WHAT IS A STRATEGIC INVESTOR?
The term "strategic investor" refers to a company that has a primary business of something other than investing, but invests, from time to time, in companies within its own market or in complementary markets. Strategic investors can be particularly quick to grasp the strength of an emerging business' strategy or technology and reasons why the business could be an attractive investment. Strategic investors also offer an emerging business more than money. They can help an emerging business achieve its objectives by providing a wealth of industry knowledge and by identifying known obstacles and overcrowded markets. Investment by an established industry player can also boost the emerging business' visibility in the marketplace.
Strategic investors come in many forms, sizes and levels of sophistication. Some are well-established semi-autonomous funds with their own management teams made up of former venture capitalists or investment bankers. These funds may resemble a traditional VC fund that specializes in a particular industry segment. At the other end of the spectrum, some strategic investors may be essentially novice investors. They tend to be more flexible than established strategic investors, making decisions on an ad hoc basis, but often with input from a CEO or CFO who has limited experience in evaluating investment opportunities.
It goes without saying that the structure and sophistication of a strategic investor will color its relationship with an emerging business both before and after the investment occurs. As a result, it is particularly important for the business to perform its own due diligence on the investor at an early stage in discussions. Management should find out as much as possible about the investor's past investment experience and what elements of the emerging business might be of particular interest to the investor. A strong financial story is usually necessary but not sufficient to interest a strategic investor. A strategic investor may view the emerging business as way to counter a competitive threat, to solve an existing business problem, or to develop new markets. In some cases, a strategic investment can be a prelude to a full acquisition of the emerging business.
INVESTMENT TERMS
Just as the structure and organization of strategic investors can vary significantly, the terms under which they invest are also not uniform. If a strategic investor is participating in a round of financing that also includes VC investors, as is often the case, the strategic investor is unlikely to lead the round, leaving negotiations about valuation and investment terms to the professional investors. When a strategic investor invests independently, and not as part of a group, an emerging business may find that the investor is less demanding on financial terms than a VC firm would be, because it typically has other reasons for wishing to pursue the investment — principally the commercial relationship that will accompany the investment. Strategic investors also may not be subject to the same high expectations for investment return that apply to VC firms.
An emerging business should be particularly cautious about offering a strategic investor the right to name a member of the Board of Directors, because of the conflicting loyalties to which a director who is also an employee of the strategic investor may be subject. As a director, the individual has a fiduciary duty to act in the best interest of the company and its stockholders. But what if the emerging business is considering a change in direction that would put it in competition with the strategic investor (or allying itself more closely with the strategic investor's major competitor)? In such cases, it may not be prudent to rely on the director's undivided loyalty.
COMMERCIAL ELEMENTS
In addition to the financial elements of a strategic investment, there is often a commercial element that makes the investment "strategic." Examples of commercial arrangements include the grant of exclusive distribution rights to the strategic investor, the licensing of key technology, or the granting of a right of first refusal on future transactions. Often the commercial arrangement provides not just cash but early stage revenue to an emerging business, which can be an important milestone for the business.
Even if a strategic investment does not include a formal commercial agreement, the strategic investor will often be prepared to help an emerging business with sales and marketing advice, technical know-how, and introductions to other industry participants. These resources can be extremely valuable to an emerging business working to establish itself in a new market. Sometimes the fact that a major industry player has made an investment in a company is enough to open doors for the company, because the investment can be viewed as a seal of approval, even if the strategic investor does not actively seek to promote the business.
RISKS OF A STRATEGIC INVESTMENT
It is clear that a strategic investment offers a number of benefits to an emerging business beyond the financial investment. But an emerging business should not lose sight of the risks that attend such an investment.
Both before and after making an investment, a strategic investor will have access to significant information about the company's financial results, its product and marketing plans, and its technology that are not known to the general public. While a well-drafted set of investment documents will require all investors to maintain the confidentiality of the information they receive, and restrict their use of such information, these protections can be difficult to enforce. The best protection is for the company to have the right to limit the information it discloses to a strategic investor in the first place.
Another risk that arises from accepting a strategic investment results from the long-term nature of a strategic investment. If the commercial relationship between the strategic investor and the emerging business sours for any reason, the business may be unable to completely wash its hands of the strategic investor because the investor will continue to be a stockholder. Once the commercial aspect of the relationship has terminated, the strategic investor may lose confidence in the company's business and become an obstacle to future transactions that require stockholder approval. It may be in both parties' interests to provide for the redemption or transfer of a strategic investor's shares if its commercial relationship with the company terminates for any reason.
An emerging business should also be mindful of the risk of appearing to be too closely allied with a particular industry participant. In some industries, this risk is negligible, but in others it may be very serious. If the company intends to enter into commercial relationships with a number of competing companies, having one of the companies as an investor may create the perception that the emerging business is biased in favor of that company. It is important to take the long view when considering accepting a strategic investment and evaluate whether the perceived alliance with the strategic investor could hinder the company's future plans.
It is also possible that a company will cease its strategic investing activities, and decide to sell its portfolio to a new investor. In such a case, an emerging business typically has little or no say in the identity of that new investor. The new investor, who may have purchased the strategic investment for pennies on the dollar, can have very different goals and motivations than those of the original strategic investor or the emerging business' other investors.
Finally, some strategic investors may utilize the leverage provided them by their investment in an effort to buy the emerging business at a cheap price. Like venture capitalists, strategic investors will often ask the emerging business for various "blocking rights," i.e. the right to approve or disapprove of various corporate actions. A strategic investor could use its blocking rights to prevent the emerging business from securing the capital necessary to expand, in an effort to drive the emerging business into a sale transaction with it on favorable terms. For this reason, management of the emerging business should carefully scrutinize the blocking rights requested by strategic investors.
CONCLUSION
Strategic investments can bring significant benefits to an emerging business, including working capital, industry knowledge, revenues, and a heightened profile in the market. These benefits should be evaluated in the context of the risks that a strategic investment can also entail. Working with seasoned counsel can help an emerging business develop the framework for a successful long-term relationship with a strategic investor.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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