Like other startup funding options, venture capital advantages and disadvantages should be considered before funding. Venture capital offers funding to startups that are growing quickly in exchange for equity. It also eliminates debt payments and provides founders with advice and guidance. These are only some of the pros and cons of venture capital to consider.
Venture Capital Advantages & Disadvantages
|Advantages of Venture Capital||Disadvantages of Venture Capital|
|Large amounts of capital can be raised||Founder ownership is reduced|
|Help managing risk is provided||Finding investors can be distracting for founders|
|Monthly payments are not required||Funding is relatively scarce & difficult to obtain|
|Personal assets don’t need to be pledged||Overall cost of financing is expensive|
|Experienced leadership & advice are available||Formal reporting structure & board of directors are required|
|Networking opportunities are provided||Extensive due diligence is required|
|Collaboration opportunities with industry experts & other startups are available||Business is expected to scale & grow rapidly|
|Assistance with hiring & building a team is available||Funds are released on a performance schedule|
|Increased publicity & exposure are likely||Losing the business for founders is possible|
|Help raising subsequent rounds of funding is available||Leverage in negotiations is rare for startups|
10 Advantages of Venture Capital
Raising venture capital has many advantages, and it may be the only option for fast-growing startups wanting to scale quickly. Besides money, venture capital firms also provide input and make introductions for potential partners, team members, and future rounds of funding. It can also make hiring easier and reduce your overall risk.
The ten advantages of raising venture capital for a startup are:
1. Large Amounts of Capital Can Be Raised
Many small business loans for startups are limited to $5 million and qualifying can be difficult. However, venture capital is available in amounts as small as $100,000 for a seed stage and more than $25 million for more mature startups in large markets. There is also a tendency for startups to raise venture capital several times, allowing companies to access a large amount of capital that would otherwise be impossible.
2. Help Managing Risk Is Provided
Bringing on venture capital helps 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 having someone to turn to for advice when a complex situation arises can improve the odds of making a good decision.
3. Monthly Payments Are Not Required
When a venture capital firm invests in your business, it will 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 capital for your business, allowing you to reinvest by improving products, hiring a larger team, or further expanding operations instead of making interest payments.
4. Personal Assets Don’t Need to Be Pledged
In most cases, you will not have to contribute additional personal assets to the growth of your business. While many startup funding options will require founders to pledge their homes as collateral or use their 401(k) for startup costs, most venture capital agreements will leave the founders personal assets outside of the discussion.
5. Experienced Leadership & Advice Is Available
Many successful startup founders become partners at venture capital firms after they exit their businesses. They often have experience scaling a company, solving day-to-day and larger problems, and monitoring financial performance. Even if they don’t have a startup background, they are often experienced at assisting startups and sit on the boards of as many as ten at a time. This can make them valuable leadership resources for the companies in which they are invested.
“Experienced investors often serve as strategic advisers to their portfolio companies’ management teams. Particularly when the management team is relatively inexperienced, that advice and mentorship can be invaluable to help entrepreneurs make key strategic decisions or avoid common mistakes.”
– Chris Sloan, Chair of Baker Donelson’s Emerging Companies Team
6. Networking Opportunities Are Provided
When you’re focused on your business, there often isn’t time to network with people who can help your business grow. Partners at a venture capital firm spend as much as 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 & Other Startups Are Available
When you get venture capital funding, you are getting what is often referred to as smart money. This means the money you get comes with the added benefit of the expertise the venture capital firm can offer. You will often 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 & Building a Team Is Available
The team you need to start a company and the team you need to scale are 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.
“Venture firms often have a network of successful entrepreneurs and executives they have backed in the past, and also know which recruiters understand what you need to source and land top candidates. Also, as part of the hiring process, we help to sell the candidate for key hires.”
