Venture building meets private equity - turnover yes, but immediately please.

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How private equity companies can use corporate venture building as an enabler for value creation. Innovation and digital transformation - two topics that are no longer foreign to German SMEs and represent an essential factor for private equity (PE) funds to increase the value of their portfolio companies.

Innovation in the corporate environment can involve a wide variety of processes and strategies: from new technologies for employees to intrapreneurship initiatives and (corporate) venture building. In principle, innovation investments are particularly important in the German SME sector, as they strengthen the economic backbone and prosperity of society. One reason for this may be that 99.5% of all German companies are small and medium-sized enterprises, which account for around 97.1% of German exports. In addition, almost half of the world's "hidden champions" are German SMEs. One thing is certain: Investments in the innovation projects of medium-sized companies are full of opportunities.

But what strategy must a PE pursue in order to achieve its goal of a short-term increase in value and an attractive company sale? And what problems and challenges do they face?

Following their investment, PEs influence the short and medium-term strategy of the medium-sized company. In the short term, the aim is to make the company more attractive and increase its (sales) value. The extent and individual initiatives of a strategy adjustment can vary depending on the investment focus, industry or personnel. PEs are confronted with numerous challenges, of which we have identified the following 3 core problems.

Innovation dilemma and cost optimization‍

The focus of a PE is on optimizing the core business. Existing innovation processes, such as efforts in traditional R&D departments, tend to play a subordinate role. These do not promise the necessary value contribution due to their high initial investment. As a result, opportunities to differentiate themselves from other funds and portfolio companies in the long term are missed. Other efforts, such as using the development of new (digital) business models as a lever to increase value, on the other hand, put PEs in the so-called innovation dilemma. On the one hand, their primary goal is to only use off-market capital if the investment promises a return of around 12-16% over a time horizon of 3-5 years that is commensurate with the risk. On the other hand, "value-add" departments are obliged to invest in the digitalization of their companies in order to stay ahead of the competition. PE companies are faced with a dilemma between short-term added value and a sustainable investment effect.

It is important to recognize that the often chosen strategy of classic process optimization is probably too one-sided and not comprehensive enough for future-proof sales growth. In addition, PEs lack adequate resources to better weigh up their investment risk. A sustainable increase in value can undoubtedly only be achieved through innovation within the company and accelerated by new digital business models. Both have the goal of always being able to meet new customer needs in the long term and to use digital applications or processes to increase efficiency.

Lack of digital expertise and control resources‍

When PEs acquire a company, there are often personnel changes in the management of the company - existing personnel are expanded or replaced by new ones. Their immediate goal is to implement their own strategies in the acquired company. Their influence on the (newly) defined strategy, the operational processes and the company's existing innovation projects is correspondingly high. The support of the SME is also important here, as there is often a certain aversion to new strategies in the company at the beginning of the collaboration.  

Despite supporting the SME in the operational implementation of the individual measures, the PE and the new management board cannot provide the necessary expertise for all areas of activity because the main expertise and focus is on the core business. The same applies to SMEs, which therefore see no need to expand the digital skills of their own employees. Employees are simply not fully qualified to drive digital projects and cannot contribute any value in this regard.

A compromise solution is often the newly appointed Chief Digital Officer (CDO) position, which is supposed to provide and promote the missing innovation expertise. However, they also have to find their way around rigid processes and a lack of resources or budgets, which takes time - and that time is lacking.

Lack of decision-making speed in the company

The strength of SMEs lies in the fact that they largely operate in integrated value chains. However, this strong integration with numerous stakeholders also leads to long content-related processes and decision-making paths. Strategy changes and process optimizations in medium-sized companies or large corporations therefore often take longer to take effect. This is compounded by the fear of business decisions that could jeopardize the core business or the relationship with the main customer. There is often a downright risk aversion to new projects and measures, which has a direct impact on the speed of decision-making.

If innovation projects such as the development of new, digital sales channels or business models are then also initiated, there is often considerable internal resistance from middle management, which robs the innovation projects of the momentum they need to function in line with the market. This is in complete contrast to the objectives of the PEs and shareholders, who are primarily interested in increasing the value of the company through rapid (new) sales or reduced costs.

The variety of challenges hinders the promising value growth of a portfolio company and thus reduces its attractiveness for potential buyers. The following key questions therefore arise:

How can the PE's innovation dilemma and the associated challenges be solved in order to promote a promising increase in value? And how can a PE's investment project in innovation projects and the associated risk be reliably assessed?  

Private equity firms and SMEs are still leaving important value creation opportunities untapped - especially when you consider that they have many opportunities to turn interesting venture ideas into actual companies. Some of these ideas could speak for the innovative capacity of SMEs and be considered positively in the evaluation. Others of these ideas could develop into unicorns. And still others could merge with existing portfolio companies and thus create added value within the Group.
A (corporate) venture builder (VB) is suitable for tapping into this potential and bridging the challenges described. A venture builder supports the development of new (digital) business models with the help of a dedicated, heterogeneous team and in close cooperation with corporate. The aim is to quickly tap into unused business areas and new customer segments in order to generate additional sources of income outside the core business.  

