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ACCEPTING STRATEGIC INVESTORS: PROS AND CONS


Getting your startup off the ground is never as easy as anticipated. Yet with relentless hard work, a thorough analysis of the niche market you apply your product or service to, empathic family and friends, and, dare we add, some luck, many entrepreneurs succeed to make their venture visible. More likely additional funding is quickly required to grow and ultimately scale the business. Moneys involved are today significant. Therefore, attracting investors is absorbing a good time of the founder(s). The spectrum of investors, as soon as a company reaches the C round, or even earlier, is essentially comprised of two major types, institutional investors on one hand, and corporate investors on the other. Family offices and foundations represent a smaller share of startup investors, that would generally co-invest alongside institutional and/or corporate investors who both happen to have a proven process and expertise in doing technology due diligence on target investments.

If entrepreneurs have a choice between selecting institutions or corporate investors, the selection must be the result of an analysis of pros and cons. In the vast majority of cases, each type tends to exclude the presence of the other. To better navigate through this conundrum, the following points are to be understood:

1. Strategic investors: who are they?

Strategic investors are corporations or affiliates of corporations that invest on behalf of their parent company, such as Intel Capital, Steamboat Ventures (Disney) or the Peacock Equity Fund (GE/NBC Universal). Sometimes they are formed as Corporate Venture Capital (CVC), other times they invest directly. Strategic investors are companies that engage in targeted investing in other companies either inside or outside of their own industry. In the latter case, only CVCs invest also outside their core business, hence the ambiguous position they hold with their non-strategic portfolio vis-à-vis institutional investors.

In fact, strategic investors are most often operating companies whose interests coincide with the interests of the company they are investing in. Their investment is first and foremost strategic in nature. In addition to providing an inflow of capital, the strategic investor wants to be exposed to a new technology which can benefit its business. The investment is often paired with business contractual agreements. Simultaneously the investor provides industry connections that are beneficial down the road for bringing in additional capital and/or assisting with the sale of the company's products and services.

2. Goals of Strategic Investors:

With strategic investors, the investment opportunities must meet two criteria: financial and strategic. The firs, are not fundamentally different from traditional VCs. Strategic criteria, however, are what distinguishes strategic investors from the rest. They bring a host of expertise that the startup lacks while the startup may be a piece of the puzzle that strengthens the strategic partners’ value proposition. In some instances, your startup business may be so much ahead in its vision about the market that a strategic investor may venture to invest at an early stage.

3. Benefits of having a strategic investor for the startup

Why would an entrepreneur take money from a strategic investor? Here are some of the benefits:

  1. A strategic partner can serve as a new business development pipeline. The outcome is additional revenue opportunities at a fast pace. Larger companies with the same target market can be instrumental in accessing customers.
     
  2. Operating partnership. From product development to sales, strategic investors act as your business operating partner. The partner’s resources replace years of expertise you would have had to build and fund. It is a great shortcut to execution of your plan.
     
  3. Industry expertise. The most important benefit your startup gets from a strategic investor is both an unparalleled domain knowledge with a long history and broad industry contacts suddenly available to you.
     
  4. No limited horizon to force an exit. Strategic investors are not bound by any investment timeline. Therefore, they can envisage a long-term participation, avoiding a chaotic end to the relationship. I have witnessed this is the main reason entrepreneurs favor strategic investors versus institutional investors. Long-cycle business entrepreneurs more than others are inclined to select strategic investors.
     
  5. Potential acquirer down the road: as strategic investors are investing in your enterprise for strategic and financial gains, you will be dealing with a potential acquirer early on. Once the opportunity arises you will have already worked with the strategic investor for some time, enough to know whether an acquisition makes sense or not. Building a pipeline to M&A may be part of the strategic investors’ strategy.
     

Some entrepreneurs are keen on luring strategic investors in the belief that they are less aggressive in negotiating on valuation, because their financial interest is secondary to their strategic interest. Though there is some truth in it, entrepreneurs should never accept an investor based on this criterion. So much value can be drawn from a right investor, that running a financing as an auction is a sure attempt at accelerating failure.

4. Benefits of inviting institutional venture capital firms for startups

In principle, and quite often in practice, venture capital investment is a great fit for high technology enterprises. Below are the three major reasons why many entrepreneurs became successful by attracting VC money:

  1. Venture capital firms focus on maximizing the value of their portfolio. They do not have any other interest on their agenda. It can be reassuring. Venture Capital firms lend their expertise and support their investments with the view to accelerate growth and optimize their internal rate of return.
     
  2. VC money can be funneled early on, unlike strategic investors who rarely invest prior to Series B rounds. There are scores of early-stage venture capital investors. Not all are equal obviously, yet one can find quality, dedicated investors in any technology hub of the VC money world.
     
