Is Strategic Money an Oxymoron?

Posted on Dec 3, 2009 | 48 comments


groundhog dayThis is part of my ongoing Raising Venture Capital (VC) series

Yesterday I had lunch with a really interesting and capable serial entrepreneur who is raising his A round.  The topic of  “strategic” investors came up.  It felt like Groundhog Day because I have this conversation again and again – literally dozens of times each year.  And I had 2 “strategic” investors in my first company.

So I thought I’d try to lay out a framework for how you should think about it as many you will inevitably be faced with this experience.

What is a “strategic” investor and why do you keep putting the word “strategic” in quotes?

When people refer to a strategic investor they are usually talking about an investor that comes from the industry you serve as opposed to an independent venture capital investor.  I put strategic in quotes because they are often anything but “strategic” and thus the term can be an oxymoron.   Many serial entrepreneurs who have been burned would use something less kind than quotes.

But they’re promising to massively increase my uptake, they’ll give me huge legitimacy and maybe they’ll buy me some day?

Yeah, I know.  And Microsoft always convinces me that their next version of Windows won’t be slow and I get fooled every time.  When they promise to help you with marketing, sales, distribution, integrated product development, etc. it sure is tempting.  And they probably have every intent of helping you.  But the venture guys don’t make the calls on what the product / business guys  do.  The reality is that their core business is not venture capital.  So push comes to shove they will be driven by their core business (as they should be) – not the $5 million they put into your company.  You are the tail, not the dog.

OK, so maybe they won’t be helpful. Most VCs aren’t either?  What’s the difference?

Great question.  It’s true that many VCs over promise how helpful they’ll be with introductions / strategic advice / recruiting, etc.  But this is benign.  Strategics can have some negative impacts:

1. You’re not their core business – their interest will swing more wildly with the markets

When times are good “strategics” want in.  They’ll pay up for it and promise much.  When times are bad many cease investment activity all together.  OK, I know this is true with VC also, but to a lesser extent.  Investing is our core business.  We have nothing else to revert to.

2. They value their core business more than your success – and they should!

I saw this directly.  I had two strategics in my first company.  One was the hardest working guy on our board and the biggest mensch.  He was also chairman of a $6 billion company!  I loved working with him and learned much from him.  He tried his best to balance his needs and ours.  He was a needle in a haystack in that I think he really cared about my success.  He also wasn’t the venture guy – he was the big cheese.  But even he would feel conflicted when I had to cut the engineering team because he valued our product more than his investment.  When we wanted to sell the company he was very hesitant because he didn’t want somebody to buy us who might not be a good steward of the product going forward.

The other strategic was a train wreck.  One month after investing the guy who invested left his firm.  The guy who took over said, “I never believed we should invest in dot com’s.  I will be on your board but don’t ask me for anything.”  He literally said it that bluntly.  His words were an understatement.  He fought me for 3 years and actively worked against our interests – I think to spite the guy who put in the money.  I struggled to get every signature or consent.  The market knew he was an investor yet he wouldn’t promote us within his own company.  You can imagine how that made us look in the German market where his company is a big deal.

In retrospect he was right for his business but it sucked for me.  Keep that in mind when you’re thinking about ‘strategic’ money.

3. Many strategics have less experience in helping entrepreneurs

Another big question you’ll want to answer is whether your strategic investor has a long history in investing in startups.  How have they behaved in good times and bad?  Make sure to reference check with other portfolio companies.  I often talk about why you want “smart” money (yes, I use quotes because I know it’s not always as smart as it promises to be).  But working with VCs means you’re working with people who deal with entrepreneurs as their career.  When you deal with doctors or dentists for angel money, for example, you’re dealing with people who don’t.  The same can be true with strategics.  So make sure you know what the team and what the individual is made of.

