Welcome to a BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
This week, BetaKit has a special submission from Christian Lassonde, founder of Toronto-based Impression Ventures. Lassonde has advice for startups that are approached by a strategic investor, but aren’t sure what to expect as they pursue investment.
We’ve been approached by a strategic investor who is interested in investing in our startup. As a potential investor in later rounds, do you have any advice or suggestions as we pursue an investment from a strategic investor?
As a startup founder, you’ll likely hear the term strategic investor thrown around. But what exactly is a strategic investor?
A strategic investor is an organization, typically a large corporation not primarily in the business of making venture investments, that invests for a reason other than financial.
Some of the typical ways a strategic firm gets involved include: providing access to its contacts, providing access to its collective experience and knowledge, being a supplier of inputs (raw materials, data sources), a buyer of the end product, a distribution partner/channel partner, and lastly, and most importantly, an acquirer of your startup.
So why would a ‘strategic’ invest early in your startup? After all, it’s likely you are trying to disrupt some or all of an incumbent’s business model. The reason is simple: optionality.
For the most part, early on in their lifecycle, startups are too small to matter, and too numerous for incumbents to pay any real attention. In fact, doing so might cause incumbents to become distracted and fail to use their size advantage to stay ahead of the competition.
Instead, smart incumbents sprinkle investment dollars in the most promising startups within their vertical to provide themselves with two separate and critically important advantages. First, visibility into what is the potential timing, scope, and likelihood of the disruption (in order to stay ahead of those disruptions), and, second, a seat at the table if any of the firm’s existing competitors try to acquire one of these promising startups.
The calculus for startups taking strategic investment dollars is different. The main reasons to accept a strategic investment, other than just simply having dollars available, are to secure the attention of key channel partners, either on the supply and/or distribution side, and to leverage the established brand and credibility of the strategic investor.
The savvy reader will already have noticed a massive problem: a misalignment of interests.
Any well-constructed strategic investment must face this misalignment of interests head-on. Both parties should actively manage the investment in such a way as to create as much alignment of interests as possible.
One important side note when dealing with incumbents: they don’t play well together. When was the last time you saw Coke and Pepsi co-sponsor an event or invest in the same bottling company? Never.
With the right partner, you will be able to access resources that startups wouldn’t normally have access to.
It’s important to note that one of the biggest risks you take when accepting a strategic investment is that you will likely alienate most, if not all, the other incumbents in your space. As it turns out, this is a good thing for your strategic investor. Through the simple act of investing in your startup, your strategic investor is preventing competition from accessing your disruptive technology. However, in order to be successful, your startup requires more than one player at the table.
Accepting a strategic investment from one of the incumbents might severely limit your startup’s ability to achieve success.
I can hear you now: “But wait! My investor wants to see me succeed!” If your investor is a strategic, that’s not necessarily the case. If the investment goes to zero, it’s likely a rounding error on their balance sheet. If you become the next billion-dollar business, they have an opportunity to buy you early and stay in business themselves. Their investment is almost purely optionality.
So why ever entertain an investment from a strategic investor? Because if you can align interests, there can be massive benefits for both sides. Being part of a ‘corporate family’ can provide your startup with a number of key advantages, such as:
Credibility:If the investment is public, your association with a well-respected and established incumbent will provide your startup with important social proof that can legitimize your product/service to your target audience.
Networking and business development opportunities: Introduction and easier partnerships with ‘sister’ companies, other entities the corporate has invested in or wholly owns.
Access to corporate resources: With the right partner, you will be able to access resources that startups wouldn’t normally have access to. This includes everything from off-site corporate retreats with exclusive access to channel partners, to something as simple as being able to talk to a senior CMO or CTO at a Fortune 500 on an issue specific to your startup.
Negotiating power: Being able to negotiate with outside suppliers from a position of strength by signalling you are part of a bigger corporate family. Being part of a corporate family will also likely include access to preferred supply pricing or large distribution channels.
Lower expansion costs: With a global partner, it’s likely you will have access to office space and personnel in other jurisdictions, which potentially will make expansion out of your local market less expensive.
Lower cost of capital*: Simply put, strategics are less sensitive to pricing, given their primary reasons for investing in the first place. If you need a large pre-money valuation, strategics are more likely to close a deal at a higher valuation.
In no way is this list exhaustive. Most benefits of a strategic investment will be industry-specific.
From my experience with strategic investments, I’ve developed some key learnings to help steer conversations towards an alignment of interests.
1.If the interest of a strategic investor is pure optionality (i.e., they don’t intend to help), then I strongly recommend inviting multiple strategic investors into the round at the same time. Having multiple incumbents mutes the “we don’t do business with our competitor’s subsidiaries” problem.
2. Avoid exclusivities. Strategic investors will always ask for these — it’s in their interest to do so — and I don’t fault them for asking. However, it’s not in a startup’s interest to oblige this demand. Should they insist on an exclusivity and should you still want them onboard as strategic partners, we recommend limiting the exclusivity to a very specific set of competitors in a well-defined geography and for a very limited duration (think months, not years). In return for this exclusivity, your new strategic partner should compensate your startup for a potential loss of revenue.
A loss of potential revenue means lower revenue growth. Lower revenue growth means the next round valuation may very well be lower. That will limit your growth and funding potential. Think twice before ever accepting an exclusivity.
3. If you announce publicly you’ve gone into a business agreement with a strategic, make it clear you have other customers a well. If they are the only customers, it will drive the other incumbents away. Consider holding off any announcements until you can make it clear that your strategic investor is one of many clients.
4. Sometime between the signed term sheet and signing the closing documents, make sure you get to know the internal team you will work with. Start working on a post-investment engagement plan. The willingness, or lack thereof, of the team to engage and come up with an action plan should be a good indicator on whether or not to proceed with the investment.
Working with the internal team will give you an idea what the relationship will be like. In one instance I found that the incumbent’s team thought they’d purchased a controlling interest in the startup (they didn’t) and could loop the startup into their corporate politics and bureaucracy. It didn’t end well.
Taking an investment from a strategic investor can lead to some big wins for your startup. However, as we’ve laid out, it isn’t nearly as straightforward as accepting angel or venture capital money.
Our last piece of advice is to consider bringing non-strategic investors into rounds with strategics. While looking out for their interests, VCs and angels will also be looking out for your startups long-term interests. They can help you navigate the complex world of strategic investors.
* This higher pre-money valuation comes with real risks, which we will cover in a future Ask An Investor.
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