Are strategic investors actually a good idea?

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Funding — how to get it, where to get it, and how to leverage it — is constantly on the minds of early-stage startupfounders. So when strategic investors proactively come along offering large checks to fund your business, it might seem like a dream come true.

But like most things in life, if an offer seems too good to be true, it probably is.

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In most cases, strategic investors (also called corporate venture capital firms) are large corporations that are already operating in your startup’s market. SAP, Intel Capital, and Microsoft are some well-known examples. They’re prospering and they have extra cash, so they aim to investin up-and-coming companies like yours, which they predict will be the future market leaders.

However, these companies’ motives are anything but altruistic. Strategic investors invest to ensure their own futures and get a share of the spoils from the next generation of innovation. They see you and your company as an experiment. What products appeal to modern consumers? How does your technology and business model stack up? Could the founders run a business unit under our umbrella?

And if the student starts to surpass the master — if your company becomes too successful — strategic investors will view you as a threat and act accordingly.

What Strategic Investments Look Like

Typically, strategic investors wait to come in until the Series B stage, when companies are more mature. They might lead a round of funding or at least be a major participant, acquiring their access to the round via promises of distribution or technology support.

For example, let’s say you are a telecoms company and you get Verizon Ventures to invest in you. They would likely offer you better access to their network (technology support) as part of the deal. Similarly, if your company were operating on the Salesforce platform and Salesforce Ventures invested in you, they might give you distribution help by pushing you on the Salesforce App Store.

This much-needed support seems extremely beneficial on the surface. After all, 55.8% of Series B startupsfail to raise a following round, so it makes sense that you’d want to secure funding anddeliver your product to the masses via a strategic investor’s huge network. But nothing is free. This assistance comes with a steep price.

If you’re looking for a silver bullet to help you with distribution, don’t look to strategic investors. Unless they have a massive existing channel that’s demonstrating volume — such as the Apple App Store or Google Play Store — they just can’t give you the distribution they’re promising. Even if they can, there’s no guarantee that their customers will respond to it. It’s much better for your company if you build a direct relationship with your target audience.

The best mechanisms for distribution are not usually related to partnerships at all. You don’t want someone else to be trying to sell your product, but that’s a completely different article.

Symbiotic Relationship … or Conflict of Interest?

Early funding and support from strategic investors may seem like the ideal symbiotic relationship: Strategic investors get to secure their futures while helping you create yours. But that’s not typically the way things play out.

Ultimately, strategic investors are interested in their growth, not yours. To contrast, think about what a typical venture capitalist wants from an investment in you. Their goal is to maximize their returns — it’s as simple as that. They hope you become the next Google or Apple and own the entire world’s market. The better you perform, the better they do, and everyone wins.

Strategic investors, on the other hand, have an angle. They view your startup as more of an experimentin how your technology works and how the market responds to you. Their goal is for their investment to be successful — but not so successful that you dominate their market.

Now there’s a conflict of interest. No longer are the strategic investors motivated to help you. In fact, they’re now motivated to limit you in an act of instinctive self-protection. They may even be compelled to mislead you or erect roadblocks to your growth. You’re the competition, and thus a threat — plain and simple.

It sounds like a nasty move on their part, but it is actually an understandable and rational reaction on the part of the strategic investor. Think about the old saying, “It’s nothing personal. It’s just business.” Why would any business continue to support a company that is now a direct competitor? They’ll use whatever access and resources they have to keep you from surpassing them. After all, there are people who work at those companies with jobs, families, mortgages, and children, and they need to earn a living, too. They’re not worth any more or less than your employees.

While self-defense is a rational response, this type of outcome points to the inherent conflict of interest that comes with strategic investor territory.

Lessons Learned

I can speak personally to having a strategic investor turn on you. At my last company, we had a strategic investor invest in our Series B. They waffled on whether they wanted to acquire us, and then they tried to interfere with our next fundraising round. It was a very challenging time for us, and the relationship soured because of it. Fast-forward five months later, and they gave us three hours’ notice on an announcement that they were acquiring one of our main competitors. Talk about a knife to the heart.

While the decision really hurt our company, these strategic investors were not bad people. That was the rational business decision for them. Their decision to fund us had been predicated on the idea that they would eventually buy us. When they decided not to, it was time for them to move on. Once they decided to acquire someone else, why would they give us, now a competitor, information about the acquisition? It wouldn’t make good business sense.

Our strategic investors’ decision was rational; the mistake was partnering with them in the first place, and we absolutely suffered the consequences. It put us in a really terrible position with all of our existing investors. We were immediately bombarded with questions. “Why don’t you know what’s going on with your strategic investors?” "Why are they acting this way?” “And why are they attacking us?” Unfortunately, we didn’t have answers. Even worse, they were still a significant shareholder when it came time for our acquisition; it’s a marriage with no divorce.

