more careful or more efficient with spending, due to their difficulty in raising risk capital and its cost. Moreover, because small firms tend to be managed by watchful owners/entrepreneurs, there might be less waste of company assets. This suggests that the potential of bringing together the cheap capital from large companies coupled with the efficiencies incorporated in small companies provides the makings of a great combination.

This is the basic premise of the SEU approach: take cheap, easily accessible risk capital from the big company and put it to work in a portfolio of small, high-growth (and efficient) small companies. Entrepreneurs and key stakeholders in the SEU should have equity and an opportunity to gain liquidity in their holdings, but should also have protections against a premature harvest. Finally, the risk capital should be managed like any other professional venture fund. This means that the fund should be diversified into a variety of different investments and funds should be allocated during both strong and weak economic conditions.

Risk capital should be invested as long as the return exceeds the cost of funds. This concept is basic to fundamental business practice and to sophisticated compensation mechanisms.^[1] However, small companies, due to their brief track record and lack of profits, often have relatively high default risk and few, expensive financing options. Large companies, on the other hand, have relatively low default risk and many, inexpensive financing options. So why do large companies with their many advantages and low cost of funds, often get beaten by small companies with their relatively high default risk and high cost of funds? The answer could be that small companies are more efficient with their scarce resources and can more quickly respond to market opportunities. For example, both Dell Computers and Gateway Computers became successful, innovative, high-growth companies and succeeded in a competitive computer industry against operating giants such as Compaq Computers, Digital Equipment, Wang Computers, IBM, and Xerox.^[2] Similarly, a start-up company, Southwest Airlines, used highly successful cost efficiencies and operating strategies to beat airline giants American, Delta, and United irrespective of high barriers to entry (high fixed and operating expenses) and traditionally tough market conditions.^[3]

Small companies frequently beat major companies despite the long odds. Small companies can generate great business ideas, keep costs low, and generate high rates of return. But they often do not have access to risk capital. Perhaps, more important, they often have insufficient risk capital to carry them through all of the critical years until they make it to profitability.

The cash flows and financings of high-potential SEU ventures are very different from typical large company investments, but are presumed to be very similar to traditional capital venture projects or other high-potential ventures. High-potential ventures tend to have very low-to-negative cash flows in the early years, and then later hope to turn cash flow positive (i.e., profitable). Most individual investors would find this gamble too much risk to handle and would normally not invest in such types of projects or organizations if it were available to them.^[4] This is one of the reasons why employees/entrepreneurs in SEUs should be entitled to an equity stake. Their risk is higher, so they should receive equity (or equity-like returns) to compensate for the additional risk in their new venture.

The cash flows in new ventures typically follow the appearance of a “J-curve” (shown in Figure 8.1). New ventures often lose money in the first few years (with the losses often increasing in the second and third years) and then become positive a few years later. If, during the low cash flow period, the project/firm does not get refinanced or an additional cash flow injection, the ballgame is over. At this stage the new company has nontransferable intellectual capital because its completion is incomplete and nearly impossible to get refinanced.

Figure 8.1. Cash flows from venture projects

This represents one of the reasons why up to 80% of all small businesses are estimated to go bankrupt within the first five years. Since the project/firm usually has a limited operating history and few credit-worthy assets, banks won’t lend money. Consequently, if the venture capitalists or risk capital providers withhold future investments, or if the entrepreneurs/owners have limited personal capital to put into their company, the ventures will have insufficient funds to continue. New ventures often deplete their funds during this early, critical time and are forced to terminate their business.

Investors in SEU ventures should expect the same cash flows. This means that employees/entrepreneurs in the SEU venture should consider the personal/professional risks of being in a venture that may not be funded during the critical first three years of venture life. Their risk will be much higher in the SEU compared to the parent firm.

Institutional investors and other sophisticated or high net worth individuals recognize the risks inherent in high-potential new ventures and invest anyway. This is due to their portfolio perspective with investing in risky investments. Professional investors anticipate that only a few good investments in their portfolio will earn money. However, it is their expectation that their few good investments will earn more than enough return to compensate for the bad investments.

Traditionally, the rule of thumb with venture investments is that out of every 100 investment opportunities, a venture capitalist will typically select 1 or 2. For purposes of this illustration, let’s assume 1. Then, out of every 10 investments (i.e., 1,000 investment opportunities), VCs will have a portfolio with approximately 6 or 7 that will either be complete duds or on death’s doorstop (also known as “walking wounded”). From this same group of 10 investments, 2 to 3 will provide a modest rate of return and 1 or 2 will provide a very strong return or “home run.” In a few cases a venture fund might experience a major “home run” investment that provides returns greater than 50 times original investment. Apple Computers, Intel, and Digital Equipment are examples of these. They more than compensated the risk capital provider for the losers and mediocre returns of the other investments.

