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«John R. Graham, Co-Supervisor David T. Robinson, Co-Supervisor Manuel Adelino Alon P. Brav Manju Puri Aaron K. Chatterji Dissertation submitted in ...»

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6.2 Innovation Improvements and CVC Termination What determines the termination and hibernation of CVCs? To echo Table 4.2, which shows that innovation deterioration motivates CVC initiations, I conclude my analysis of the CVC life cycle by examining corporate innovation at termination.

Table 6.2 Panel A performs simple statistical tests that compare innovation levels at the initiation and termination of the CVC life cycle.

The analysis is performed on all CVCs that can be assigned a termination date (upper panel) and on the subgroup that stayed in business for at least five years. When examining the industry-year adjusted innovation measures, we observe statistically significant improvements at the CVC termination point compared to the initiation stage.

I exploit a hazard model to statistically relate innovation improvements and the decision to terminate a CVC. A CVC parent firm enters the sample in the year of CVC initiation. The key variable of interest is ∆Innovation, which measures the difference between innovation level in year t and that of the initiation year. The result is shown in columns (1) and (2) of Table 6.2 Panel B. The positive and significant coefficients mean that larger improvements of innovation from the initiation year motivate parent firms to terminate CVC investment.

To capture how innovation improvements affect the decision to put CVC into 66 Table 6.2: This table studies the decision to terminate Corporate Venture Capital.

Panel A examines average innovation improvement through the CVC life cycle by comparing innovation performance at CVC initiation and CVC termination (definition as in Table 6.1). Innovation performance is measured using innovation quantity and quality, and both are adjusted using the industry (3-digit SIC level) peers in the same year. I also report the t-statistics for the differences in means between the two time points. *, **, *** denote statistical significance at the 10%, 5%, and 1% levels, respectively. The analysis is performed on all CVCs with a disclosed or defined termination date and the subgroup that lasts for at least five years.

Panel B studies the effect of innovation improvement on CVC termination and investment decisions. The regressions are performed on the panel of CVC sample in their active years. The key variable ∆Innovationi,t is defined as the difference of innovation between year t and the year of initiation. In columns (1) and (2), the dependent variable is a CVC termination dummy, and the specification is estimated using a Hazard model. In columns (3) and (4), the dependent variable is the annual number of investments in portfolio companies, and the model is estimated using Ordinary Least Squares (OLS). Firm-level control variables include ROA, size (logarithm of total assets), leverage, and R&D ratio (R&D expenditures scaled by total assets). *, **, *** denote statistical significance at the 10%, 5%, and 1% levels, respectively.

Panel A: Innovation at CVC Initiation and Termination

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67 hibernation, I investigate the intensive margin of CVC investment—the number of portfolio companies a CVC invests in each year and the key variables of interests, ∆Innovation, are defined as above. Columns (3) and (4) present the results, and the findings are consistent with columns (1) and (2)—innovation improvements are associated with a lower level of CVC activities.

Overall, Table 6.2 matches the finding at the initiation stage, and is consistent with the information acquisition hypothesis, which predicts that when firms regain their upward trajectory in corporate innovation, the marginal informational benefit of CVC shrinks, which in turn leads to the termination or hibernation of the CVC unit.

68 7 Conclusion and Literature Revisited

How do corporations finance and manage their innovation process in the pursuit of long-term growth? This paper sheds light on this fundamental question by studying an emerging economic phenomenon, Corporate Venture Capital (CVC). Armed with an identification strategy that allows me to isolate firm-specific innovation shocks, I find that firms launch CVC programs following a deterioration in innovation, and their main motivation is to acquire information and innovation knowledge from the entrepreneurial sector. This information acquisition rationale leads me to characterize the life-cycle dynamics of CVC—evolving through the initiation, operation, and termination stages—in which CVC parent firms strategically select information sources (portfolio companies), actively integrate newly acquired information into corporate decisions, and terminate CVCs when the informational benefit diminishes.

Beyond establishing the CVC life cycle and the information acquisition rationale behind these activities, the paper is a stepping stone toward understanding several broad economic questions.

Organizing Innovation. This paper joins the endeavor to understand the architecture of innovation and contributes to this literature by suggesting three areas 69 for future work. First, more research should be done to achieve a better understanding of details in CVC operations. Second, the information acquisition motive behind organizing innovation, which I highlight in this paper, has been largely overlooked in the literature (Tirole, 2010) but is worth further exploration. Third, the interaction between CVC investment and alternative organizational forms considered here calls for future studies that could consider the system of organizing innovation as a whole by seriously incorporating the interactions among different organizational structures and a dynamic intertemporal scope.

Information Economics. Information is important in all areas of finance, yet information choices have been hard to study both in asset pricing and in corporate finance, either theoretically or empirically (Van Nieuwerburgh and Veldkamp, 2010).

Empirical work on corporate decisions regarding information management is especially limited by the unobservability of related behaviors. By examining the CVC life cycle, this paper obtains several results regarding information acquisition and use that are hard to show under alternative settings. Future work could explore the CVC setting to answer more questions at the intersection of information economics and corporate finance.

Creative Destruction. In broader terms, this paper provides new evidence concerning the co-movement of entrepreneurship, creative destruction, and economic growth. Entrepreneurial companies and incumbent firms differ in their ability to develop radical and disruptive innovation and to capture new investment opportunities (Hall, 1993; Henderson, 1993; Jensen, 1993; Adelino, Ma, and Robinson, 2016;

Acemoglu and Cao, 2015), and this difference generates the creative destruction momentum. By highlighting CVC as an effective incumbent-entrepreneur bridge, this paper essentially suggests that the two seemingly disentangled sectors could be closely intertwined, which in turn affects both micro-level corporate behaviors and the aggregate process of creative destruction.

