This article is part of a larger series on Business Financing.
As with any startup funding option, it’s a good idea to consider all the pros and cons of venture capital before you pursue funding. These are 10 advantages and 10 disadvantages of venture capital to consider:
|Large amounts of capital can be raised||Founder ownership stake is reduced|
|Help managing risk is provided||Finding investors can distract founders from their business|
|Monthly payments are not required||Funding is relatively scarce and difficult to obtain|
|Personal assets don’t need to be pledged||The overall cost of financing is expensive|
|Experienced leadership and advice are available||A formal reporting structure and board of directors are required|
|Networking opportunities are provided||Extensive due diligence is required|
|Collaboration opportunities with industry experts and other startups are available||Business is expected to grow rapidly|
|Assistance with hiring and building a team is provided||Funds are released on a performance schedule|
|Increased publicity and exposure are likely||Underperformers can lose their business|
|Help raising future rounds of funding is available.||Leverage in negotiations is rare|
Advantages of Venture Capital
Obtaining venture capital has several advantages. For fast-growing startups wanting to scale quickly, it might be the only viable option. Besides money, venture capital firms also provide input and introductions to potential future investment partners. They may also help secure future rounds of funding.
1. Large Amounts of Capital Can Be Raised
Many startups seeking small business loans may only qualify for $5 million or less in financing and qualifying can be difficult. However, venture capital is available in amounts as small as $100,000 for the seed stage and more than $25 million for more mature startups. There’s also a tendency for startups to raise venture capital several times, allowing companies to access large amounts of capital that would otherwise be impossible to obtain.
2. Can Provide Risk Management Support
Obtaining venture capital can help startup founders manage the risk inherent in most startups. By having an experienced team oversee growth and operations, startups are more likely to avoid major issues. The rate of failure for startups is still 20% in the first year, but when a complex situation arises, having a partner or investor with experience in helping startups succeed can improve the odds of making a good decision.
3. No Monthly Payments
When a venture capital firm invests in your business, it’ll do so for equity in the company. This means that, unlike small business and personal loans, there are no regular payments for your business to make. This frees up working capital for your business, allowing you to reinvest by improving products, hiring a larger team, or further expanding operations.
4. Personal Assets Don’t Need To Be Pledged
In most cases, you won’t have to contribute additional personal assets to the growth of your business. While many startup funding options will require founders to pledge some form of personal assets as collateral, most venture capital agreements won’t require a pledge of personal assets when the agreement is drafted.
5. Experienced Leadership and Advice Is Available
Many successful startup founders become partners at venture capital firms after they exit their businesses. These individuals often have experience scaling a company, solving day-to-day and longer-term problems, and monitoring financial performance. Even if they don’t have a startup background, they often have experience with assisting startups and sit on the boards of as many as 10 at a time. This can make them valuable leadership resources for the companies in which they’re invested.
6. Networking Opportunities Are Provided
When you’re focused on your business, there isn’t much time to network with people that can help your business grow. Partners at a venture capital firm may spend up to 50% of their time building their network to assist the companies they invest in. Having access to this network can help you forge new partnerships, build out your clients, hire key employees, and raise future rounds of funding.
7. Collaboration Opportunities With Industry Experts and Other Startups Are Available
When you receive venture capital funding, you’re getting what’s often referred to as “smart money.” This means the money you get comes with the added benefit of the expertise of the venture capital firm. Often, you’ll work with partners from the firm, other startup founders who have received funding, and experts from both of their networks to get your company on the right path to growth and success.
8. Assistance With Hiring and Building a Team
The team you need to start a company and the team you need to scale are often not the same, and venture capital firms can help get key people in place at the company to help you grow. Also, many potential employees may consider a venture-backed startup less risky than a traditional startup with no funding, making it easier to recruit a talented and well-rounded team.
9. Increased Publicity and Exposure Is Likely
Most venture capital firms have a public relations team and media contacts, and it’s in their best interest to get exposure for your startup. Working with a venture capital firm can add credibility to a startup, especially for founders that haven’t built other successful companies. The increased publicity can lead to getting noticed by potential employees, customers, partners, and other venture capital firms interested in raising funding.
10. Help Raising Future Rounds of Funding Is Available
Venture capital firms are interested in seeing your company raise additional funding at a higher valuation as it increases the return on their investment. They can introduce you to additional firms that can better assist you at later stages and provide additional funding. Venture capital firms often reserve the right to invest in future rounds of funding and often contribute additional capital as your business grows.
Disadvantages of Venture Capital
While the allure of raising sums of money to scale and grow your business is tempting, receiving venture capital means giving up some level of your control in your business. Besides maintaining growth, you’ll need to pass a due diligence process and have someone from the venture capital firm sit on your board of directors to oversee your actions.
1. Founder Ownership Stake Is Reduced
When raising a funding round, you’ll need to dilute your equity to issue new shares to your investors. Many companies outgrow their initial funding and have to raise additional rounds from venture capital firms. This process results in founders gradually losing percentages of equity in their company, along with reduced control and decision-making power. Founders can mitigate this risk by only raising the amount that’s necessary.
