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HEIDI: Welcome to The Startup Solution, and “The Case of the Strategic Sucker Punch.”
Hello, I'm Heidi Roizen from Threshold Ventures. The Startup Solution is a podcast where we unpack the “oh shit” moments faced by entrepreneurs, and then find the best ways to get through those moments alive — and with a little luck, maybe even better off.
. . .
I got a call recently from a CEO I first met when he was the chief product officer at another company we had invested in. As always, I protect the identities of the people and the companies I talk about by changing their names, altering details, and employing composites. So let’s call him Trent.
Trent’s really terrific. So when he went on to found his own company and got back in touch with me, I was excited to hear what he was up to. He was doing something in the manufacturing space, and he’d been self-financing for about a year. He was in discussions with a strategic investor — that is, a corporation that also does venture investing. For the purposes of our discussion, let’s call them BigCo.
BigCo had recently given him a term sheet to co-lead his series A round. So Trent offered me a look at the deal, to see if I was interested in co-investing. But when I looked, I found some problems. For one, the price was about double what I thought his company should be worth. And in addition, there were a number of non-market terms that I didn’t like, either. So, I declined the opportunity to invest, but he and I agreed to keep in touch.
About three months later, Trent called me:
TRENT: I’m hoping I can talk to you about something that just happened to me. BigCo just let me know that they’re letting their term sheet expire. Long story short, I tried to find co-investors to fill out the round, but everyone kinda had the same reaction you did. All the VCs said the price was too high and the terms BigCo wanted weren’t attractive to them. Since we couldn’t fully fund the plan without the whole round, and BigCo didn’t want to double down, they simply let the term sheet expire. Honestly, I think they started to feel like schmucks for pricing it so high, but I just feel like an idiot for not listening to the market signals when I got all of those no’s in the first place. So now I’m starting from square zero, and I’m three months behind on my fundraise and that’s going to start affecting our ability to meet our buildout plan this quarter. Can you give me some advice about how to get this restarted, and quickly? I’d really appreciate a call as soon as you can. Thanks so much.
HEIDI: Before I dive into what happened and why — and what Trent and you can learn from this — let me talk a bit about what a strategic investor is and how they work. That knowledge will be critical to understanding today’s case.
Strategic investors, or corporate investors as they’re sometimes called, are in many ways similar to venture investors. However, the business model of most strategic investors differs from the business model of a pure venture investor. And that difference has important implications for entrepreneurs who are funded by them.
I like to say that when we, as venture capitalists, invest in your company, we only make money if your stock goes up. That’s the only business model we have.
However, strategic investors are quite different. They have two ways to make money when investing in startups. One is the same way we do: They make money if they buy startup stock low, and someday sell it high. But even more importantly, they can also make money when their stock price goes up, by virtue of the great business deals they do with those startups — potentially even acquiring them down the line.
In fact, most strategic investors do not cite “make money off startup stock” as their primary strategic goal for investing. I mean, for many of the biggest ones, any amount they’d likely make from strategic investing would be dwarfed by their revenues and profits anyway.
Instead, for most corporations, their primary goal in investing in startups is to help the corporation achieve its own strategic goals. They may make investments in startups with new technologies or products that might augment their existing product lines. They may look to startups to extend them into new vertical markets. Sometimes, they even invest in startups that may become disruptive to their own product lines.
Strategic investors can be great partners to a startup. For example, they can provide deep expertise in their sectors, access to sought-after supply chains, or revenue opportunities with their much larger customer bases.
And strategic investing has become a big, big thing.
According to Global Corporate Venturing, the leading organization in the space, there are over 2,000 strategic investor entities actively operating as of 2022. Also, according to them, corporate investors deployed $192 billion, yes with a B, into investments across all stages of the startup world in 2022. Almost 20% of all VC deals done globally include at least one strategic backer. And some of the most active strategic investors include Softbank, Alphabet, Salesforce, GM, Sony, Intel, and Citigroup. Certainly, big names that I’m sure you’re familiar with. So yeah, it’s kind of a big deal.
So now that you understand what strategic investors are, and generally why they invest, let’s return to Trent and his crisis.
I think Trent is a fantastic entrepreneur. But, I also think he may have doomed his fundraise from the very start when he signed the BigCo term sheet. So let’s start there.
Trent’s startup, in the manufacturing sector, is what we call a capital-intensive business. That means he has to spend a ton of money on a plant and fill it with specialized, expensive equipment before he can ever generate even a penny of revenue. He needed to raise a huge series A — fifty million dollars — in order to build out that pilot plant.
BigCo was interested in part because they wanted to manufacture some of the equipment Trent would be using. If this plant really worked, it would open a huge new market for BigCo as well. Trent had lofty ideas for valuation, which VCs like me thought was a lot higher than it should have been. But because BigCo’s primary objective was strategic — that is, selling their equipment into a new market — they were less price-sensitive. So they met Trent’s ask.
BigCo also negotiated an additional term: that Trent would use only their equipment in his plants. And they also negotiated a ROFR — which stands for a “Right of First Refusal” — to buy Trent’s company. That means if Trent ever wanted to sell, he’d have to give BigCo the opportunity to buy it at whatever price any other winning bidder had offered. And if BigCo wanted it at that price, he’d then be required to sell it to them. In return, BigCo committed $25 million dollars into the round — fully half of the $50 million Trent needed. They also made closing the round contingent on Trent raising the rest of the money from other investors and gave him three months to do so.
As Trent took this term sheet to market, the feedback was pretty negative. Pure investors like me, who were not getting the additional benefits such as guaranteed equipment sales and ROFRs, didn’t want to pay the high price.
