by Nitin Nohria and Hemant Taneja
May 12, 2021
Impressed by the breakneck growth of digitally-native companies such as Amazon, Alphabet, and Alibaba, established companies are spending enormous energy and money on digital transformation efforts. Many of these projects are led by scrappy “intrapreneurs” who launch a new digital venture inside an existing firm. They have the vision and persuasive powers to convince their company to provide early funding — driven, in part, by the desire of the company’s leadership to pursue a compelling digital initiative.
But the “intrapreneur” model presents obstacles, many of them unacknowledged or underappreciated. Unlike an external start-up whose plan and prowess are being evaluated by experienced venture capitalists — and compared against hundreds of competing investment opportunities — internal ventures do not have to meet a stringent market test. If the internal venture achieves initial funding, it may yet face a constant uphill battle to secure additional resources (including capital and talent), competing against other units that may have better short-term upside and more internal legitimacy. Existing business units may chafe at the notion of their hard-won cash flows being allocated to fanciful ventures with uncertain prospects. And even if the new venture begins making real money, it may not get much respect within a large company. Consider this: an internal start-up that reaches $100 million in annual revenue (a remarkable feat for a start-up that can earn it a stratospheric valuation) will have delivered just one percent in incremental growth for a $10 billion company.
Intrapreneurs and the companies that back them would benefit if there were a different funding mechanism available to support their efforts — what we have termed a venture buyout, or VBO. The VBO structure allows existing companies to tap into the powerful company-building ecosystem of the VC world — and give these companies the same access to the innovation at scale and financial returns that have fueled the rapid ascent of their disruptive competitors.
The VBO idea emerged from a joint field trip to India we took a few years ago when we met with several accelerating start-ups, as well as several large businesses that were trying to launch their own internal digital ventures. The contrast between their cultures, growth orientation, leadership focus, and rates of progress was stark. Since then, the venture capital firm General Catalyst, where one of us (Hemant) is the managing partner, decided to launch this new VBO structure, and is currently partnering with a handful of established companies to spin-out and rapidly scale digital ventures they have hatched internally.
Conceptually, VBOs have parallels with the leveraged buyouts (or LBOs) that rose to prominence in the 1980s. As dramatized in the 1987 film Wall Street, LBOs used newly-available, high-yield bonds to allow financiers to buy all the outstanding equity of a publicly-traded company. Many of the early LBOs were “hostile” deals, in which a would-be buyer (often disparaged as a “corporate raider”) launched the acquisition bid without the consent of existing management. LBOs were celebrated for their ability to increase efficiencies, cash flows, and earnings inside companies that had become bloated and bureaucratic. LBOs then fell from favor, after several high-profile bankruptcy filings (including that of Drexel Burnham Lambert, the firm which, ironically, helped spawn the movement). But the general concept of using leverage to take companies private, remains sound — and became the basis for the private equity industry structure that has since become a vital part of the global economy.
At its core, a VBO involves an established company partnering with a venture capital firm to spin out an internal venture. A VBO brings high-risk growth capital to drive accelerated revenue growth and superior unit economics, much as an LBO deploys high-yield levered capital to drive increased cash flows and earnings. It also enables a growth-centric transformation versus an LBO’s profit-centric transformation, and it benefits from the expertise and experience of venture capital firms to make stage-gated investments based on growth milestones, much as LBOs bring the fiscal and capital allocation discipline of private equity firms. VBOs can identify and provide the right incentives to attract the entrepreneurial talent needed to grow the new venture, much as LBOs get seasoned management talent to help their companies identify and capture operating efficiencies and incremental revenue growth. VBOs create a strong incentive, pathway, and time-frame for the venture to go public or to be acquired, just as LBOs do. And importantly, unlike the unwelcome “corporate raiders” of the LBO era, we believe the VBO will usher in a new era of partnership with “venture builders.”
Another less obvious advantage of the VBO structure is the broader market perspective it affords. Internal ventures often tackle problems and opportunities seen from their own firm’s vantage point, trapping themselves within an inside-out framing of the market opportunity versus outside-in. Because the start-up was built to solve its parent company’s problem, its solution may not fit or scale to external customers. In contrast, with help from its VC advisors, a VBO may build out a more extensible technology — and because its external funding creates a more independent identity, a VBO might help attract new customers who may otherwise have been wary buyers.
Another issue: when an internal start-up succeeds, it’s often absorbed back into the mainline business. Though celebrated as a victory, this is often the death knell for the new venture. Established leaders who lack the vision, energy, or skill to continue to grow the venture supplant the mavericks driving it, sapping the venture’s energy and vitality.
Although a VBO is conceptually straightforward, companies that hope to create one will need to navigate through some practical obstacles. Valuing a business while negotiating its funding may be difficult, as a traditional company may overvalue what it has built while simultaneously underestimating a VC firm’s value-add. Incumbent leadership may believe that it’s best-suited to continue to grow the business after the VBO; in practice, VC firms consider the right to replace existing managers a threshold issue to making an investment, which might make incumbent leadership wary of the very idea of a VBO. And what if a VBO fails? VCs, accustomed to betting on a portfolio of highly-risky investments, are comfortable with the prospect of any one failing. The parent company of a VBO may have a lower risk tolerance.
Although these challenges are real, the rewards outweigh the risks.
Why is this the right time for VCs and large-company executives to bet on VBOs? Part of the answer lies in the pace and disruptiveness of digital transformation. Large companies need to innovate now, and the traditional methods they use to create new ventures tend to be fraught with difficulty. In contrast, VC-funded new ventures not only work quickly — they also think more imaginatively about new kinds of business models, new customer experiences, new ecosystems, and new ways of leveraging data through artificial intelligence and machine learning.
Are the seeds of the next Stripe already sitting within JP Morgan Chase or American Express? Is the next Airbnb being hatched somewhere deep inside Marriott or Hilton? Is the next Lemonade lurking somewhere within Allstate or Geico? If so, this new kind of financial structure could give legacy companies a new tool and mechanism to nurture innovation without stifling it, absorbing it, or abandoning it, prematurely — one that allows them to tap into the unique VC skill set to help grow and sustain enduring, innovative companies.
In the 1980s, one of us (Nitin) wrote a doctoral thesis at MIT that examined why Eastman Kodak had such a difficult time enabling intrapreneurs to succeed, despite having very promising internal start-ups. Even then, years before Clayton Christensen began writing about disruptive innovation, it was clear that established companies tend to cast a shadow that stifles innovation, the same way shade from established plants can limit the growth of seedlings underneath. One popular solution to this problem has been to advise intrapreneurs to create “skunkworks” located within, yet physically apart from, the established organization — but despite the appeal of this concept, it has shown limited success. We hope VBOs come to be seen as a different approach to the same problem. Perhaps, the type of funding and governance, which only a different kind of owner/partner such as a VC firm can provide, is more important than all the other protections a company can try to give a new venture.
Just as LBOs came of age in the 1980s, VBOs present a similar opportunity to drive innovation that lasts. If VC firms can bring their access to growth capital and their scaling playbook to start-ups that come to life inside established companies, they can help these legacy organizations unlock the full potential of their digital ventures. To be sure, this can produce a win-win opportunity for everyone involved.