Harnessing innovation: corporate VC arms fund smaller companies with big ideas.

Last September, Intel Capital, the venture arm of Intel, invested $2 million in a relatively unknown Japanese battery technology company named Pionics. While a tiny amount for the giant $30 billion chipmaker, the investment has proven to be highly strategic.

Since then, engineers have huddled in R & D labs in Japan and Silicon Valley, together figuring out how to double the battery life of PDAs and notebook PCs. Their research could very well lead to the next breakthrough for Intel. Indeed, Intel's highly successful new Centrino chip was partly inspired by a $50 million Intel Capital investment in U.K.-based Cambridge Silicon Radio, a pioneer in short-range wireless communications. Through that investment four years ago, Intel got "early knowledge of what was going on in wireless, which helped to shape the strategy for the Centrino chip," says Claude Leglise, vice president at Intel Capital in Santa Clara, Calif. The Centrino chip, which provides wireless access and improved battery performance on lighter, slimmer notebooks, helped Intel increase its market share lead by nearly 3 percent, to 88.1 percent in mobile PC microprocessors, according to International Data Group, and accounted for 25 percent of Intel revenues last year.

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Leading cell phone maker Nokia and huge Japanese trading company Itochu also are relying on in-house venture units to spot new technology and improve their balance sheets, supplementing research and development departments in an economical way. At its most ideal, corporate venture groups help to fund a startup firm's technology through the laborious and costly testing and prototype stage until the startup can be acquired at a low valuation when it needs capital for expansion.

During the recent tech downturn, many corporate venture units got the ax, as companies hunkered down and focused sharply on cost cutting. Among those shut down were Compaq Computer and Commerce One. But while corporate VC peaked in 2000, it still accounts for one-fourth of the 169 venture deals and one-sixth of the $18 billion in venture spending last year, according to the National Venture Capital Association in Washington (see chart). And it appears to have stabilized at those still very significant levels. "The ones (corporate venturers) who are in there now are the ones who are committed, the ones who were there prior to the big run-up," says John Taylor, director of research at the National Venture Capital Association. He cites Intel, Nokia, Kodak, SmithKline and Softbank as being some of the major worldwide players in corporate VC.

Avoiding Bureaucracy

Moreover, with CEOs these days debating ways to achieve top-line growth through innovation, corporate venturing shapes up as an important avenue. The reason is that some internal R & D operations can become overly bureaucratic and therefore are slower to market. Smaller companies often come up with great ideas but lack the resources to commercialize them. So when a major company can identify and provide funding for those innovations, it can later benefit by becoming a major customer for the smaller entity. It may also decide to buy the company outright, or can simply remain invested as part of a financial portfolio strategy.

At Nokia, an entire new division, Nokia Enterprise Solutions, was created from investments made by Nokia Ventures Organization. Over a typically Finnish seafood lunch at Nokia's R & D campus on the outskirts of Helsinki, director Jyrki Rosenberg explains that the venture group is comprised of six units with an overall budget that amounts to 9 percent of Nokia's total revenues of $36.2 billion. This entity was patched together from two prior investments by the venture group: Nokia One, a provider of mobile email access, and Nokia Internet Communications, a supplier of security systems and private networks. These groups were then combined with a unit selling Nokia phones to businesses.

A departure for Nokia, the enterprise solutions group is geared to selling mobile phones, email services and security systems to the faster-growth business sector, and its products compete with Oracle, Hewlett-Packard and Microsoft rather than with traditional rivals such as Motorola, Ericsson and Samsung. Business communications services are growing by more than 40 percent per year, according to research firm IDG, while cell phone sales have stagnated.

One of four major divisions now, the enterprise solutions group reported revenues of $234 million in Nokia's first quarter 2004, representing a growth rate of 95 percent compared with the first quarter of '03. That was a much-needed boost, given overall sales were down by 2 percent last year and by the same percent for this year's first quarter. Continuing to leverage the new division, Nokia recently hired Hewlett-Packard veteran Mary McDowell as head of the enterprise unit and moved the operation to New York from Helsinki to be closer to business customers.

Itochu, too, is fueling its growth with investments from an internal venture group. One star is MeshNetworks, a wireless networking firm funded by Itochu Technology last year with a mere $1 million. Itochu set up its Japanese business under a licensing agreement and today MeshNetworks Japan is wholly owned by Itochu, with a $2 million contract to supply Japan's transport system with information needed during traffic jams, accidents and natural disasters. "One of the strengths of our group is that we are not only a VC group, but a support to Itochu technology," says Kazuhiko "Bob" Sunada, president and CEO of Itochu Technology in Santa Clara. "We get good access to technology from the startup community, so we don't just look at this as a return on investment."

In-the-know CEOs are maintaining or even increasing support for their venture units, economic downturn or not. This year's budget at the 100-person Intel Capital is $700 million, twice as much as the year before, says Leglise. Meanwhile, Intel's R & D spending is also rising, up to $4.4 billion last year from $3.1 billion in 1999. CEO Craig Barrett leads the innovation charge, noting recently in a speech at the Intel Developer Forum for hardware and software developers that "Intel has always invested heavily during the downturns as a way to continue to innovate and emerge from the downturn stronger than before."

