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I Know You Want to – But …Think Twice About Taking Capital From a Strategic Partner When You’re a Small Business

Growing a small business is hard.  Bootstrapping the capital necessary to grow is difficult and time consuming and most entrepreneurs would rather get to the business of their business versus raising or thinking about money.  So when a large corporation, perhaps a super big competitor or a household name stops by and suggests giving you a small investment, it may seem like a dream come true.

Strategic or corporate investments in small businesses can dramatically affect your valuation in a sale process later on but many business owners can’t see past the cash at hand.

Why Do Big Companies Invest in Small Companies?

Large businesses are clunky and they know it.  These are not the optimal places to drive change and innovation.  Yet, they have shareholders and growth plans that demand that they stay ahead of the market.  One way to insure that they have access to market-leading technology is to continually scan the available start-ups and purchase or partner with them.  

How Do Big Companies Invest in Small Companies?

The capital infusion from a corporate partner can take several forms and you should be aware of what they look like.

1) Some companies have in-house incubators or venture capital funds

Fortune 500 Companies have innovation departments of corporate venture capital funds whose purpose is to invest in start-up technology.  These groups act just like independent VC funds but with the dollars and the cache of the large strategic partner behind them.

2) An investment can take the form of a strategic license or royalty arrangement

These kinds of deals package up a particular market segment or product and make it available to only that strategic partner.  For example, you could license your technology for use in the healthcare market to your large company partner.  You would have the ability to sell it to other customers in different markets, but only the large company partner in the healthcare market.  This can feel like an investment, because it usually comes with an upfront payment and/or minimum purchases over a period of time — providing capital and guaranteed cash flow.  

3) They become a concentrated customer (sometimes with specialized equipment)

A large company can place a large order with you that effectively takes up all of your capacity.   Another version of this involves your manufacturing or operational talent, but some investment in CAPEX from the large company.  Sometimes they buy a machine and put it in your facility.  In either case, you become an outsourced supplier for the large company.

4) They make a minority investment

The most common approach is pretty straightforward.  The large company makes a minority investment in your business at some agreed upon valuation.

So What’s the Catch?

I know that the attention from a big strategic can feel glamorous and exciting.  The capital you receive can be a welcome relief.  However, this usually comes at a cost that most small company entrepreneurs don’t (or don’t want to) think about. 

The demands & limitations of the fine print

That big order or investment is usually tied to some type of exclusivity or most favored nation pricing.  In some cases it goes further and the large company extracts value in the form of stock warrants.  

We were selling a company that had a large, strategic customer that demanded preferential manufacturing scheduling, which essentially meant that this client had to keep “open time” on the floor in case this customer needed to place an order.  Talk about inefficient and costly!

The biggest cost – the low cost option to buy

Here’s the biggest problem.  We sit down with a small- to mid-sized business that is ready to sell.  They are excited about their exit plans.  We ask them about how their company has been financed to date and they mention that they have taken a small investment from Big Company XYZ and given them exclusivity in a certain market.  

When you take an investment from a large company, you are effectively giving them a low-cost option on buying your business (and the ability to do due diligence).

The fact that a large part of your growth and profitability comes from a single, large competitor, that may or may not have a hold on a specific market or some of your equity, is going to make your company very difficult to market to other large companies.  Let’s say you make a special measurement tool and you have licensed the healthcare market to Johnson & Johnson.  J&J is also a great buyer for your business.  When it comes time to sell your business, who do you think is going to have the most leverage – you or J&J?  Do you think you will be able to sell it Merck?  Probably not.  You have effectively sold your business to J&J at whatever price you negotiated that early investment – without the benefit of running a full investment banking process.  

Be especially wary of early investors who are obvious acquirers of your business.  Not only will they see your weaknesses as you grow, they will have no incentive to offer you top dollar when it comes time to sell.  

Ok – So How Do I Avoid These Traps?  

Of course you can have blue chip, large customers.  But – keep them as customers.  You need to avoid exclusive arrangements or early investments if you can.  You can co-develop products or run pilots with big companies only if they agree to pay the same costs as every other customer.  Make sure that distribution deals that you agree to have concrete actions that have mutually agreed upon goals that will allow YOU to cancel later on.  And lastly, never sign an agreement that allows a large company the right to buy you as part of a large order.  

Starting a business is difficult and the allure of capital from a big company might be hard to pass up.  However, you have to remember why you are an entrepreneur in the first place.  If you wanted big company control, you would probably be working at one.  Don’t give away a low cost option to buy your business.  Be careful about how and with whom you partner in the growth phase of your business. 

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