chumpeter portended the new economy in his seminal book Capitalism, Socialism and Democracy (1942). He believed new technologies and “combinations” that disrupt the prevailing equilibrium were the key to long-term growth and the development of capitalist economies – not the steady accumulation of capital stock, as economic orthodoxy held. “The process of industrial mutation,” he wrote, “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Schumpeter dubbed this process “creative destruction,” and argued that it was “the essential fact about capitalism.” This idea is so powerful that even people who have never heard of the long-deceased economist are familiar with the phrase he coined.

Schumpeter was referring to the processes that influence the outcome of a collection of companies rather than the processes that occur within a single company. But creative destruction can take place in both a macro and a micro setting. In a corporate setting the most dramatic acts of “destruction” are the decisions to sell or shut down a division. A milder form might be to spin off a business unit. The point of destruction in these cases is, as Schumpeter implied, to make way for creation, to refresh or renew the corporation.

But individual companies do not do nearly as good a job of creative destruction as capital markets. Richard Foster and Sarah Kaplan, co-authors of the recent book Creative Destruction, argue that markets – not corporations – allow new companies to enter more freely, and ruthlessly force the elimination of those companies without competitive prospects. Moreover, markets change much faster and on a larger scale than do corporations. Whereas markets operate on the assumption of discontinuity and accommodate continuity, corporations assume continuity and attempt to accommodate discontinuity.

These major differences pose a serious threat to managers of even the most successful and well-established corporations. Based on the results of a McKinsey & Co.-sponsored study of more than 1000 companies in 15 industries over almost four decades, Foster and Kaplan predict that by 2020 more than three quarters of the S&P 500 will consist of new companies that will be drawn into the maelstrom of economic activity from the periphery.

So, how can corporations make themselves more like the market? The answer, according to Foster and Kaplan, is to establish a more dynamic view that mandates managing creative destruction first and operations second. But the corporation must do so in a highly decentralized way, without sacrificing control.

This is easier said than done. Few corporate leaders have the energy or time to manage the processes of creative destruction, especially at the pace and scale necessary to compete with the market.

Corporate Venturing

One answer that many have turned to is corporate venturing. Corporate venturing is a practice that aims to enable companies to successfully surf the waves of creative destruction. It involves the development of an organized effort to leverage existing assets and capabilities to help create new businesses. It differs from other traditional business practices that facilitate growth through access to new technology, such as acquisitions and corporate research and development (R&D). New businesses developed through corporate venturing are typically developed through an incubation process rather than through acquisition and integration into the company. Corporate venturing investments are usually riskier and less subject to rigid management of internal costs than conventional R&D. In fact, protecting venture investments from such controls is a key reason why start-ups are organized separately from the ongoing corporate business.

The history of corporate venturing reflects an enduring corporate fascination with the success of venture capital (VC) firms over the last forty years. Venture capitalists are certainly not infallible; they are eminently capable of entering markets too early or too late, picking the wrong start-up teams, and riding some investments longer than they should. But over the past twenty years, VC firms have done a far better job of embracing the spirit of creative destruction than traditional operating companies. In replacing the traditional assumption of continuity with the assumption of discontinuity, they have become important drivers of change in the world’s largest economy, created enormous wealth for their investors, and shown how individual companies can create value at the pace and scale of the market.

he first corporate venture programs were inspired by the successes of the VC firms that backed such start-ups as Digital Equipment and Raychem. During the late 1960s and early 1970s, more than 25% of Fortune 500 firms had corporate venturing programs. Many were disbanded in the second half of the 1970s following a severe decline in public market and VC activity. Following dramatic growth in the VC market in the early 1980s and the successes of firms that backed such smash hits as Apple and Genentech, corporations again set up venturing programs. By 1986, corporate venture capital represented 12% of total VC investing. Many of these programs were again discontinued after the 1987 market downturn and the ensuing dramatic drop in VC fundraising. Almost 40% of corporate venturing programs were abandoned within four years of their initiation. By 1992, corporate venture capital had fallen to 5% of total venture capital investing.

The second half of the 1990s brought a third wave of venture capital success and inspiration. Fueled by emerging technologies, opportunities posed by the Internet and a robust economy, independent venture funds began to notch annual returns of more than 50% after 1995. VC investment rebounded from an annual average of $6 billion in the mid- 1980s to over $17 billion in 1998, and to over $100 billion in 2000. And once again, corporate venturing programs followed. Between 1995 and 1999, the number of U.S. companies that made corporate venture investments increased from 62 to 415. According to the research firm Venture Economics, corporate venture capital activity soared from $542 million in 1996 to $1.1 billion in 1997, $1.6 billion in 1998, $8.6 billion in 1999, and $16.5 billion in 2000.

