An injection of money into your business account is an appealing proposition, but is accepting money from venture capitalists the best thing for your business? In this article, we’ll talk you through the pros and cons of venture capitalists and whether the investment is really worth the hype.
Of course, when you start up a new business, one of the first things you must address is how you’re going to fund it. Funding helps you cover wages, product or service development and basic business needs.
Venture capitalists are one of the many options you can choose when looking for funding. It can be an excellent fit for early-stage businesses. However, it is important to be aware of the disadvantages that come with venture capitalists.
Due to insufficient financial backing, many great ideas fail before they get off the ground. As a result, some startup founders rely on personal savings to run their businesses via bootstrapping. Unfortunately, this is not an option for many people who have an idea, but don’t have the financial cushion to quit their job and work on it full-time.
That’s where venture capitalists (VCs) come in. VCs provide external financial help that often comes with mentoring, support and an expansive network. However, nothing is without a price tag attached.
So, let’s get into the pros and cons of venture capitalists.
What is Venture Capital Funding
Before we dive into the pros and cons of venture capitalists, first let’s define what a venture capitalist is.
Put simply, venture capital funding is when well-off investors, financial institutions and/or investment banks finance early-stage companies. It is a type of private equity typically offered to smaller companies or startups.
Venture capitalists will invest in startups in return for shares in the company. The aim is for the company to become profitable and offer them a good investment return.
It is risky for venture capitalists because the businesses are so early-stage that you cannot be sure whether they will succeed or fail. In fact, 90% of businesses fail. This is why VCs will typically take equity and a board position in the business, so they can help steer and increase the chances of success.
There are benefits and sacrifices to venture capital funding. So let’s look in more detail at the pros and cons of venture capitalists to understand it further.
Pros and Cons of Venture Capitalists
Below we have provides a table to give you an overview of the advantages and disadvantages of venture capital - carry on reading below to see each of these broken down in further detail.
Advantages of Venture Capital Funding
There are many advantages of venture capitalist funding, from the money you get to the network opportunities it offers.
Venture capitalist firms have become increasingly popular in the past years. In fact, venture capital funding has been glorified by many. For example, you may have seen various LinkedIn posts by founders sharing their latest funding press release on Tech Crunch. This glorification can be for good reason.
So, what are the pros of venture capitalists?
Let’s start with the most obvious positive of venture capitalist funding, the money.
Venture capitalist firms all work to pool their fund from numerous sources (often from LPs) to be able to fund startups. In turn, your business could benefit from a large sum of capital that you may be unable to raise from elsewhere.
Most small business loans are hard to qualify for and only usually reach up to $5 million. In contrast, venture capital can reach as high as $25 million and beyond. You have to pay back business loans, whereas venture capitalist investments you don’t. You can also raise several venture capital rounds.
VC funding allows startups to obtain large amounts of capital to fuel the business and reach heights they may be unable to otherwise. In addition, it gives founders the runway to get their heads down and concentrate on building their businesses, knowing they have the backing of a venture capitalist.
Open To Risk
When looking at the pros and cons of venture capitalists, one advantage is that startups can take more risks.
Traditional banks tend to be very risk averse and will likely avoid lending money to a startup they don’t see any potential in. In contrast, venture capitalists are more open to risk and specialize in early-stage startups. So, if you know you have high growth potential and struggle to get funding elsewhere, a VC might be worth considering.
That being said, it is not as easy as that. Yes, venture capitalists are more open to risk, but they want that risk to translate into reward. They want a return on their investment, usually at least 25-35%, if not much more, to cover their fund size. So you need to ensure you are confident that your offer is commercially viable.
Suppose you are lucky enough for a venture capitalist to take a chance on you. In that case, it allows you to take more risks with your business knowing you have the security of their financial backing.
Therefore, if you do need support for a high-risk idea, venture capitalist investment might be for you. It will allow you to turn your idea into a real business that generates profits for you and your VC.
We believe that this pro of venture capitalist backing is unmatched. The hands-on support that comes with venture capitalist backing can help transform your idea into a full-blown business.
Not only are you getting funding, but you are getting an added layer of support from successful entrepreneurs. Venture capitalists haven’t just magically made their money from thin air to be able to invest in you. They clearly have a wealth of knowledge that you now have access to.
