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Industrial venture capitalism: Sharing ownership to create value

The idea is this: share ownership of assets with the managers responsible for generating value from them Then create greater transparency between markets and these owners And make sure intervention is both dicult and expensive

many companies claim. Are they right? Yes and no. Valuable, certainly; many business leaders and management thinkers believe that only a small number of people in every company are responsible for creating a major part of its wealth. But an asset? Not really; as economists would say, a corporation has no rights of possession over its employees. And the corporate assets property, plant, and equipment that traditionally conferred power over workers are less efective with knowledge workers, who carry most of their tools with them when they walk out the door each day.

UR EMPLOYEES ARE OUR MOST VALUABLE ASSET,

Rather, corporations and their top talent which doesnt just mean that at the top of the hierarchy are engaged in a kind of joint venture or partnership, a relationship whose future both sides continually evaluate. As in any relationship, both sides need incentives if they are to cooperate. And even in the closest partnership, there is competition to capture value. The design of incentives, both nancial and non-nancial, is therefore a critical skill for tomorrows managers. In industries such as sotware and wholesale banking, efective incentive systems and nancial structures for delivering incentives have long been recognized as an important source of advantage.

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Industries such as steel making, which appear to be less knowledge-intensive but increasingly rely on the talent and energy of a few individuals to make them protable, will soon nd themselves in the same position. Strong incentives, devolved accountability, and credible performance measures are economic complements. Each reinforces the rest, and if one is missing or weak, less value is created. Fortunately, organizational economics has useful theory and practice to ofer companies keen to improve their incentive design.

The industrial venture capital model

Until recently, enterprising individuals seeking substantial nancial rewards had little choice but to leave their employers and seek outside venture capital to set up their own businesses. But new models are emerging that embed the initiative of an entrepreneurial rm within a large corporation. We might describe them as forms of industrial venture capitalism. The industrial venture capital (IVC) company attempts to marry the environment of a small entrepreneurial start-up with the administrative convenience, scale economies, and risk reduction of a large corporation. Like conventional corporations, IVC companies own assets that allow them to deliver products or services to customers in order to create value for shareholders. But there are several fundamental diferences in the way they work. Whereas large corporations tend to hold all assets in common (either in one entity or through subsidiaries), IVC companies share the ownership of certain assets with the managers who are responsible for generating value from them. They nd that managers who own a share in the business they are running extract more value from it, just as workers who own their tools will tend to take better care of them Large corporations can shelter unproductive assets or subsidize businesses that destroy shareholder value; IVC companies, by contrast, subject many of their business activities to the direct scrutiny of the capital markets. This limits any tendency they might otherwise have to hold on to unproductive assets. Indeed, IVC companies, like ordinary venture capitalists, are quick to divest an asset when they are no longer advantaged owners compared with other capital providers.

Becoming an IVC: The case of TAMC

The Asset Management Company (TAMC), a real but heavily disguised company, has a market capitalization of US$5 billion and prots ater tax of roughly US$300 million. Active in a wide range of retail and wholesale

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nancial services, it has consistently outperformed the S&P 500, with prot growth of about 15 percent per year for the past two decades. TAMC aims to transform itself into a Fortune Global 100 company. Over the past few years, it has successfully expanded its fund management and distribution capabilities to Europe and Australasia, and centralized its global xed-income funds management business. In pursuit of its growth strategy, TAMC is undertaking a series of projects to begin its transformation into an IVC company. Their purpose is to create an entrepreneurial environment that will attract, retain, and motivate talented people. TAMC wants to set up a pension fund distribution venture to reach retail customers directly, without recourse to brokers or advisors. Its growth prospects are attractive, but threats from foreign and domestic competitors make success uncertain. Hiring the right person to lead the venture would be dicult under a traditional management approach. If, as oten happens, the chosen manager has the option of returning to the parent company should the venture fail, he or she will lack the commitment to devote extraordinary eforts to building it. On the other hand, if that option is not available, failure of the venture will mean serious career damage for its manager, while success will bring only moderate benet. The IVC model helps overcome this diculty by providing incentives that are both powerful and symmetrical. TAMC holds 75 percent of the equity of a number of smaller businesses; the remaining 25 percent is held by their managers. These businesses attract talented people because they ofer powerful equity-based incentives and the freedom to make decisions that will increase shareholder value. At the same time, they benet from their parent companys distribution power, global reach, reputation, and scale economies. TAMC provides ecient back-oce, accounting, and legal services for the new venture so that its managers can concentrate on their core business. As well as attracting talented people, equity-based incentives align managers interests with those of the parent company. Both are seeking to maximize the long-term value of the subsidiary. In this arrangement, the managers gain autonomy and nancial reward, while the parent company participates in the value created by the new venture something it could not do if the subsidiary purchased products or distribution at arms length.