4. Many strategics have bureaucratic decision-making processes

One of the problems in working with corporate entities is that the venture arm doesn’t always have an autonomous decision-making ability.  As a VC I need to get buy-in from my partners when tough stuff comes up.   But I only have 3 of them and they spend every day dealing with these kinds of situations.  Imagine your investor has to call the CEO of a $20 billion company for approval for your merger or sale.  Fun.

5. You may struggle to land their competitors as your clients

So you took money from the largest player in your industry.  That’s awesome because you now have credibility.  But guess what – number 2-10 in the sector now you view as an agent for the evil empire.  It will be much harder to get deals done there and may drive people to your competitors.  I know that you’ll tell them that BigCo owns less than 20% of your company.  Remember, they’re not venture investors.  They don’t see it that way.  They see you as an extension of their competitor and that all information will flow to the corporate parent.

6. You may find that when you want to sell your company it is harder to get a fair price

See point 5 above.  If you thought it was hard to sell your product to the competition try selling your company.  Yeah, I know it happens all the time.  But for an M&A department that is already super busy they don’t want to be seen as a stalking horse for the company that owns 20% of you so sometimes they don’t even want to bother.  Plus, many acquisitions happen when you are already partnered with the company so you may have to get beyond the hurdle in point 5 before getting to this step.  So if you ask many bankers they’ll tell you that there’s a “discount premium” that you’ll get at the time of the sale as a result of having a strategic.

So should I ever consider taking money from strategic investors?

There are times where strategic money makes sense.  I personally recommend it in the following situation: When you have your A round and/or B round done, the business is progressing well and you’re not early stage.  That way the strategic isn’t as involved in the early-stage messy stuff when you need to quickly change direction when your strategy isn’t working and need to get more funding rounds done.

There is a second reason I recommend this.  You can often get 3 or 4 strategics to invest alongside each other and then nobody sees you as an extension of another company.  You may not get fierce competitors to co-invest but perhaps you can get enough closely related companies that you don’t have the branding problem I’ve spoken about.  Also, you have more leverage to not take them all on as full board members.

You may also do your due diligence on the firm you’re talking to and find that they’re an outlier.  You may find that they’ve been investing for 15 years, their entrepreneurs love them and they’re entrepreneur friendly.  So if you get good feedback just make sure that you understand the framework above to think about how to best mitigate your risks.

Are any strategic investors better than others?

Yes.  There are many funds that are associated with corporation that are structured as proper VCs.  Three examples where I know the teams personally, respect them and have heard great feedback are: Steamboat (Disney), Comcast Interactive Capital (CIC) and Intel Capital.  I’m sure there are many more.  What I’d point out in all of these firms is that they have had a long view of the VC market, they are pretty independent from company decision making, they aspire to make money on the fund rather than fuel their core business, they are structured like VCs and therefore attract A-quality people and none of them over promise that their company will ‘make you.’  As a result the market knows this about them and doesn’t view them in the same way.  They are strategic with no quotes ;-)

Where can I go for help?

Try VentureHacks, The Funded or OnStartups- three great communities to tap into other entrepreneurs and ask them for their experiences.  Oh, and maybe a few of you will meet me in the comments section to discuss your experiences.  I’d love to get the debate going.  And if you know any great strategics please list them.  I’d love to give them some recognition.

  • http://twitter.com/bch132 Ben Haynor

    Great points, Mark, never thought about the potential backlash from “strategic” investors' competitors – I always figures, perhaps naively, that potential customers don't necessarily care about who is an investor, only about the product…

    What about a situation when one is raising angel funding and a potential angel is a large franchisee of a company that is viewed as a large potential customer? For example, say the potential angel is a large franchisee of Subway restaurants, and one plans on targeting Subway, McDonalds, and all other large fast-food restaurants – would you say the same (or similar) advice would apply?

