With venture capital increasingly difficult to come by as the industry faces consolidation and its own fundraising challenges, entrepreneurs are looking to any and all potential sources of investment capital with which to build their businesses. Turning to angel investors for seed capital is just one example of this “any port in a storm” mentality.
Corporate investors, once again focusing their attention to the start-up domain, represent another potential source of growth capital and, perhaps more importantly, strategic partnerships.
The case for startup/corporate collaboration is clearly compelling. Startups are renowned for their creativity and efficient innovation models, but are often challenged in bringing their products and services to markets where they have no established brand identity and little if any distribution or customer support infrastructure. Building these elements of business infrastructure are expensive, time consuming and fraught with significant levels of implementation risk. Corporate investors on the other hand have established distribution channels, recognized brands and trusted customer relationships. What they often lack is a culture of innovation that can keep pace with markets that are evolving at the speed of the Internet’s growth. By combining the strengths of the startup and the corporate partner – the potential for synergies can be seductive.
But what is obvious is not always easy to achieve or even attainable. Having worked actively with more than 50 major corporations over the past 15 years in structuring strategic partnerships with our portfolio companies, we are strong advocates for the win/win potential in these relationships. At the same time, it is essential for entrepreneurs to walk into discussions around these partnerships with their eyes wide open.
In dealing with venture capitalists, the alignment of interests is centered on maximizing the value of the start-up enterprise – more or less for the benefit of all equity holders. In dealing with many corporate partners, the direct return on equity is a secondary consideration to the strategic benefits the corporation hopes to derive from its partnership with the startup. Exceptions to this general characterization are dedicated venture capital arms of major corporations who measure their success and/or failure at least partially on their direct returns from invested capital.
In most cases, the corporate partner is engaging with a startup to either fill a product/technology void or to secure a call option on innovation that may prove to be interesting, useful and/or disruptive in the future. In other words, the corporation is looking out for its own enlightened and selfish interests. Startups must do the same. Strategic partnerships are time and resource consuming and should be undertaken carefully. This is a case where less can often be more – at least in terms of the number of relationships. A large corporation can overwhelm the resources of its much smaller strategic partner. Likewise, the mere existence of a strategic partnership is no guarantee of a successful outcome. A large corporation can walk away from a strategic partnership with no more than a bruise. The consequences can be much more dire for the startup – a resource sink that never delivers.
In looking at potential strategic partnerships, the start-up management team is well served to look for a clear alignment of interests – “do you need each other to the same extent”? As difficult as it can be, strive to develop a partnership of “equals” – milestones, commitments, benchmarks should apply equally to both parties. Exclusivity in relationships should be tied to performance – plan and simple. Corporations will often look to “sweeten” their deal with a request for warrants tied to their performance – this was common practice in the dot.com bubble days. For a corporation, this can be a way to lower the price of an eventual acquisition – keep that in mind. At the same time, once you walk down this path, every strategic partner you engage with will be looking for similar treatment. Likewise, a corporate partner may ask for your financial records on a periodic basis – “to ensure your financial stability given the risks we are taking in working with a start-up”.
This is akin to letting the fox in side the hen house and challenges the “partnership of equals” structure we strive towards. How do you negotiate with a “partner” when they know all of the cards in your hand?
Increasingly, corporations are looking to take equity interests in startups where they believe they may have a strategic interest. While often important sources of capital, remember these investments often come with strings attached. Watch for the rights of “first refusal” or of “last offer” – both can make it difficult to bring another interested acquirer to the party at the appropriate time. There will be times when you may well want to exclude a strategic investor from a Board conversation or business discussion when you believe there may be a conflict of interest – make sure you can exclude then when “you” and your other Board members share this concern. If at all possible, when taking in strategic investors, try to take more than one so that you can avoid the perception of being “captive” to a single strategic relationship.
Strategic partnerships – including investments – can provide tremendous leverage to a young company. Properly structured, they can accelerate growth, lower capital requirements, and erect barriers to competition while improving the probability of success for the startup. That said, these benefits are a result of careful, deliberate and disciplined negotiations with the potential corporate partner.
The corporation is trying to get the best deal they can from the start-up to further their own goals and objectives. The startup needs to do the same – always mindful of the fact that sometimes it’s better to walk away, at least for today.
Bob Ackerman is the founder and managing director of Allegis Capital (www.allegiscapital.com), a seed and early-stage venture firm headquartered in Palo Alto, California. Ackerman has worked with more than 50 corporate investment partners over the past 20 years as both a venture capitalist and a startup executive. Read his past peHUB posts here