Corporate venture, business partners, and development agencies can be great investors for startups, but beware of dangerous complications.

You’ve created a new organic protein drink and signed up a supermarket chain. Congratulations! Now you’re looking for investors to help you take the business to the next level. Who’s at the top of your list of dream investors? I’ll bet it’s Coca-Cola.

Or you’ve invented a better Li-ion battery. Wouldn’t you kill to have your board filled with representatives from BMW, Volvo, and Ford?

Corporate investors are wonderful. Not only do they offer much needed investment, but they become your first customer, invested in your success. They can provide valuable guidance on product needs and open doors into the industry. They provide validation to other investors and a clear path to an exit.

Sounds perfect, right? Well…not so fast. Because when an ant dances with an elephant, it’s easy to get stomped on.

Not only do startups gets killed by lumbering giants, but along the way, so do other investors. While financial investors (venture funds and angels) welcome strategic investors to the team, we’re wary of them as well.

Not only founders but financial investors have been burned before by strategic investors and will be burned again. More than the gargantuan size and stifling bureaucracy of strategic investors is the fundamental fact that they’re investing for strategic reasons rather than financial gain, and that breaks the venture model. The needs and incentives of financial and strategic investors are different, and often come into conflict.

Here’s what founders need to understand about these two very different types of investors and how to balance the needs of each.

Who Are Strategic Investors?

We’re all familiar with venture capital and angel investors. They invest in startups to make money. But they’re not the only people investing in startups. Some organizations invest in startups to support other goals. Making a financial return on their investment is just one criteria, and not the most important.

Corporate venture capital is the archetypal example of a strategic investor. If Coca-Cola or Ford invests $250K in your startup, it’s not because they’re aiming for a $2.5M return to pad their yearly earnings ten years from now. It’s because the startup has the potential to solve a major problem for their business.

It may mean your product solves an operational problem, like a better, cheaper EV battery. Or it might mean an early look and first dibs on a startup they could consider acquiring someday. It could be a new product that fits into their distribution, or supplements their own product with a useful new feature their customers are clambering for.

But corporate investors aren’t the only strategic investors. Others include:

  • State and local economic development agencies
  • Industry associations
  • Industry-focused incubators and accelerators
  • Sovereign wealth funds

It’s easy to tell the difference between strategic and financial investors. If the overwhelming goal is anything other than making a financial return from their investment, they’re a strategic investor.

(There are some corporate venture capital groups that invest primarily to meet financial rather than strategic goals and will act more like financial investors than strategic investors. The same for sovereign wealth funds.)

The question then is: what does the strategic investor want to accomplish by investing in your startup, and how can that conflict with the goal of the financial investor to make as large a financial return as possible as quickly as possible?

The Conflict Between Strategic and Financial Investors

Venture capital, especially at the early stages, has a pretty simple model: put in investment and wait for the company to grow exponentially to $100M and sell to the highest bidder for a big return. Rinse and repeat.

This model relies on everyone’s interests being aligned in a sprint towards that big exit.

Strategic investors bring needed capital, validation, and industry connections. But they also upset the venture business model.

A big exit doesn’t matter to strategic investors. They’re investing not for financial reasons but to further their company’s strategic goals. And that can cause complications and conflicts.

  • Coca-Cola won’t be happy if you sign a distribution deal with Pepsi. And they’ll want to block you from being acquired by a competitor.
  • Intel and Qualcomm won’t be thrilled if you decide to use chips from AMD, even if those chips are a better fit for the product.
  • Ford and GM won’t support a pivot from EVs to grid batteries, even if that’s where you’re finding product-market fit.
  • The economic development agency of Kentucky doesn’t want you opening your headquarters in New York, even if you’re making fintech software for the banking industry. They may prohibit you from registering the business in Delaware even if that’s a requirement of venture investors.

Examples go on and on. Examples I’ve seen in person. These aren’t just customers and suppliers that you can renegotiate with or ditch when they no longer fit your needs. You’ve sold a significant portion of the business to them on the promise that you’ll fit their strategic goals.

At a minimum, they won’t be investing in your next round, a negative sign for future investors. If they’re on your board or have other special rights, they may stop you from making needed changes.

Do they care that their demands could damage your business, prevent you from finding a large market, and reaching a successful exit? No. That’s not why they invested in you. The company’s failure will mean little to them.

For the cynical, the startup may even be better off dead to a strategic investor than being successful. The strategic investor can buy up the patents and other intellectual property from a failed startup for pennies. Or they can do an acquire-hire or grab the business for cheap. Personally, I don’t think very many would deliberately destroy a startup (though there are plenty of examples of both strategic and financial investors acting with malign intent) but it is another way that financial success of the startup is not the critical factor for strategic investors that it is for financial investors.

Taking Advantage of Strategic Investors While Mitigating the Risks

As the investor with the biggest pockets, the most industry knowledge, and the biggest risk appetite, strategic investors are often called upon to be the lead investor. This is a huge mistake.

Other investors rely on the lead investor perform a thorough diligence process. But Coca-Cola’s diligence process is about the risk to them, not the risk of company failure. Their decision to invest is about the benefits to them, not the probability of financial success of the venture.

Strategic investors don’t really care whether your startup is valued at $8M or $12M. For big strategic investors, the valuation at this early stage doesn’t really matter. For angel investors like me, that difference of 50% in valuation is likely to determine whether I invest or not. A too-high valuation not only scares off other investors but sets the bar too high for the next round.

The terms strategic investors care about are not the same as financial investors. It’s having a board seat. It’s right of first refusal of acquisitions. It’s control over where the company is incorporated and where it opens its offices. It’s about having veto rights over who else can invest in your startup. All of which are problematic to obtaining a big exit as quickly as possible.

So what should you do? The answer is surprisingly simple.

Absolutely bring strategic investors into the company. Take advantage of their money, their expertise, their connections. Make them your first customer or your trusted partner.

But do not make strategic investors your lead investor. Do not give them any special terms other investors do not get. In particular:

  • Do not give strategic investors a board seat, even as board observer. Pepsi isn’t going to negotiate a distribution deal with you if they know Coke gets to see all the details.
  • Do not give them a right of first refusal on an acquisition. Pepsi isn’t going to spend months in negotiations and millions of dollars in lawyers and bankers fees to acquire the company if Coke has the right to grab it out from under them.
  • Do not give them the right to buy equity for in-kind payments of their own products or services.
  • Do not allow them, singularly or as a group, to take 50% of any class of shares. Each class has veto rights on major changes to the business including new funding rounds. This is how strategic investors can assert their strength. Ready to raise a Series A round? You’ll be blocked if you don’t agree to the demands of those strategic seed round investors. Financial investors simply want to see a path towards financial success. Strategic investors, if they own more than 50% of the shares, may have other demands that are not in the company’s best interests.

So long as strategic investors have the same terms as financial investors, they’re a great addition to the cap table. Keep the investment relationship separate from the business partnership.