More in the 50 Questions Series

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Together with Nic Brisbourne of The Equity Kicker / DFJ Esprit, I am writing a series of 50 questions you should ask when raising venture capital. We expect the series to run for a year, after which we will collate the answers into a book. We view this as a collaboration, so please comment to help make this series even more useful. This is #32 in the series.

Getting a strategic investor interested in their business is an exciting moment for entrepreneurs.

It provides validation that for the startup. It shows that major corporations have paid attention to – and been impressed by – whatever the startup has built. It seems like a good way to build a close relationship with a potential acquiror of the business when the time to exit comes around.

Be cautious. Accepting money from a strategic investor is a double-edge sword.

Why corporates have venture arms

There are many reasons why a corporate might set up a venture capital fund. Some of the more common ones include:

• As a form of corporate R&D that seems to cost less than working-capital-based R&D
• As a way of sniffing out what is happening in the market
• As a way to redeploy excess capital (although efficient market theory would prefer that capital is returned to shareholders so they can choose where to redeploy it)

Many corporates have venture arms. Disney has Steamboat, Intel has Intel Capital. WPP invested directly into Realtime Worlds. Nokia has its own venture fund. There are many others.

The idea behind most corporate venture arms is that they can work with innovative startups, have a first look at the changes coming through the market and, if the company develops in an interesting way, buy it.

That might be good for them, but is it good for you?

The Kronos effect, or why corporates eat startups

In his masterful work, The Master Switch (which you should really read if you are interested in the future of media and technology businesses, Tim Wu describes the Kronos effect thus:

In antiquity, Kronos, second ruler of the universe according to Greek mythology, had a problem. The Delphic oracle having warned him that one of his children would dethrone him, he was more than troubled to hear his wife was pregnant. He waited for her to give birth then took the child and ate it.

And so derives the Kronos Effect: the efforts undertaken by a dominant company to consume its potential successors in their infancy.

In effect, Tim sees the role of much corporate M&A activity as being destructive. The large companies acquire those that they see as a threat not in order to exploit the opportunities, but to destroy them. (By this measure, even Yahoo!’s acquisition record begins to look positive).

I don’t entirely agree with Tim’s assessment, not least because, as a former investment banker, I worked on enough deals where people really believed in the value of the business they were acquiring. In my experience, the deal teams believe in the transaction. I am more inclined to believe that an organisation’s internal processes can, in effect, kill a business; I just don’t believe that it is a conspiracy.

The downsides for a startup can stretch beyond sprogophragy though.

The good things a corporate investor can bring you include:

• Cash
• Deep connectionswith their corporate parent, which may lead to better commercial opportunities
• A solid understanding of the marketin which you operate (perhaps more than a generalist investor)
• An easy route to exit

The negative things include:

• Limiting your commercial opportunities:Will a Viacom-owned business be keen to work with a Steamboat-backed venture?
• Limiting your exit:if your investor declines to buy you, who else will? After all, their competitors will wonder why the team who knows your business best declined to purchase. What do they know that other potential investors don’t?
• Limiting your ability to raise later funding: Based on the two points above, a strategic investor has the potential to reduce your ability to raise funds in the future.

Are strategic investments always a bad idea?

No. There can be times when a strategic investor puts the best offer on the table, or where a deal brings a commercial partnership that would be impossible without equity changing hands.

If there are equal offers on the table from an independent VC fund and from a corporate investor, though, I would think very, very hard before taking the corporate money.

(Thanks to Brian Baglow for the neologism of “sprogophragy”)

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