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Background Reading on Corporate Venture Capital A.1 What Is (not) Corporate Venture Capital?

Corporate Venture Capital (CVC) is the investment of corporate funds directly in external startup companies (Chesbrough, 2002), usually in the form of minority equity investment (Gompers and Lerner, 2000) made through organized and systematic effort (Ivanov and Xie, 2010). In practice, a CVC parent initiates CVC business by launching a unit (formally or informally), which manages CVC investment for the firm.

In addition to the definition above, it is helpful to describe CVC by explaining what it is not. When a corporation funds an external fund managed by a third party and effectively works as a limited partner, it is usually not considered as a CVC.

CVC is also distinctive from strategic alliances or joint ventures in which two or multiple parties reach an agreement to pursue a set of agreed-upon objectives; in contrast, CVC is an investment-based relationship without specific objectives, and the investment amount is significantly smaller. In essence, it is best to think of CVC as a subset of Venture Capital whereby an established firm is systematically investing, 71 without using a third-party investment firm, in an external, early-stage startup that it does not own or control.

CVC is typically organized as a normal corporate division rather than a traditional VC fund. First, capital sourced to a CVC is almost 100% from its corporate parent (either the headquarters or related business units); more than 60% do not have a fixed amount and fund is allocated on deal-by-deal basis (like capital budgeting).

Second, most CVCs have a corporate mission, and more than two-thirds of them report directly to the corporate headquarter. Third, CVC executives are typically compensated through traditional corporate schemes such as salary or bonus, and rarely via carried interests or schemes similar to carried interests.

A.2 Economic Motivation and Operation: Survey Evidence

In Macmillan et al. (2008), a survey jointly conducted by the National Venture Capital Association, the Wharton School, and the MIT Sloan School, CVC practitioners provide rich evidence that can be seen as supporting the information acquisition hypothesis behind CVC investment.1 In response to a question regarding the important strategic aims of CVC investment, 100% of the respondents agreed on the importance of “CVC provides window on new technology,” 54% considering it extremely important. Ninety-sic percent agreed on CVC’s advantages in “providing window on new markets.” When asked about the specific use of new information accessed through CVC investment, Corporate Venture Capitalists responded: “seek new directions” (92%), “develop new products” (90%), and “supporting existing businesses” (94%).

To fulfill the role of acquiring technological and market knowledge from entrepreneurial companies, CVCs are organized and operated to bridge their corporate parents with their portfolio startups. On the one hand, CVCs actively interact with 1 I urge interested readers to refer to the original report.

72 portfolio companies by taking board seats. More than 75% of CVCs frequently take board seats in their portfolio companies, and two-thirds always take a seat. These board seats are as often non-voting board observers rather than as voting board members. On the other hand, CVCs communicate with business units within their parent firm that are relevant to their CVC portfolio companies—98% CVCs involve R&D or business development personnel in their operation, and 64% intensely do so.

A.3 Acquiring Portfolio Companies

Information acquisition through CVCs seldom evolves into asset consolidation (i.e., acquisition of the portfolio companies). Recent studies examine acquisition cases when CVC investors acquire portfolio companies in which they invested (Benson and Ziedonis, 2010; Dimitrova, 2013). In general, acquiring portfolio companies is rare—fewer than one-fifth of CVC investors acquired their portfolio companies.

CVCs that did conduct such acquisitions acquired fewer than 5% of their portfolio companies (that is, one out of 20 investments). In another tabulation, acquiring portfolio companies constitute about 16% of all the acquisitions conducted by those CVC investors.

Interestingly, Benson and Ziedonis (2010) show that acquiring portfolio companies destroys shareholder value, because the market usually reacts negatively to such deals.

Dimitrova (2013) shows that CVC parents acquire portfolio companies when their innovation productivity is low and that those acquisitions on average signal poor future innovation prospects. In broader terms, these findings are consistent with the information acquisition rationale proposed in this paper—the main benefit of CVC investment is from acquiring information from not specific assets of, portfolio companies.

73A.4 Macromedia: An Illustrative Case

As an illustration of Corporate Venture Capital, consider Macromedia Ventures, a CVC unit launched in early 2000 by Macromedia, Inc., a California-based graphics and web development software company. In the late 1990s, the firm experienced a downturn in its traditional area of media-design authoring software. It therefore laid out a blueprint to explore new technologies on the market such as Internet-based tools and services, and the CVC unit was an integral part of the blueprint. Macromedia Ventures was organized as an internal division of Macromedia, Inc., and invested in entrepreneurial companies on behalf of its corporate parent. Within two years of CVC initiation, Macromedia Ventures had invested in nine companies (12 rounds in total), covering Internet-based technologies such as online distribution and mobile solutions.

The reason behind the CVC investment, declared by Rob Burgess, then Chairman and CEO of Macromedia, “Macromedia already delivers products that define the cutting edge of the Internet, but it is in our best interest to tap the entrepreneurial innovation going on around us, given the pace of the Internet.” The short period for conducting CVC investment was important for Macromedia, because it enabled the firm to recover from its deteriorated condition and firmly establish itself as a successful web firm. The selected portfolio companies guided and facilitated the redevelopment of Macromedia’s product lines and future business models. For instance, Macromedia Ventures invested in Alterego Networks, a developer of enterprise web services that is an innovative extension of Macromedia’s technology, and AtomFilms, an innovative online short-film distributer that facilitated Macromedia’s extension to online entertainment services. Some other portfolio companies were also successful.

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This appendix provides more discussions on the instrument Obsolescence, which is used in the paper to shock corporate innovation.

B.1 The Conceptual Idea and Its Roots The proposition that knowledge obsolescence affects innovation has its roots in four basic observations.

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