  • http://walkercorporatelaw.com Scott Edward Walker

    Another solid post, Mark; indeed, impact #4 (i.e., that [m]any strategics have bureaucratic decision-making processes) is spot-on. As a corporate associate at a major law firm in New York City, I represented Sony in connection with a number of “strategic” investments. Talk about bureaucratic: (i) all major decisions had to be signed-off by HQ in Japan; and (ii) there was no “venture arm” in the organizational chart. Needless to say, it was a nightmare. (We had the same problem with joint ventures as well – it took weeks to get major decisions approved.) Needless to say, none of the investments seemed to pan out. Keep up the good work. Thanks, @ScottEdWalker

  • http://giffconstable.com giffc

    After my experience with a strategic, I completely agree with you. They were happy when we were the hottest thing on the planet, and then sadly became a block to progress when things took a rocky turn. It wasn't malicious, but I don't think they really cared about an exit, and became a block to taking risks and big changes that could inject new value into the equity.

  • http://reidcurley.com Reid Curley

    Excellent post, Mark. I would also point out that sometimes strategic investors invest with your points 5 and 6 in mind. I have seen companies where a strategic investor had a ROFR to buy the company and had to advise them that they couldn't raise capital unless they were able to get the strategic to give up that right (since no one else would ever bid on the company). Similarly, I have seen investor rights agreements specify that companies can't modify anything “in a way that would adversely affect” the strategic investor. I have seen situations where strategics had information rights that later proved very problematic for everyday business reasons. Granted, none of these things would have happened to a company that had decent VC backers and strong legal counsel, but for entrepreneurs that haven't been through the drill and don't have that kind of support (or don't realize that they need it), there are a lot of potential landmines. In general, I would only take strategic money if the terms were such that I would be okay (able to raise more money, sell the company, etc.) even if the strategic investor decides that they would like to put me out of business somehow or merely if they would never return my phone calls or sign consents.

  • http://bothsidesofthetable.com msuster

    Same advice. Caveat Emptor.

  • http://bothsidesofthetable.com msuster

    Thanks for sharing, Scott. This is a typical story that happens in my Groundhog Day chats. And JV's are worse than having corporate investors with no proper venture arm. It's why I'm still cynical about the long-term potential of Hulu. But that's for a later post.

  • http://bothsidesofthetable.com msuster

    Exactly right. And it's not only malicious – it's in their best company interest to act this way.

  • http://bothsidesofthetable.com msuster

    Thanks, Reid. Valuable input. I was going to talk about ROFRs (right of first refusal … on the sale of your company) which I'm vehemently against but my post was (as always) getting long. Glad it came up in the comments. Appreciate it.

  • http://twitter.com/bch132 Ben Haynor

    Great points, Mark, never thought about the potential backlash from “strategic” investors' competitors – I always figures, perhaps naively, that potential customers don't necessarily care about who is an investor, only about the product…

    What about a situation when one is raising angel funding and a potential angel is a large franchisee of a company that is viewed as a large potential customer? For example, say the potential angel is a large franchisee of Subway restaurants, and one plans on targeting Subway, McDonalds, and all other large fast-food restaurants – would you say the same (or similar) advice would apply?

  • http://walkercorporatelaw.com Scott Edward Walker

    Another solid post, Mark; indeed, impact #4 (i.e., that [m]any strategics have bureaucratic decision-making processes) is spot-on. As a corporate associate at a major law firm in New York City, I represented Sony in connection with a number of “strategic” investments. Talk about bureaucratic: (i) all major decisions had to be signed-off by HQ in Japan; and (ii) there was no “venture arm” in the organizational chart. Needless to say, it was a nightmare. (We had the same problem with joint ventures as well – it took weeks to get major decisions approved.) Needless to say, none of the investments seemed to pan out. Keep up the good work. Thanks, @ScottEdWalker

  • http://giffconstable.com giffc

    After my experience with a strategic, I completely agree with you. They were happy when we were the hottest thing on the planet, and then sadly became a block to progress when things took a rocky turn. It wasn't malicious, but I don't think they really cared about an exit, and became a block to taking risks and big changes that could inject new value into the equity.

  • branding_firms

    haha, love your quote about microsoft ;) … i can definitely relate to that!

