Where to Invest

Private enterprises that have served sectors and industries for extended periods of time build a deep understanding of the opportunities that surround those businesses. The people who focus on those areas often have knowledge of where solutions can be developed that don’t exist today, so it can be fertile ground to start. Initial questions include evaluating the gaps in the market – where are they? Are there extensions to existing products of the operating business that have attractive growth and value profiles? The costs of building new capabilities can sometimes be limited and incremental if the new products and services rely on an infrastructure similar to that of the existing business, so they can be quite advantageous to pursue.

For others, however, there is a different reality, with unfavorable characteristics surrounding one or more existing businesses – margin erosion caused by commoditization and/or increased competition, product obsolescence risk, or declining market demand. In those cases, it may make sense to pursue investments in other, uncorrelated areas. While existing market knowledge may not be helpful in this instance, there may be effective business approaches or time-tested values that can create a competitive advantage in a new market. The benefits of ownership and capital also remain.

In the latter instance, there comes a need to ask the honest question: Are we the best people to build this new and unfamiliar capability, or should someone else do it? There is a gradient of approaches to consider. One is to acquire new capabilities through merger. The intention with that strategy is to integrate those newly acquired capabilities into the legacy business to leverage the talent and know-how in the combined enterprise. For this to work, however, the legacy and target businesses need to have cultures that will pragmatically fit together post-merger.

Another approach is to acquire an emerging business and leave it as a standalone operating entity. Here, the owners must rely on the strength of the management team to execute on their vision. Owners must also accept risk of the unknown – whether that industry or business will create or sustain the value that is anticipated.

Emerging industries and businesses are tricky when the industry/business has little track record, or where an investor has little domain expertise. It can be unsettling for business owners who are not accustomed to this kind of uncertainty. In fact, it’s challenging for people who do it professionally.

“Picking unicorns isn’t easy,” says Scott Kupor, managing partner at Andreesen Horowitz, one of the largest venture capital firms in the United States. An investor may have a thesis about an industry and its impact, but it isn’t always clear which businesses will come out a winner. “One of the biggest mistakes that can be made here is getting the category right but picking the wrong company,” Kupor says. Taking a broad investment approach to an emerging industry during early stages increases your chances of finding your way to value creation.

Attitudes Toward Risk

Depending upon the individual, the prospect of innovating can be viewed as a path to salvation or a money pit. Perceptions are usually driven both by intergenerational dynamics and individuals’ risk tolerance.

Leaders in control can have profiles of many types. They can be “builders” – figures who take big risks on big ideas that start with little resources and grow them into large businesses through perseverance. They can be “improvers” who refine the big ideas and make them bigger and better. Then there are “maintainers,” who see opportunity in an existing business to improve profit, scale infrastructure, and navigate changes in the business landscape.

Depending on the type of leader and their time horizon of ownership, the attitude toward risk can vary. Builders are often more willing to put capital at risk with less data because they have strong convictions in their vision for the future and how the business will change it. It doesn’t matter if the enterprise has “been there before” because they have a clear idea of how the business will fit regardless of what exists today. Improvers will tend to be slightly less interested in unfamiliar risk. They will be comfortable with bigger bets when they see the relationship between the existing enterprise and the new venture. Maintainers are typically least comfortable with taking risky capital positions, yet they are often conflicted because they can see risks to a maturing business. Nevertheless, they know they need to do something.

Then there comes the intergenerational dynamics. Rising generations can feel more comfortable taking risk because they might have decades to wait for an investment return to materialize. Conversely, the controlling generation may struggle to see how groundbreaking ventures will ever become profitable. These clashes in comfort levels make it important that the two generations devise a strategy that allocates resources toward things that may never pan out during the lifetime of the generation that is currently in control, recognizing those investments are being made for the benefit of future generations.

Capital Allocation

Innovation capital is inherently risky and gets riskier the further one gets from the things they know and understand. So how do you strategically allocate capital to it given the level of uncertainty? We again turn to Kupor for insight on how professional venture capital investors think about this issue: “We like to make investments incrementally. We will make initial investments in ideas we think have promise. As those businesses hit success milestones, we’ll make follow-on investments. This allows us to increase our position as conviction in the business increases.” He goes on to note that funds also have constraints on how much capital they can invest by virtue of how much they raised.

Family enterprises usually face similar constraints, because there are limits on how much an ownership group either can or wants to deploy into innovation initiatives overall. “It’s critical to preserve capacity to make follow-on investments with the businesses that shine,” Kupor says. For family businesses, this means thinking bifurcating capital into these two buckets and shaping the investment selection around this approach.

Embracing Family and Failure

In family businesses, a desire for innovation is often driven by a rising generation. They observe the enterprise with a broader, desensitized view. They think about what can be done to further build the enterprise for their lifetime. With that comes new ideas about where to find new value.

As with most things involving family, there are some irrational aspects that must be considered. When a next generation member asks an elder generation for resources to invest in innovation, it can be received with inherent positive or negative bias. The positive bias is, “I want to do everything I can to support the next generation and help them flourish. I’ll give them anything they want.” The negative bias would be, “The next generation is disconnected from reality. They don’t understand the world yet. They don’t know what they are doing.” Acting extremely in either direction has consequences. Providing resources without limitation reduces the likelihood of a discipline around investing and filtering quality. If the next generation is barred from thoughtful experimentation, no opportunity can be seized.

Relatedly, failure in innovation is expected, and it is crucial that it be a welcomed outcome by all of those who are involved. Regardless of whether it is a family member or a professional investor, many fail with innovation, and fail often. The key is identifying when it is optimal to fail and how it will look. For example, if a number of investments must be made with limited data points on the probability of success, it should be expected that multiple investments will result in a permanent loss.

The strategy for acceptance is that if enough thoughtful investments are made, the few that make it will more than recover the losses on the others. As follow-on capital is invested, so too is the need for greater visibility and increasing vigilance to think about the overall capital risk position. If an investment progresses, the option set to be considered is always to hold, invest more, or exit. Decisions here must always be dynamics based on all available information.

Growing Value for Future Generations

Innovation and entrepreneurship in family enterprises is essential. To the extent it is an embedded activity by ownership and management, investment activities can help position the enterprise to protect and grow value for future generations. If it’s not an existing activity, owners need not fear starting. Thinking through where to invest – looking internally and externally for opportunity, considering attitudes of owners across generations in devising a strategy, using capital allocation to new ventures thoughtfully, and embracing failure as an expected outcome – will create an environment where investment in innovation can thrive. It’s a great way to collaborate across generations, and when it’s driven by rising generations, watch them have great success while carrying on the family legacy.

Reach out to our Center for Family Business if you are interested in discussing this topic further.

This article was originally published in Family Business Magazine. Read the piece here.