Corporates beware — investing in startups is a different ball game
Let’s talk about how corporates, even those with the best intentions, can end up hurting promising startups.
It is a known fact that investing in startups is not the same as buying shares in the open market, nor is it the same as investing in established privately held companies. So how come some corporates investing in startups seem to miss that startup investing is truly a different ball game?
Having worked a couple of years as a management consultant, I have witnessed countless deals where corporates invest in, or acquire, other corporates. Through this experience I have gained a good understanding of how and why corporates need to position themselves both strategically and legally to achieve the desired outcome on a deal. Now, working in Arkwright X, where we invest in early-phase startup companies, I see a different side of the investment game, one that is, and often should be, less complex. Unfortunately, from time to time, we experience that some corporate investors do not fully understand or realize the influence of their investments in startup companies, and that what they do in the early days of the startup’s life can have fatal results down the road. Corporate investors can risk crushing fragile startups in their big corporate hands by making ‘corporate decisions’ in the very beginning of a future collaboration.
In the following, I will elaborate on some of the situations I have witnessed where I believe corporate investors (including their advisors) need a shift in mentality when investing in startups. This post will primarily address the issues that arise in the negotiation phase and leave the discussion around the pros and cons of corporate-startups-collaboration for another post.
I am excited to see that Corporate Venture Capital (CVC) is on a continuous rise. Globally, CVC represents close to ~25% of all venture investments, totaling over $50 billion spread over ~2700 deals in 2018. In addition, corporate-backed deals, where corporates invest directly off their balance sheet into startups, has shown impressive growth, with an average yearly increase of 39% from 2013 to 2018, representing over 4300 deals in 2018 (CB Insights, 2018). This reflects corporates’ increasing value perception of investing in startups, as they see how such investments can lead to increased innovation power, understanding of disruptive technology and the opening of new markets.
This massive growth naturally includes a group of corporates engaging in startup investments for the first time. It is here, that we occasionally see the dark side of this otherwise appealing CVC story. The investments can be done wrong in such a way, that in a worst-case scenario, it can kill the entire startup. Yes, I know, bold statement, but it actually happens over and over again.
The common denominator is that some corporate investors seem to stick with the mentality of; “More is always better”, but what they seem to miss is that more today, could end up resulting in less tomorrow. By taking excessive control in the early days of a startup, the corporate investor risks taking the incentive away from the founders, who are the ones actually doing the work, and might scare away other future investors. The result of this being, that the corporate investor ends up with a large piece of a very small pie or no pie at all (and who doesn’t want pie?!)
The kind of mistakes corporate investors make that can kill their investments
Corporate investors with limited experience in startup investments often find themselves treading unknown waters. A natural step in any corporate investment process is to involve lawyers to cover the legal setup of the deal. But as startup investing, in the Nordics at least, is fairly new for both established corporates and law firms, we see that the deals offered to the startups are often overly complex and exploits the size and power of the corporate investor. This can be the result of three core pitfalls which I will elaborate on in the following.
1) The corporate investor requires too much control
One key characteristic that differ between startups and corporates is their different level and appetite for risk. As I see it, there are two main reasons for this;
- Let’s face it, the corporate often has a lot more to lose in terms of brand value, reputation, assets, etc.
- You do not become a founder or even an early startup employee if you are not a risk seeker and thrilled by the fact that you are balancing between the make-or-break scenario.
Risk is often correlated with control — with an increased share of control, you generally have a perception of decreased risk. Thus, it is natural for corporates to strive for as much control as possible. There are several ways corporates can gain this control; most commonly it is done by taking a large equity share, requiring special rights or by demanding several seats on the board.
So, what’s really the issue with too much corporate control?
There are several reasons why it is often not beneficial for a startup to have a corporate investor with too large of an equity share and/or decision power. There are of course cases where the corporate simply just want to make sure that they can control potential disruptive competition (i.e. the startup), but I will focus on the somewhat honest mistakes from the corporates, that in my experience often is the case.
One of the absolute key criteria for investing in a startup is that you believe that the founders and their team are the right people to take this solution/product to the moon and back.
If you think that your corporate is better equipped to realize the underlying potential and sit in the front seat, then you should consider an acquisition rather than an investment. You invest in that startup for a reason — you believe that the founders and their team have something that you don’t. Of course, the guidance and help from corporate investors can mean the world for startups, if it is used wisely. It should be a win-win collaboration that is mainly built on an opportunistic approach, and not agreements put in stone before the collaboration is even started.
Another drawback appears when the corporate takes too large an equity share so that there is little left for future capital raising. For certain kinds of companies, extensive growth will require extensive funding, thus there will be several new funding rounds. Founders who don’t think about their dilution will sooner than later end up with a cap table that no future investors want to be a part of. Also, for talent attraction and engagement, it’s important to hold off a chunk of shares for future employees. This should be just as valid a concern for the corporate investor as it is for the founders of the company.