And we didn’t like that ROFR, because it can make other acquirers less interested in even trying to buy the company in the future. That’s because BigCo would have the right to swoop in and demand the deal be theirs. And that puts a real damper on the competitive sale process, which is kinda how we VCs make our money.
As the months passed, and Trent continued to receive no’s, he tried to get BigCo to either provide all $50 million, or at least close on the $25 million they had already committed to. But BigCo didn’t want to do that, because they didn’t want a whole $50 million of exposure. Also, they knew Trent needed the whole $50 million, as half a plant was about as good as none. So they didn’t want to put their $25 million at risk without having the plant fully funded. And Trent didn’t want to give up on that high valuation, so he just kept pitching new investors — until the clock ran out.
BigCo probably also got cold feet that nobody else was showing up. That likely pushed them into worrying that maybe this investment wasn’t such a good idea. It’s only human nature to feel that way when everyone else says no to a deal that you already said yes to. So when the term sheet expired, they told Trent they were not going to move forward. And that’s when Trent called me.
Trent primarily failed to understand that his strategic investor was investing for both financial and strategic gains, and as such, was willing to price the investment at a higher value. Pure venture investors, on the other hand, who only make money by buying and selling stock, were not getting that extra value and were, therefore, not willing to pay as high a price. So they all declined to participate. And without that $25 million from investors other than BigCo, the whole round fell apart.
Before we figure out how to salvage Trent’s situation, I want to underscore what you might want to consider when negotiating business development deals with strategics.
These types of agreements can be great. But you really need to make sure you fully understand and value what you are giving up to get whatever you are getting. For example, if you agree to buy only the strategic’s products — or to exclusively sell to only them — then you are shutting off future opportunities to negotiate in the open market for better deals. That decision may harm you in the long run. It may even stunt the growth of your enterprise value. And so, if you do a deal like this, you need to get properly compensated for it.
Some deals I’ve seen work really well, like giving a strategic the rights to a certain territory — or maybe creating and licensing a version of your product for a particular vertical market. These arrangements could make great sense — especially when the strategic can invest in launching and growing those territories or products in ways you wouldn’t have been able to for financial or other reasons. But, just remember that these deals have real value to your strategic partner, and should provide real value to you too. While the trade could be for investment capital, it could instead be for something different, such as revenue sharing from those expansions. These can be great deals for both the startup and the strategic partner if done properly, and they may not even involve investment capital at all — though they certainly can.
So what did Trent do?
Well, my advice to him was to start by seeing if he could negotiate a clean investment deal with a pure VC investor, and then see if he could put together a strategic deal with BigCo that could stand alone on its own merits — without the need for BigCo to invest. So he started by going back to the pure VC who expressed the greatest interest. He needed to see if they would issue a clean term sheet at whatever valuation they felt was appropriate — with no strategic bells and whistles for BigCo or anyone else. The VC did make an offer — a clean deal at a little more than half the price of BigCo’s term sheet. The VC also committed to funding $25 million of the $50 million the term sheet called for, and gave Trent 60 days to raise it. Trent gulped, swallowed his valuation nostalgia, and signed the term sheet.
Then he went back to BigCo.
BigCo’s team was encouraged by the brand name VC validating Trent’s company — and they liked the lower price, too. Trent negotiated a standalone agreement giving him discounts on BigCo’s equipment in exchange for hitting certain volumes. The deal they settled on was a decent one for both sides, and it didn’t require BigCo to invest at all. But BigCo did decide to invest their $25 million, and so the round closed, fully funded.
And what should you take away from The Case of the Strategic Sucker Punch?
First of all, remember that strategic investors have two ways to make money when they invest in you. They hope that your shares will rise in value, but they also hope that their shares will ultimately rise too, as they generate their own enhanced revenue and profit from working with you.
And because this is different from how pure venture investors make their money, this likely means that a strategic investor will need different or additional terms to encapsulate that working relationship. It also means that the strategic investor may be less concerned with the price they pay for your stock, since it is only one of multiple ways that they may benefit financially from the deal.
Second thing to take away is that strategic investors can be great partners for your company, but if you intend to have pure financial investors come in alongside them, you’ll need to come up with a valuation and terms that are attractive to all. And if you get a lot of no’s from the market as you seek to fill out your round, chances are you haven’t gotten it right. In that case, you’ll need to adjust your price, your terms, or both, until you find the market-clearing value and terms that get it over the finish line.
By the way, one creative solution I’ve seen is that some entrepreneurs concurrently close a pure financial round and a strategic round with different terms and different prices, and different classes of stock. This approach is somewhat complicated, but it can also make a lot of sense. Of course, each of those rounds still has to appeal to the investor it’s intended for. And in addition, the relative price and terms that differentiate the two deals will have to also make sense to the participants in both. Otherwise, one side may not invest if they feel they are being treated unfairly.
And finally, corporations can be great business partners even independent of strategic investments. It’s a really smart idea to think through any business development deal independent from fundraising — and to craft one that can stand on its own merits.
After all, that’s how Trent ultimately worked out his deal with BigCo and got his round back on track.
And that concludes “The Case of the Strategic Sucker Punch.” For the record, this situation is real, but Trent and BigCo are composites. And no startups or strategic investors were exposed or harmed in the recording of this podcast.
Thanks for listening to this episode of “The Startup Solution,” a podcast from the venture capital firm Threshold Ventures. We hope you have enjoyed this episode, and if you have, please leave a rating or review in your favorite podcast app. I’m Heidi Roizen.
A comprehensive summary of the pros and cons of strategic investors
Excellent view from the “other side” – things strategic investors should consider in investing in a startup
Data about corporate venturing (and much, much more) that Heidi references in the podcast