  3. Venture capital investors are geared towards scalable business models. This is where they are most helpful to first-time technology entrepreneurs who are in discovery phase as to these matters.
     

5. Risks of taking a strategic investor onboard:

There are multiple risks entrepreneurs need be aware of and evaluate before deciding to seal a deal with a strategic investor.

  1. Operating risks: having a visible strategic investor in the capital of your business may reduce the potential sales for your products or services, as you may be barred to sell to your partners’ competitors. Strategic investors have their own operations at heart, hence will favor any initiative that benefits their own operations in the future. Two issues can be flagged here: founding entrepreneurs find the interests are not as mutual as envisaged during the “prenup”; while other investors in the startup consider they are shortchanged.
     
  2. If the strategic investor is a big company, their investment in a startup is quickly drowned within a large bureaucracy. The motivation that was high when the investment was enthusiastically made tends to fade away, and the special relationship between the two entities, investor and investee, loses its character. Consequently, all the benefits of the strategic link will not be realized.
     
  3. When a liquidity event for the venture comes up, strategic investors can oppose a deal, if they have a right of first refusal, because the potential acquirer may be one of their competitors.
     
  4. In the same token, having a strategic investor may prove to be a handicap when trying to engage with other industry players, namely, to negotiate the sale of the company. What was deemed a good potential acquirer will stay away from your venture at any rate.
     

6. Risks of bringing in venture capital investor(s):

  1. governance risk: venture capital investors play an active role in boards as they are keen to influence strategic decisions. Their representation is often disproportionate compared to their relative shareholding. In addition, they negotiate very generous liquidation preference rights in their favor. Many founders tell stories of watching late investors netting a positive return, while other investors could not get their money back, and they, the entrepreneurs, did not pocket a penny from the distribution of the remaining assets in bankruptcy.
     
  2. Forced exit: this is really where venture capital can become toxic. Fortunately, it is a rare occurrence. It involves venture capital funds that are structured to receive money from limited partners, most of whom are financial institutions, large corporations, foundations and family offices of wealthy individuals. The investment horizon of the fund at creation is generally 10 years. As, obviously, the funds are not fully invested in the first year, your startup may attract an investor’s fund with a remaining horizon of only 6 years, after which the investor needs to find an exit. This can translate into a forced sale of the startup, against the will of founders who are penalized for executing on their vision with delays due to unanticipated obstacles of any kind.
     

7. Can you entertain both strategic and venture capital investors?

It is no secret that many VCs have no kind words towards strategic investors and corporate VCs in general. I can’t help quoting Fed Wilson from Union Square Ventures who voiced three years ago his feelings without the least reservation: “‘corporate investing is dumb. I think corporations should BUY companies. Investing in companies makes no sense. Don’t waste your money being a minority investor in something you don’t control. You’re a corporation! You want the asset? Buy it…Making a minority investment in something? What does that do? Make you look smart in front of your boss?”

There are however multiple success stories of technology startups making the best of strategic and VC investors. It is, when tactfully managed, the best way to maximize the creation of value while maintaining, or broadening, the vision. In an ideal world, entrepreneurs step the stages to welcome strategic investors at each level of their execution, as they would also bring in venture capital investors specializing in early stage, A rounds, B rounds etc.

There are examples of recent startups in which strategic and venture capital investors share a common interest: Andapt, Expansion Therapeutics, Nantero, to name a few.

8. What you need to do

  1. First of all, as we at J and M Lab are constantly reminding our clients, each startup is unique. Ask yourself the fundamental basic questions, highlighting the specificity of your domain, your business model, the expertise of the team. What makes more sense to acquire the required resources, accelerate revenue growth, without endangering one aspect of the business, or closing options you want to remain opened as long as possible?
     
  2. As in any aspect of your business, it is advisable to make a minimum of a priori due diligence on investors. Does the strategic investor who courts your business have a good track record in assisting startups and making them blossom? Does it make sense to partner with them, besides the capital made available? Do you have a good apprehension of culture compatibility? Do not hesitate to talk with founders from their investment portfolio companies to obtain information about how the relationship is managed and evolves. Be over cautious when it comes to accepting a “rich” startup as a strategic investor. In the last few years many startups have dedicated significant funds to invest in early-stage startups. They are not equipped to handle investments; they can still go bankrupt sooner than they think; they do not have enough history to warrant a serious commitment in good and bad years.
     
  3. Get the assurance required as to the ownership of the intellectual property your team develops. It can easily become a point of contention in the future.
     
  4. With the help of a good law firm, make sure you go over all the rights to grant the strategic investor, while not locking yourself out from other investors.
     
  5. Never lose sight of your vision. Building an independent company is what you are to focus on to create long term value. Hence you work hard to maintain a balance between investors in your company and remain the arbiter. To be good at it, the recipe is simple: execute flawlessly.