It works both ways. Venture capitalists that invest in your company want to ensure a return on their investment. Therefore, they are happy to work alongside you to ensure it is as profitable as possible. However, in some cases, investors don’t get as involved, particularly when they have made many investments.
In turn, you get access to guidance, resources, HR, logistics and a broad network. This is helpful in the early stages of development as it allows you to build a strong foundation that will not only be beneficial now but also for your company’s future.
Who doesn’t want money that you don’t have to pay back?
Well, not quite.
Yes, unlike small business loans, there are no monthly repayments with venture capital investment. These repayment burdens are what many startups fear as it places stress on the cash flow needed to ensure payments are being met.
Instead, they ask for shares in your company. So, when your business grows and becomes worth more money, they can sell the shares for more than they initially paid.
This takes the pressure of paying back your venture capitalists and allows you to concentrate on improving your business, hiring a bigger team and expanding further. Your investor could get a return through different means, including the business getting bought, a future investment round where they sell some shares or the company going for an IPO.
A well-connected network makes a world of difference when becoming an entrepreneur.
Venture capitalists find investment opportunities through their network, so it’s their job to remain well connected. This comes with the added benefit that VC-backed startups can tap into their network of successful entrepreneurs and investors.
That is one of the attractive features of venture capital investment as you gain access to their network, which took them years to build up. When starting your business, you might not have time to focus on networking to help grow your business.
The partners of venture capitalist firms will spend a lot of their time cultivating new relationships and networks to assist their companies. Unfortunately, managing long-term and short-term relationships in a network takes time, energy and money, which startups don’t have a lot of.
Therefore, having access to an extensive network can help you forge new partnerships, build a client base and even raise future funding rounds.
Suppose you are in the position at the point of funding to scale your business. In that case, venture capitalists can offer rapid business growth.
The money provided by venture capitalists helps grow and expand the business faster, which is vital in the current fast-moving marketplaces. Having growth-enabling capital behind you will give you an advantage in the swift expansion of new markets.
Quick growth is needed when starting up because you can outpace competitors and achieve a defendable market share. VCs will want to see this growth, as it’s an indicator that you will lead to future returns and that you will need more money in the future to continue growing - allowing them to increase their position in the business.
Disadvantages of Venture Capitalists
Now, we couldn’t look at the pros and cons of venture capitalists without mentioning some of the downsides of VC investments. But, like anything, there are two sides to every story.
The temptation of raising a large sum of money that will scale and grow your business means you have to be comfortable giving up some control. There are also due diligence processes to pass and people to please.
Let’s look at the cons of venture capital investments.
VCs Have High Standards
Only 0.05% of startups successfully raise money from venture capitalists firms. That is 1 in 2000!
Now, we don’t want that to put you off at all, but it is essential to highlight how hard it is to get approved. This is one of the biggest challenges when raising a funding round.
It can be a lengthy process (sometimes over 9 months!) as venture capitalist firms will conduct due diligence on your business to ensure the partnership is suitable. If they are parting with their LP’s hard-earned money, they want to ensure they will get a good return on their investment.
The criteria usually consist of the total addressable market, the commercial potential of your services or products, your management team’s strength and whether the rewards outweigh the risks.
Venture capitalist firms will want to see your business plan and financial forecasts. In these, you need to show the value of your enterprise and make the growth potential clear to see. We understand more than anyone how long of a process this is, which is why we are here to help.
To ensure you put your best foot forward, check out our startup fundraising bundle. It helps eliminate the stress and time to create a strong business plan needed to win funding from VCs.
Giving Away Shares
One of the most prevalent disadvantages when looking and the pros and cons of a venture capitalist is giving up part of your business.
This is one of the most debated elements of venture capital investment. It might not sound that bad to start with because, as we mentioned earlier, startups benefit from networks and guidance.
However, companies very quickly outgrow their initial funding. This means they have to raise more rounds from VC firms, which also means giving up more equity. Therefore, in the process, the founders will gradually lose more equity in their own company.
Along with this comes reduced control and power to make decisions. Bringing in more shareholders also brings in more opinions on how you should run your business. Some stakeholders will have a lot of involvement others will choose not to. It could lead to obstacles in your growth.
Keep in mind that venture capital firms can ask for anywhere between 10 to even 80% of your business! So when you start earning a profit, a significant percentage could go to your investors rather than yours.
Pushed Too Far, Too Fast
As eager as you may be to scale and grow your business, some companies can grow too fast.
