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Wednesday, September 24, 2008

How Entrepreneurs Can Get the Love Without a Bear Hug

from John Greathouse





In the 1960s cop show "The Mod Squad," Linc played a vital role as the tough, street-savvy member of the hip, made-for-TV crime-fighting team. When you shake down a drug-addled informant, Lincs are a great asset. However, when you are negotiating with a Big Dumb Corporate Investor (BDCI), links between the strategic aspect of your partnership and the investment terms can be fatal to your venture.

Each aspect of your BDCI relationship, financial and operational, should stand separately on its own merits. If there is not adequate strategic value in the relationship, do not accept BDCI funding.

Delink

Funding from a corporate investor should be considered guilty until proven innocent. In other words, you should assume that such funds will come with adverse stipulations unless you contractually limit the negative impact of any potential conflict between your companyís strategic goals and those of the BDCI.

One way to prove corporate investment dollars innocent is to draft a definitive, strategic agreement that clearly outlines the scope and nature of your startupís operational obligations to the BDCI. If the strategic, non-financial aspect of the partnership is not one you would enter into without an investment component, then you should reject the partnership and the investment. There are plenty of venture investors who are willing to invest their funds with no operational strings attached. As such, it never makes sense for you to encumber your venture with guilty funding.

Ensure that the non-financial aspect of your BDCI relationship is adequately strategic by decoupling it from the investment discussions. The strategic deal should not be the tail that wags the investment dog. This approach will help ensure that you maximize the deal terms of both the partnership and the investment. Any unilateral financial concessions you make for your BDCI could adversely impact your ability to cut an optimum deal with other, non-strategic investors.

In two separate ventures, I had very positive experiences with respect to corporate investments. In both cases, we crafted a separate partnership agreement that clearly specified the responsibilities and expectations of both parties and allowed my companies the flexibility to charter our own course. The corporate investments were made on the same terms as all the other investors and the BDCIís were not granted any meaningful preferences with regard to the timing, scope or nature of our exit. Such a healthy separation between the strategic and financial aspects of a Corporate Investment is key to ensuring that the relationship is rewarding for all parties.

Potential Advantages of a Corporate Investment

  • Valuation Insensitivity Ė BDCIís often accept higher valuations than Institutional Investors
  • Stalking Horse Ė BDCIís can motivate Institutional Investors to act
  • Passivity Ė BDCIís generally do not attempt to influence a startupís overall business
  • Non-Investment Funding Ė BDCIís often provide startups with non-investment cash infusions
  • Vested in Your Success Ė BDCIís can be powerful market allies
  • Market Validation Ė BDCIís involvement can represent significant market acceptance

Valuation Insensitivity

One of the most positive aspects of a BDCI is that they generally are not as valuation-sensitive as a traditional Institutional Investor, such as venture capitalists. This is driven by the fact that a corporate investorís primary goal is to gain a strategic advantage over their competitors. The return on their investment in your venture is of secondary consideration. Use this fact to your advantage.

BDCIs will generally not establish the valuation of an investment round and thus will not lead an investment. However, as noted in the following section, the BDCIís relative lack of valuation sensitivity can influence your valuation upward, especially if the Institutional Investors are concerned that one or more BDCIís will edge them out by funding the entire round. In such cases, the Institutional Investor may accept a higher valuation than they otherwise would have preferred in order to fund the entire deal and keep the BDCI out of the funding equation.

Stalking Horse

BDCIís can act as powerful competition to Institutional Investors. One of the most challenging aspects of fundraising is to force investors to commit their funds. In nearly every instance, in the absence of competition, investors are better served to wait as long as possible before committing their money.

The longer they wait, the more time they have to assess your ability to deliver on your promises. With the achievement of each milestone, you reduce your ventureís market uncertainty and operational risk. The most insidious reason investors tend to delay their investment decision is that they know you will be more pliable as your cash balance approaches zero. Thus, by stalling, they can place you and your venture under duress, which may lead to disadvantageous terms for you and highly advantageous terms for them.

Given the natural inertia that precedes a funding event, you must engender competition among your potential investors. A BDCI can often serve as such a catalyst. For many of the same reasons you want to include a BDCI in your funding round, many Institutional Investors prefer to avoid deals in which BDCIís participate. As such, you may be able to force the Institutional Investorís hand by indicating that a BDCI may fund the entire deal or even buy you outright.

Passivity

Most BDCIís invest in smaller companies as a way to stake a claim in an emerging market that is currently outside the scope of their near-term strategic roadmap, but may eventually become more central to their long-term plans as they continue to grow. In such cases, the financial aspect of the investment is of secondary importance, and the BDCI is content to stay in the background to a greater extent than the typical Institutional Investor.