Finally, as a corporate investor you often have some link to the company that you are investing in (this depends on the investment strategy of course), either as a part of the supply chain (customer/supplier) or as a potential partner or competitor. But you are most likely not the only one, and you might be scaring off other crucial industry partners if you take too much ownership and control.
2) The corporate investor has a ‘dominating approach’
The balance of power is often skewed between corporate investors and startups. However, the smart, and long-term oriented corporate investor realizes that this does not give them right to ‘force’ the startup to accept a non-favorable deal. A white paper from World Economic Forum (2018) states that one of the challenges that startups meet in relation to corporate investors is a ‘dominating approach’ from the corporate.
Startups often feel treated in a top-down way instead of at eye level, and they find it challenging to be perceived as a serious business (source).
Innovation is happening at an accelerating speed, the leading businesses of tomorrow might just be startup companies today. This is the mentality corporates need to hold. The resources available to a large corporate investor is of course highly valuable, but the corporate players often lack agility and innovation power, which is exactly why they engage with startup companies. It is important to keep in mind that when a corporate invests in a startup it should be a two-way interview ending up benefiting both parties. Bear in mind that the best startups rarely struggle to get funding, and thus the corporate investors need to think about how they bring more value to the table than their competitors or other professional investors in order to secure the best deals. A first step is to make sure that the investment agreement and setup is fair for both parties.
3) The corporate investor uses external advisors with limited experience from startup investments
As mentioned above, the field of startup investments in the Nordics is quite new for corporates and their trusted advisors (advisors typically being investment banks and law firms). These advisors usually work on larger deals than the typical early-phase startup investments, and such deals often require a different approach and methodology. On the larger deals, one of the key roles of the adviser is to ensure that their client get the most of out the deal here and now, i.e. the fair price, rights etc. When you invest in startups, you invest in the dream that they can make it from (almost) nothing to the big leagues. This also means that it is not just about getting the best terms here and now, but ensuring that the deal and terms are flexible such that the parties involved create a foundation for future collaboration and value creation.
As a corporate wanting to invest in an early-phase startup, you need to think about whether you (or your advisors) are trying to dress a baby in a grown man’s suit (yes, I just made that analogy up…).
Some might wonder why a startup would ever agree to unfair terms like some of those described above. In the Nordics, and especially in Norway, the venture scene is not as mature as it is in the US or even central Europe. Thus, a large share of founders and employees have little-to-no experience from working in or with startups and they often have limited insight about what the road ahead will look like. As the startup scene is relatively small, it is not easy to get qualified guidance either. Inexperienced founders might therefore trust the word of a large successful corporate, and often just be excited that they have managed to get backed by such a large and successful company. Sometimes, they might be well-aware of the potential drawbacks the corporate investor might bring with them, but they are simply desperate to land the funding from that particular corporate.
Alright, summing up, I just (again) want to make one thing clear, I am all for corporate-startup collaborations! I am super excited to see the that CVC activity is growing, and I truly hope this will continue, but it needs to be done right, for all parties involved.
Tips for corporate startup investments
There is no general formula for how to conduct startup investments. It will always be necessary to tailor the approach to the corporate’s strategy and the objectives of the specific startup investment, whether they are strategic, financial, or a combination of the two.
I have tried to note down some high-level tips based on our experience from working with both large corporates and young aspiring startups. This list is not exhaustive, but I hope it can be useful nonetheless
View the investment as a future long-term collaboration
At the end of the day, you should want what is best for the company you invest in, as this will in most cases also be what is best for you as an investor. To increase the probability of a successful collaboration, it is important that the chemistry is good between the startup and their investors. A startup investment is a long-term, close and complicated relationship. I quote the cliché Venture Capital comment: “It’s easier to get divorced from your spouse than to get rid of your investors”, as a matter of fact, investor-startup relationships lasts longer than an average US marriage of eight years! Thus, you should get to know the people you are investing in to ensure that these are people that you trust and want to interact with several years going forward.
Early-stage investments require increased flexibility and trust
It will not make sense for the corporates to simply apply the same approach and process to a startup investment as they do on other general investments. This regards to most aspects of the deal, both in terms of valuating financials, data requirements, proof of processes, detailing of legal documents, and so on. For an early-phase company, there will be limited historical data, and definitely not a strict 5 years plan for the road ahead. Startups are dependent on their flexibility to succeed, which needs to be reflected in the terms of the deal. Trust between the two parts is crucial, as there will be limited hard facts to rely on.
Leave room for other investors who can bring value to the table
The right investors can be an important factor for a startups’ success. Of course investors will contribute with often highly needed capital, but the right investors will also contribute with complimentary strengths to what the startup might be lacking. This will differ in every startup/investor relationship, but can for example be network, knowledge, pilot customer(s), and branding. Thus, corporate investors should be open for valuable co-investors if they can contribute to the future success of the company.
Get help and guidance from someone with experience on the field
It is quite simple actually, corporates should check if their advisors have worked on startups/early-phase deals before (preferably with references). A lot of knowledge in this field comes from firsthand experience, so make sure you get advice from someone who knows how early-stage investment works.
Thank you for reading!