To maximize the chances of receiving a return on their investment, venture capitalists need to ensure your startup will appreciate in value. They have taken a risk in investing in you with no guarantee that you will give them their money back.
Therefore, there can be pressure on startups to grow as quickly as possible and be on their way to going public or getting acquired.
Of course, having the backing of venture capital funding is exciting. But you do need time to develop your services or products. Of course, the quicker, the better, but it can be detrimental to those not ready for the market or to fulfill the demand of demanding customers. For example, a B2B company may not be prepared to meet the large volume of customer service required to work with the customers VCs will want you to target.
Keep this in mind when choosing which venture capitalist firm you go to and ensure they align with your goals. You want to be able to learn from them and communicate the speed at which you want to move.
An excellent way to gauge this is to speak to founders in the portfolio of the VC; they will be able to give insight into what it’s like to receive investment from that particular firm.
When looking at the pros and cons of venture capitalists, it is often overlooked how much of a distraction it can be.
It is easy to consume yourself with the process of applying for venture capital funding. You can get lost in the process of pitching business plans. Our pitch deck templates help to alleviate some of that stress! Make sure you are still focusing on growing your company while applying for venture capital funding.
Similarly, the injection of cash also means an infusion of opinions. Ideas, demands and queries from your investors can sometimes distract you from your goals. You might find yourself trying to please your investors and forget what you, as a business, might want.
It is easy for your judgment to be clouded by money and allow for your goals to change when others are factored in. But of course, this doesn’t happen to every company that gets venture capital funding, but it is just something to be aware of.
Alternatives to Venture Capital
As you can tell, it is a pretty evenly balanced argument for the advantages and disadvantages of venture capitalist investment. Therefore, we thought it might be helpful to also run through some of the alternatives to venture capital investment.
Often confused with venture capital firms, angel investors are similar. However, the difference is that they are individuals that invest in startups, typically before they are ready for venture capital funding.
They still expect equity in return for the funds but tend to be a one-time investment to help the business get off the ground. However, they can be an ongoing injection to help carry the company through tricky periods.
Angel investors tend to be friends or family because of the risk associated with the funding. However, they are more accessible to startups if you know where to look and offer a more relaxed approach. There is not as much structure as they don’t look for growth as much as they look for potential.
Also known as royalty-based financing, it is an excellent alternative to venture capital funding. What’s reasonable about revenue-based financing is that investors receive a regular share of your business income until a pre-decided amount has been paid.
This predetermined amount is usually three-five times the original amount invested. There is no interest on top of the balance, and there are no fixed payments. Instead, payments are made in proportion to how well the business is doing.
So, the payments back to the investor will mirror the growth of the business. This is great for startups as there is no pressure from fixed payments.
SBA stands for Small Business Administration. SBA loans are not to be confused with standard bank loans.
SBA loans eliminate risk for the financial institution by being partially guaranteed by the Government. The SBA is not the one doing the lending; it works with approved financial institutions, such as banks to lend money to small businesses.
These loans do require you to make monthly repayments. However, the partial guarantees mean that SBA will back part of the loan that the small business receives. Therefore, if you are unable to pay it back, the lender knows the SBA will cover the small proportion.
It is an excellent alternative to venture capital funding as it has competitive interest rates and repayment terms of ~10 years. In addition, founders don’t have to give up equity. So as long as they have the cash flow to repay the loan, it could be a good option.
We’ve covered most of the pros and cons of venture capitalists, and as you can tell, there is plenty to consider.
We don’t think there is a right or wrong answer when it comes to getting investment for your startup; it really depends on what suits you and your business.
Venture capitalist funding has high rewards, a high-value source of financing and unmatched support from risk-taking entrepreneurs. That being said, it has to get past strict criteria and scrutiny, and it won’t suit every business style.
Some businesses will thrive off the control and pressure to scale as quickly as possible. Others will fold under pressure and won’t like other opinions interfering with their goals. It is different from business to business.
One thing we do know is that any form of funding has an element of risk attached to it. So during your research, it is essential you consider this and come to terms with that no matter what you do, business holds risk.
Venture capitalist backing is great for startups that are ready to scale. In contrast, some businesses do great with an SBA loan.
However, if you do want to maximize your opportunities of getting it right, feel free to check out our course on how to fundraise and build a pitch deck. Or, check our variety of templates that can help kick off your preparation for the perfect pitch.