Although most BDCIís are too distracted to become active in the operations of the companies in which they invest, a minority of BDCIís do take active investor roles and others treat their startup investments as outsourced developers. It is vital that you fully vet such motives during the structuring of your strategic agreement, as a non-passive BDCI is almost always detrimental to a startupís ultimate success.

If the BDCI requests a Board seat, you can reinforce their passive role by limiting their Board-level involvement to a non-voting Observation seat. This will allow them to attend Board meetings, but without the ability to vote on Board resolutions, thereby greatly diminishing the impact the BDCI can have on your ventureís operations.

Non-investment Funding

Profitable, growing BDCIís often do not know what to do with their mounting cash reserves. Help them out. Allow them to become your never-ending source of non-investment funds, much like a gullible, rich uncle. Such funds will help you execute your strategy, without suffering the dilution associated with an equity investment. Some of these funding vehicles include:

  • Co-marketing Funds Ė Co-marketing partnerships often include matching funds in which you and the BDCI share certain marketing costs. Associating your venture with a more widely known and respected brand will enhance your legitimacy, while effectively doubling the size and reach of a portion of your marketing budget.
  • Paid Pilots / NRE Fees Ė In most instances, the strategic aspect of your relationship will involve your team building something on behalf of the BDCI, usually an interface between your solution and their legacy product(s). Mitigate your opportunity cost by charging for all the development work you perform. If you craft such deals appropriately, you can get the BDCI to fund projects that are already on your development roadmap and that you can sell to a wider market, independent of the BDCIís needs.
  • License Fees / Product Sales Ė Just because the BDCI is an investor does not mean it can utilize your technology for free. A "friends and family" discount might be appropriate, but BDCIís should always pay a fair price for any and all products or services you make available to them.
  • Free Tradeshow Space ĖBDCIís can save you significant money, while providing you with meaningful visibility within your industry, by allowing you to utilize space within their tradeshow booths.

Vested In Your Success

George Orwell was wrong. Sometimes having a Big Brother around is a good thing, especially if you are the new kid on the playground. For instance, if your technology is bundled with one or more of the BDCIís key products, the BDCI will have a vested interest in your success that supersedes their financial interest. This may prove handy in the event that a competitor attempts to disrupt your business via a price war, an intellectual property lawsuit, etc. The fact that competitors may also have to deal with your strategic partner if they play rough with you may increase the chances that they give you a wide berth.

Market Validation

Even though they are generally not considered sophisticated investors, obtaining money from a BDCI remains a significant point of third-party validation. Such an investment communicates to the market that your solution is important enough to warrant the time, attention and cash of an established (and hopefully respected) market player. The formal association with a BDCI can bolster your credibility with potential partners and customers while mitigating the natural concern associated with your startupís financial viability. You can generate a great deal of comfort in the minds of your prospects by having a household corporate name on your investor roster. I routinely and shamelessly dropped the name of my BDC Investors when I was pitching to prospective customers, employee candidates and potential partners.

Potential Disadvantages of a Corporate Investment

  • Bad Touch Ė BDCIís can overwhelm and disrupt your team
  • Round Trip Ė False funding, as investment dollars flow back to BDCI
  • Follow The Leader Ė BDCIís seldom act as a lead investor
  • No Exit Ė A BDCI can reduce a startupís exit options
  • Corporate Pet Ė Market may assume the startup lacks independence and autonomy
  • An Open Kimono Is Drafty - Due diligence activities could allow BDCI to compete

Bad Touch

Just as children should understand the difference between good touches and bad touches, startups must recognize the difference in their interactions with BDCIís.

For instance, you should always be in a position to say "No." One of the most important aspects of a strategic deal with a larger company is to clearly and pedantically articulate the Statement of Work (SOW). If the relationship grows beyond the scope of the SOW, your firm should always have the option to decline the expansion of your operational commitment. If you choose to devote resources beyond those obligated in the SOW, the BDCI should know the cost in advance and agree to compensate you for your out-of-pocket expenses and opportunity cost.

Round Trip

Although changes in accounting rules following the bursting of the Internet bubble in 2001 caused Round Trip investments to be less prevalent, they still exist. Such deals require the startup to purchase certain goods and/or services from the BDCI. Thus the investment dollars come in one door and immediately go out another. For instance, a corporate investment might be tied to the exclusive use of certain routers (e.g., Cisco) or you might be required to incorporate certain microprocessors into your product designs (e.g., Intel) or you may be forced to utilize certain hardware in your datacenter (e.g., Sun).

In some circumstances, Round Trips can make sense for all parties. However, never ever agree to purchase goods or services from a BDCI if such purchases will not improve your probability of success or if such items are not competitively priced.