Other IVC models

The model adopted by TAMC to exploit growth opportunities is not the only option. Some corporations have used the IVC model to commercialize ideas that are peripheral to their core business. Others have employed it to create

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value in situations where businesses could not prosper within a large and bureaucratic corporation. Finding that certain routes persistently turn in a loss, some airlines have sold those routes to local management, only to see them become highly protable under their new ownership. Similarly, many oil companies have watched divested assets multiply in value as soon as they leave the management processes and culture of a giant corporation. Had they adopted the IVC model, the sellers would have received a share of that value. Other companies have used IVC approaches to take options on technologies whose future value is uncertain. Talented researchers in industries such as electronics, sotware, and pharmaceuticals oten have little interest in being employees in a giant corporation. The IVC model lets corporations use equity stakes to gain options on technologies should they become valuable, either by buying into small research rms or by setting up quasi-independent subsidiaries in which the researchers can work. These examples illustrate that there is no ideal way to act as an IVC company. Choosing an appropriate model is a critical strategic decision.

Making an IVC work

To succeed as an IVC, companies must overcome at least ve challenges:

1. Secure the value

The IVC company must ensure that it captures a substantial share of the value that is created by its subsidiary. TAMC faced the risk that its best fund managers might defect to competitors, taking their clients with them. To prevent them doing so, it tailored incentive systems to make staying with the company more attractive than leaving. Managers stakes were structured so that their value was depressed in the rst four years of the subsidiarys operation as a deterrent to moving on. TAMC also uses policy and contractual mechanisms to retain its managers: Non-compete clauses seek to prevent managers from working for a competitor for a long period. All client contracts are written with TAMC, not its subsidiaries, helping ensure that the company owns relationships with clients. Spun-of subsidiaries continue to rely on the parent company in their dealings with the capital markets and for accounting, back-oce support, and risk management. As well as producing economies of scale, these shared

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services raise the cost of switching should the managers of a subsidiary wish to move to another parent. TAMC controls marketing activities, ensuring that the corporate brand appears on all literature and is not subordinated to individual managers identities.

2. Ensure knowledge is shared with the IVC

One of the key challenges for an IVC company is to ensure that as much knowledge as possible is transferred from the subsidiary to the parent so that its knowledge is constantly refreshed. Some companies use information systems to link subsidiary to parent. Others devise incentives to align managers interests with the success not only of the subsidiary but also of the parent, thereby promoting knowledge sharing.

3. Devolve decision-making authority

A great temptation for the IVC company is to intervene in the management of the subsidiarys business. If the full benets of entrepreneurialism are to be captured, IVC companies must devolve decision-making authority in a credible way. To this end, TAMC executed a letter of intent with one subsidiary stating that it would not intervene in the management of the business. Although not formally binding, the letter signaled TAMCs wish to act like a real industrial venture capitalist.

4. Minimize reputation risk

One of the costs of devolving decision-making authority is risk to the parent companys reputation. Fraud or deception in one subsidiary would harm TAMCs reputation and jeopardize the success of its other subsidiaries. To mitigate this risk, TAMC attempts to inculcate its own values within its subsidiaries. It selects partner companies and managers with great care, gets its subsidiaries management teams to take part in its training programs, and links some of their incentives to the performance of the parent company. Through its majority ownership, TAMC maintains the right to remove a subsidiarys management team if it is acting against the interests of the parent. Such a move would be costly and dicult to carry out, and would be reserved for serious regulatory violations, unethical behavior, or prolonged underperformance.

