When entrepreneurs seek backing from venture capitalists, they should be looking for many things besides just cold hard cash. In today’s startup market – where funding rounds are smaller and entrepreneurs must do more with less – one of the most important steps they must take early on is to form a strategic relationship with a potential partner.
It’s tempting for a startup to simply take funding wherever they can get it and not bother with anything else. But startups must learn to understand that they should look for venture backers who have money and the experience to help them through the ups and downs of the partnerships process.
For early-stage technology companies, having strong technical innovations and the ability to bring them to market in the least amount of time with the least amount of capital remain critical. But investors are looking hard at how much capital it takes to bring an enterprise to cash flow breakeven. Strategic partnerships properly thought through and implemented can help companies achieve this goal. The right partner can help to conserve capital, as well as provide leverage in the target market. Experienced VCs can also provide startups with assistance in the many aspects of developing, managing and harvesting the kinds of partnerships that can best help them to succeed in the long-term.
New companies certainly will still go the traditional route of raising capital, building products and developing initial distribution capability, and then go to the market to get revenue. But with the scarcity and higher price of capital today, more and more early-stage companies are opting for models based on developing partner relationships that they can rely on from inception through the life of company.
There are many kinds of partner relationships that can save capital, enhance revenue and create market opportunities. And partnerships can be structured in many ways, which may not necessarily involve giving up equity.
In terms of partnerships that save capital, Solid Works, a successful 3D computer aided design early-stage software company provides a good case in point. This startup did a terrific job of partnering with multiple companies early on to save capital by getting access to the various existing component technologies that were incorporated into its final product. The founders’ vision was to incorporate the various technologies to build the very best product and get it to market as quickly as possible. One of the principle value adds the founders brought to the company was the knowledge of which companies to partner with, which components to rely on, and the details of how best to integrate the components into the revolutionary new product that resulted. But had they built the product themselves from the ground up, they would have missed the market opportunity.
Startups might also enter into partnerships to gain the expertise and knowledge that the larger, established companies can offer. These partnerships can help startups avoid common mistakes and gain industry endorsements from leading vendors. In this way an early-stage company, which has a hot technology innovation but no visibility in the market, can be recognized through its relationship with the larger company.
For example, Epoch Systems, a startup storage management company, was unknown in the market and was unsuccessful selling its products to large corporate customers. But after the startup announced a relationship with the largest storage company in the industry, it gained credibility with end users and analysts.
Other types of partnerships can open up distribution channels that startups can leverage for market validation and endorsement, as well as greater near-term revenue. And partners with established market positions can not only validate ideas and products, but also can provide access to their own existing customers early on so that the startups can get to market quicker. A quicker entry into the market means the startup will generate revenue much sooner.
Partnerships that are focused on distribution sometimes can be structured with prepayments, which provide needed capital without causing equity dilution. Generally, companies that agree to prepay for future products in this way typically do so only in cases where they view the technology as especially innovative. Once they make prepayments, however, they are motivated to help the sell the product so that they get value from their investment.
As an example, Atria Software, an early-stage development tools company, was able to structure an early OEM deal with a leading workstation manufacturer in which that company prepaid $1.5 million for future product. The prepayment significantly lowered the equity capital requirements for Atria. The workstation company also introduced the product to its customer base early, thus giving the startup valuable feedback. That feedback showed that the customers wanted to work directly with Atria and revealed the need for the startup to add a direct distribution channel and rely less on indirect channels.
No doubt strategic partnerships can be key success factors for early stage companies in today’s market. But these relationships can carry a number of potential drawbacks that entrepreneurs need to understand to avoid.
For instance, startups should watch out for partners who try to “acquire the company without buying the company. This occurs when a company inserts restrictive terms or obtains certain rights. Because strategic partners generally are larger and have significantly more resources and experiences, the young companies can be intimidated into accepting whatever unfavorable and restrictive terms and conditions are presented to them.
Of the many unfavorable terms and conditions that partners might impose, some of the most typical ones are the “right of first refusal” and “ownership of intellectual property.”
With the right of first refusal, strategic partners would have the right to match any potential offers to buy the business. This condition, although it may sound inviting, discourages potential suitors. Intellectual property restrictions can be even more detrimental. Under such conditions, in the event of an acquisition, the strategic partner would own access to the startup’s core technology, allowing them to buy the company without paying for it.
One way to avoid the pitfalls is to make sure up front that there is a clear understanding of the real goals of each of the parties involved and to set expectations accordingly. Startups that fail to take these steps beforehand, find out later that the benefits of the relationship are disproportionately weighted in favor of the strategic partner. To ensure mutual satisfaction, early-stage companies should through what would constitute a fair deal for both parties and then bounced those ideas off of their venture investors.
By following this process, startups will be able to articulate an understanding of the opportunity when the partnership meeting first takes place. For example, they will be able to communicate their key requirements for the deal and demonstrate that any potential entanglements (such as the first right of refusal) have been thought out in advance. In general, a good rule of thumb in establishing strategic partnerships is to view as deal breakers any terms and conditions that limit the upside for the newly formed company.
Clearly, the right strategic partnership holds huge benefits for startups. But partnerships are ongoing relationships and must be managed properly if they are to be effective. All too often, the view of early-stage companies is that, once the deal is signed and everyone toasts with champagne, the work is over. But the reality is that once the deal is signed, the real work begins. And unless there is a focus on managing the relationship throughout its life, it will not be successful. Startups must have accountable and even dedicated resources to manage the relationship, ensuring that milestones (and the means to measure them) are in place.
Where VCs Come In
Experienced VCs can help entrepreneurs think through the process of securing partnerships, understand potential pitfalls and how to avoid them. VCs also can provide access to their own networks of valuable partner resources. In fact, the network of relevant business and technology partnerships VCs can bring to the equation can be just as important as the cash they can provide. So startups need to carefully consider which VCs to approach.
Entrepreneurs should select VCs in much the same way VCs select them – by establishing criteria up front to determine which ones can best help them reach their business goals. Talking with limited partners from one of the firm’s investment funds or team members at current portfolio companies can be an effective way of obtaining useful background information on the principals at the VC firm and the kinds of partnerships they can bring to the table. Only investors that are a part of the fabric of the industry in this way have the far-reaching partner networks that can give startups an advantage right out of the gate.
With the ongoing scarcity and high price of capital, startups today definitely will not succeed by cash alone. But they will succeed if they form strategic partnerships. In seeking out the best partner relationships, startups that enlist the backing of carefully chosen VCs, will gain valuable help in learning how to develop, manage and make the most of these important resources.
Elliot Katzman is a General Partner at Kodiak Venture Partners. Kodiak, based in Waltham, Mass., is a seed- and early-stage venture capital firm focused on the areas of communications, semiconductors and software. Katzman focuses on software investments.