Strategic investment isn’t always a good strategy — Part I of II
You hear about ‘strategic’ investments every day, and they generally come in two flavors. The first is an “off balance sheet” investment in a private tech company. Examples include Toyota’s investment in Uber earlier this year, and Apple’s $1bn infusion into Didi Kuadi. These are generally one off in nature, and are generally handled within existing organizational structures.
However, some corporations have gone even further, and formed dedicated venture capital funds specifically geared toward investing in startups. Comcast, Time Warner, Intel, Google and GM have all gone this route and are now part of a rapidly expanding ecosystem. CB Insights estimates that 53 new corporate VC units globally began deploying capital in the first half of 2016. With even old-economy corporations such as General Mills and Campbell Soup entering the venture game, it’s clear that everyone wants in on startups.
Erin Griffith recently said that financial VC’s are now competing with their potential (strategic) buyers for startups, as CPG giants increasingly look to build relationships and invest in upstart disrupters earlier and earlier. Fred Wilson calls corporate VC’s ‘the devil’ and argues that it’s ‘last resort’ money for founders to take, whereas Accel’s Rich Wong recommends founders ‘tamp down disdain’ for strategic investors, understanding that said companies may one day become your acquirer.
There are differing views on strategic VC’s from among the financial investor community. I’ll provide a framework for how to think about corporate investments in a 2 part article (this being part I).
Why are corporate VCs interested in your startup?
While visiting Japan a few months ago for a tech conference, I was interested in meeting some of my Tokyo-based venture compatriots. I was surprised to learn that a culture of venture capital doesn’t really exist in Japan because corporate R&D teams do a great job of building exploratory new expertise and products, combined with Japan’s ‘job for life’ legacy whereby would-be entrepreneurs are less likely to leave their corporate mothership to start a new company.
While U.S. corporate R&D spending is commendable by international standards — $145 billion in-country in 2015, more than any other country — it is not sufficient for keeping large companies at the forefront of innovation nor keep them safe from the threat of Schumpeter’s creative destruction. Combating risk of their own obsolescence, corporates will pursue one of the following strategies:
1. Acquire a startup for its team, talent, and tech
2. Partner (or launch) an accelerator, working with startups whose products are of strategic relevance to the company
3. Non-recurring engineering paid projects where the corporate provides resources and payment in exchange for a specified project to be completed by the startup
In each instance, the corporate will likely consider the startup as an experiment. An experiment in whether or not the startup’s tech works, whether there’s product market fit, and whether or not it makes sense to acquire the company (or a rival in the same space). If the startup folds, then it’s no big deal for the deep-pocketed corporate. By investing, the corporate saw a quick and nimble failure in a new industry sub-space, saving 10x the resources spent should the mothership have been redirected with similar exploratory aim.
Union Square’s Fred Wilson, in mid 2016, argued against taking corporate investment and didn’t believe strategics served startups well through investing. He said ‘corporate investing is dumb. I think corporations should BUY companies. Investing in companies makes no sense. Don’t waste your money being a minority investor in something you don’t control. You’re a corporation! You want the asset? Buy it…Making a minority investment in something? What does that do? Make you look smart in front of your boss?’
From the point of view of the corporation, appearing innovative can also be a good thing for large corporations for marketing purposes. Beyond just perception management, internal incubators and accelerators can genuinely get calcified cogs turning at lethargic, fat corporates by inspiring internal innovation.
How are corporate VCs different from financial VCs?
For early stage companies, financial VCs (such as Signia) will rarely invest in a startup after a strategic has already invested. This is often due to the strategic’s relative price inelasticity compared to early stage financial VCs. It’s common parlance to assume ‘strategics don’t mind paying up.’ Those without dedicated funds are not in the market every day and don’t really know what comparable deals are getting priced at, so founders can typically argue for higher pre-money valuations at the negotiating table.