The Track Record

Early studies of corporate venturing programs, which took place in the 1980s and early 1990s, led many to conclude that they were inherently unstable and unlikely to succeed. Researchers observe such difficulties as building and sustaining internal support for new ventures from top management, potential inherent conflicts of interest arising between the sponsoring firm and the new venture, and the inability of the corporation to provide an appropriate risk/reward compensation to new venture managers.

But more recent empirical research paints a much more positive picture of the value of corporate venturing programs. In a study comparing over thirty thousand investments in start-ups over a 15- year period, Professors Paul Gompers and Josh Lerner found that corporate venture investments appear to be at least as successful (using such measures as the probability of a portfolio firm going public) as traditional venture capital firms. In another study analyzing over 300 venture capital-backed, information technology IPOs in 1998-1999, researchers Marku Maula and Gordon Murray demonstrated that emerging technology companies performed better with corporate equity investments than with traditional VC investors. The financial involvement of Global Fortune 500 ‘Infocom’ companies was directly associated with higher first-day valuations. In both these studies, success is correlated with the strategic fit between the corporate parent or corporate investor and the venture.

Both the problems and successes in corporate venturing can be traced to the fundamental difference between such programs and independent venture capital. In contrast to VC firms, which have financial returns as their fundamental goal, most companies pursuing corporate venturing programs cite strategic returns as their fundamental aim. Strategic returns include exposure to radically new and disruptive technologies, access to new products and markets, and identification of acquisition targets.

major cause of corporate venturing failure is the desire to accomplish a wide array of objectives that are not necessarily compatible. To maximize financial returns, firms are best advised to emulate independent VC firms. They need to provide complete autonomy to the new ventures’ managers and to compensate risk-taking behavior with equity stakes. They also need to exercise strict discipline by staging the financial support pending the achievement of certain milestone events and by providing intensive guidance and oversight without interfering with the basic decision-making responsibilities of the entrepreneurs who run the business. This includes a practiced indifference to potential synergies or complementarities with other businesses in the corporate portfolio.

Resolving Conflicts

But this posture can create conflicts. By emulating such venture capital practices, firms negate the important strategic mandate of corporate venturing programs. If the prime motivation for the new venture is strategic, then providing greater autonomy, a disproportionately higher compensation level, strict financial discipline on the downside, and ignoring strategic complementarities will increase the likelihood of potential conflict between the new venture and the established business.

Given such conflicts, it is not enough for corporate venturing programs to be managed more like private venture capital. Instead, they must be hybrids. Corporate venturing programs must be designed to benefit from certain practices employed by venture capitalists, while at the same time leveraging structural advantages to manage the development and commercialization of new technologies that are not available to independent venture capital firms.

Let’s take a few examples of how this works. All investments made by private venture capital firms are assumed to have a limited life – typically seven to 10 years or less. At the end of that time VCs are required to sell their investments and return the capital to their limited partners. This limited horizon creates an incentive alignment between limited partners and the venture capital partners that encourages venture capitalists to invest only when they have a clear idea about the pace and scale of the gains that can be achieved. Corporations, on the other hand, do not face the same pressure to produce liquidity events for new businesses. As a result, they can fund and sustain longer-term projects, which often involve the development of radical innovations and technological breakthroughs.

A second important structural advantage comes from the corporation’s ownership of important physical, knowledge-based and intangible complementary assets that cannot be freely traded in the external markets, like a company’s brand name or its reputation. In addition, certain technologies require the coordination of complementary technologies in order to deliver value. For example, last year Qualcomm, the wireless telephone company, created a $500 million corporate venture fund to invest in start-ups that develop wireless Internet applications – particularly those that will lead to the adoption of a technology for transmissions that complements the standards employed by Qualcomm.

Finally, there is the potential learning advantage companies gain from investing in new ventures even when they fail. For example, 3M has developed a culture that not only tolerates failure but has also institutionalized practices that facilitate learning and knowledge transfer among employees involved in technological innovation. Each of the investments made by Eastman Chemical Company this past year led to the development of a strategic relationship that has given the company access to early development of important technology.

Elements of Corporate Venturing Strategy

So what can a corporation do to increase its odds of succeeding at corporate venturing? First, it must be committed to the mantra of creative destruction. Does senior management regularly think about the companies that define the periphery of the industry? Do they have the courage to shut down ventures that are not working out? Is the company willing to let customer demand control how its corporate venturing investments are allocated even if this means less control over the direction the new venture will take?

