Simply put, I have seen this play out in three different ways after such an investment:
Strategic partner is helpful.
Strategic partner is not helpful.
Strategic partner is painful.
With financial investors, the incentives are typically aligned with the founders, but strategic customers that own equity in your start-up have different interests – they care about their own company first, as you would expect.
A few suggestions to keep in mind:
Put together an outline/termsheet of a business relationship you want with the strategic partner and make sure
you both see the world the same way. Getting a business deal done along with an equity investment can be a good way to discover key sticking issues.
Consider what happens if the strategic partner terminates the business agreement over time but still owns equity in your company. This is a likely scenario so it is important to think about.
Often the strategic investor will want some type of blocking right – that is the ability to block a sale of your company.
The rationale: the investor does not want to see your company being sold to a competitor. Blocking rights are either spelled out as such specifically or there is a softer version of this in a ROFR (right of first refusal). In reality a ROFR is just the same thing and I would not accept that. One way I have seen a start-up navigate this clause is by narrowing the timing of such a blocking right to six months or 12 months. I am not a fan of that either.
Avoid having a strategic customer on your board of directors.
One way to give your strategic customer incentives in your business without selling equity is by giving performance- based warrants. That way if they do not deliver the goods the customer does not own any equity.
Consider how this strategic investment will affect your ability to work with other strategic partners/customers.
Beware of the complicated deal.
If the tone of this post suggests I am not a big fan of strastrategic investments then I have done my job. I am really not. So just be careful and keep your eyes wide open.
Reader reaction
Peter: I have also found strategic investors, thinking about their product first as you mentioned, like to have a disproportionate amount of influence on the direction of your product – that is, it integrates better into theirs, it has features X, Y and Z that only their customers will care about. This is not necessarily a good thing as it can divert you from the bigger product picture that will drive your business beyond that one partnership/investment. Then again, if you need the investment to grow and that is the best scenario to get it…
Bill Jackson: Having been on the "strategic end" of this equation, I believe you need to tread very carefully with strategic investors. They can work but you have to make absolutely sure the goals are very well aligned. Often (in fact nearly always) I have seen investments come along with a business deal, which further complicates the relationship.
For example, I invested in a small company to expand the product line of a very large consumer products company. What we got was a quick way to "experiment" with a new category of product. What the start-up got was a big brand name on their side. Sounded like a great deal. In the end though the experiment for the large company was the lifeblood of the start-up. The results were disastrous and in the end the start-up folded and the strategic ended up buying the assets at an out-of-court bankruptcy. Oh, and I absolutely agree about letting strategics on the board. It is not saying the people who land on your board are bad, it is just that they have other priorities.
Adam Wexler: I agree the cons outweigh the pros.
Paul Lee: Let me bring up two quick points. First, in regards to the board seat, there is a fiduciary duty assigned to the [directorship] and any legitimate investor takes that seriously. I think even strategic investors take that seriously and would not open themselves up to legal liabilities by not acting in the best interests of shareholders.
Second, in terms of the entrepreneur, I think most realise the trade-off here (high-profile business relationship, attractive public relations) and know what they are getting into when they consummate these deals (but in case they do not, your post is a good read).
TekTonic Shift: Suggestion, burn the following into your ROM: keep the strategic’s ownership small, as warrants, no blocking rights and keep them off your board.
Richard Lewis: I believe you did not mention one of the biggest and costliest issues – corporate espionage. There have been numerous, documented cases where a big business "partner" has blatantly stolen technology or prevented it from coming to market.
Scott Ford: Nice perspective Bijan. I would say strategic or corporate investors as a class have wildly diverse motivations. ROFRs are bad (really bad) for the most part, but there are circumstances where they might make sense for the start-up. Tying commercial deals to equity can bring unwanted future complications.
In my experience, the business decision-maker at a big company does not have equity interests nor control of a budget from which to invest. Of course this depends on the size and the importance of the start-up. Some big companies will have a fund to invest in early-stage deals – these investments usually come with no strings that can limit business prospects. A representative from the big company on the start-up board (observer preferably) can be very beneficial, particularly by adding big-company perspective in complex industries. I believe considering strategic investment is a very good idea and can bring multiple benefits – but care must be taken to ensure future complications do not arise as a result.
MITDGreenb: Great post, Bijan. Having been on the big corporate side, I would point out two important factors.
First (obvious), the start-up is a lot smaller than the strategic investor. Except in the rarest circumstances, the start-up will not "move the needle" for the strategic investor’s own products. In an effort to make the deal matter – to make the needle move – the strategic investor will thus "encourage" the start-up to serve clients globally and/or in adjacent markets far before the resources of the startup can support this. This is a recipe for disaster.
Second (less obvious), large companies have a different time constant. Venture funds have a clear timeline relative to the age of the fund, with good visibility over several years. Strategic investors, almost invariably, have an annual budget cycle – even if they have a fiveyear strategy planning interval. That annual budget cycle brings change in product priorities, personnel, and even business models within the investor.
A start-up may get everything aligned on the day of the investment and then find that, as of New Year’s Day, there is a different internal advocate, a different joint promotional plan, a different market strategy and so on. And just when things get going, it is another year and everything changes again. But note that while "everything" may change from the start-up’s point of view, these are marginal, insignificant changes to the investor. Even the strongest internal advocate cannot always ensure the start-up gets a fair say, let alone any sort of compensation for being whipsawed. (Believe me, I tried on behalf of multiple partnerships I created!)
Strategic investor: I am sure the observations in this post are true of some strategic investors, but painting a broad brush like this clearly does not do justice to all the other strategic investors who do not behave as described.
This is analogous to a post on why entrepreneurs should not take money from VCs, as they do not add value, will run for the exits at the first sign of trouble and are only interested in maximising their return at the expense of the employees. Obviously the above description is not true of all VCs, just as Bijan’s description represents less than 10% of strategic VCs.
The kinds of things mentioned in this post (ROFR, for example) are relics of the late 1990s and early 2000s when corporate VCs were new to the investing world. Today’s corporate VCs have learned from past mistakes and are more likely to behave like financial VCs, as there is an arm’s-length relationship between the corporate parent and the VC arm.
Also, with the shrinking number of financial VCs, corporate VCs are stepping up to help fill the funding hole. Most big corporations with VC arms have very good balance sheets and are likely to be less of a syndicate risk compared with financial VCs whose next fund is not guaranteed and in many cases reserves have not been properly allocated. The issue of board seats is also overblown. All directors have the same fiduciary responsibility once they are on the board.
The difference is that in many cases, financial VCs who are board members try to force exits because they are fundraising and need to show returns to potential limited partners while strategic investors have much more patience as they likely have an evergreen fund based on corporate balance sheets.
There are also instances of VCs on the board forcing early exits this year because of potential changes in carried interest taxation.
From his blog at bijansabet.com
Discussion board at LinkedIn Global Corporate Venturing group:
www.linkedin.com/groups?mostPopular=&gid=3102397