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What Are the Pros and Cons of Investment From a Strategic Entity?

Q:  Can you please touch on issues associated with first round financings from corporate or strategic investors. Particularly when the strategic is a competitor. What are some of the pitfalls and opportunities associated with this type of an investor in an early stage company?

A: (Jason)  There are both potential positives and negatives taking money from a strategic investor.  And despite the arguments for and against, there is also are no bright line rules on wether or not you should accept strategic money.

Let us first look to the positives.  Usually the biggest perk is the ability for a strategic investor to be able to accelerate and help your business in ways that a venture capitalist can’t.  Strategics can offer access to manufacturing capabilities, technical resources, sales channels, foreign joint ventures, guaranteed retail shelve space, etc.  The strategic can leverage their business to help you.

Also many strategic investors don’t consider themselves "financial investors" in the same way that venture capitalists do.  So while a VC might need to realize a return in 5-8 years and be happy with a certain return, many strategics are deriving other benefits besides the ultimate return.  Therefore, they may be a little easier on you if things don’t go quite as planned, so long as they are still deriving utility from the other benefits. 

This also can lead to a problem, though.  If you investor isn’t ultimately financially motivated to see your company succeed, that can be a conflict between them, you (assuming that you are financially motivated) and any venture investors (who I guarantee are financially motivated).  You may find yourself trying to make decisions that will promote one set of interests over the other.

We’ve seen this many times.  The questions is "how do I know of my strategic investor is motivated by venture-type returns versus ‘something else?’"  Here are some clues:

  • If your strategic investor is asking for terms that a venture capitalist would not, such as:
    • A right to buy the company / first look / call agreement (which you should never agree to, as this will kill any other potential suitor from speaking to you);
    • Warrants / other equity kicker for free or based on services provided to the company;
    • Restrictions on who you can sell your product to; or
    • As a condition to financing, entering into some sort of business arrangement.
  • If you ask them if they are financially motivated and they say no.  (Don’t laugh, many will be completely open about this.

To be clear, even if your strategic is not financially motivated, it still might make a ton of sense to take money from them, you just need to weigh the benefits of the "stuff" they bring to the relationship besides money.  For instance, a performance-based warrant for true performance may be appropriate. 

One thing to consider is a board / observer seat.  Most strategics don’t want a board seat as they don’t want the fiduciary duty issues present with their own business and yours.  This is especially true if your strategic is a competitor.  But they many times will ask for an observer seat and you need to carefully consider what type of information will be in their hands at the end of the day. 

A note on competitors investing in your company.  I haven’t seen many of these arrangements end well.  Usually, the distrust of sending information back and forth quickly chills the relationship.  Do you really want your competitor getting your financials and board presentations?  Do you want them to know if you are negotiating a deal with one of their other competitors?

In general, we’ve had both good and bad experiences with strategic investors.  We’ve had deals that without them, we wouldn’t have had nearly the success that we did.  We’ve had deals where we never saw or heard from them again after the funding.  We’ve had other cases where the noise in the machine caused by their wake was quite disturbing.  In this particular case, it appeared that the strategic’s sole intention was the bankrupt the company and take their technology. 

It’s really an individual choice.  I’d recommend getting references from prior investments that they’ve made to see how helpful they really can be. 

August 20th, 2008 by     Categories: Fundraising    
  • http://startupcfo.ca Mark MacLeod

    I have mixed feelings about strategic investors. Can be really good or really bad. Here's my take: http://startupcfo.ca/2007/05/strategic-investor.h

  • http://www.bakerpacific.com/blog/blog.html David Shanberg

    On the other side of the coin, but not inconsistent, here's my viewpoint on the pros and cons from the standpoint of the potential strategic investor:
    http://www.bakerpacific.com/blog/2007/09/should-w

  • tony huang

    Suppose corporate investor A made a strategic investment in startup company XYZ. Later another company let's call corporate investor B makes an attractive acquisition offer for XYZ. The only problem is that A and B are direct competitors to each other. Now, what's company A suppose to do? It took a risk and invested money in XYZ, and now it has to hand over XYZ's technology to its direct competitor? If I am share holder of company A, I won't be too happy about this outcome, but if company A doesn't accept company B's offer, it will be standing in the way of XYZ company's best interest. This is a catch 22 scenario that I've often used to question the merits of corporate investing but have never received a satisfactory answer to.

    • http://www.jasonmendelson.com Jason Mendelson

      It

  • tony huang

    So you might say, okay, then why doesn't company B make an offer to acquire XYZ? Well, we all know corporate investors don't always make strategic investments with the intention of buying the company later on. Often times it just wants first look at leading edge technologies. So if company A won't (or can't) make a matching offer, but fears XYZ's technology fallen into the hands of company B and hence make life difficult for XYZ to pursue the M&A deal with company A, nobody wins.

    • http://www.jasonmendelson.com Jason Mendelson

      Except the startup might win.

  • http://martijnpannevis.nl/blog/ PanMan

    Another worry with a strategic investor can be that he might slow your growth, if he wants certain exclusivity over its own competitors, that otherwise could have become your customers.