Strategic Investment Done Strategically

Part II of my blogpost on how startups should think about taking investment from strategic corporations. Once decided that it’s the best course of action, this post talks about how to go about structuring that investment. 

Part I highlighted problems associated with strategic investment and can be found here. This post was originally published in Forbes. Read more of my thoughts on tech on Twitter (@SunDhillon) or Snapchat (@SunnyDhillon25)

When done well, strategic investment can create tremendous value for portfolio companies. Some of these include:

· Internal navigation of a corporate giant: Strategic investors know the right ‘go to’ folks internally to help evangelize and grow your customer-vendor relationship with the company.

· Product support and innovation: Instead of building them out yourself, you can take advantage of big product testing and R&D teams with expansive resources. 

· Market insights: Your corporate investor has big market research and consumer insights divisions whose data you can take advantage of to better refine your product.

· Distribution/Operations/IP: Strategic investors may have access to supply chain expertise and real estate locations that will help scale your production and product rollout. They may also possess key branded IP to help your product’s market launch. For example, at the Disney Accelerator, Sphero produced a smartphone-controlled robot ball. Disney’s CEO, Bog Iger, had just come from his office having seen daily rushes from Star Wars: The Force Awakens when he visited the Disney Accelerator, and realized that the movie’s BB-8 droid and Sphero had a natural partnership to come. Sphero was granted Disney Star Wars IP as a result of going through the company’s accelerator and its BB-8 Sphero toy was the must have Christmas toy of 2015. Disney gave Sphero the biggest possible boost in customer acquisition and retail shelf space.

What Sphero turned into thanks to the company's partnership with the Disney Accelerator

What Sphero turned into thanks to the company's partnership with the Disney Accelerator

How much responsibility should you bestow upon a strategic investor?

How close is too close? Sometimes the investor needs to get out of your space

Do you want the strategic’s representative as a full-time board member? Board observer? Or perhaps just provide the strategic with basic information rights? Who will be your board member or touchpoint at the corporate? If it’s someone junior from the strategic’s ventures group, for example, then you should probably object and ask for the most senior person you can get. He/she is likely to have the power to get things done on your proposed partnership investment.

It’s worth noting that a way of getting access to strategic benefits accompanying an investment is through your advisory board or angel investors. A startup’s advisory board could grant equity to senior and experienced executives from their relevant industry, assuming the executive got sign off from conflicts of interest by their compliance department. Alternatively, appointing ex-senior directors and executives from said corporate could be an idea to pursue as they’re likely to have strong remaining ties to their former employer — or at the very least, can help you understand how decisions get made and who the right point people are to benefit your business.

M&A

 Strategics will increasingly be the source of venture capitalists’ returns in a hot M&A market under the Trump administration’s foreign profits repatriation efforts

Strategics will increasingly be the source of venture capitalists’ returns in a hot M&A market under the Trump administration’s foreign profits repatriation efforts

If strategics enter a startup’s cap table, as discussed above, they often do so as a call option for acquisition down the line. Certain legal terms like Right-of-first-refusal and Right-of-first-negotiation come up here. My friend and long time lawyer, Justin Hovey, partner at Pillsbury, had the following to say:

‘Founders and investors typically seek a path to liquidity, i.e. sale or IPO. Strategic investors typically seek a path to control. So there is a potential misalignment of objectives and founders have to be careful about creating impediments to the liquidity event, such as providing the strategic investor a blocking right or a “last look” benefit. If the founder isn’t able to resist these rights altogether, then they should at the least look to define events that they won’t apply to — such as any sale with a 5x return.’

Acquisition is usually preceded by a business relationship whereby the corporate is a customer of the startup, but a customer with increasingly stronger ties over time. The startup’s value creation and value-creation-trajectory becomes clearer as both parties fall deeper into bed with one another, culminating in a wedding day acquisition. Daniel Kan, co-founder of Cruise Automation, one of my portfolio companies that sold to GM for reportedly north of $1 billion this year, said: “It’s definitely a benefit to having strategic investors. Whenever you are easing you have to tell the story on why your company is going to be the next Apple or Google. Having people in your industry showing their support through their wallet will go a long way towards telling that story.”

Problems may arise when a strategic investor does not elect to buy a startup in which it has already invested. This can create bad signalling for other potential strategic acquirers as a competitor will wonder why the strategic didn’t want to buy — what’s wrong with the business? The prevailing thought becomes: ‘They obviously know more about the company than I do, so there must be something wrong with it if they’re not buying, therefore neither will I.’

Other times a strategic will intentionally acquire a startup to prevent its competitor from doing so. As a startup, you should be talking to several strategic competitors when looking for a buyer, perhaps even seeking a sector-focused banker to help navigate the transaction. It’s worth noting that you may be shutting the door to other strategics if you take money from one, with its competitors possibly less likely to work with you. Even more egregious is when the strategic chooses to compete directly with its portfolio company . For example, Google invested in Uber and recently stepped off Uber’s board to compete more directly in ride sharing and autonomous vehicles with the ‘startup’ it once looked to help.

“There are many things that we would throw away if we were not afraid that others might pick them up.” — Oscar Wilde

A seed or Series A investment is a small initial cash outlay for a strategic — a small initial experiment. An acquisition worth several hundred million dollars is a different matter entirely. The former may be mentioned in passing at a strategic’s board meeting, if it’s even deemed important enough to discuss at all. The latter will take time, discussion over several board meetings, and perhaps even an EGM (extraordinary general meeting) to get mass shareholder approval. Therefore, just because a strategic invested in a particular startup does not mean the strategic’s only acquisition target choice will be said startup. The strategic will seek the best opportunity to take advantage of industry lessons learned through its initial investment.

James Joaquin, cofounder of Ophoto and Obvious Ventures, told me a story about this. Ophoto raised money from HP, among other parties, at the Series B. Lyft Chief Strategy Officer and ex-Mayfield Fund partner Raj Kapoor had a competing photo startup named Snapfish in which Kodak had invested. In a strange turn of events, HP acquired Snapfish and Kodak acquired Ophoto. Neither strategic bought the startup in which it had invested, instead opting to buy the one in which its competitor had invested. In this instance, the strategic used its investment as a learning opportunity — getting smarter and then realizing that a better alternative existed for target acquisition than the petri dish in which it had already invested. 

The lesson here: Corporate M&A doesn’t always follow conventional logic from corporate venture investing.

Be strategic about strategic investment

In many ways, strategic investors have the same appeal for entrepreneurs as celebrity investors: It gives them the opportunity to be associated with a household name, generate buzz and gain access to key players. But it’s not a standard investment, and startups would be wise to not treat it as one. Ask the right questions, talk to past portfolio companies, clearly define the strategic benefits to be gleaned PRIOR to taking strategic investment, and be prepared to push back at the negotiating table if asked for any privileges that would be non-standard in a financial VC’s investment discussion.

Sunny Dhillon is a partner at Signia Ventures, an early stage VC fund in San Francisco. He was previously a corporate strategist at Warner Bros in LA, the first business development employee at a VC-backed spin-off of New Line Cinema, and a former entrepreneur, having launched one of the App Store's first social-local-mobile apps (named BarStool) in 2011. Follow him on Linkedin and on Twitter (@SigniaVC).

 

Sandeep Dhillon