THE NEW ECONOMICS OF ORGANIZATION

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 diƒficult and expensive

UR EMPLOYEES ARE OUR MOST VALUABLE ASSET,” many companies

O
“ 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 eƒfective with knowledge workers, who carry most of their
tools with them when they walk out the door each day.

Rather, corporations and their top talent – which doesn’t 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 financial and non-financial, is therefore a critical

skill for tomorrow’s managers. In industries such as soƒtware and wholesale
banking, eƒfective incentive systems and financial structures for delivering
incentives have long been recognized as an important source of advantage.

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 THE NEW ECONOMICS OF ORGANIZATION

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 profitable, will soon find 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 oƒfer companies keen to improve their
incentive design.

The industrial venture capital model

Until recently, enterprising individuals seeking substantial financial 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 firm 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 diƒferences 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 find 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 profits aƒter tax of
roughly US$300 million. Active in a wide range of retail and wholesale

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THE NEW ECONOMICS OF ORGANIZATION

financial services, it has consistently outperformed the S&P 500, with profit
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
fixed-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 diƒficult under a traditional management approach. If, as oƒten 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
eƒforts 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 benefit.

The IVC model helps overcome this diƒficulty 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 oƒfer
powerful equity-based incentives and the freedom to make decisions that
will increase shareholder value. At the same time, they benefit from their
parent company’s distribution power, global reach, reputation, and scale
economies. TAMC provides eƒficient back-oƒfice, 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 financial 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 arm’s 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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 THE NEW ECONOMICS OF ORGANIZATION

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 profitable
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, soƒtware, and pharmaceuticals oƒten 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 firms 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 five 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
first four years of the subsidiary’s 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-oƒf subsidiaries continue to rely on the parent company in their

dealings with the capital markets and for accounting, back-oƒfice support,
and risk management. As well as producing economies of scale, these shared

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THE NEW ECONOMICS OF ORGANIZATION

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 subsidiary’s business. If the full benefits 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 TAMC’s 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 company’s reputation. Fraud or deception in one subsidiary would
harm TAMC’s reputation and jeopardize the success of its other sub-
sidiaries. 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 train-
ing 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

subsidiary’s management team if it is acting against the interests of the parent.
Such a move would be costly and diƒficult to carry out, and would be reserved
for serious regulatory violations, unethical behavior, or prolonged under-
performance.
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
diƒferent, but some issues will apply to all:

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 THE NEW ECONOMICS OF ORGANIZATION

• 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.
• Defining 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 capi-
talist 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 arbi-

trageur, 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 find this step diƒficult. In some cases, an internal mech-
anism 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 financing 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 finding the right
manager or management team. Yet ordinary corporations all too oƒten 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 oƒten 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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THE NEW ECONOMICS OF ORGANIZATION

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-oƒf businesses in a way that
both managers and investors find 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 finances of an IVC company

make intervention diƒficult and expensive. IVC parents typically run numer-
ous subsidiaries from a lean corporate center whose staƒf have little time to
monitor and intervene in day-to-day management. Public shareholding, with
the financial transparency and stronger corporate governance it imposes,
limits the parent’s 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 find 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