Playing by the Rules: Optionality and Investing

Playing by the Rules: Optionality and Investing

May 16, 2024

Interviewed by Nicolas Sauvage on July 13, 2023

Venture investing is a game of big risks and high rewards. As Girish Nadkarni, former President of TotalEnergies Ventures, told Corporate Venturing Insider, it’s a domain where success stories often erase the memory of countless failures.

Early-Stage vs. Late-Stage Investing: The Barbell Strategy

Girish pointed out that while technology risk is very real in early-stage investments, his experience is that market risk presents a greater challenge. The industrial and energy sectors, for instance, require a long time to mature, and market acceptance is a protracted battle. Startups in these sectors are not like typical B2C companies, which either succeed or fail within the first few years. They need time to establish themselves, overcome infrastructure challenges, switching costs, budget adjustments, and perhaps the most challenging of all, customer skepticism.

“The problem is everyone wants to pluck the fruits and enjoy them, but no one wants to water the trees,” explained Girish.

To tackle these challenges effectively, Girish shared his strategic approach: the Barbell Strategy. This method involves investing in two distinct categories- very early-stage companies with the potential for disruption and companies with at least $5 million in revenue. The $5 million threshold demonstrates market acceptance and product-market fit and distinguishes companies that have overcome the initial hurdles of market skepticism to attract actual paying customers. By adopting the Barbell Strategy, investors can access both the fragile yet innovative early-stage startups and the more established companies with proven market traction.

Girish explained why he chooses to personally not invest in companies that occupy the middle ground. He says they carry a high level of uncertainty associated with market acceptance. They find themselves walking through a valley of death, with burn rate and adoption rate threats looming in the cliffs. Companies that can’t afford to wait for the market to catch up often perish while trying endlessly to enhance their products in hopes of making them more appealing. Adopting a minimum viable product mindset and having the courage to walk away if the market doesn’t embrace the offering separates the good investors from the smart ones.

The Role of Optionality in CVCs

As Girish reflected on his experience with ABB Technology Ventures, a pivotal concept emerged. He stressed that the primary value a CVC arm brings to the mothership is the ability to create optionality. By investing in a portfolio of startups, each with the potential to disrupt or excel in its respective domain, CVCs give their organizations the chance to bet on several potential unicorns but to hedge those bets through diversification.

That luxury is maximized by being early but not too early. While traditional VC investors might seek the next Google or Apple, corporate VCs, particularly in the industrial and energy sectors, should focus on creating multiple pathways to success. This requires the conviction to invest in opportunities that might not seem immediately relevant to the corporation, coupled with the humility to admit that you might be wrong.

“In the industrial and energy space, there are no Apples or Googles,” Girish lamented. “So you need to make sure that you’re getting success across the companies, and the best way of ensuring that is that you don’t lose money.”

The concept of optionality also led to a strategic shift within ABB Technology Ventures. While the tech startup world often celebrates high-risk, high-reward bets, Girish recognized that in the industrial and energy sectors, there were no guarantees of finding the next giant. Therefore, he implemented a more defensive mandate. The goal was not to lose money. In this context, a 3x or 4x return on investment from a startup was to be prized over chasing a potential and elusive 10x or 100-bagger. Ensuring the CVC portfolio’s financial health was paramount because every successful investment contributed to optionality for the future.

Rule-Based Decision Making

Every CVC struggles to decide when the time is right to lock in a win and when it’s better to continue nurturing a promising investment. Girish said that when a company is on the verge of success, and the exit markets seem favorable, the natural inclination might be to ride the wave. However, it’s crucial to recognize that the IPO market can be rough. Locking up capital for an extended period without guaranteed returns can be risky. Girish emphasizes the importance of financial prudence in these scenarios.

“When you have hedge funds coming in, when you have mutual funds coming in when you have non-traditional inventors coming in, it’s the time to run away,” he said.

Girish shares his rule-based approach to protecting the CVC’s interests, When business groups push for investments that might not make financial sense, a put agreement can introduce a measure of safety, allowing the CVC to return its shares to the business at their cost if the investment doesn’t turn out as expected. It’s a smart way to mitigate risk and maintain control over investment decisions.

• Rule One: Show Me the Money — Girish underscores the significance of demonstrating financial success to corporate higher-ups. It’s key to showcase cash flowing into the organization, even if it’s not spectacularly high
• Rule Two: Assess Exit Markets -When evaluating whether to lock in a win or let an investment run, closely examine the exit markets. Consider the company’s performance and the potential for a successful IPO
• Rule Three: Valuation Metrics Matter — Be mindful of valuation metrics. If the market appears overvalued, securing gains can be a prudent choice, especially when the IPO market is challenging
• Rule Four: Put Agreements — When pushed to invest in a deal with questionable financial prospects but benefits the business, demand a put agreement.
• Rule Five: No Riding the Market — Upon an exit event, especially when a company goes public, stick to a rule of selling. Avoid becoming a public market investor, as timing the market may not be within your expertise
• Rule Six: Market Price or Nothing — When the business wants strategic benefits at your expense, insist on selling at market price as this ensures your interests are well protected.

From Girish’s strategic Barbell approach, which effectively separates early-stage innovation from established market players, to his profound emphasis on the importance of optionality in diversifying investments, his journey stands as an excellent example for CVC leaders.