When working with a VB, PE and SMEs benefit from four core elements in particular:

The VB acts as a mentor for SMEs and as an enabler for PE

‍Inthe joint and operational conception of digital business models, the VB takes on an active mentoring role for SMEs in order to support them in the implementation of their start-up endeavors. The enriched experience and expertise gained through working with other clients enables the VB to encourage the SME's team to adopt new and previously unknown behaviors and to break up old processes in the process. For example, the VB encourages all team members to take on a proactive role in the project approach in order to penetrate the existing hierarchical structures. The basic aim is to "infect" the team of the medium-sized company with the working methods and the innovative founding idea of the VB in order to gain speed and achieve relevant results in both the short and long term.

At the same time, this puts the VB in the role of enabler for the PE. This means that they act as an extension of the PE and implement the PE's innovation and value enhancement strategies. In this way, they take on the resources that the PE lacks and supplement them with their digital expertise. The PE also benefits from valuable synergy effects for other portfolio companies from the same sector or similar innovation approaches. The VB can support these in the form of knowledge transfer and the exchange of insights and industry experience with other portfolio companies. PEs can also merge various innovation projects with each other if they exist outside the corporate structures and thus generate overarching effects to increase the value of their portfolio companies.

The venture building process corresponds to the approach of a PE‍

The general venture building approach is particularly suited to the needs of PEs, as it involves greater speed and lower innovation risk. These advantages result from a methodology that is common for innovation over an approximate period of 12 months, starting with the identification of problem and solution areas, the validation of a derived business idea through to the establishment and support of a finished venture team. In all these phases, the new product is tested for its market attractiveness at all times. In addition, value drivers such as prototypes, landing pages, leads and much more are created at an early stage, reflecting the initial sales potential. This allows the investment risk to be assessed in the best possible way.

During the innovation process, hypothesis-based work, the creation of market-oriented prototypes and business potential assessments drive the work results forward in an iterative and forward-looking manner. Regular decision gates between the development phases promote transparency and communication between all those involved and help to steer the innovation process. The PE in particular receives a reliable "360 degree" overview of the impact of its investment and can follow up on the most convincing ventures.

During the entire innovation process, the venture building team ideally works independently of the core organization and is supported at management or CDO level. This means that project-dependent decisions can be made more quickly and rapid progress is guaranteed. This is of particular interest to a PE due to the investment horizon.

Other evaluation criteria‍

In contrast to core business optimization or classic innovation from within the company, new (independent) corporate values are created in venture building. This is not only evident in the spin-off with its own product/service or team, but already in the early phases of venture building. It is certainly difficult for PEs to evaluate these newly created assets, as standard return-on-investment (ROI) metrics are imprecise and of limited value in this early phase of the company. For this reason, other criteria are required to reliably evaluate the innovation or venture building process and its results.

First of all, all venture building measures are assigned a confidence level. This allows the resilience of business ideas to be checked at any time. PEs can thus derive and evaluate business developments, such as tech, infrastructure, target groups and customer growth, in line with their time horizon at an early stage. The assessment of the security level is based in particular on the number and strength of the experiments carried out, such as market analyses, interviews with customers and product testing. With the help of this customer-centric approach to venture building, customers are integrated into the process of identifying problem areas and solutions at an early stage. Letters of intent (LOI) are used to establish further cooperation with customers and prove their general willingness to pay, which in turn indicates sales growth. All of this information allows for an initial evaluation of new business models.

Active partnership instead of entertaining advice‍

At least as significant as the previous findings is the (new) importance that PEs, SMEs and VB attach to their partnership and cooperation. In its function, the VB does not act like a classic service provider. Instead, they are willing to participate in the risk and success of the venture at an early stage and are actively involved in the success of the business with their own strategic mission. At an operational level, this can manifest itself in a flexible remuneration model including a performance-based fee or bonus if targets are successfully achieved. Ultimately, this represents a win-win-win situation for all three parties: PE companies take away the fear of risky investments; SMEs achieve real results; and VB can build a sustainable profitable stake in the venture.

Closing words‍

Corporate venture building is the fastest way to maximize the valuation of medium-sized companies. Even if innovations may initially be a cost driver, they should not be measured in terms of a company's EBIT, but in terms of long-term sales growth. Newly established business models already generate these sales in the short term and thus contribute positively to the company valuation, even if this is reflected in earnings (EBIT) in the long term.
Of course, PEs have to face the aforementioned challenges. One of these challenges is the innovation dilemma, which forces PEs to position their innovation investment in a targeted manner and then be able to value it. It is also important to supplement the lack of digital expertise in SMEs, both through new management or departments and through external partners. This creates new skills and, above all, is a driver for previously slow (innovation) processes in SMEs.

Feel free to contact us if you want to drive innovation in your (portfolio) company through venture building!


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