The Two Sides of Strategic Investors
As startups grow over time, founders eventually require additional capital to continue scaling and meeting customer demands. To acquire this capital, founders pitch their business to a few types of investors: angel investors, venture capitalists, and strategic investors. The differences among the various groups of investors are rooted mainly in size and intent.
An angel investor is a party of one who exchanges capital for a stake in the company, just like the other groups of investors. However, the amount of capital they can provide is usually limited compared to that of venture capitalists and strategic investors, which is why they normally invest in the seed round and not in any of the series funding rounds. A venture capitalist works for a firm that contains other partners (general and limited) and can provide significantly more capital than an angel investor can. They also source for deals anywhere from the seed round to Stage A and beyond. With both of these groups, their main intent is to lend capital and resources to a promising startup with the hopes of seeing a significant return on their investment.
Strategic investors, however, are cut from a different cloth. They represent a big company or institution, which means they can throw wads of capital without blinking an eye. In addition to capital, a strategic investor can also allocate necessary resources (market information, powerful connections, vast amounts of experience) to founders to help fulfill any gaps between where the startup is now and where it needs to be, much like venture capitalists can. Because strategic investors come from big name corporations (Google, Amazon, Microsoft, etc.), successfully investing with them can open doors not previously seen by founders.
However, there’s a reason they’re called “strategic” investors. As tempting as it sounds to get in bed with a strategic investor, there are always two sides of the coin to be aware of. Firstly, having a strategic investor involved instills a sense of confidence. It demonstrates validation to the outside world, which causes people to take notice. It also becomes easier for founders to raise additional capital if they have a big name backing them up. Because strategic investors are part of an enormous corporation, they have access to resources and distribution channels that startups can only dream of. For founders concerned about the back and forth of valuation and term sheets, strategic investors are willing to accept a higher valuation for the same equity. This can be both good and bad.
With all of their advantages, strategic investors seem like a home run to invest with. So why caution? Because there are strings attached. The first thing to keep in mind is that these investors are part of a larger company, one with many moving parts and different priorities. There are times where the startup’s goals, both short-term and long-term, don’t align with those of the strategic investor, and this can certainly cause friction. The startup may prioritize growing the business by increasing the customer base and expanding market share, but perhaps the strategic investor is simply interested in getting access to the tech instead and waiting for the right stage at which the startup can be bought.
Another item of note is the idea that doing this kind of deal may inhibit founders from talking to competitors associated with the strategic investor. If a founder decides to raise additional capital or looks to sell, being backed by a strategic investor likely prevents the startup from being sold at a high price to a competitor or allowing for additional capital from a competitor. In addition to this, there may be a Right of First Refusal (ROFR) clause in the agreement between the two parties. Essentially, if a company looks to buy the startup, the strategic investor has first pick in whether to buy the startup first or not. This is bad for multiple reasons, depending on what their answer is. If they look at the numbers and decide to pass, the startup can be seen as damaged goods to the outside world. If they do decide to buy, it will likely be at a lower price than what can be had in the open market. Either way, nothing good comes out of it.
It’s okay for founders to receive capital from strategic investors, as long as they understand what this agreement entails. Like most other things, there is the good and there is the bad. If they do proceed, it’s best to bring them in a later round and with a group of other investors. In the end, if strategic investors are the only option to raise capital, founders may be better off just selling the company to them.