Our case isn’t an isolated incident: Craigslist learned the same lesson, except more painfully. Due to a messy beginning, the company ended up in a situation in which it was partially owned (25%) by eBay.

Now, of course, Craigslist and eBay are direct competitors. Craigslist is a paradigm shift in the resale market in sense that it, for the most part, offers sellers and buyers a free service. It’s clearly a threat to an organization like eBay, which charges for many services. Naturally, eBay struck back and has systematically engaged in long-term lawsuits against Craigslist. Not only did this tie up Craigslist’s executive team with endless depositions for years, but it also made it more challenging for Craigslist to maintain its business and operations.

If not from me, take it from Craigslist: You don’t want someone in your market to own a big chunk of your company. When you do well, they stop seeing you as the little business they’re helping out and instead start viewing you as a big, bad threat they need to take down. Avoid the conflict and don’t put yourself in that position.

Better Funding Alternatives

Strategic investors aren’t worth the risk. Nowadays, if you’re struggling to fill out the last part of your round, I would recommend the following options:

1. Crowdfunding

This technique collects small amounts from dozens, and sometimes even thousands, of investors. While creative projects are listed on platforms like Kickstarter and Indiegogo, startup fundraising tends to occur on websites like AngelList, MicroVentures, and CircleUp.

The check size from this kind of fundraising is usually $100,000 to $500,000, and you should plan at least six weeks for the process end to end. However, all of this is very much dependent on who is leading the syndicate.

Outside of the capital, having a group of small but enthusiastic investors can be helpful for things like social media distribution and recruiting. But beware: A lot of investors who may have difficult questions can be significant drain on your time. I recommend agreeing to a communication cadence in advance with your syndicate lead.

1. Angel Consortiums

These are individual angel investors who have a structured process of group investing. Angel consortiums come in all shapes and are often tied to a university or a location (e.g., Wharton Angel Networkand Sand Hill Angels, the latter of which has members who’ve invested in my fund, Sterling Road).

The main differences between an angel consortium and an individual angel are the check sizes and overall process. While a typical individual angel check might be $10,000 to $100,000, angel consortiums tend to have a $100,000 minimum and often invest $500,000 or more. However, they usually have a longer, four- to six-week process. You can expect multiple initial meetings with one or two members as a filter before presenting to the entire group. After the final presentation, the consortium members commit individually, and their investments are pooled into one entity to invest in your startup.

The pros and cons of angel consortiums are the same as those of angel investors: They can be enthusiastic and helpful, but their questions, document requests, and office visits can be time-consuming.

1. Venture Debt

As the name suggests, venture debt firms provide startups with capital through debt. Founders see the appeal in this option because it lets them retain their companies’ equity (although most deals include a small amount, usually 0.5% to 2.5%). However, unlike equity investments, the debt must be repaid.

Venture debt firms are relatively rare compared with venture capitalists, making up only 10% of the venture market. Thus, most founders go with banks like SVBor firms like WTI(disclosure: WTI partners have invested in Sterling Road). Check sizes usually start at $500,000, and the process can be very quick if your business passes their initial filters. However, all your current investors must agree to be subordinate to the venture debt, so collecting those signatures can take time.

Interest rates on venture debt range from 8% to 20% per year, so you need to be prepared to make payments for a while. If you can’t pay, you risk losing the company. However, if things go well, venture debt providers are usually very happy to keep supplying you with capital. This can make the relationship extremely fruitful for both sides. Your business can get the capital it needs without fundraising, and the venture debt firm can keep collecting interest on the debt while its equity value grows.

If you have contracts for recurring revenue that can support your payments it’s a relatively safe funding option, especially for teams hitting high growth, with the added advantage of lots more capital being available.

If you’re looking through rose-colored glasses, strategic investors may seem like a great opportunity. They often promise funding, distribution, and technology support to startups, but these boons become a double-edged sword in the end. Strategic investors are looking out for only themselves, after all. Instead, take a look at crowdfunding, angel consortiums, or venture debt. These safer funding alternatives won’t punish you for your success down the line.


About the Author

Ash Rust, founder and managing partner of Sterling Road, is an entrepreneur turned pre-seed investor. Sterling Road is a venture fund focused on pre-seed B2B companies. Ash has mentored hundreds of startups through accelerator programs including Y-Combinator, Techstars, Alchemist, and universities such as Stanford, UC Berkeley, and Oxford. Connect with Ash on Twitter @AshRust.