However, the orientation for venture funds is much different than with traditional investments. With traditional investments, the investor expects each to provide at least some modest return, compared to the lopsided nature of venture investments (where most of the return comes from a small percentage of the projects). There are many other differences among the types of investments, with SEUs expected to follow a pattern similar to other venture fund projects.

SEU ventures will be much riskier than the average investment made by a large, publicly held firm. This must be true almost by definition. If the investment or project had the same risk as all other big-company projects or investments, the company would simply fund the project through its normal capital budgeting process (approach toward funding long-life projects). These companies would evaluate the investment, assess the risk, and determine whether or not the risk warranted the investment. Large companies do this all the time. This is part of their traditional growth process and part of their existing R&D. A venture deal, such as an SEU, is different. A venture investment is typically performed in a new, unproven sector of the industry. The risks are higher, but so are the returns. It takes a certain mindset and discipline to handle this type of investment. Historically, large companies have not been very good at exploiting venture deals, but the potential, nevertheless, still exists. Part of the problem may be the manner in which large companies set up their funds. In particular, they often do not diversify in the same manner as professional investors.

Most investors know a little something about diversification. The phrase “don’t put all of your eggs in one basket” usually comes to mind. Certainly professional money managers and venture capitalists know all about diversification. Professional investors tend to live by this mantra, otherwise in one bad year they can be eliminated. But when it comes to venture investments in large corporations, sometimes market conditions and corporate policies limit all the different ways that venture funds can diversify. There are basically four different ways in which venture funds, including SEUs, can be diversified. These include the following.

Financiers or risk capital providers to SEU ventures do not need to follow each of these approaches. In fact, in some cases, such as the “industrial sector” category, risk capital providers may not want to invest outside certain industry classifications in which they do not have specific industry expertise. But they need to realize that by not diversifying in one of these areas that they have risk exposure to failure. Perhaps not surprisingly, the entrepreneur or fund recipient needs to think about these considerations as well. What happens if the funding agent has all (or most) of its liquid funding reserves dry up during the young firm’s second year? What if the young firm is at its lowest point on the J curve? Unfortunately, many would-be dot.com success stories discovered the funding risk problems the hard way. During the 2000–2003 economic downturn, the risk capital market shrank by 50 to 75% and with it, the extra reserves to continue operations. Only the best organizations received the second- and third-stage rounds of financing. Many of the other venture projects shriveled up and disappeared.

Big companies got into the venture market late (i.e., mid- to late-1990s) and many left it early (2000–2003). In essence, they bought into the market at the high end of the demand and pricing and may have bailed out at the low end. This becomes problematic as they were not able to diversify by the year of the investment. Given the poor cash flows of many large companies during the 2000–2003 time period, they couldn’t. In many cases they were scrambling for funds to pay to meet existing operational needs, let alone new initiatives in high-risk venturing activities.

But a corporate venture fund generally requires a long-term approach. This is the approach that professional money managers and venture capitalists employ, even though corporate venture funds may not. Large companies, such as Lucent, Cisco, Nortel, Motorola, and Panasonic, created venture initiatives to take advantage of explosive growth in technology companies and new industry sectors. During the mid- to late-1990s, many of the corporate venture funds had a nearly limitless cash reservoir to tap for new initiatives. Further, many managers of the funds anticipated that future cash flows from the investment pool would be used to finance additional investments in the future. However, during the recession years 2000–2003, many of these corporate venture capitalists have since terminated their funds. In some cases, such as with Lucent, the firms have sold off all of their holdings and completely dismantled their venture group.^[5]

Unfortunately, the portfolio investments went down at precisely the same time that the organization’s primary business was faltering. Thus, any spare funds from the investments needed to be funneled back to the parent. There was no spare cash left over to put into new venture investments. Large company pension fund managers have learned how to deal with this same risk and now know how to invest in a manner so that the investments in company pension funds do not also decline at the same time as the corporate cash flows. Corporate venture funds for SEU investments will need to be handled in the same manner. This means that the investments in SEU ventures should be diversified by the year of investment. Moreover, because SEU ventures, unlike capital venture fund investments, are not geared toward a harvest, risk capital providers need to focus on the annual rate of return, rather than a one-time large cash distribution.

