Strategic Investing: Pros and Cons for Startups
One of the startups I am working with is looking at taking money from a strategic investor. What are some of the pros and cons of taking strategic money?
Excellent question. On a simplistic level, a strategic investor is one who derives value from working with your company beyond the investment itself, and often has some parallel commercial arrangement with you. If you had a service you wanted to test with Amazon to increase its sales 1% (that’s nearly $1 billion extra to Amazon, by the way!) and Amazon wanted to invest during the test, Amazon would be a strategic investor.
Because a strategic investor benefits from your business success, it can afford to be generous by giving you a high valuation, as stock is not its only way of making money from you (unlike a venture fund). Strategics provide other benefits, such as knowledge, equipment, test facilities, laboratory space, distribution, enterprise test environments, sales assistance, and market validation.
There are many downsides, however, which will occupy a whole lesson in a future course — and which you need to manage. Strategics often want the right to buy you later if they make you successful. Their negotiated rights might deter other buyers from making an aggressive bid, or even bothering to try to buy you at all. Indeed, the fact that you are working with one strategic player at all might make you “contaminated” in the eyes of the other potential buyers in your space who compete with your strategic, decreasing your future value.
Strategics often demand rights to information and to attend board meetings, where they can gain confidential information about your deals with their competitors and obtain knowledge which makes it easier for them to exploit you in future negotiations. Larger companies also often insist on heavy-handed intellectual property ownership rights for services you perform for them, which might make it harder for you to build value and be independent later.
Two final risks: The first is customer concentration. If the relationship fails for any reason, you could be perceived as damaged goods in your industry. More fundamentally, if you are devoting a significant portion of your business to your strategic partner, a cancellation of that relationship might be a death sentence for your startup. I have many stories where this outcome occurred.
The second is that the strategic might turn around and compete against you, misusing the knowledge it gained from working with you to try to destroy you. That was exactly what was alleged in the Craigslist litigation against EBay. Although Craigslist had the resources to defend itself and force a favorable outcome, most startups do not.
We will discuss strategic investors, and other non-venture sources of capital, in the future.
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