6 Risks of Raising Capital from Strategic Investors

In addition to pursuing independent venture capital firms, entrepreneurs and business owners often seek funding from the “in-house” venture capital arms of large companies. Receiving funding from the likes of an Intel Capital or Comcast Interactive Capital does have its advantages. First, in today’s tighter capital environment, increasing the number of sources you pursue for capital makes sense. Second, obtaining funding from strategic investors can offer a certain credibility and validation of a emerging company’s technology and/or business momentum. 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 these reasons and advantages to pursue strategic investors, entrepreneurs should be aware of the risks and long-term implications of taking capital from a corporation’s strategic investment vehicle.

A few of these concerns include:

Strategic Interests Diverge

Company strategy is dynamic, both for small companies and large ones alike. This means that as time goes on, the interests of strategic investors can begin to diverge from those of the entrepreneur in whom they’ve invested. For example, a strategic investor might take an interest in an emerging company to incorporate its technology but then realize that its technology, if broadly adopted, would disrupt one of the strategic investor’s most profitable business units. Strategic investors also make an investment to keep the young company’s technology from reaching the market, thereby eliminating competition for its established product line. (KEY TIP: One way to determine how likely these scenarios are is to ascertain how the strategic venture capitalists are compensated. Are they compensated for the strategic value that they bring to their company? If so, be wary and very thoughtful about getting into bed w/ them. If they are compensated for the returns that their funds independently, you can breathe easier.

Competitive Overlap

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. This can occur with independent VCs too, though, so it really comes with the territory no matter what if you raise any outside capital.

Customer Acquisition Limitations

Having a strategic investor can block or complicate customer acquisition opportunities. Competitors to the strategic investor may not wish to purchase products from a young company, if doing so will enrich their larger adversary. For example, if GE invests a company that makes an amazing component technology for jet engines, Honeywell might hold off on a big order even if the product is a total bulls-eye for their needs.

Change of Strategy Forces Premature Liquidation

Many companies have tenuous commitments to their venture capital arms. When the venture capital business experiences stress or a new management team takes charge of the overall company, the venture capital divisions are susceptible to being shut down or meaningfully altered in terms of objective. This can result in an untimely liquidation of a fund’s investments or a change in the nature of the partnership.

Signaling Risk

Strategic investors have a reputation for being less valuation sensitive–often because they are also calculating the strategic significance of their investments. This is good initially for the entrepreneur. But, if the strategic doesn’t defend its holdings in subsequent rounds of financing, the entrepreneur may be disadvantaged.

Exit Strategy Issues

Strategic investors can introduce problems during exits. There are typically fewer strategic buyers that bid for companies funded by strategics because of the entanglements. To go back to our GE and Honeywell example, Honeywell might be an ideal buyer but hold off on bidding because GE was an early investor. Problem. 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:

1. 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.
2. Secondly, partner with a strategic investor as late as possible in your company’s development. Otherwise, you are more beholden to the changes in strategy that they may impose on you that hamstring your freedom of action

This featured guest post is written by David Wanetick, Managing Director at IncreMental Advantage, a strategic advisory firm. He leads all of the firm’s Devil’s Advocacy Audits. He teaches courses on Negotiations, Behavioral Economics and Decision Making at The Business Development Academy. David can be reached at [email protected].