Benefits and risks of strategic investment

Kevin owned a company offering online marketing opportunities for multinational companies. The demand for such a service was huge. However, owing to small size of his company he was not able to meet the rising demands of his customers.

This is when Sameer, the CEO of another company, providing a similar kind of service albeit with their focus on other services, and an acquaintance of Kevin stepped in to help him out.

Sameer's company provided some strategic investments to Kevin's company, which enabled Kevin's company to grow and expand its business offerings.

This is just half the story. Most of us do not know what strategic investments are and how they work. We also do not know how it benefits a company. Let's try and understand the basics of strategic investment.

What is strategic investment?

The term 'strategic investments', applies to two different ways of investment in the financial world. The first is when an individual or a company invests with the goal of generating safe, steady returns, usually with the advice of a consulting company, which keeps up with trends in the market and addresses the needs of the customer.

In the second instance, it applies to a company's decision to invest in another, smaller company, usually a startup, with long-term strategy in mind, rather than simple profit. We would be taking a closer at this aspect of investment.

Why is strategic investment done?

Strategic investments are often used to raise capital and credibility for new companies which are struggling to make their way in the market. Larger companies make strategic investments in smaller ones for an assortment of reasons:

• The investment is made because the smaller company makes similar products
• The smaller company may eventually become a client of the big company
• The smaller company might be working on new and innovative technologies and ideas

Wouldn't an acquisition of the smaller company be better?

Industry experts disagree. For the smaller company, the 'strategic investment' arrangement is often beneficial as it allows the company to remain autonomous, and it encourages other investors to get involved, since they believe that they may profit from their investments.

Larger companies also benefit from these arrangements because they carry less risk than acquisitions, allowing the bigger company to receive benefits from the smaller company when it does well, or to jettison the investment if the situation does not work out.

How does it work?

Strategic investment begins with identifying and evaluating various projects and making a selection that is likely to boost the company's competitive advantage.

In a strategic investment, the investor generally acquires common or preferred stocks in the target company. A loan may also be taken for acquiring the debt securities of the target company.

Moreover, the two companies may enter into supply and sourcing contracts, technology-sharing agreements or research and development agreements.

They may also form separate, joint-venture entities for engaging in specified businesses. A strategic investment typically influences what a company does (what products/services it offers), where it does it (the locations of its operations) and/or how it does it (processes and practices).

What are the benefits and risks involved?

Some of the benefits involved in strategic investing include the following:

• Strategic investment gives the investing company access to resources at a fairly low cost. For instance, when the targeted company's business is to develop technology, which the investing company find useful, the latter can make a strategic investment in the former company instead of developing its own technology. This will reduce the cost of developing that technology to a great extent.

• For the investing company, an investment is usually made in exchange for a share of control over the company. This allows the company to protect its investment, and to shape the direction of the smaller company's business and product lines.

On the flip side:

• The process of identifying and evaluating various strategic investment options could be significantly complex, time consuming and expensive.

• The larger company may express a desire to take over the smaller company at some point in the future, once the small company has proved itself viable and productive.

• If the smaller company fails to keep up to its agreement due to any reason, there is always the threat of the investment being pulled out.