Weekly Update

Raising money: Venture capital versus strategic partners

I moderated a panel on startups at data center and interconnect provider Telx’s recent conference. The panel included some career entrepreneurs, some of whom were on their fourth or fifth startup—not your typically 20something, working out of an incubator, stereotype of someone running a startup. We were there to help attendees glean some insight into the issues facing startups.

The collective experience of the panelists is asset on a lot of levels and one issue that arose on the panel was the difference between raising money from venture capital versus strategic investors. After all, these were a group that had had to raise capital many times.

Strategic investors are typically representing the investment arms at large corporations like Intel Capital or Steamboat Ventures (Disney) versus venture capital firms like Sequoia or Kleiner Perkins, which are exclusively trying to generate a return for their limited partners (pension funds, university endowments, etc). While both groups have benchmarks and expectations in terms of their returns, the attitudes at each class of investor can differ.

One reaction expressed at the question was that strategic investors could be less concerned about merely traction and numbers, and more concerned with aligning the startup they’ve invested in with the business interests of their parent company. The potential benefit to startups here is that it allows them some breathing room in product development and that strategic investors might be less quick to pull the funding cord at the first sign of failure. On the flip side, the criticism of strategic investors has often been that they can attempt to exert too much influence in company operations because the product outcome needs to align with their own strategic interests.

In 2009, then VP at Peacock Equity (Disney) and current Lightbank venture partner Paul Lee, argued that there were benefits for startups taking strategic capital in terms of operating partnerships with the corporate investor, industry expertise, and access/visibility of your company at a new potential customer. Lee cited an interesting study that showed that “startups with CVC (corporate venture capital) backing obtain higher valuations at the IPO than those without.”

The catch? The valuations were only higher “when the startups have a strategic fit with the parent corporation of CVCs.” On many levels this makes intuitive sense. One might expect VC firms like Sequoia and Kleiner to be superior at generating returns purely on an investment only consideration. After all, they’ve been doing this for decades.

But if the strategic investors can genuinely align the business models of the startup with those of the parent company it stands to reason that the startup could generate additional value and revenue through sales, cost savings, technology development and access to new markets through its relationship with a corporate VC. That value would be reflected during the IPO, particularly since IPO valuations aren’t just about numbers but about the potential for growth and capturing future markets.

On the flip side there are some warnings about strategic VC that startups should consider, presuming they have the luxury of choosing between funders. Robert Siegel of Xseed Capital who once helped Intel put capital into startups wrote last year of the realities of the perspective of strategic investors.

Siegel makes a number of points—namely that startups should be aware that at early stages of its founding, the startup is most vulnerable to disproportionate input from corporate venture backers. He adds that strategic VCs are more than happy to turn off funding if they think the startup no longer serves the corporate partner and adds a note of caution to startups about not taking development agreements or commercial arrangements that are tied to an investment round.

So what’s the truth? It would seem that if a startup is going to take strategic investment, it would be well served in seeing a clear case for it aligning strategically with the corporate investor, both in terms of long term valuation and in terms of likelihood of attaining lasting support from the corporate partner. Startups evolve in their business model and strategies, as do corporate partners, so there are never any guarantees, and many young startups are happy just to find a committed funder. But it never hurts to really understand the interests of the people who will own a chunk of your startup.