Second, senior management must decide on the principal goals of the corporate venturing initiative. This means more than declaring that the goals are primarily strategic. It means identifying the specific type of goal and ensuring that multiple goals are compatible. Does the corporation want to have access to new technology that will lead to capitalizing on the next “new, new thing?” Does it wish to invest in competing technologies in which a dominant new standard is likely to emerge, but in which the outcome is unclear? Does the company want to invest in start-ups that will serve to promote demand for its core products? Or does the company just want to expand its current R&D efforts by complementing them with external investments?

Third, senior management must determine whether it has the resources and talent necessary to carry out these goals. Does it have employees with the requisite experience to lead the initiative? Can it easily hire them? Does it have the capital to finance the large investments that are required? Does it have a culture that encourages the sharing of information across units?

Fourth, senior management must decide on the appropriate design for the corporate venturing unit and its governance. Corporations use a variety of structural forms to engage in venturing. These forms reflect increasing corporate internalization or involvement, and range from acting as a limited partner in venture funds established by independent venture capitalists to creating a corporate unit that makes direct investments in start-ups, some of which are subsequently “spun out” as independent companies while others are “spun in” as acquisitions. For example, when Procter & Gamble’s new venture, Reflect.com, confronted the corporation’s inability to provide it with necessary know-how regarding the Internet and e-commerce, P&G opted to use an “outsourced model,” in which the company worked in partnership with an independent venture capital firm. P&G agreed to invest $35 million in the Web business and keep a 65% equity stake, licensing its patented manufacturing technology to Reflect.com. The independent venture capital firm agreed to invest $15 million and take a 15% equity stake. Each party received two seats on the board. Xerox, in contrast, has opted for a “business incubation” model, forming a new entity – Xerox New Enterprises – in 1996 to capture the value of Xerox technologies in a portfolio of entrepreneurial companies with important document processing hardware and software technologies in various stages of development.

wo other important aspects of design involve the reporting structure and the incentive system. Research suggests that to be successful, a corporate venturing unit must have a high-level champion within the corporation. To increase company-wide support, corporate venturing units should have their managers report directly to the CEO or to a key business-unit head. Designing incentive packages to be in line with the market for venture capitalists as well as with the compensation received by employee peers within the corporation poses an inherent conflict. An effort should nevertheless be made to design an incentive system that fits the goals of the corporate venturing initiative, the risk/reward levels involved, and the length of the performance horizon.

A New Wave

Given the “boom and bust” history of corporate venturing that took place over the last forty years, one cannot but wonder whether the recent economic downturn and the ensuing meltdown among VC firms will lead once again to a reduction in corporate venturing activity. There are certainly some signs of retrenchment. During the first six months of 2001, a number of major corporations disclosed that their venture capital portfolios incurred significant losses. These include banking and investment giants J.P. Morgan Chase & Co. and Wells Fargo, and leading computer companies Compaq and Dell. Lucent Venture Partners, the venture capital unit of Lucent Technologies, is now investing at a slower pace than in years past because of the pull-back among the traditional VCs with which Lucent co-invests. And Motorola Ventures, the venture capital unit of Motorola, will be investing in fewer deals this year due to a shift in investment strategy.

In general however, this go-around appears to be different than past cycles. Companies such as Qualcomm, Nokia, Eastman Chemical Corporation, UPS, General Mills, and even Coca-Cola continued to invest aggressively, even in the dismal fourth quarter of 2000 and the gloomy first quarter of 2001. Despite the serious problems plaguing both Motorola and Lucent, neither company has slated its corporate venturing programs for elimination. And while Compaq recently shut down its corporate development office in the wake of a company-wide restructuring, it still expects to make the same number of venture deals through its existing business units.

he most recent wave of corporate venturing activity reflects a much greater focus on strategic benefits and much stronger long-term commitment by parent companies. The dramatic reduction in funding by independent venture capitalists during this time has created more opportunities for corporations to invest. And the impressive track record of many corporate venturing programs in helping early stage companies develop has given them more credibility with entrepreneurs as well as conventional VCs, who are now much less prone to viewing corporate venture capital as “dumb money.”

Increasingly mindful of the disruptive capabilities of new business entrants, managers of large corporations are more aggressive than ever about winning the creative destruction game. And they appear to have a much better grasp of the important role of corporate venturing in creating opportunities for corporate growth and renewal. Strong financial pressures will certainly force some corporations to reorganize or downsize their corporate venturing efforts. But savvy executives have come to understand that their companies cannot afford to stop investing in innovation during an economic slowdown. So while many VC firms continue to lick their wounds from the “destructive creation” they helped generate among Internet start-ups, corporate venturing has an unprecedented opportunity to drive the next wave of technological change and economic growth.

Ari Ginsberg is Harold Price professor of entrepreneurship and director of the Berkley Center for Entrepreneurial Studies at NYU Stern.