There are many types of investors that participate in financing startups, ranging from angels and family offices to venture capitalists and strategic investors. This piece focuses on considerations related to taking on a strategic investor. Traditional venture capitalists make investments using money primarily raised from external investors, called limited partners, and deploy capital with the aim of a financial return on exit of the investment. Strategic investors (strategics), however, come in all shapes and sizes. Broadly speaking, they are affiliates of corporations that invest on the parent company’s behalf. A strategic investor can take the form of a dedicated venture capital platform, or, more simply, a group within the corporation that makes direct investments. The considerations raised below are generalizations and each investor-investee relationship should be judged on its own merits.
What motivates a traditional venture capitalist is relatively straightforward: the prospect of a return on investment. For a strategic investor, however, motivation can be more difficult to identify. A strategic investor has its own objectives and interests, which may develop and change in line with business need. Here, one may see a divide between strategics investing through a dedicated platform and those making direct investments from within a corporation. Dedicated platforms operate much like their traditional counterparts in seeking a return on investment, but also aim to serve their parent’s strategy. By contrast, pure strategics may focus less on return and more on corporate benefits, like the probability of the startup becoming useful to the corporation’s future operations. A short cut to innovation typically drives strategic investment. Investment can circumvent the need to expend time and money on internal research and development by giving the strategic an inside look at a startup’s frontline innovation. Strategic investors may also want a right of first refusal on a proposed sale of a startup or a right of first look, both of which are explained further below. As strategic investors can vary greatly in their reason for investing, startups should probe a strategic’s overall investing and operational strategy at the outset.
One of the greatest challenges many startups face is gaining access to a market for their products or services. A strategic’s ready-made sales, distribution and other commercial channels that a startup can tap can be a major selling point of strategic investment. In addition to facilitating a market, a strategic investor may even become a key customer of a startup. Separately, startups often require guidance and insight to scale. Strategic investors may be able to offer industry knowledge and connections that their traditional venture capital counterparts cannot.
Sometimes taking strategic investment can hinder business activity in certain respects. For example, some strategics, typically pure strategics, i.e., not those operating through a venture platform, may limit a startup’s ability to sell products or services to the startup’s competitors. A strategic investor may also require a right of first refusal on a sale of the company, which grants the strategic a right to acquire the startup before a transaction can be entered into with a third party. Depending on the terms, this right of first refusal may give the strategic the ability to block a sale to a competitor or any other party, which may have a chilling effect on other potential acquirers who may not wish to negotiate a deal which the strategic investor can later override. Finally, occasionally traditional venture capitalists are somewhat reluctant to invest in startups that have taken on early or large pure strategic investment. Traditional venture capitalists may be concerned that the original strategic may have molded the startup enough at an early stage that pivoting and reorganizing relationships may be difficult. That said, one could argue that having a reputable cornerstone strategic investor can add significant legitimacy to a startup and thereby help attract further capital.
Strategic investors can differ greatly in their investment experience, dealing with entrepreneurs and implementing strategies for success. Strategic investors operating through a designated platform likely will have comparable experience to their traditional venture capital counterparts in deal-making and addressing common issues of entrepreneurs. With respect to pure strategics, however, levels of experience can vary. Startups should always inquire into the experience of the team or person in charge of the relationship at the strategic to ensure the startup will get appropriate input. In addition to conducting due diligence about a strategic’s team, a startup should also conduct due diligence on a strategic’s prior investments.
Strategic investment is mainly attractive because of its comparative price inelasticity, i.e., strategics may be able to write bigger checks than traditional venture capitalists and may be less price sensitive given their strategic objectives. Strategic investors may be willing and able to invest at a higher valuation because profit return is not always the only metric by which they measure the success of an investment. However, a lofty valuation can present the risk of a “down round” in the future, meaning a financing round priced lower than that of the prior round, i.e., the one in which the strategic initially invested. A “down round” can adversely affect employee morale, dilute founder stock and damage a startup’s reputation, to name just a few negative consequences. The risks of an inflated valuation are not, however, unique to strategic investment and would apply to any other non-strategic investment at the same level. Regardless of the type of investor, a lower and more appropriate valuation can sometimes be helpful to a startup in the long run.