  • http://reidcurley.com Reid Curley

    Excellent post, Mark. I would also point out that sometimes strategic investors invest with your points 5 and 6 in mind. I have seen companies where a strategic investor had a ROFR to buy the company and had to advise them that they couldn't raise capital unless they were able to get the strategic to give up that right (since no one else would ever bid on the company). Similarly, I have seen investor rights agreements specify that companies can't modify anything “in a way that would adversely affect” the strategic investor. I have seen situations where strategics had information rights that later proved very problematic for everyday business reasons. Granted, none of these things would have happened to a company that had decent VC backers and strong legal counsel, but for entrepreneurs that haven't been through the drill and don't have that kind of support (or don't realize that they need it), there are a lot of potential landmines. In general, I would only take strategic money if the terms were such that I would be okay (able to raise more money, sell the company, etc.) even if the strategic investor decides that they would like to put me out of business somehow or merely if they would never return my phone calls or sign consents.

  • AlexLloyd

    There was an impirical study done a while ago and apparently 'strategic' investors pay more for your equity. That could be a plus, but given your negatives, that extra few percent probably isn't worth it.

  • http://bothsidesofthetable.com msuster

    Same advice. Caveat Emptor.

  • http://bothsidesofthetable.com msuster

    Thanks for sharing, Scott. This is a typical story that happens in my Groundhog Day chats. And JV's are worse than having corporate investors with no proper venture arm. It's why I'm still cynical about the long-term potential of Hulu. But that's for a later post.

  • http://bothsidesofthetable.com msuster

    Exactly right. And it's not only malicious – it's in their best company interest to act this way.

  • http://bothsidesofthetable.com msuster

    Thanks, Reid. Valuable input. I was going to talk about ROFRs (right of first refusal … on the sale of your company) which I'm vehemently against but my post was (as always) getting long. Glad it came up in the comments. Appreciate it.

  • http://neu.com.au/ branding_firm

    haha, love your quote about microsoft ;) … i can definitely relate to that!

    . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
    branding firms rock my world

  • http://arnoldwaldstein.com awaldstein

    Mark, great points.

    There are more horror stories than positive case studies but when a strategic works, its magic. I did a raise where the funder provided services to customize an app and take it out to distribution through their network. A rare but beautiful thing but a corner case.

  • http://ss.spingo.com/ Tom Blondi

    Another “great” post, Mark.

    It's amazing as entrepreneurs how little we validate the “strategic's” track record of investing and exiting. Good to know going in what they consider a successful exit and timeframe before we go into battle together. If they won't divulge their track record it's a red flag.

    I've had mostly bad experiences with strategics but one which was superb and deserves credit was Intel…as you point out, the Intel Capital group used to operate independently and could make decisions on their own.

  • http://twitter.com/shapirosteve Steve Shapiro

    “Yeah, I know. And Microsoft always convinces me that their next version of Windows won’t be slow and I get fooled every time.”

    Not this time – they finally got it right with 7 :)

  • http://www.alexlloyd.posterous.com Alex Lloyd

    There was an impirical study done a while ago and apparently 'strategic' investors pay more for your equity. That could be a plus, but given your negatives, that extra few percent probably isn't worth it.

  • http://arnoldwaldstein.com awaldstein

    Mark, great points.

    There are more horror stories than positive case studies but when a strategic works, its magic. I did a raise where the funder provided services to customize an app and take it out to distribution through their network. A rare but beautiful thing but a corner case.

  • http://ss.spingo.com/ Tom Blondi

    Another “great” post, Mark.

    It's amazing as entrepreneurs how little we validate the “strategic's” track record of investing and exiting. Good to know going in what they consider a successful exit and timeframe before we go into battle together. If they won't divulge their track record it's a red flag.

    I've had mostly bad experiences with strategics but one which was superb and deserves credit was Intel…as you point out, the Intel Capital group used to operate independently and could make decisions on their own.