Risk capital providers, such as venture capitalists, tend to focus on the harvest. As Figure 8.2 shows, the reasons should be clear. Venture capitalists only receive a financial windfall if they can achieve a harvest with a large distribution. But one of the big differences between investing in VC projects and SEUs is that SEUs are not set up with a harvest in mind. Consequently, the financial focus of SEUs should be geared toward the annual cash flows or return generated and not the cash distribution from a sale or harvest. This means that the risk capital financier that provides funds to a SEU needs to reevaluate the rules of success.

Figure 8.2. Rules of Success for Venture Capitalists

Venture capitalists derive their compensation from two central areas: capital commitment and capital gains on investments.

The first point addresses the total amount of funds that the risk provider has under management. Typically, the VC earns a 1 to 2% fee on the amount of the commitment from the investor (e.g., institutional investor like a pension fund, etc.)—not the amount invested. They earn their fees this way to prevent a moral hazard. If they earned fees on the amount of money invested they would have a bias toward making an investment, even a bad investment, just to earn their fees. This way they can pay for their overhead and operate as they should. The amount of the “capital call” represents how much the VC actually puts to work. As a practical matter, they often do not invest all of the money that is available (e.g., total capital commitment). They expect (and hope) that some money from prior investments will start to earn a return before the total capital commitment is exhausted.

The “real money” that venture capitalists earn comes from the harvest of deals. Venture capitalists usually have an 80/20 split. This means that they earn 20% of all gains, even though the vast majority of the capital invested in the project is not theirs. The capital comes from their investors (pension funds, high net worth individuals, etc.). Therefore, VCs have great incentive to see these deals work out well and provide an early harvest. The timing of the harvest depends on current market conditions and expectations of future growth. Generally, VCs are motivated to harvest as soon as possible. Harvest opportunities are very sensitive to market conditions and VCs are eager to lock in their profits given the chance. Thus, unless the venture shows extraordinary potential for explosive growth, VCs are inclined to cash out the first chance they get.

The actual returns on a VC fund demonstrate that the realized return on VCs is far less than the usual media hype of 40 to 70% returns. In fact, the actual return performance has been in the 10 to 20% range.^[6] The probability of high performance hinges almost exclusively on the “home run” investment. Venture returns are not uniformly distributed across investments. One half of the gains come from 7% of the investments (about 1 in 15). Moreover, diversification is important. Studies have shown that approximately one third of all investments lose money and one tenth to one sixth of all investments loses 100% of the funds invested. Clearly, these are not the typical returns for the average, individual investor.^[7]

Figure 8.2 shows the bias toward getting to harvest. The venture capitalist can only earn big returns if the investments are harvested. Empirical evidence suggests that venture capitalists are good at timing the market. They know when to sell. Because most investments do not provide much, if any, return, the venture capitalist has tremendous incentive to harvest their investments earlier, rather than later in the development cycle. They might, and probably will, sacrifice some greater return in the future to achieve a good return in the short term. They would have to be highly confident that the returns in future years will be terrific to delay the harvest. They wouldn’t want to risk a bad capital market to delay or possibly destroy altogether the possibility of harvest. This is one fundamental problem with the VC process.

In a venture capitalist’s ideal scenario, after a few years the distributions (income returns and capital gains) start to exceed the original investment. This implies that the venture capitalist has received more money back from distributions than what they originally put into the total portfolio. They received all of their original money back plus some extra cash. This is their goal. They then scour the markets for their next investment opportunity.

Investments in SEUs will have a different orientation than investments in traditional venture fund portfolios. Because the intent of the SEU is not to harvest through a strategic sale or IPO, the venture should continue with a strategic link to the parent for a longer time period (compared to the average holding period with a normal VC investment). Consequently, the financial success or failure should be viewed in the context of the annual returns (or contribution toward large company profits) relative to the original investment. Although the early returns should be expected to be low (owing to the “J” curve effect), cash flow returns in later years should be relatively strong (particularly given a portfolio context). Thus, a portfolio of SEU investments should provide a steady stream of rising cash flow/dividends to the investor with a very strong annual return. Assuming that the cash flows of an SEU venture approach or exceed those of other corporate venturing or capital venture projects, the annual returns should be equally high (or higher) than the returns on other venture funds. The primary difference with this investment is that the investor should not expect the fund to be forced into liquidation after five to seven years, and the initial investment may be left in the SEU venture. However, as we discuss later, any risk capital investor that desires to receive liquidity for his, her, or their original investment will have an opportunity to convert the SEU stock into the stock of the parent company. Thus, the investor will be allowed liquidity in the SEU stock investment without forcing the SEU investment to liquidate.^[8]

