Working with a startup: should you buy, co-develop or invest?

Corporates have been big players in the startup sphere for many years now. Having built strong innovation departments, they’ve made strides whether it be through partnerships, acquisitions, or investments. However, working with a startup isn’t only beneficial to large companies. Indeed, growing SMEs also have a lot to gain from developing strong ties with startups. Yet, since they often lack prior experience in this arena, or a dedicated department working on innovation, questions might arise on what the best strategy is.

In this article, we’ll look at some of the many pros and cons that come with investing in, co-developing with or acquiring a startup as an SME.

Investing in a startup

Let’s say you’re working with a startup that supplies a service to your business. To run your operations, you might work with many suppliers, most of which likely aren’t strategic to the success and survival of your company. However, this particular startup is providing a service that is key to your company and it would be challenging to replace them. One option to help secure the relationship and extend the possibilities of your relationship with this startup is equity investment.

Through equity investment, you’re able to align your interests with those of the startup you’ve been working with. As a supplier, a business doesn’t have a stake in your success. You are one client among many others. As long as you pay for their service, there’s not typically much more interest in you and your company. By becoming an equity investor, you now have an interest in helping that startup thrive. On the flip side, that startup also wants to see you succeed, as it will only be beneficial to them.

With your interests now aligned, your partnership with this startup is open to more possibilities. You can introduce more flexibility in the relationship. For example, the startup will likely be more inclined to provide or develop services tailored to your needs. You've also secured long-term access to this startup's service, reducing risk on your end. This is valuable in situations where alternative suppliers are scarce.

However, what if you want to go beyond securing this service and having a more flexible business relationship? What should you be considering if you want to actually co-develop a product with a startup?

Co-developing a product with a startup

Working with a startup within the framework of a co-development partnership also provides many benefits. At its core, the primary benefit is that of pooling your resources. By working with a startup, you bring together the strengths and expertise of both sides' teams. This can help reduce development costs and also speed up the development process. You also accomplish what we mentioned earlier regarding investments: opening up possibilities and aligning the interests of both parties. An investment doesn't guarantee you'll be able to request new or more in-depth services/products. A partnership helps structure your relationship with a startup to achieve a specific goal. However, co-development partnerships also present some challenges worth keeping in mind.

When launching a partnership, both sides must ensure their interests truly are compatible. What is the goal of the partnership? What outcome do you both expect? If it's determined you both have the same expectations, you'll need to fine-tune all the logistics and details that come with partnerships. You’ll have to decide on how to split profits and ensure both parties gain enough from the partnership for it to be considered secured. Furthermore, IP can be a critical issue depending on the type of project being developed. Determining who will own the rights to IP can be a major source of stress in a business relationship.

If you're already an equity investor, launching a co-development project with a startup could prove slightly easier. You already have an established involvement in the company, and you have equity, which should make coming to decisions together a bit simpler. There's also a level of trust that has been built.

However, it’s important to note that investing in a startup doesn’t necessarily reduce the cost of a partnership. In this partnership, you’re the one with the most access to funding, and if more capital is required you’ll likely be the one providing it. Furthermore, the startup’s problems and challenges have a stronger impact on you as an equity investor. If the partnership doesn’t work out, if the startup isn't able to fulfil its end of the deal, or if money runs out, you have more to lose at the end of the day.

Acquiring a startup

Acquiring a startup as an SME is a decision that should typically be limited to scenarios where it’s critical to your company's strategy. However, it shouldn't be seen as a means to save your business if it's declining. Indeed, acquisitions generally help further boost an already-existing success and upwards trajectory. But, they can't save a struggling SME alone.

An acquisition might initially seem like a simpler strategy than launching a co-development partnership. Opted for by many SMEs and corporates alike, it’s a one-time transaction rather than an ongoing relationship with a partner that needs to be managed and maintained. This mindset has some validity behind it, and acquisition can be a good strategy, especially in scenarios where you’re acquiring a competitor. However, you must carefully plan out and strategise why the acquisition is key to your business and how you'll use this company's technology, team, or product to help your own entity.

Furthermore, good timing and establishing the right valuation for an acquisition are key. Before acquiring a startup you want to ensure it hasn't peaked - that its growth is set to continue. You should also be wary of overvaluing the startup. ScaleX helps accompany SMEs through this decision process, which can be especially tricky with early-stage startups. Our methodology helps clients establish a startup's growth potential and determine a recommended valuation based on already-existing valuation models that we adapt to each specific startup assessed.

Lastly, deciding whether you'll be integrating the startup's team into your company or letting them stay independent is a crucial choice to make. The integration of a startup into the mothership is a costly operation. It can also turn ugly if the startup's team doesn't jive well with the work environment of a larger structure. An MIT study showed 33% of acquired workers leave in the first year of their startup's purchase.

Making the decision

Overall, one of the benefits SMEs have over corporates is their flexibility and ability to make decisions more quickly. Startups can gain from the expertise and access to funding your SME has to offer, but also from your ability to move faster than corporates can. However, the questions SMEs face when forging ties with startups remain similar to those of corporates:

• What does your company need?
• What does this startup provide that is critical to your operations?
• Does maintaining a supplier-client relationship pose a significant risk?
• Is this the right startup to co-develop your new product with?
• How will you reach the desired outcome through your decision?
• Are you sure the price is right for this acquisition?
• Are you coming in too late to invest in this booming technology?

To learn more about how ScaleX can help your SME make informed partnership, M&A and investment decisions, get in touch with our team.