It can certainly make sense to bring strategics on board later in a company’s life cycle, off the back of a growing and successful customer — vendor relationship between the two, for example. The value add that seed-stage financial investors bring to the table in terms of help with hiring, product launch, preparing the business for follow on funding, etc. — there’s less of a standard path to add that kind of value with early stage startups from strategics. Their ‘day job’ is not to help the startup grow — it’s to run their corporation to the benefit of shareholders — and mentoring startup experiments can fall to the bottom of the list when standard work beckons. For example, even with in-house incubators, startups can sometimes attract initial attention from divisional heads, but fast become forgotten when traditional everyday business takes up their time.
When a new market is taking time to develop, strategics may lead the charge in terms of investment. I’ve been spending a fair amount of time in the VR/AR market the past few years and have seen strong deployment of strategic investor dollars from Intel Capital, Comcast Ventures, Time Warner Investments, BDMI, HTC, GREE, Colopl, and Gumi. As the VR/AR market is so nascent, many financial VCs have been reticent to dive in with meaningful checks beyond the seed stage. This has left a glut of companies looking to Series B (and beyond) with a large likelihood of them withering on the vineunless they can access strategic capital to help sustain the business until the coveted consumer monetizing market arrives. Strategics know that VR/AR is going to be an important computing platform for their businesses and are patient in watching it unfurl — not needing the same 5–7 year return of capital that financial VCs do.
It could be argued that many ‘traditional’ financial venture funds also have strategic ties with corporate ‘high net worth individuals,’ company pension funds, and corporate balance sheets making LP investments in financial VCs as limited partners. However, there’s a difference between a strategic fund and a financial venture fund with strategic links. In the former, absolute return may not always be the primary measure of success as it is with the latter: TVPI, DPI, money multiples, and IRR — i.e. the metrics that matter for LPs — are not always the driving force behind investing for strategics as they are with regular venture funds.
What have they promised you?
Understanding the corporate’s commitment to innovation within the startup ecosystem is integral to any kind of meaningful, long-term mentorship from a strategic investor. Do they have a successful track record of helping past startups they’ve invested in or have said startups littered the graveyard as casualties of changing corporate objectives? Have previously promised ‘strategic benefits’ materialized or have they dissipated into the ether of forgetful deprioritization once the beauty parade of winning a place on the cap table is over? More importantly, from an investment perspective, does the strategic have allocated funds reserved for follow-on funding? How are you to know whether or not they’ll be around at your next round of funding should they have a bad fiscal quarter, for example?
In either case, it’s best to clearly define how the relationship will develop over time as a result of the strategic investment and learn why said relationship could not develop sans investment in the first place. What does strategic investment do to benefit the startup besides capital (which can be found elsewhere)? If the relationship is mutually beneficial, why does the corporate need cap table access?
Entrepreneurs need to ask these questions and for past evidence of strategic value add. They should reach out to past startups that have taken investment from the strategic to assess follow-through from the strategic on promises made.
Who is your champion?
Does he/she actually have the power internally to help get your startup prioritized at the corporation?
How serious is the corporation taking its startup investments? Is it a top-down core imperative espoused by the CEO? If this weren’t the case, how powerful is your point person inside his/her corporation? For example, if your initial point person/champion quits tomorrow, will the corporate’s commitment to your startup evaporate along with your internal sponsor?
Multiple entry points can exist for touching base with strategic investors. There can be several pools of investing capital within the same strategic a la Samsung (e.g., Open Innovation Center, Samsung Ventures) or Google (GV, Capital G, Google corporate development), and it can become confusing as to which capital source is best suited for a potential investment. Entrepreneurs can usually tell which kinds of deals each sub-fund makes through their respective Crunchbase profiles. Sometimes there’s a clear demarcation of territory. Capital G (formerly Google Capital) does later stage growth investments and GV (formerly Google Ventures) tends to do earlier stage investing, for example. Other times, confusing overlap of portfolio companies by stage or sector can indeed represent confused and non-uniform internal policy from the corporate, possibly signaling internal political fiefdoms developed with their own, competing investment agendas.
Spend some time thinking about the above if your startup is considering raising capital from strategic investors. All money is green but isn’t the same — know who’s giving you cash and what it means to take it.
Watch this space for Part II of my blog series, where I’ll discuss the benefits of taking strategic investment, how to structure the relationship once investment is agreed upon, and M&A. Follow me on Snapchat (@sunnydhillon25) and on Twitter (@SunDhillon)