5. Optimize deal structure

A key success factor for an IVC company is the design of the contracts between the parent and the managers of its subsidiaries. Every deal is diferent, but some issues will apply to all:

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Determining the ownership split between the IVC company and the management of the subsidiary;* the type of equity, real or phantom; public or private equity; and whether management has to purchase the equity or earn into it. Determining how disputes should be formally resolved and ensuring that contracts are enforceable. Dening the exit plans: exit triggers, valuation methods, and mechanisms for asset disposal.

New mindset and skills

The transition from an ordinary corporation to an industrial venture capitalist company is not a simple one. In particular, it calls for a new mindset and new skills. Readiness to exit. A true venture capitalist operates as a knowledge arbitrageur, buying assets that the market lacks the knowledge to value fully, and selling them as this knowledge asymmetry with the market evaporates. Venture capitalists therefore think about exit at least as much as they think about entry. An IVC must operate with a similar mindset. When it is no longer the natural owner of a business because its information advantage or other form of synergy has disappeared, it withdraws capital from it. Most corporations nd this step dicult. In some cases, an internal mechanism is needed: one oil company operates an independent investment bank charged with selling assets for which the company is no longer the natural owner. It has the power to sell over the heads of protesting business unit managers. Other companies have used innovative nancing vehicles securitization in particular to withdraw capital. Management selection and development as the primary means of intervention. Venture capitalists put a lot of energy into nding the right manager or management team. Yet ordinary corporations all too oten act as though managers are dispensable. The head of an IVC must become a skilled selector and developer of people. In many cases, this means giving managers more scope than conventional personnel processes would allow. The chief executive of one top energy company was concerned that his managers were not ready to start operating in an IVC mode. But as he
The ownership split is oten a function of the strategic role of the subsidiary. IVC companies tend to hold small shares of subsidiaries whose primary role is to test uncertain technologies, but retain a majority holding of those created in order to exploit a proven technology in a more entrepreneurial environment.

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increased their freedom and exposure to market discipline, their performance improved so dramatically that they were targeted by headhunters as potential chief executives for independent energy companies. Making subsidiaries credible to the capital markets. As noted, an IVC needs to give managers control of their spun-of businesses in a way that both managers and investors nd credible. Investors will discount shares if they believe that the parent company can withdraw critical resources from its quoted subsidiary on a whim. In most cases, intervention by the corporate center is still possible because the parent owns a majority interest in the subsidiaries. However, the disaggregated organization and nances of an IVC company make intervention dicult and expensive. IVC parents typically run numerous subsidiaries from a lean corporate center whose staf have little time to monitor and intervene in day-to-day management. Public shareholding, with the nancial transparency and stronger corporate governance it imposes, limits the parents right to withdraw capital, make radical strategic changes, and even reallocate key managers. Both subsidiary managers and investors know that the parent company will intervene only if the subsidiary acts in a way that threatens the corporation as a whole. By publicly demonstrating the high cost and complexity of routine intervention, IVC parent companies can provide investors in the subsidiaries with assurance that their fortunes will not be unreasonably compromised. Operating as an IVC company thus demands a wholesale change in the attitude of senior executives. In particular, it calls for a readiness to confer considerable responsibility on less senior managers. But, as many companies have discovered, it can unlock hidden entrepreneurial energy and create substantial shareholder value.

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THE CEO AS ORGANIZATION DESIGNER Twenty years ago, very few managers thought in terms of designing a corporation. But the number is growing. Two reasons lie behind the increase. First, many organizations sense that things are no longer going well. Consequently, many senior executives see that their primary role is no longer to exert direct control, but to educate their people. They may not be sure precisely what education is needed, but they have stepped away from running everyday operations to lay the groundwork through education so that other people can make better decisions. Second, many managers no longer nd a computer frightening. They have had experience with computers and are willing to apply them in new ways. We are moving toward a time when increasing numbers of corporate executives will be ready to take on the role of corporate designers. To succeed, they must realize that redesigning a corporation will take even longer than designing, producing, and marketing a major new product. Corporate redesign can be a ten-year job.
Mark Keough and Andrew Doman, The McKinsey Quarterly, 1992 Number 2