2. Finding Investors Can Distract Founders From Their Business
Startups decide it’s time to raise venture capital when other funding sources have been exhausted and more money is necessary for growth. However, fundraising can take several months and shouldn’t come at the cost of managing the company. By starting the process before funding is critical, founders give themselves enough time to both continue to manage the company and raise enough money to keep growing.
3. Funding Is Relatively Scarce and Difficult to Obtain
According to a report by the National Venture Capital Association (NVCA), only about 5,000 venture capital deals were made in the United States in 2020. Almost 3,000 of these companies had already received venture capital in the past. Venture capitalists point out they receive about 1,000 proposals for every three or four companies they fund.
One option for startups seeking first-time funding is an incubator or an accelerator. They often provide as much as $150,000 in funding and a three-month crash course that prepares companies for growth and future rounds of funding. Startups should also consider angel investment for smaller amounts of funding on more flexible terms.
4. Overall Cost of Financing Is Expensive
Giving up equity in your company may seem inexpensive compared to taking out a loan. However, the cost of equity is only realized when the business is sold. Venture capital provides much more than capital, like advice and introductions. However, the decision shouldn’t be made lightly, especially if there are other funding alternatives.
For example, two startups both need $1 million and are valued at $10 million. The first company takes out a Small Business Administration (SBA) loan for 10 years at 10% interest, the other raises $1 million for 10% equity. In 10 years, if both companies sell for $100 million, the founders of the first company paid $600,000 in interest for the loan and retained full equity while the second company gave up $10 million of proceeds from the sale due to the equity dilution.
5. Formal Reporting Structure and Board of Directors Is Required
When you get venture capital funding, you’ll be required to set up a board of directors and a formalized internal structure. Both facilitate growth and transparency for the company, enabling it to scale. However, this can limit the flexibility of the company and reduce the amount of control that the founders have.
Venture capital firms impose this structure to provide governance oversight and help diagnose any problems. At a faster pace of growth, problems also arrive more quickly and need to be fixed before they get out of control. This structure also gives venture capital firms comfort because of increased levels of reporting and transparency.
6. Extensive Due Diligence Is Required
Venture capital partners need to screen startups because they’re investing money that belongs to outside contributors. This happens in two stages. Initially, your technology and business fundamentals are evaluated to determine if the market exists and if the business can be scaled. Then, venture capital partners conduct a more thorough review of your team’s background and the company’s financial and legal position.
Although this process can take several months, it’s beneficial for the companies that go through it. By identifying problems and addressing them early in a startup’s development, it’s much easier to correct them. Future rounds of funding will become simpler because many issues will have already been reviewed and corrected.
7. Business Is Expected to Grow Rapidly
To get a return on their investment, venture capital firms need your startup to appreciate in value on its way to being either acquired or publicly traded on the stock market. Knowing that the business needs to get there can often increase the already high pressure that founders experience.
However, there are ways to manage this stress. Founders can ensure that they’re aligned on goals and can learn from the wisdom of others by communicating with other founders and their investors. They should also reduce their workload by delegating when appropriate. This will allow them to focus their time and energy on critical components of the business.
8. Funds Are Released on a Performance Schedule
Funds raised from venture capital firms are gradually released as the startup hits certain milestones. These goals are specific to the business but include revenue, customer acquisition, and other metrics determined by the venture capital firm. This can distract founders if the targets are the only things being chased, but it also leads to greater business success.
9. Underperformers Can Lose Their Business
Founders that aren’t performing can lose their business. If founders aren’t engaging in behavior that maximizes shareholder value or are using company funds recklessly for personal use while neglecting the business, they’re often let go. To minimize this risk, founders should accept their boards’ advice and communicate frequently about plans and goals.
10. Leverage in Negotiations Is Rare
Many startups seek venture capital when it’s the only source of funding that can meet their needs. In rare circumstances, there are too many investors interested, which is known as being “oversubscribed,” and the startup has leverage over the terms. However, most startups won’t have much leverage besides rejecting the deal. This can be mitigated by starting your search early to find a venture capital firm that understands your goals and funding needs.
Alternatives to Venture Capital
Venture capital is best for companies needing funding to scale quickly in exchange for equity. If your company is still growing slowly and finding its way, there are other alternatives to consider:
- Angel investors: These individuals typically invest before a startup is ready for venture capital. Their investment amount can exceed $250,000, but they don’t look for as much growth as they do potential for it. They also provide many of the same benefits as a venture capital firm without the structure, and they’re more available to startups.
- Revenue-based financing: This can be a great alternative to venture capital because it doesn’t require founders to give up equity. Your payments are variable and based on the revenue the company generates, which is great for launching a product. Loan amounts are available up to $3 million, and startups can take advantage of quick online applications.
- SBA loans: The Small Business Administration guarantees loans originated by lenders for up to $5 million. Although these loans require a credit score above 680 and monthly payments, they also have some benefits, including competitive interest rates and repayment terms of 10 years for working capital. SBA startup loans don’t require founders to give up equity, making them a great alternative to venture capital.
Before pursuing venture capital, it’s important to consider its advantages and disadvantages. Although you can get access to a large amount of financing with no monthly payments, it comes at the cost of equity. You’ll also receive advice and guidance in growing your business, but you must give up a measure of control over your business in the process.