Here's why you should invest in early-stage startups, not acquire them

When corporates finally realize how hard it is to incubate genuine innovations inside operational business units, their first port of call is usually an incubator, accelerator, or startup referral program tasked with finding a startup solving a specific problem that the corporate has. Unfortunately, it happens too frequently that it's not too far a step from pilots with a startup to the corporate acquiring all or a substantial portion of that startup’s equity as a pre-emptive and selfish act of resource hoarding. This acquisitive behavior is socially and economically undesirable and counterproductive with early-stage startups.

Operationally immature

Classifying a startup as early-stage or not can be hard based on revenue alone because different business models express total revenue and customer lifetime values differently. The easiest way to classify them is simply on age - less than five years old is usually a good indication of a business that is operationally immature and has not fully worked out its product-market fit.

Early-stage startups are typically operationally immature and struggle to scale nationally or internationally once they’ve been acquired by a corporate because they usually lack existing resources like employees, robust processes, experienced management at different layers of the organization, and a playbook acquired through past successes. Acquiring a small startup and expecting it to solve corporate problems at scale within relatively short periods is fraught with challenges and has a low probability of success.?

The faster that corporate tries to scale a startup, the more operationally intensive it becomes for executives at the corporate level and the less capital efficient the scaling becomes. The startup becomes a big black hole that consumes cash in return for relatively little near-term revenue growth, which lags operationalization and thus infrastructure costs.

Solving the corporate’s problem, not the market’s problem

Corporates that acquire early-stage startups will often do so on the back of a need that they’ve identified in their operations, frequently in response to a request by a large customer. There is usually not a lot of work that goes into establishing whether or not there is a large enough addressable market for solving that way in a competitively differentiated and economically viable way with a compelling value proposition.

Early-stage startups acquired by corporates are lucky if they survive to become product features. They will hardly ever make it to becoming a fully-functional, at-scale division within the corporate. Add to this the dramatic change in work style, decision making, and accountability demanded of entrepreneurs transitioning to becoming employees. Startup founders should think very carefully about what they’re getting themselves into when they sell their business to a corporate.

Low revenue contributions make startups 2nd rate citizens

Early-stage startups acquired by corporates are usually sub-scale and at low total revenue levels. The rationale for the transaction on both sides is frequently market access as a tool to scale the startup. This is the process of integrating the startup into the corporate value chain and selling the capability or solution to the corporate customers.?

In practice, once a startup has been acquired, it has to fight for its resources in the annual budget. Its requirements are often deprioritized when larger or more profitable business units demand more resources. Counterintuitively, the smaller business units which need the extra resources to grow revenue will usually lose out to larger business units that demand more resources?because?of their size. If the newly acquired startup doesn’t have the necessary executive sponsorship with a willingness to expend political capital, the startup will struggle to get out of the starting gates and will languish inside its new parent.

Many of the challenges that present themselves to both the corporate acquirer and the early-stage startup acquiree can be better managed in a formal corporate venture capital program managed by an external fund manager where corporates invest in startups:

• Startups are allowed to grow at a realistic pace, and corporate value chain integration will only be attempted once the startup is operationally mature enough.
• The startup will always attempt to address the needs of a large and growing addressable market, not a single corporate customer. The external fund manager’s job is to grow the startup's value, not solve the corporate’s problems that may not be market problems.
• Entrepreneurs retain their entrepreneurial agility and don’t become corporate employees.
• Startups don’t have to fight against corporate antibodies and competing business units for resources to grow as they’re not reliant on a single source of financing. They can raise capital externally and add new investors to unlock further customer and partnership opportunities.

See how we enable corporate venture capital for South African corporates to reach beyond the confines of their own structures and directly invest and participate in disruptive technology innovations.

This article was first published on Fin24. This is the free version for our subscribers.