Pros and Cons of Strategic Investors in Early-Stage Companies

• 2.6.2015
• Mick Bain

Strategic investors can be an important part of the funding and growth strategy for many companies. Strategic investors are typically companies in the same industry or an industry related to your venture that offer 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.    

For example, your technology might complement their products, and their sales and distribution 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 leverage their investments in early-stage biotechnology companies as a way to access innovative R&D. In exchange, life sciences startups 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 startup.

So while strategic capital often comes with a number of benefits—access to a broader and more diverse source of capital, the chance to share intellectual property or other resources, and the alignment of important customer or partner incentives, among others—be sure you weigh the possible costs against those benefits. 

What are those costs?

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 offer, negotiation or notice).

Giving up these rights should be analyzed carefully and critically in juxtaposition to the benefits you believe the strategic investor offers your business. If you can raise the capital from a pure financial investor, 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 financial investor.

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 offer 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. 

Even without contractual limitations, the mere fact that you have 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.

So my advice is this: Look at all your options. Consider all sources of capital. Do your due diligence. Strategic capital can offer 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 options too early. Take strategic capital when and only when you've convinced yourself that the benefits of doing so outweigh the costs for your venture.