– Bill Baumel, Managing Director of the venture capital firm Ohio Innovation Fund
9. Increased Publicity & Exposure Are Likely
Most venture capital firms have a PR group and media contacts, and it’s in their best interest to get exposure for your startup. Often being associated can add a great deal of credibility to a startup, especially for founders who 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.
“If the ‘brand’ of the venture capital fund is well known, that can attract other funds and individuals that believe that this well-known fund has a track record of high success, so they don’t want to miss out on the opportunity.”
– Kevin Pollard, Professor, A.B. Freeman School of Business at Tulane University
10. Help Raising Subsequent Rounds of Funding Is Available
Venture capital firms are interested in seeing your company raise additional funding at a higher valuation. They can introduce you to additional venture capital 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 the startup grows.
10 Disadvantages of Venture Capital
Losing complete control over your company is difficult, but this is part of raising venture capital. It also isn’t easy to get funding. Besides maintaining growth, you will 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.
The ten disadvantages of raising venture capital for a startup are:
1. Founder Ownership Is Reduced
When raising a funding round, you will 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 losing the majority ownership in their company and with it, the control and decision-making power that comes with being a majority shareholder. Founders can mitigate this risk by only raising the amount that’s necessary.
2. Finding Investors Can Be Distracting for Founders
Startups decide it’s time to raise venture capital when other funding sources have been exhausted and the 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 grow the company and raise enough money to keep growing.
3. Funding Is Relatively Scarce & Difficult to Obtain
According to a report by the National Venture Capital Association, only about 5,000 venture capital deals were made in the U.S. in 2018. 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 should not 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 an SBA loan for startups for 10 years at 10% interest, and the other raises $1 million for 10% equity. In ten years, if both companies sell for $100 million, the founders of the first company paid $600,000 in interest for the loan and retained equity, while the second company lost $10 million of proceeds from the sale due to the equity dilution.
5. Formal Reporting Structure & Board of Directors Are Required
When you get venture capital funding, you’ll be required to set up a board of directors and a more rigid internal structure. Both facilitate growth and transparency for the company, enabling it to scale. This can limit the flexibility of the company and reduce the amount of control that the founders have. However, it is beneficial to a company that is growing rapidly.
Venture capital firms impose this structure to oversee the company and 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 the 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 are investing money that belongs to outside contributors. This happens in two stages. In the initial stage, your technology and business fundamentals are evaluated to determine if the market exists and if the business can be scaled. In the second stage, they conduct a more thorough review of your teams’ background and the startups financial and legal position.
Although this process can take several months, it is beneficial for the startups that go through it. By identifying problems and addressing them early in the startups’ development, it is much easier to correct them. Future rounds of funding become simpler too, because many issues have already been reviewed and corrected.
7. Business Is Expected to Scale & 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 listed on a public stock exchange. Knowing the business needs to get there can often increase the already high pressure that founders experience. However, there are ways founders can manage this stress.
By communicating with other founders and their investors, founders can ensure that they are aligned on goals and can learn from the wisdom of others. Founders should also be cognizant of reducing their workload by delegating when appropriate to 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 released gradually as the startup hits certain milestones. These are specific to the business but include revenue goals, customer acquisition, and other metrics determined by the venture capital firm. These goals and any conflicts should raise a flag for discussion with the board. It can distract founders if the targets are the only things being chased, but it also leads to greater business success.
Ted Chan, CEO of CareDash, provides insight into how he works with the venture capital partners on his board of directors:
“There’s a clear amount of funding and a directive established from the beginning in terms of how to use it and what the goals are, given the amount spent. From my experience and those of my friends, VCs don’t care so much how you spend it but the value you are creating. I find my board asks good questions and has helped me rein in spending, but also gives me the freedom to take risks or pursue routes that I understand better based on my expertise.”
9. Losing the Business for Founders Is Possible
Founders who are underperforming can lose their business. If founders are not engaging in behavior that maximizes shareholder value, or are reckless and are using company funds for personal use while neglecting the business, they are often let go. To minimize this risk, founders should accept their board’s advice and communicate frequently about plans and goals.
