Capital Raising: Why You Might Not Want a Strategic Investor — Part One
Many a first-time entrepreneur is convinced that they must find a “strategic investor.” Finding a “financial investor” will not suffice. An investor who simply puts in money is not as good as one who will not only put in money, but also provide contacts, advice, manufacturing facilities, distribution channels, market clout and everything else that is needed to become a $100m revenue company.
Most entrepreneurs (and most investors, for that matter) see the world divided into two types of investor:
- Financial investor: one which is focused on maximising the return on the investment. Examples are angels, VCs and PE companies in more established companies. They want to maximise their financial return because they have no other way of benefitting from the investment.
- Strategic investor: one which is less focused on maximising the return and more focused on the other benefits it may get from its investment. Examples are large companies directly investing in start ups, distributors investing in the companies making the products they distribute or retailers investing in their suppliers. They want to get access to new technology, get a foothold in a niche market, cement a strategic alliance or deprive a competitor of any or all of these benefits.
The appeal of finding a strategic investor is undeniable — they are less likely to care if your company doesn’t make money and more likely to provide the comfort of a mother ship for your young company to take on the world.
This appeal is often especially strong if you start to collapse everything that is needed to create a successful company into the one investor persona. This persona provides not only the money, but also becomes an “older brother” figure to look after you in the big bad world of commerce.
The real issue is the tendency to at once identify a bigger company as a possible key client, distributor or supplier — and at the same time characterise it as a benevolent benefactor. In this case, you forget that they are looking after their own interests, not yours. This is in contrast to the financial investor who simply wants to make as much money as possible on exit. To this extent, the interests of financial investors is much more aligned with most entrepreneurs who also want to make as much money as possible on exit.
Reasons You Might Not Want a Strategic Investor
There are a number of reasons that you might not want a strategic investor in the early rounds. Sure, in the later rounds prior to exit it is good to have a potential strategic buyer on your register, but set out below are some of the problems with having them on your register early on.
They Had No Intention of Investing
The reason that they were interested in your company was that you had something that they didn’t. Your agile start-up probably beat their laborious R&D department by 12 months or more. So flattered by their attention to your star product, you got them to sign a non-disclosure agreement and showed them everything you had in the due diligence. The problem was that they never invested — and now they are producing products uncomfortably similar to yours.
Conflict of Interest in the Exit Strategy
Strategic investors are usually looking for new businesses for reasons other than maximising their returns. Entrepreneurs are usually looking for strategic investors to assist them expanding their company and to eventually buy them out. And there is the problem: the investor doesn’t want to maximise its returns (by selling their shares at a high price) and you do. In fact, if they want to buy your company out at all, they want to do it for a low price, not a high one.
Shifting Views on their Continued Involvement
Some strategic investments are championed by an executive in the bigger company in line with that company’s current thinking. The difficulty arises when that executive leaves or is replaced, or that company’s thinking changes. These fair weather investors on your register mean that the future of your company can be at the mercy of the changing winds within your strategic investor’s board and business plan. Some old hands call it “drive-by investing.”
Won’t Support Your Pivot
One of the tenets of lean start up is to pivot direction when you don’t have product/market fit or you are not getting the market traction you need to go forward. You change your product or your offering to something that might work. Unfortunately, your strategic investor got involved because your last iteration fitted in with their overall strategy. They really don’t like this new idea of yours. In fact, they dislike it intensely because it has nothing to do with their strategy for their own business. Therefore they do everything they can from board level down to sabotage your pivot and block your new direction or product.
Competitors to Your Strategic Investor Won’t Deal With You
Once it is known that your strategic investor is on your register, it is possible that your investor’s competitors won’t deal with you.
They Are Your Biggest Customer and Now They Know Your Cost Structure
Whether they are your customer, distributor or supplier, when they are on your register, and particularly if they have a seat on the board, they know your cost structure. This leads to them “revising” the prices they pay you/buy from you to be “in line” with what they believe are more “reasonable” profits.
Venture Capitalists Are Not Interested in You
Angels and VCs are financial investors. PE companies in later stage investments are financial investors. They are all interested in exiting their investment at the highest price. Once they know you have a strategic investor (who might not be interested in selling for the highest price because they want to buy it at the lowest price), these angels, VCs and PE companies may well lose interest in investing in the first place.
Their Core Business is More Important to Them than Yours
Whatever the attraction your company holds to the strategic investor in the beginning, in the end its own business is more important to them than yours. This may mean a slow decline in the time and attention you get from the investor’s executives, or it may mean the swift descent of the axe when there is an emergency within the investor’s ranks.
Their Decision Making Process is Too Slow
Young companies pride themselves on quick decisions, turning on a dime and being nimble. Large companies are famous for slow decisions, turning like an ocean liner and sticking to old strategies until the company goes down. This might not matter when the investor is at 20%, but at 40% or more (two or more directors) it may well be a big issue.
They Copy Your IP
Think back to the reason that they were attractive to you in the first place — it’s usually because they are in a similar industry. Think back to the reason that you were attractive to them in the first place — it’s usually because you had products, technology, markets, people or customers that they wanted. After a year or two, they may start to independently develop products that look, feel or perform like yours. How did that happen?
You Are Bound By Non-Competes
In your excitement to sign up the terms sheet, you agreed to the innocuous clauses entitled “Non-Compete” and “Right of First Refusal.” Later you find that this means that you can’t sell your products to their competitors, you can’t compete with their core business and if you are successful, they have the right to buy your company before any other buyer.
They Pay Too Much
At first blush, the fact that a strategic investor might accept a higher valuation in your early rounds than financial investors would should not be a problem. You made more money, right? Well, unfortunately, it can be a problem. The problem is that the inflated valuation in the early rounds means future rounds are either flat rounds or, worse still, down rounds where you get diluted.
You Concentrate on Solving Their Problem, Not Everyone Else’s
Now that they are on your board and providing all the help they can, you duly focus your product’s development on solving their problems, not the problems of the wider market in general. This doesn’t help the search for the highest and best use of your technology or products — and it can therefore limit the ultimate value of your company.
I agree a strategic investor on your register just prior to exit is a good idea — they have had a chance to see close-up how good your business is and how it would fit into their bigger picture. Having them involved in the early days, however, has a number of well-known problems.
You may well be better off with financial investors whose interests are aligned with yours (exiting at the highest price) and simply use their money to hire people who give you the same advantages you thought you were going to get with a strategic investor.
You could even use your new funds simply to hire the general manager of your proposed strategic investor!