Strategic investors- it’s not always what you think

According to CBInsights Corporate VCs investment has hit an all-time high. While there are some great corporate investors (also known as strategic investors), the truth is that you should think hard before raising money from them.

For a traditional VC, the model is very simple: We make more money when the exit valuation increases. Therefore, in most cases the interests of the VC and the entrepreneur are well aligned. However, this is not always the case with strategic investors.

A strategic investor can sometimes be a potential acquirer and therefore has a conflicting interest in increasing the company’s valuation. Moreover, for a large strategic such as Cisco, EMC or Samsung the financial return from investing in a startup is often negligible. The real interest is in staying close to disruptive technologies and potentially being able to bring them in house. This is why strategic investors ask for Right of First Negotiation (ROFN) or a Right of First Refusal (ROFR) on an acquisition, which provides them special rights when the company is about to get acquired. The ROFN terms can be light (provide a notice when the company receives a written offer letter) or draconian (company needs to notify who gave the offer, what were the terms, and must wait for the strategic to respond with a counter offer). Needless to say, the more draconian these terms are, the more it hurts the company when it is about to get acquired. At some point it can even deter other acquirers from making an offer since they know that the strategic investor can easily take the deal from them.

But there is more than just the ROFN which you should think about. Knowing your startup is associated with a strategic investor creates a signaling effect. The competitors of the strategic investor might be less likely to work with you and other industry players will view you as “the Samsung/EMC/NetApp company”. Furthermore, the strategic investor will see the “sausage making” and can better optimize the timing and the price of an acquisition. This optimization will come out of your pocket.

This doesn’t mean you shouldn’t raise money from strategic investors. In many cases they add a lot of value to the company (you can read more about this in this great post). But you need to be very cautious when you do so. In most cases it is better to wait for later financing rounds when the startup is more established and less dependent on the strategic investor. Also, it is good to bring in several strategic investors at the same time so that you are not tied to any one of them.

Bottom line is don’t get dazzled by the high valuations that some strategic investors offer. Make sure you know what you are getting into when you chose a new investor.

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