Taking Money From “Strategics”

15 Dec

A good indication of how challenging funding has become for many startups in the current environment is the amount of capital being sought from (and extended by) strategic investors in rounds recently closed. The renewed influence of strategic investors is a function of a number of things. Some of the more traditional investors in start-up companies (i.e. VC funds and angel investors) have cut back their activities or receded from view altogether. Some funds have been quietly wound down, others have tabled their activities while they determine their future, and still more have been pre-occupied raising capital for their own funds and not yet in a position to deploy capital. Filling this gap have been other venture firms deploying fresh capital in new investment vehicles, other alternative asset groups (i.e. hedge funds) that are not traditional start-up investors but are looking for returns anywhere they can get them, and strategic partners.

Strategic investors, for certain, can be great partners for an emerging growth company. The cachet and validation that come from the investment into a start-up from a big, established player can have significant value and “signalling strength” across the start-up’s ecosystem. Beyond the obvious monetary benefits, having the seal of approval of a well-respected incumbent can accelerate the business and open any number of doors — to other strategic partners, to new hires, and new sources of funding. It can also have a chilling effect on that start-up’s competitors. Like the impact of securing a key endorsement in a political campaign, having an industry leader partner and fund a start-up can set off a wave of scrambling by others in the same space eager to “lock up” the remaining established incumbents lest they be lost to still other start-ups. 

This is all well and good and generally healthy for innovation and competition. However, I get concerned when I hear start-up teams boast about all the inroads they are making with established incumbents without their clearly weighing the significant costs and risks associated with taking capital from large incumbents. There is an uneasy alliance in many start-up/strategic investor partnerships that should not be underestimated or examined cavalierly. It’s good to remember that by their definition (in many cases) start-ups are often seeking to upset the apple cart in a given sector through a new technology. business model innovation, or other means. This is what VCs mean when they go on about their interest in backing disruptive technologies and business models. In many cases, “disruptive” means disruptive to established players and their franchises.

1. Weigh the impact of the capital against strings attached. Management teams should engage with strategics early and often, but they should never lose sight of the impact and costs of having a strategic investor in their company. There is no free lunch in life and certainly not in venture deals. Why does the team think the strategic partner is making the investment? What motivates them? Are there terms in the investment that could complicate things later? How is the investment treated — equity, debt, a blend?

2. Will having the strategic as investor prevent the start-up from working with the strategic’s competitors? Another big concern that should be weighed by management teams is whether taking capital from the strategic partner will jeopardize the start-up’s ability to partner with the strategic partner’s own competitors. In other words, if my mobile apps company takes money from Palm, can we expect to walk into the offices of Apple or Research in Motion (RIM/Blackberry) and expect them to become clients? Do we lose access to those marquee customers by virtue of selling a piece of our company to Palm?

3. Keep an eye out for ticking time bombs. What IP does the strategic feel entitled to as an investor in the company? Are their markets that the start-up might be prevented from entering or products that it may be prevented from launching as a condition of accepting the strategic’s capital? Are their ROFR (right of first refusal) provisions to be concerned about? All these issues could cripple the company later on as it tries to expand or raise additional venture capital.

As with all things related to taking investment dollars into a growing business, careful examination is key. There really are no “good” or “bad” strategics to partner with but there are good and bad deals depending on how they were struck and how the relationships were managed after the deals closed. The temptation to close rounds by any means necessary now is enormous, particularly given the tight funding environment. Some CEOs may be persuaded to simply accept capital from a strategic in order to get off the funding treadmill and back to running their businesses, but the risks of a poorly structured deal and a bad actor can be severe. Time invested now in examining all the angles before agreeing to take in strategic capital will be well worth it in the long run. Unfortunately, your company just might depend upon it.

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