Pros and Cons of Strategic Investors in Early-Stage Companies
- 8.7.2023
- Gary Schall, Daniel Zimmermann
Jahnvi Desai was a co-author for this post.
When early stage companies look for sources of capital, they sometimes consider investments from strategic investors in addition to investments from venture capital firms. But what is a strategic investment and what are the benefits and downsides from taking investment from such an investor? In this blog post we’ll answer these questions and provide guidance on how to think through such an investment.
What is a strategic investment?
Strategic investors can be an important part of the funding and growth strategy for many early-stage companies. Strategic investors are typically companies selling products and/or services in the same industry or an industry related to your venture that strategic value beyond the dollars they invest. So while they are making a financial investment, they are also hoping to get something else, hopefully something that is beneficial to both companies out of the relationship. Companies that make strategic investments may look for synergies in finances, culture or operations. While a venture capital firm is more interested in return on investment, a strategic investor has other interests, such as how collaboration with the company’s products or services could add to its own business model or future product services offerings. Such investments may inform product roadmaps and strategies. For example, your technology might complement their products, and their sales and channels might be a way for you to reach a broader market. They may even be a strong possible acquisition candidate for your company.
In some industries, strategic investors are critical. In the life sciences space, for example, the large pharmaceutical companies their investments in early-stage biotechnology companies as a way to access innovative R&D. In , life sciences rely on those strategic dollars to augment the other capital they raise and as a way to help them get through clinical trials and distribute the drugs they are developing. Often, the strategic partner will ultimately acquire the .
What are the Benefits of Strategic Investment?
A strategic investor can guidance for growth and success, providing industry knowledge and connections that may greatly benefit your growing company. Often times, experienced strategic investors will have access to a large pool of customers, partners or vendors that could be valuable in the growth of your company. You may also have the chance to make use of the strategic investor’s intellectual property or know-how which could be beneficial to your business. A seasoned strategic investor may provide invaluable guidance and expertise that will help scale your business in all areas including sales, marketing, and finance, and may bring operational rigor to your own organization.
A strategic investor may invest in your company at a higher valuation as opposed to a venture capital firm and may be willing to take a smaller equity holding in your company for the same amount of investment as a venture capital firm.
So while strategic capital often comes with a number of benefits, be sure you weigh the possible costs against those benefits.
What are the costs of Strategic Investment?
First of all, be aware of any contractual limitations or obligations the strategic investor may impose on your business. Examples include exclusive rights to your intellectual property or products; commitments from you to devote resources to a particular project that is strategically important to that investor; or rights to acquire the company or have a strategic advantage in M&A discussions (for example, by having a right of first , negotiation or notice). Be mindful of crafting any arrangements with the strategic investor in a manner that provides your company with adequate access to its own intellectual property to be able to succeed if the strategic investor was to withdraw support.
A strategic investor may for the right to designate a director on your company’s board. The director’s interests may often compete with the company’s interests, so special care should be taken when confidential and proprietary information is shared with the director if there is a potential conflict of interest with the strategic investor.
The strategic investor may also for a preemptive right to invest in future financings of the company on the same terms presented by any third party where the strategic investor acquires all securities issued in the future financing. On the other hand, a venture capital firm, will for a more common right which simply permits the venture capital firm to participate in the future financing round on a pro rata to maintain the venture capital firm’s existing ownership percentage in the company. A preemptive right could pose danger to the company because it allows the strategic investor to participate for the full proposed investment amount for the financing, ousting any investments from third parties. Such are discouraging to any new investors considering a potential investment in your company as they will be able to invest unless the strategic investor waives its preemptive right.
Similarly, a strategic investor may also negotiate for a in the event of a potential sale of your company. A provides the strategic investor with the right to acquire the company on the same terms proposed by a third party acquirer superseding any acquisition provided such third party. In some cases, strategic investors look to negotiate call and force the sale of your company. You should be cautious while negotiating any special rights with a strategic investor in the acquisition context since such rights may be a critical issue that a third party acquirer or investor may bear in mind while considering an investment in or acquisition of your company. This right may have a chilling effect on potential to acquire the company by potential third party acquirers, which could have a negative impact on the acquisition price for your company.
Additionally, while it might be tempting for company to take funding from a strategic investor because of the high valuation, it’s important to consider the motivations of the investor and whether they align with your own objectives. Remember that a very high valuation also poses the threat of a future “”. A is when the pre-money valuation of a fundraising round is lower than the post-money valuation of the round previous. A implicates a negative signal to the market and investors, a loss of confidence in the company and a negative hit to management and employee morale. While considering any investment strategic or otherwise, study if a lower and more appropriate valuation will be more beneficial to your company in the long run.
A strategic investor could cause other companies—competitors of your strategic investor, for example, to hesitate to do business with you. They may be worried that the strategic investor will access confidential information through your company. They may simply not want to help your company because that would result in a benefit to their competitor. And they may be deterred from considering acquiring your company if they think the strategic investor has an inside track on the acquisition. So merely having a strategic investor can, in some cases, close doors to you and how you want to grow the business.
Weighing the Benefits and Costs
Giving a strategic investor the rights described above should be analyzed carefully and critically in juxtaposition to the benefits you believe the strategic investor your business. If you can raise the capital from a venture capital firm, then it is generally best to think of this cost-benefit analysis separately from the financial investment. In other words, do the strategic benefits of the relationship justify the costs of giving up the limitations and obligations imposed on your business without regard to the cash you receive from the investment? If not, just go raise the money from a venture capital firm.
A word of caution: For early-stage companies, the costs tend to be much higher, and the benefits tend to be much less certain. That's because you don't know exactly what direction your company is going to go in. How will the market evolve? What's the best business model to build the company? As those questions are answered, the third parties that the most strategic value to your business may change. So tying your future to a third party too early, before you've had a chance to answer those questions is risky. Often the benefits you thought you'd realize from that relationship won't turn out to be as important depending on how you ultimately decide to build the company, and the costs (e.g., requirements to devote resources to a certain project that is no longer deemed by your company to be on the critical path to success) can be devastating.
So our advice is this: Look at all your . Consider all sources of capital. Do your . Strategic capital can many benefits that financial capital cannot. But like all good things, it comes with a cost. Wait if you can so you don't foreclose your too early. Take strategic capital only if you’ve convinced yourself that the benefits of doing so outweigh the costs for your venture.
Tags: investors, venture capital