  • http://twitter.com/shapirosteve Steve Shapiro

    “Yeah, I know. And Microsoft always convinces me that their next version of Windows won’t be slow and I get fooled every time.”

    Not this time – they finally got it right with 7 :)

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  • danstuart

    Great article. It's actually eerily accurate. Unless a potential strategic investor – in the form of the investment arm of a corporation – actually creates a structure for investment and sets aside the funds for investment, potential investment WILL at the mercy of the month-to-month, quarter-by-quarter health of the core business. Unless key people in the business have bandwidth in their roles to get involved more than through periodic mentoring, they won't because they can't. These are your key points from both sides in my estimate.

  • http://www.vcdeallawyer.com/ Chris McDemus

    Mark, great post. I thought I'd add a link to a post I made on my blog on the same topic. http://www.vcdeallawyer.com/2009/10/27/should-y… I actually noticed that I referred to an earlier post of your's in my entry. Small world.

  • danstuart

    Great article. It's actually eerily accurate. Unless a potential strategic investor – in the form of the investment arm of a corporation – actually creates a structure for investment and sets aside the funds for investment, potential investment WILL at the mercy of the month-to-month, quarter-by-quarter health of the core business. Unless key people in the business have bandwidth in their roles to get involved more than through periodic mentoring, they won't because they can't. These are your key points from both sides in my estimate.

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  • http://twitter.com/PhilipHotchkiss Philip Hotchkiss

    I would underscore Mark's point #5 -the risk of losing neutrality in your market. As founder and CEO of BigCharts, we continually had major financial brands that licensed our tools and content ask if they could make a strategic investment. My answer was always the same, “the company is always for sale at the right price.” We were very focused on being Switzerland to the online brokerage and financial media markets. It worked, the interested “strategic” investors understood and respected us for having such a clear position on the matter, and we ended up licensing our tools and content to 93% of online brokerage accounts worldwide.

  • http://bothsidesofthetable.com msuster

    Yeah, it might be true the strategics pay more for their equity. But that doesn't help you in the long run. So you have high-priced equity in your B round … ultimately that either comes back to bite you in the C round or when you go to sell the company. And as I mentioned I believe when you go to sell the company you'll be able to sell it for less if you have just one strategic. So the real question for entrepreneurs is … would you rather have a higher price on an investment round or when you sell the company?

  • http://bothsidesofthetable.com msuster

    Yes, I have heard of great stories also. A group that I looked at funding had previously taken money from Qualcomm's venture capital arm. They had nothing but positive things to say about Qualcomm and didn't have any problems when they sold their company.

  • http://bothsidesofthetable.com msuster

    Yeah, I think it's important to reference ANY investor so strategics should be referenced as well. re: Intel Capital – I almost don't even see them as a corporate investor. They take VC seriously.

  • http://bothsidesofthetable.com msuster

    Ha. I'm 3 weeks in and must admit that so far I'm pretty happy.

  • http://bothsidesofthetable.com msuster

    Thanks, Dan. Unfortunately the “eerily accurate” is only because I lived it! I appreciate your input.

  • http://bothsidesofthetable.com msuster

    Awesome story, Philip. I'm involved with a young startup now and every strategic partner wants a small piece of equity. I told the young entrepreneur my story that every one of my early partners wanted the same. We wasted days talking to them about it and in the end couldn't reach agreement. When the stock market continued to crash throughout 00/01 both our partners and we were happy we hadn't reached agreement. They were happy for obvious reasons. We were happy because had we taken their money I would never have been able to restructure the company as I did in 01 and we wouldn't have survived.

    Ultimately it's tempting when partners want small pieces of equity. But if you have a strong response to anyone who asks that no partners will get equity they often respect this and at least find comfort that they won't find their competitor with equity. Being Switzerland as a startup is important.

