Why do incumbents fund startups?

Around a decade ago, incumbent companies in many sectors were extremely wary of the incoming wave of industry disruptors. This was particularly true of the FinTech sector, where the new breed of nimble, light-footed arrivistes armed with the Y Combinator playbook threatened to wreak havoc among venerable incumbents everywhere.

Fast forward a few years, however, and the picture had changed significantly, with incumbents beginning to work closely with startups. And today the picture has changed again, with established firms instrumental in funding entrepreneurial ventures, a practice known as corporate venture capital (CVC).

The prevailing scholarly explanation for this type of corporate collaboration (or “corporate venturing”), calibrated by numerous studies of the USA and Europe, is that incumbents use CVC as a “window on technology”; i.e. as a way to harness the massive, market-distorting power of all that scary technology – artificial intelligence, big data and blockchain – without having to understand it, yet alone develop it in-house.

A puzzling anomaly

But, as a new research paper by Gary Dushnitsky and Lei Yu argues, this geographical focus makes for a rather narrow lens to understand global CVC practices and objectives. Dr Dushnitsky explains: “The study was motivated by a puzzling anomaly – corporate venturing has expanded well beyond the US setting. CVC investments in the US accounted for more than 60% of global CVC deals in 2013, but by 2018 the proportion had shrunk to 41% and is now on par with CVC activity in Asia. The literature is largely informed by the study of corporate venturing in developed countries, but it seems highly unlikely that CVC investors in developing countries are engaging in corporate venturing to gain a window-on-technology, because startups in such countries often profit from dramatic demand growth and are not usually a source of novel technologies; hence the existing scholarly explanation cannot account for the growth of CVC in China.”

To explain the anomaly, the researchers adopted an abductive approach to study the antecedents of CVC in China. China was chosen as the setting of the study because, as Dr Dushnitsky says, it is “a vibrant entrepreneurial setting”, and is second only to the USA in terms of total startup numbers and amounts of funding.

Further, prominent CVC exponents in China – whom the authors quote in their paper – appeared to be motivated by different considerations to the window-on-technology orthodoxy. For example, Bangxin Zhang, Chairman and CEO of educational technology company TAL Group, told his company’s 2016 annual conference that TAL was intent on grasping the many opportunities it foresaw in the education sector but, as it was “not suitable” for the company to develop some of them internally, it would use its “capital, business and resources to support external ventures.”

Likewise, Alibaba Vice President Joseph Tsai told the company’s 2017 Investor Day that, when evaluating potential CVC targets, Alibaba’s primary considerations were (1) whether the target firm could help Alibaba acquire more users and improve their engagement; (2) help it improve customer experience; and (3) help it expand its products and services.

A market-based explanation of CVC

Informed by these and similar industry insights, Dushnitsky and Yu constructed a comprehensive dataset of Chinese CVCs active in the late 2010s by integrating Chinese and international databases. Analysis of the dataset to uncover cross-industry CVC patterns reveals an alternative CVC objective; one that is predominantly associated with harnessing growth through market expansion, rather than the prevailing view of CVC as a window on technology. Dr Dushnitsky says, “The findings mirror the features of the Chinese setting, where entrepreneurs profit from the dramatic expansion in economic activity and serve as a vehicle to leverage the global innovation frontier.”

The researchers cite prior work that finds that “firms in developing countries can enjoy superior performance by leveraging rapid industry expansion; all while using technologies that already exist in the developed world”, again suggesting that industry growth is a key driver of investments in the developing world. Dushnitsky and Yu accordingly introduce a market-based explanation of CVC activity, alongside the traditional technology-based view. In other words, they argue, “many investors are attracted to entrepreneurial ventures that pursue growth by serving rapidly expanding market needs (market-based), rather than by developing novel technology (technology-based).”

Harnessing industry growth

Given the very different institutional setting that China represents compared to Western institutions, the researchers also considered a possible third explanation for CVC growth in China: a government-based argument. Here, Dr Dushnitsky explains, “CVC would be most salient in industries of national strategic priority, consistent with the argument that venture activities differ across institutional settings.”

Possibly counter-intuitively, given the command-and-control nature of the Chinese market context (and the weight accorded to it in the academic literature), the research notably finds that, at the time the study was set (the late 2010s), the cross-industry CVC patterns in China did not map onto industries designated by the government as sectors of national priority.

Instead, the researchers suggest that, while “a broad set of antecedents drive incumbent-startup interactions in the Chinese setting, [CVC] activity predominantly follows a “harness industry growth” rationale and, to a lesser extent, exhibits a “window on technology” objective.

This, says Dr Dushnitsky, is probably due to structural differences between the US and Chinese economies, which “underscores the different roles of CVC (in particular) and incumbent-startup collaboration (more generally) in unlocking corporate growth.”

Different evolutionary paths

The research offers a broader set of explanations for the potential use-case for CVC strategy. The paper argues that, while CVC activities in developed countries “are often driven by technological ferment and a strong corporate R&D base”, there is only “partial support” for such factors in China. The findings highlight that, while “technological advance can be an important inducement for CVC activities, its effects do not rely on the R&D bases within a particular industry. In China, industries that provide firms with resources and opportunities to expand (namely, munificent industries) exhibit a substantial level of CVC activity.”

Dr Dushnitsky says, the implications of the study go beyond geographical coverage “and have the potential to fundamentally reshape our understanding of CVC strategy and its objectives.”

While it’s important to note that the study’s findings are for the period 2014-18 (hence, because the Chinese setting has changed significantly since, they are not necessarily indicative of current VC practices in China), the key point is that CVC is not limited to a strategy for gaining a window on technology – it can also be used to harness market growth.

Dr Dushnitsky offers an instructive analogy: “Every firm has a marketing strategy, but it is not the case that all firms pursue the same marketing strategy. Our study illustrates that point using China as a setting. That is, in countries that experience dramatic GDP growth, it’s possible for firms to use CVC as a strategy to harness market growth.”

Dr Gary Dushnitsky is Associate Professor of Strategy and Entrepreneurship at London Business School. Lei Yu is an Assistant Professor at the Business School of Sun Yat-sen University, Shenzhen, China.