Entrepreneurs often seek funding from the venture capital arms of large companies. Receiving funding from the likes of Intel Capital or Comcast Interactive Capital does have its advantages. First, in today’s credit drought, capital from any source can be critical for a company’s survival. Second, obtaining funding from strategic investors does offer a certain panache, a certain validation of a recipient’s technology and business strategy. Third, the strategic investor could become a purchaser of the company’s products and boost sales further by plugging the company’s products through its distribution channels.
Despite the advantages of attracting strategic investors, entrepreneurs should be aware of the risks of accepting capital from corporate investors. A few of these concerns include:
· Strategic investors often have interests that diverge from those of the entrepreneurs. For instance, a strategic investor might take an interest in an emerging company to incorporate its technology in existing products at below market rates. Strategic investors may also make an investment to keep the young company’s technology from reaching the market, thereby eliminating competition for its more established products. (One way to determine how likely these scenarios are is to ascertain how the strategic venture capitalists are compensated. If they are compensated for the strategic value that they bring to their company, be wary. If they are compensated for the returns that their strategic funds deliver, you can breathe easier.)
· Strategic investors often invest in many competitors in a given market segment to hedge their bets. When this happens, there is a risk that some of the portfolio companies’ trade secrets and intellectual property will be compromised and find their way to competing companies.
· Having a strategic investor can result in the loss of business opportunities. Competitors may not wish to purchase products from a young company, if doing so will enrich their larger adversary.
· Many companies’ commitment to their venture capital units is tenuous. When the venture capital business experiences stress or a new management team takes charge, the venture capital divisions are susceptible to being shut down. This may result in the untimely liquidation of a fund’s investments.
· Strategic investors have a reputation for being less valuation sensitive—because they are also calculating the strategic significance of their investments—during negotiations for subsequent rounds of financing. Thus, the entrepreneur may be disadvantaged when its existing strategic investors are less vocal in pressing for higher valuations. However, if the funded company becomes completely dependent on its strategic investor for further rounds of capital, the corporate investor would be able to leverage its disproportionate power in those negotiations.
· Strategic investors introduce problems during exits. There is typically less bidding for companies funded by strategics because of the entanglements. Also, if the strategic investor declines to bid to acquire the portion of the company that it doesn’t already own, it sends a signal to other potential bidders that there is a deficiency with the company.
In conclusion, if you are contemplating receiving venture funding from strategic investors, I offer two final pieces of advice. Introduce your technology to the technical team at the target company. If you can recruit a technology champion within the large company, that advocate will have more influence as an insider with his counterparts on the strategic investments side. Technology champions can dramatically enhance your negotiating leverage. Secondly, partner with a strategic investor as late as possible in your capital raising campaign.
David Wanetick is a Managing Director at IncreMental Advantage, a research and valuation firm based in Princeton, NJ. He is an instructor at The Business Development Academy. His most recent book is The Power of Incremental Advantage: How Incremental Improvements Produce Dramatically Disproportionate Results.