Insights from CompanyCrafters #7

Building Shareholder Value With Internal Start-ups

This article is part of a series that explores how established organizations – corporations, research institutions, even nonprofits – can apply entrepreneurial thinking to become more innovative and successful.

In our last issue, we discussed reasons why so few corporate innovations ever see the light of day.  We mentioned some frequently-cited (and, on the surface, perfectly valid) "excuses" voiced by our corporate colleagues, and we offered some counter-arguments.  Bottom line: it seems a shame that more corporate innovations never come close to reaching their market potential. 

One of the arguments against commercializing a new innovation oft-heard in the halls of Fortune 500 companies is that the potential addressable market isn't big enough.  As an already-huge enterprise, so the argument goes, only very large new business opportunities (measured in hundreds of millions or even billions of dollars in new revenue) will help move the needle on the stock price.

Recently, a division general manager of a diversified industrial products company (let's call it "Major Corporation") was reviewing a break-out new business venture being incubated in her division.  She interrupted the presentation, pounded her fist on the table and declared, "I want tonnage, and I want it now."  She was dismayed by the relatively modest and admittedly uncertain revenue streams her internal startup team was forecasting, and as a result was threatening to cancel the project. 

The problem was that the internal startup they were discussing entailed marketing an experimental new product that was targeted toward a market related to, but not exactly coinciding with, Major Corp.'s multi-billion-dollar mainstream markets and channels.  The new product's design, market segment focus and value proposition all needed further refinement that could best be accomplished by getting out and working interactively with various customers, distributors and partners.  Fundamental aspects of the business model – the product mix, channels and pricing – were therefore still in flux.  Looking at it in isolation, the startup situation called for running a series of small, quick, inexpensive market experiments to determine the idea's potential and map out next steps.  So it was clear that by forcing the "tonnage" issue in the near-term, this fragile new venture would likely be crushed (or its funding cut off because near-term forecasts weren't sufficiently impressive).    

Admittedly, at some level the executive's "tonnage" demand was a rational and responsible one.  After all, as a general manager of an established, half-billion-dollar business unit, this woman's performance was measured on her ability to maintain and grow revenue within a certain profitability range.  Her existing revenue base came from cranking out thousands of units per day of an established, proven set of products and moving them through established, proven distribution channels to address established, proven market demand. 

Indeed, the division chief's marching orders made sense from her CEO's perspective as well.  Major Corp.'s stock was trading at well under 1.0 times annual revenue (and a P/E of 10-12 depending on the day), and the analysts and institutional shareholders were telling the CEO that revenue growth was the way to a higher stock price.  The underlying assumption, obviously, was that Major Corp.'s fundamental market or business model – and therefore its basic margin and market-growth and competitive characteristics – weren't going to significantly change.  Therefore, a simple prescription: more tonnage.

From another perspective, this corporation's single-minded focus on revenue growth was illogical at its core.  After all, the "game of business," at first principles, is all about creating and growing new shareholder wealth.  And whereas Major Corp.'s current, mature businesses were garnering revenue multiples of less than 1.0, the capital markets were valuing high-growth, innovative businesses – ones comparable to this company's nascent internal startup – at revenue multiples ranging from 5 to 12 or higher. 

And, unlike the hundred-million or billion dollar capital investments routinely considered by this company for production or market expansion in its core businesses, the internal startup in question required only a few million dollars per year of "internal venture capital" to see if they had a real winner.  Even if Major Corp. didn't want to continue to house the risky venture internally, they could have spun it out, possibly attracted funding partners, and benefited from a potentially significant equity upside (while being shielded from financial downside risk).