Intel's investments act as a kind of early warning radar system, allowing it to peer into promising technologies across a variety of businesses. "Because we have a portfolio of 350 companies, we do get a fair amount of knowledge about worldwide technological developments, and we are able to synthesize that learning and bring it back to the engineers to influence their long-term thinking," says Leglise, who travels frequently to Bangalore, Shanghai and other innovation hot spots in search of entrepreneurs to back. With Silicon Valley "not the only center of innovation" and with "world class centers of excellence with different market needs for different countries," he says, it helps to have that broad spectrum.

Leglise, who is on the road about half of the time, oversees Intel's venture investments outside the U.S., which began in 1998 and now account for 40 percent of the group's investments. Among the markets he cites for innovation are Japan, for semiconductor manufacturing technology, consumer electronics and cellular applications; Korea, for broadband applications and information technology networks; the U.K., for wireless capabilities; and China, for adapting technology for unique local needs, such as the low-cost mobile phone PAS technology made popular by UT Starcom.

At the best corporate venture units such as Intel, Nokia and Itochu, the groups not only stimulate new product innovation but also can be a profit center and fund their own initiatives. Much as with a typical venture capital firm, investments in startups lead to money-making small businesses that provide a return on investment when merged, acquired or taken public on NASDAQ or another exchange.

Acting Like a VC

Intel's Leglise has no trouble ticking off successes from his group: Cisco's acquisition of Israeli startup Riverhead Networks in April for $39 million; a "good financial return" from the acquisition of European-leading Linux provider, Suse Linux, to Novell last November; and a "good IPO in London" when Cambridge Silicon Radio, a maker of silicon chips for bluetooth-enabled wireless devices, went public on the London Stock Exchange in February. "We look for the same good returns as a VC," says Leglise. Just like any good venture firm, Intel is not afraid to make a mistake either. "If you don't make mistakes, you are not taking enough risks," he says. "We are not worried about making mistakes, but about discovery of an incredible amount of technology talent."

Nokia has taken an extra step into the venture world by setting up in Silicon Valley a unit called Nokia Venture Partners. It operates like a venture capital firm with outside limited partners or investors, including Goldman Sachs. From a $650 million fund, Nokia's venture arm has made some 30 investments since it was formed five years ago, with its biggest success coming with the acquisition of portfolio company PayPal to eBay in late 2002 for $1.5 billion.

Tucked in a nondescript office suite along the Great American Parkway in Santa Clara, Itochu Technology has invested an average of $2 million in 90 U.S. technology companies and achieved an impressive 45 percent return on these investments since 1994. About 30 percent of the companies it has invested in have gone public, while another 40 percent were acquired. Among the success stories are Siebel Systems (an IPO in 1996 with a 47-times return on an investment made in 1995); Openwave (merged in 1999 with phone.com); Nvidia (public listing in 1999 with a 114 percent return on a 1994 investment); and Recourse Technologies (acquired in 2002 by Symantec at a 300 percent return on a deal financed in 2001). The firm, like most other venturers in Silicon Valley, has not escaped writing off an investment or two, admitted Takashi Kameda, vice president, venture investment.

With lots of startups looking for financial support in the Valley, Itochu has its pick of information technology companies and looks at several hundred potential deals each year. Last year, Itochu backed five companies, all of them hungry for Japanese sales to offset sluggish U.S. growth in the large Japanese IT market. Currently, Itochu sees opportunities for U.S. high-tech companies in Japan and Asia in four areas: wireless, security, storage and broadband.

But Itochu's "secret sauce" is in helping its investees break into the Japanese market. Through the trading firm's 1,500 salespeople in Japan, Itochu gets firsthand market intelligence about consumer trends. The Itochu team then assesses how ready a portfolio company is for Japan and how ready the Japanese market is for their product. If it looks like a go, then Itochu counsels the firm on market strategy and introduces the management to Itochu distributors. Itochu earns money on these "finds" by entering into reseller licensing agreements with the U.S. firms. Itochu also negotiates distribution agreements and handles export regulation and tax paperwork. "We are able to see growth in certain market sectors, and we help firms to develop the Japan market. It would be very hard for them to do it on their own," says Kameda. He adds, "For U.S. companies that are not shipping their own product to Japanese markets, we make $100 million annually in revenues for shipping their product."

Of course, winning the game of corporate VC isn't easy. CEOs who go down this path have to make sure their investment managers are more than just money people; they have to be sophisticated enough to understand the implication of new technologies for the company's core businesses. CEOs also must be prepared for the corporate VC unit to have a sizeable budget that may not produce immediate results for the bottom line. It can take three to five years before viable products are developed. But the evidence seems unmistakable: Corporate VC can yield powerful results.

Post-Bubble Recovery

VC investment ends downward spiral

       Deals  Dollars

1994    6%     3%
1995    7%     6%
1996    8%     6%
1997   11%     7%
1998   14%     8%
1999   24%    15%
2000   27%    16%
2001   22%    12%
2002   18%     9%
2003   15%     6%
2004*  15%     6%

Source: MoneyTree Survey[TM]
* Estimates

Note: Table made from line graph.