Does your startup need cash? Unfortunately, even though interest rates are at historical lows, the current economic uncertainly makes it difficult to secure debt financing. In addition, even institutional investors (VC’s, PE firms, etc.), who generally maintain a long-term view of markets, tend to slow their rate of new investments in turbulent times. As such, entrepreneurs must seek non-traditional sources of capital in an economic downturn.
One non-traditional source of funds is from strategic partners and customers (“Strategics”). In some cases, the capital is invested by professional investors who run the Strategic’s corporate venture capital fund (e.g., Intel Ventures, Google Ventures, etc.). In other instances, corporations make one-off, ad hoc investments in startups which they believe to be strategically complimentary.
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6 Potential Advantages of a Corporate Investment
Valuation Insensitivity – Strategics often accept higher valuations than institutional investors
One of the most positive aspects of taking capital from a strategic partner is that they generally are not as valuation sensitive as VC’s or private equity investors. This make sense, as most Strategics invest in startups to gain a strategic advantage. The return on their investment is of secondary consideration.
Stalking Horse – Strategics can motivate institutional investors to act
Strategics can act as competition to institutional investors. One of the most challenging aspects of fundraising is motivating investors to commit their funds. In the absence of competition, investors are usually better served to wait, before committing their money. The more visibility they have regarding your ability to execute on your milestones, the lower their risk.
Given the natural inertia that precedes a funding event, you must create competition among your potential investors. A corporate investor can often serve as such a catalyst.
Passivity – because the financial return on their investment is of secondary importance, Strategics are often passive investors
Most corporations invest in smaller companies to stake a claim in an emerging market that is outside the scope of their near-term strategic capabilities. For liability reasons, corporations seldom ask for a Board seat. If a Strategic does want a position on your Board, offer them a non-voting, observation seat.
Non-investment Funding – Strategics often provide startups with non-investment cash infusions
Sources of non-investment funds from Strategics include: co-marketing dollars, paid pilots, non-recurring engineering fees, technology licenses, revenue sharing from products sold through the Strategic’s sales channels and products and services purchased directly by the Strategic.
Vested In Your Success – Strategics can be powerful market allies
If your technology is bundled with one or more of your Strategic’s products, it will have a vested interest in your success which supersedes their financial interest. This may prove handy in the event a competitor attempts to disrupt your business, via a price war, intellectual property lawsuit, etc.
Market Validation – a Strategic’s involvement signals market acceptance
Strategic investments communicate that your solution warrants the time, attention and cash of an established player in your space. Thus, an investment from a corporation can bolster your credibility with potential partners and customers.
6 Potential Disadvantages of a Corporate Investment
A Paralyzing Bear Hug – Strategics can overwhelm and disrupt your team
One of the most important aspects of a strategic deal is a pedantically clear Statement of Work (“SOW”). If the Strategic requests that you apply resources beyond the scope of the SOW, you should have the option to say “No.”
If you chose to devote resources beyond those specified in the SOW, the non-recurring engineering fees should be mutually agreed upon before you begin any incremental work.
Round Trip – investment dollars that flow back to Strategic in the form of required purchases made by your venture
Although changes in accounting revenue recognition rules have largely eliminated round trip agreements, they still occasionally crop up in strategic investment deals.
Such deals require the startup to purchase certain goods and/or services from the Strategic. Thus, the investment dollars come in one door and subsequently go out another, adding little value to the venture’s efforts.
Follow The Leader – Strategics seldom act as lead investors
Although including a Strategic in a potential funding round might motivate an institutional investor to act, most Strategics will not lead an investment. Instead, they usually invest after the deal terms have been negotiated and the due diligence has been performed by a professional investor. The exception are corporations which have in-house venture teams, who are more comfortable establishing deal terms and moving forward without waiting for an outside lead investor.
No Exit – Strategics can reduce a startup’s exit options
Corporate investors may attempt to limit and/or influence the nature of your venture’s exit by requesting a Right of First Refusal. This provision gives the Strategic an opportunity to review acquisition offers and issue a counteroffer. Such provisions can encumber your ability to maximize the value of your exit.
If the Strategic insists on this provision, offer them a Right of First Offer. A First Offer provision is somewhat less onerous, as it simply requires you to notify the strategic investor when you receive an acquisition overture. The strategic investor then has a defined time period to make an offer.
Corporate Sidekick – the market may presume your startup lacks independence and autonomy, after taking money from a Strategic
Depending on your relationship with your corporate investor, and the competitive makeup of your industry, there may be a risk that accepting a corporate investment will complicate your ability to partner with, or even sell to, your Strategic’s competitors.
Mitigate this risk in your corporate communications by emphasizing the non-exclusive, arms-length nature of your relationship and make it clear you are open to partnering with everyone in your industry.
An Open Kimono Is Drafty – due diligence can provide prospective corporate investors with insights that make them more formidable competitors
In some instances, a potential corporate investor will decline to move forward with an investment and use the information they’ve learned during the diligence process to more effectively compete with your startup.
One way to limit your exposure is to judiciously share information with the potential investor, as your relationship matures. Don’t over share information too early. Your most sensitive, proprietary information should be withheld until all other aspects of due diligence have been completed, including customer reference calls. Don’t hesitant to say “No” to requests that seem too premature. You can also negotiate a “break up” fee, in the event the potential corporate investor unilaterally backs out of the deal.
Although risks clearly exist within the context of any partner or investor discussions, the advantages of a corporate investment can outweigh the potential disadvantages, if you carefully craft a strategic investment agreement that allows you to call the shots at your venture, including your ultimate exit.