Large, publicly traded organizations have access to cheap capital and have the ability to provide the capital to small, emerging companies at rates that are much lower than what these small companies could otherwise get. They also provide an opportunity to provide liquidity to investors in the SEU projects without forcing a sale or IPO. This presents an opportunity for both the large company and SEU venture. Large companies can act as a financial intermediary by taking their cheap capital from public and institutional investors and putting it to work where they have strategic insight by investing in SEUs. SEUs should pay the market rates for funds because this will encourage them to be selective with their spending. Moreover, market interest rates will reward the large company for its ability to act as a financial intermediary. The funds have an opportunity cost and the large firms are entitled to the benefits related to the risk capital they provide.

Large companies employ talented individuals with expertise in their industry. They can recognize new talent and a potentially valuable enterprise. Moreover, large companies have the power of production, distribution, and goodwill. These are invaluable traits that can assist a fledgling operation. Potentially, these attributes are even more valuable than the cash itself.

Small entrepreneurial companies know how to invest cash efficiently. At least this is probably a good filter for the successful ones. Given their relatively unstable cash flow and inability to generate excess cash, they need to operate with an eye on severe capital constraints and savvy resource management. These are skills often found lacking in a large organization with an abundance of capital. In fact, this may be one factor among many that distinguishes between a large and a small company. Small, successful entrepreneurial companies use expensive risk capital judiciously and keep their overhead costs very low.

The savings from using less capital will usually offset the higher cost per dollar used. Let’s assume that a small company can use half the capital of a big firm but has to pay double the rate. The scenarios are not the same. As shown in Table 8.1, if a small company has to pay a 20% effective interest rate for its capital and only uses $1M of funding, it would use appreciably less total capital than a large firm requiring $2M in funding (double the investment) with a 10% effective interest rate (half the rate). In this example, the small firm pays a total of $1.2M compared to the $2.2M that the large company would pay. Obviously, this illustrates an extreme example, but the message is nonetheless obvious. Capital costs may be less of a factor than efficient utilization. Further, if small companies can earn an equal or higher return on the investment compared to large companies, despite the higher cost of funds, then the best or optimal combination would provide the small company the funds at the large company rate. This would create an incremental return of $.1M ($1.1 vs. $1.2) for the small firm and be exactly half the total cost for the large firm ($1.1M vs. $2.2M).

If the small firm is in fact more efficient with its capital utilization and the large firm is able to attract risk capital at a lower rate, the best combination should be apparent. Large companies should bring cheap money to the small companies who can most efficiently put it to work. The small firm/large firm combination makes sense from both a theoretical and practical perspective.

In a perfect world (from a large company’s perspective), the world’s most efficient capital user would also be the company that has the best projects and the lowest cost of funds. This efficient model of an organization would grow larger, more efficient, and more profitable. These firms would become more powerful over time and dominate all others.

However, despite the implied advantages and access to inexpensive capital, large organizations fail to capitalize on their strategic advantage. The problem therefore has little to do with the cost of funds and perhaps more to do with its successful allocation. Who gets the funds and how efficiently is this process handled?

Large companies need a better way to distribute their inexpensive risk capital. They have a clear advantage over other firms in this regard and need to utilize funds in an efficient, cost-effective manner. Either they will need to spend money with a cost-conscious orientation or they will need to allocate funds to a small group that already has this inherent view. Because the former might require a complicated corporate culture overhaul, the latter becomes a more pragmatic approach.

Large companies should continue with experimentations in small venture financings. Moreover, they should invest the funds as professional fund managers and apply a portfolio context so that they are fully diversified based on timing of distribution, risk of venture opportunity, geographic representation, and (wherein possible) industrial allocation. The basic concept for venture financing is already readily accepted within most major companies, but the existing approach requires some modifications. Large companies should continue to partner with many small companies and provide their cheap capital to those that can make them both a profit.

Capital allocations will need a slightly different risk-return oriented approach with different incentives for the members of the venture. The focus will be geared toward annual returns from the investments rather than a large cash distribution or harvest. Further, this will encourage long-term thinking by members of the SEU ventures and participating stakeholders. The SEU format should also assist large organizations with appropriate allocations of its scarce resources.