Follow The Leader

Although the introduction of a BDCI into the investment equation may motivate Institutional Investors to act, most BDCIís will not lead an investment. In other words, they will only put their money into your venture after the deal terms have been negotiated and the due diligence has been performed by an Institutional Investor.

However, having the commitment from a BDCI can provide an Institutional Investor the comfort they need to move forward with an investment. Even though BDCIís are often looked down upon by Institutional Investors, their presence in a deal can reduce a startupís risk of failure, especially if there is a compelling strategic aspect of the BDCI relationship.

No Exit

BDCIís will often attempt to significantly limit and/or influence the nature of your ventureís exit. This control most commonly manifests itself in the form of a Right of First Refusal. This onerous provision requires the startup to notify the BDCI whenever it is approached by another company that expresses an interest in acquiring the startup. The BDCI then has an opportunity to review any such acquisition offers and issue a counteroffer, if they so choose.

Obviously, such a provision will greatly encumber your ability to maximize the value of your exit. If the BDCI is insistent with regard to the inclusion of this provision and there is a compelling strategic aspect to an operational partnership, consider compromising by agreeing to a Right of First Offer. This somewhat less onerous provision simply requires you to notify the BDCI anytime you receive an acquisition overture. The BDCI then has a defined period of time to make the first offer. Although such a provision will slow down your acquisition discussions, it greatly limits the degree to which the BDCI can control the process and it allows you the flexibility necessary to negotiate the highest price possible for your company.

Corporate Pet

Depending on your relationship with the BDCI and the competitive makeup of your industry, there is a significant risk that accepting a corporate investment could limit and possibly preclude business interactions with your BDCIís competitors. The potential impact of this risk should not be underestimated.

Fortunately, you can mitigate this risk. For instance, in your discussions with the BDCIís competitors, make it clear that you maintain your independence, and that your company does not share competitive, confidential information with the BDCI. In your press releases referencing your BDCI, emphasis the non-exclusive nature of your relationship, by way of phrases such as: "We continue to search for opportunities to partner with other companies in a similar manner."

I have been able to successfully manage around this potential conflict, although I know of investments that have been returned to BDCIís because of the detrimental impact they had on the startupís ability to grow their business. As Kevin OíConnor, Founder and former CEO of DoubleClick explains in his book The Map Of Innovation, Bozell Advertisingís investment in DoubleClick was detrimental to DoubleClickís ability to establish partnership with other advertising agencies. These competitive agencies perceived DoubleClick to be Bozellís surrogate and thus equated working with DoubleClick to working with their archenemy, Bozell. Fortunately for Kevin and his team, they convinced Bozell to significantly reduce their investment to the point that it was immaterial and no longer a barrier to DoubleClickís ability to establish other ad agency partnerships.

An Open Kimono Is Drafty

In rare instances, a BDCI will leverage a promised investment as a means of learning as much about your secret sauce as possible. A certain PC software company comes to mindÖ Fortunately, such predatory BDCIís quickly develop a suitably negative reputation after they take advantage of a couple small companies, and find it difficult to sustain such blatantly nefarious practices.

Even though an overtly duplicitous approach is unusual, you should keep it in mind as you entertain potential corporate investors. One way to limit your exposure as you open your kimono (sadly, pun intended) is to judiciously share information in concert with the maturation of your relationship. As your relationship with a potential investor develops and becomes more and more likely to result in a meaningful partnership/investment, incrementally increase the sensitivity, proprietary nature of the information you share with the potential BDCI. Your most sensitive, proprietary information should be withheld until all other aspects of due diligence have been completed. Do not be hesitant to say "No" to requests that seem too premature. This is a great way to establish ground rules that will lead to a healthy, bilateral relationship.

Although risks clearly exist within the context of any partner or investor discussions, the advantages of a corporate investment can outweigh the potential disadvantages, if you craft separate partnership and investment agreements that allow you to call the shots at your venture, including your ultimate exit. As such, do not be afraid to establish a healthy, armís-length relationship with a BDCI. A properly crafted strategic BDCI relationship could result in a business version of the Mod Squad that allows you and your BDCI to collectively vanquish your villainous competitors.

John Greathouse has held a number of senior executive positions with successful startups during the past fifteen years. At Computer Motion (RBOT), he was the CFO and VP of Business Development. At Citrix Online (CTXS - formerly Expertcity), Greathouse served as CFO and SVP of Strategic Development. At CallWave (CALL), he served as the SVP of Sales & Bus Dev. In his capacities at Computer Motion and Citrix; Greathouse spearheaded transactions which generated more than $350 million of shareholder value, including Computer Motion's initial public offering and the sale of Expertcity to Citrix for over $230M. Greathouse is a Partner at Rincon Venture Partners (www.rinconvp.com).


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