A nontraditional type of venture capitalist is gaining ground. More than 200 corporate venture arms have been established in the last 18 months alone.
Corporate VCs from IBM (NYSE: IBM), Illumina Inc. (Nasdaq: ILMN) and Eli Lilly & Co. (NYSE: LLY) revealed what they are looking for when they invest in startups at a San Diego Venture Group breakfast Wednesday at the Hyatt Regency La Jolla.
“This is one area that is growing,” said Dave Titus, president of SDVG.
Nick Naclerio, senior vice president of corporate development and ventures at Illumina, got his first taste of corporate venturing at Motorola Inc. (Nasdaq: MOT) 12 years ago, when he was asked to find ways to apply the company’s technology in the life sciences space.
“Eventually the telecom business went in the tank and had to exit that business and sell it to Amersham PLC [in 2002],” he said.
He took away a love for life science tools and uprooted to California. After investing in a series of startups he returned to a large company. Illumina, a top DNA sequencer maker, posts $1 billion a year in sales.
“Most customers are in academic research, though we are recently moving to clinical diagnostics,” said Naclerio.
Its venture fund was founded two years ago with a mission to invest in the ecosystem.
Lilly Ventures is a separate and distinct entity within Eli Lilly, as a limited partner. The venture unit, founded inside Lilly in 2000, spun out in May 2009. Lilly Ventures' first fund was just shy of $200 million.
Lilly Ventures is interested in pursuing companies that could be of interest to Eli Lilly today, as well as any other therapeutic area where there’s a high unmet medical need.
Lilly Ventures has invested in San Diego-based companies since day one, said Ed Torres, co-founder and managing director of Lilly Ventures.
One of those was Conforma Therapeutics, an oncology company bought by Biogen Idec (Nasdaq: BIIB) in 2006 for $150 million.
“It was a great success for us,” said Torres. “Our inside sales pitch for Lilly as a limited partner is we are a supplemental window on innovation in a cost-effective manner. If we are doing our job, they are making money off of us.”
Naclerio’s criteria for investing is first looking at strategic objectives and then the financial return.
It typically invests in Series A and B companies, sticking with a $2 million to $3 million Series A investment range.
Since investments of Illumina and IBM corporate arms are reflected on their parent company's balance sheet, they need to consider the bottom line. Because of that, Illumina typically wants to stay within a 10 to 15 percent ownership range. Investments that reach a 20 percent stake can negatively impact earnings.
Since Lilly Ventures is a spinout, it has more flexibility than other corporate VCs.
Its position is unique because it can invest in areas that may be counter to Eli Lilly’s strategy.
“A lot of others can’t get away with that,” said Torres. “We call them hedges, or exploratory.”
An example is Avid Radiopharmaceuticals, founded by a “brilliant” young man in Philadelphia, Torres said. Its molecular positron emission tomography (PET) imaging agent detects the presence of amyloid plaque in the brain, which is believed to be a sign of Alzheimer’s.
Torres’ team decided to invest in the company at a time when Eli Lilly was using a competing PET imaging agent from GE (NYSE: GE).
“Fast forward to December 2010 and we had an $800 million deal selling Avid to Lilly. So that was a great outcome,” said Torres.
Claudia Fan Munce, managing director of IBM Venture Capital Group and vice president of IBM corporate strategy, started working at the company 28 years ago right out of graduate school. A dozen years ago she helped launched its VC unit.
She doesn't shy away from calling IBM a big buyer. Over the past 12 years, the company has bought 62 companies and partnered with more than 1,000.
“In the pharma space you don’t see that happening at all. It took us 10 years before our parent company bought one of our companies,” said Torres. “Everyone recognizes that life cycles in pharma are so long.”
Historically, looking at the “granddaddies” of pharmas with venture arms — including Johnson & Johnson (NYSE: JNJ), GlaxoSmithKline plc (NYSE: GSK) and Lilly — there are less than half a dozen acquisitions out of a portfolio of hundreds of companies over the past 30-plus years.
“It’s very different on the pharma side. I think the strategic trade-off decision an entrepreneur has to make is different as a result when we think about corporate VCs,” said Torres.
IBM Venture Capital Group relies on its engineers' eyes for strategy and the latest technology. Then it links up with VCs to find companies that would fit into their portfolio.
“We make a very good complementary team with the venture community,” Fan Munce said.
IBM engages with companies “fairly early” on.
“We like to develop that strategic synergy with the company. You need that level of robustness from young partners,” she said.
Once a company is targeted, at least three to five pilots need to be tested successfully in the marketplace before they become an integration partner. At the late stage, they are fed into the acquisition pipeline.
“It’s a long cycle,” Fan Munce said.
She spelled out just how lengthy the process can be. One company that was discovered by IBM in 2004, for example, got invested in 2006, by 2008 had their first pilot and was acquired by IBM in 2011.
Panelists also discussed the dynamics and similarities between strategic corporate investors and traditional VC.
Both VC groups conduct classic due diligence before investing in a company.
Illumina’s fund is small, and most likely, it’s someone else who will be buying the firm. Naclerio prefers not to take a board seat.
“Therefore we are looking for strong VCs who will be active board members, and help drive decisions,” he said. “As a corporate VC you don’t want to be the guy who comes in to fire the CEO. That happens sometimes. You want people around the table who are going to be prepared to carry that burden.”
Torres' team made the decision 12 years ago to always be in a position to at least try and make money.
“That promotes certain behavior," he said. "We are looking for high-quality VCs. We are looking for those with the same investment philosophies and the same pocketbook strength to go through a lifecycle.”
Fan Munce respects financial VCs that possess an "incredible confidence" to identify a young company and a tremendous understanding of the marketplace and technology.
“Our general manager will walk up to financial VCs and literally say, 'so what do you have that I should be buying?'”
IBM's partnerships with large and small venture-backed companies make up a third of its worldwide revenue, which exceeded $106 billion in 2011.
Corporate VCs have also learned some hard lessons along the way.
One of Lilly Ventures’ companies in south San Francisco had a founding CEO who loved the technology so much that “without us realizing it, wasn’t asking the experimental questions,” said Torres.
So, Torres transitioned the founding CEO sideways and brought in someone with big pharma chops and no emotional attachment to the technology.
Nine months later, the replacement CEO strolled into a board meeting and revealed some bad news: the company is a research, not a development, project.
“He said, ‘You have invested in a development project and I think that means you want to shut the company down,’” said Torres.
While they lost all their money in the investment, there was a positive takeaway: He said Lilly Ventures would bank on that straight-forward CEO again.
The panelists also offered up advice for entrepreneurs looking to sell their company to a corporate VC one day.
“When dealing with a large corporation you have to keep your [intellectual property] very clean,” said Fan Munce.
From IBM’s standpoint, taking on the burden of a company muddled in IP lawsuits is not attractive.
Due diligence on the IP side takes the longest, she said, and they have backed out a deal with a company because IBM did not want to take on their legal woes.
In the life sciences sector, a groundbreaking discovery can go a long way.
“If you have really great science, and at end of the day if you do a good job in getting on the radar screen of potential acquirers, science will win,” said Torres.