10. Leverage in Negotiations Is Rare for Startups
Most startups seek venture capital only when it is 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.
Who Venture Capital Is Right For
Founders use venture capital funding for scaling a company. Founders who don’t have experience scaling or need specific advice and contacts in a new industry to scale can benefit from venture capital funding. Also, if the startup requires multiple rounds of funding in the millions of dollars for growth or is in an untapped growing market, venture capital can be a great source of funding.
Venture capital funding is right for:
- Founders with no experience scaling a startup: Venture capital partners have scaled dozens of startups in the past, making them a great source of knowledge and expertise. Founders with little experience scaling can take advantage of this resource in addition to the capital.
- Startups experiencing high growth needing to scale: If your startup is already growing quickly, getting venture capital funding can help build out your operations. By doing so, you can reduce the number of pain points within the startup and keep up with demand while maintaining or improving your product quality.
- Founders needing several multimillion dollar rounds of funding: Venture capital is one of the few sources of funding that can offer several million dollars over the course of several years. Some startups require large amounts of capital, especially if they delay profitability to continue to acquire users.
- Startups in rapidly growing untapped markets: Startups often find themselves as one of the few competitors in a booming market. Traditional lenders won’t lend based on a trend to startups, but venture capital firms will. This funding can help startups scale and attempt to capture a large share of a growing market.
- Founders needing specific industry expertise and connections: If your startup is entering a new market you have limited experience with, the right venture capital firm can make a huge difference. By leveraging their experience and connections, the startup has a much higher chance of succeeding by avoiding mistakes.
Venture capital is best for startups with high growth potential in rapidly expanding markets. They can offer large amounts of capital over several years in addition to expertise in scaling and in specific industries. However, not every startup is scalable right away and until they get there, founders can rely on some alternatives to venture capital for funding.
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, angel investors may be a better alternative. Additionally, if you are unwilling to give up equity, revenue-based financing and SBA loans for startups are great alternatives to venture capital.
Some alternatives to raising funds from a venture capital firm are:
Angel investors 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 are more available to startups.
Revenue-based financing is 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 for Startups
The Small Business Administration guarantees loans originated by traditional lenders for up to $5 million. Although these loans require a good credit score above 680 and monthly payments, they also have some benefits. These include lower rates of up to 11% and longer terms up to 10 years. SBA startup loans don’t require founders to give up equity, making them a great alternative to venture capital.
Frequently Asked Questions (FAQs) About Venture Capital
In this article, we covered the main advantages and disadvantages of venture capital funding. Every venture capital deal is unique and raises questions that we may not have addressed in this article. Below we’ve assembled the most frequently asked questions about venture capital. If your question wasn’t answered, feel free to ask it in the Fit Small Business Forum.
The most frequently asked questions about the advantages and disadvantages of venture capital are:
What are the types of venture capital?
Venture capital firms specialize in providing seed, growth, and acquisition financing. Seed financing is typically used to round out a team and prepare for a growth round. The growth round is used for scaling the existing startup. Finally, acquisition financing is usually raised before an acquisition or an IPO to fund the process.
What is venture capital used for?
Venture capital fills a gap left by traditional financing by investing in high-risk startups with potential for growth. Typically, it’s used by founders to scale their startups, reach a larger audience, and refine their product or services. It’s also used to fund startups that are preparing for an acquisition or IPO.
What documents are required for venture capital?
When you are pitching a venture capital firm, you will typically need to have a business plan that includes information about your team, company, and funding needs. Once you have a term sheet, a venture capital firm will often require additional documentation to conduct due diligence and better understand your business.
Bottom Line: Pros & Cons of Venture Capital
Before raising money as a founder, it’s important to consider the pros and cons of venture capital. Although you can get access to a large amount of capital with no monthly payments, it comes at the cost of equity. You will also receive advice and guidance in growing your business, but you must give up some control in the process.