  • http://twitter.com/PhilipHotchkiss Philip Hotchkiss

    I would underscore Mark's point #5 -the risk of losing neutrality in your market. As founder and CEO of BigCharts, we continually had major financial brands that licensed our tools and content ask if they could make a strategic investment. My answer was always the same, “the company is always for sale at the right price.” We were very focused on being Switzerland to the online brokerage and financial media markets. It worked, the interested “strategic” investors understood and respected us for having such a clear position on the matter, and we ended up licensing our tools and content to 93% of online brokerage accounts worldwide.

  • http://bothsidesofthetable.com msuster

    Yeah, it might be true the strategics pay more for their equity. But that doesn't help you in the long run. So you have high-priced equity in your B round … ultimately that either comes back to bite you in the C round or when you go to sell the company. And as I mentioned I believe when you go to sell the company you'll be able to sell it for less if you have just one strategic. So the real question for entrepreneurs is … would you rather have a higher price on an investment round or when you sell the company?

  • http://bothsidesofthetable.com msuster

    Yes, I have heard of great stories also. A group that I looked at funding had previously taken money from Qualcomm's venture capital arm. They had nothing but positive things to say about Qualcomm and didn't have any problems when they sold their company.

  • http://bothsidesofthetable.com msuster

    Yeah, I think it's important to reference ANY investor so strategics should be referenced as well. re: Intel Capital – I almost don't even see them as a corporate investor. They take VC seriously.

  • http://bothsidesofthetable.com msuster

    Ha. I'm 3 weeks in and must admit that so far I'm pretty happy.

  • http://bothsidesofthetable.com msuster

    Thanks, Dan. Unfortunately the “eerily accurate” is only because I lived it! I appreciate your input.

  • http://bothsidesofthetable.com msuster

    Awesome story, Philip. I'm involved with a young startup now and every strategic partner wants a small piece of equity. I told the young entrepreneur my story that every one of my early partners wanted the same. We wasted days talking to them about it and in the end couldn't reach agreement. When the stock market continued to crash throughout 00/01 both our partners and we were happy we hadn't reached agreement. They were happy for obvious reasons. We were happy because had we taken their money I would never have been able to restructure the company as I did in 01 and we wouldn't have survived.

    Ultimately it's tempting when partners want small pieces of equity. But if you have a strong response to anyone who asks that no partners will get equity they often respect this and at least find comfort that they won't find their competitor with equity. Being Switzerland as a startup is important.

  • http://maxbley.typepad.com/ Max Bleyleben

    This is a great summary, Mark. I also feel like I have this discussion with European entrepreneurs every week. Strategic investors are a double-edged sword, but in most cases they limit a company's ability to maximise equity value, either because they limit what you can do commercially, or because they restrict the number of potential acquirers. From now on I'll point entrepreneurs to your post… thanks!

  • http://maxbley.typepad.com/ Max Bleyleben

    This is a great summary, Mark. I also feel like I have this discussion with European entrepreneurs every week. Strategic investors are a double-edged sword, but in most cases they limit a company's ability to maximise equity value, either because they limit what you can do commercially, or because they restrict the number of potential acquirers. From now on I'll point entrepreneurs to your post… thanks!

  • http://bothsidesofthetable.com msuster

    Thanks, Max. Even worse in Europe, I'm afraid. We just got completely “torpedoed” by a “strategic” investor in France. They launched a hostile takeover of the company at a low price that screwed everybody and the court system in France recognized their legitimacy because they were a large company and the jobs were seen as more protected under their ownership. A big FAIL for French entrepreneurship and for having strategic investors. It is unlikely we would ever invest in this country again after such an outrageous incidence.

  • http://bothsidesofthetable.com msuster

    Thanks, Max. Even worse in Europe, I'm afraid. We just got completely “torpedoed” by a “strategic” investor in France. They launched a hostile takeover of the company at a low price that screwed everybody and the court system in France recognized their legitimacy because they were a large company and the jobs were seen as more protected under their ownership. A big FAIL for French entrepreneurship and for having strategic investors. It is unlikely we would ever invest in this country again after such an outrageous incidence.