Financial investing is a piece of cake. Well, not really, but measuring success is straightforward – return on investment (ROI). Strategic investing, which corporate incumbents utilise to invest in business partners, is much more nuanced, balancing the alignment between strategic intent and ROI.
Strategic business units (SBUs) within incumbents, the business sponsors for the deal, want to meet their own specific business objectives, while business partners want to maximise their market value. Upfront, interests may be aligned, which is why partners take investments from incumbents – they value the opportunity to leverage an incumbent’s sales channels, technology and so on.
However, if the parties are not careful, alignment can quickly deviate, especially as strategies evolve in a constantly changing market, creating costly distractions and value erosion. Incumbents need to remember that an investment does not mean control. Rather, it is an arm’s-length relationship that requires time and attention to ensure continued alignment to create win-win scenarios. Below are five success factors that incumbents should consider when making strategic investments.
• Invest in quality partners, not commercial deals.
• Consider co-investing alongside professional investors.
• Implement disciplined investment governance.
• Ensure clear business unit accountability.
• Assume every investment has a shelf life and negotiate accordingly.
Invest in quality partners, not commercial deals: Many incumbents look at investments as ways to secure enhanced commercial deals. For example, an incumbent will agree to participate in a partner’s funding round in exchange for competitive or market exclusivity on its technology. As a result, incumbents may have a tendency to overlook key elements that make early-stage companies successful – most notably, the management team.
Conversely, partners that are willing to give up exclusivity to incumbents may be signalling a lack of other options. Furthermore, too much emphasis on the commercial deal has a tendency to drive up prices, as partners will offer exclusivity by asking for a higher pre-money valuation.
Without the proper checks and balances, SBUs may be more willing to accept this since investments are capitalised, rather than immediately expensed to their profit and loss statements like a vanilla commercial payment. This could result in surprise investment impairments down the road.
Incumbents need to be mindful of these grey areas and ensure proper due diligence on management teams, as well as show discipline in deal structuring.
Consider co-investing alongside professional investors: While it is critical for incumbents to invest in quality partners first and foremost, the mindset of incumbents is still to drive strategic value – and it should be. Ultimately, the value incumbents and partners bring to each other is the ability to leverage one another’s assets and capabilities. However, early-stage companies typically have management and operational issues that incumbents are not equipped to deal with.
Bringing in professional venture capital or private equity co-investors can be critical, since these investors typically have a wealth of experience in working closely with management teams on these issues. In turn, this enhances a partner’s ability to work with incumbents, leveraging the guidance of professional investors to help navigate through these larger, more complex organisations.
As a result, incumbents should seek to establish deep relationships with a select number of venture capital or private equity firms that look to invest in the same sectors and identify co-investment opportunities.
Implement disciplined investment governance: Incumbents, which typically ask for board director or observer representation on investments, may seek to put a member of the sponsoring SBU on the board, with the justification that SBUs have the most industry expertise. In theory, the partner benefits from this expertise, and the incumbent benefits from its SBUs acquiring direct insight into the partner’s strategic direction.
But having SBU representatives on boards could create a conflict of interest, as an SBU’s objective is to maximise the value of its own business, which may or may not benefit the partner. Having an investment professional sit on a board provides an appropriate buffer to make sure interests are balanced.
As the steward of the incumbent’s shareholder capital, an investment professional’s objective is to maximise corporate ROI. Internal investment governance is also critical, but many incumbents do not have a disciplined investment approval process. Rather, investments are shepherded through various stage gates of approvals, dragging out deal execution and adding additional strain to the partner, which should otherwise be focused on business execution.
As part of a disciplined investment governance system, incumbents should consider creating a formal investment committee consisting of senior executives with a significant amount of investment experience, to approve deals more swiftly and efficiently.
Ensure clear business unit accountability: One of the biggest challenges with strategic investing is that SBU leaders rotate to new positions frequently. They rarely stay in a single position for the life of an early-stage investment, which can take up to seven years to liquidation, if not more. This has profound impact on an incumbent’s ability to realise value from its investments.
It is not uncommon to see an SBU executive sponsor an investment, but then a mere few months down the road, take a new role within the organisation, or leave altogether. As a result, investments can quickly become orphaned within an incumbent, as the successor may not view the investment as a strategic priority. This has a ripple effect to the partner, which was likely to be counting on the incumbent for specific business needs, impacting the relationship between the parties and even the reputation of the incumbent in the process.
Incumbents should ensure SBU sponsors have objectives directly tied to investment success that may ultimately drive compensation decisions, so that sponsors cannot escape accountability by changing roles. Such expectation-setting can also help ensure greater diligence is performed before an SBU sponsor considers putting an investment up for approval.
Assume every investment has a shelf life and negotiate accordingly: As many incumbents do not adopt the fund management mentality of financial investors, they may not see an investment as having a fixed time horizon. As with an acquisition, incumbents may assume an investment will be perpetual. However, when it comes to investments, an incumbent does not have control, and at some point strategic priorities between the incumbent and the partner may diverge. This is especially true in technology industries where change can occur rapidly.
Unless an incumbent is aware that this is a plausible scenario, it could end up locked into a non-strategic investment with limited exit rights, compelling the incumbent to devote more resources to such a deal than they otherwise should.
Incumbents need to adopt a financial investor’s portfolio management mindset, and negotiate some level of flexibility upfront to secure future liquidity, and then redeploy that capital to new, strategic investments. Furthermore, building relationships with secondary funds can serve as efficient ways to divest such assets.
Of course, these success factors are not meant to be an exhaustive list, and some may be more applicable than others, depending on the firm.
This is an edited version of an article first published on LinkedIn