Venture capital can be a lucrative source of funding for growing businesses, but it also comes with its own set of pros and cons.
In this post, we’ll explore the advantages and disadvantages of venture capital, including the potential for high returns, the expertise and resources provided by investors, and the potential loss of control for founders. We’ll also discuss alternative funding options and help you decide if venture capital is the right choice for your business.
What is Venture Capital Financing?
Venture capital financing, also known as venture capital funding, is when high-net-worth individuals, venture capital firms, or other financial institutions, provide funding to early-stage businesses.
In return for their funding, VC firms will receive a minority stake in the companies they invest in.
On top of supplying capital, venture capitalists will also provide founders with industry contacts, business development opportunities, and valuable expertise on how to successfully scale a business.
While venture capital investment can be an extremely effective way to provide capital for growing businesses, there are advantages and disadvantages every business owner should be aware of.
Advantages of Venture Capital
1.) Access to Mentorship Opportunities
Most venture capitalists were once entrepreneurs themselves. This means that the individuals who are investing in your company have experience with scaling a business, communicating with investors, and solving the common challenges associated with entrepreneurship. Most partners at a venture capital firm will sit on the board of many different startup organizations and can provide invaluable advice and mentorship to the businesses they work with.
2.) Support with Building a Team
Successful entrepreneurs usually have very different skills than the rest of the business world. They specialize in thinking big, disrupting the status quo, and transforming their ideas into viable business models.
Consequently, entrepreneurs oftentimes find themselves struggling when doing other tasks like managing a large team or getting too caught up in the finer details of their business.
A good venture capitalist can recognize the strengths and weaknesses of the entrepreneurs they partner with and help them build a supporting team that will complement their strengths and balance out their weaknesses.
3.) No Recurring Payments
VC firms invest in businesses by taking an ownership stake in exchange for funding. This means that, unlike traditional bank loans that require regular payments, the business has no ongoing financial obligations to meet.
4.) Networking Opportunities
Running a business requires a significant time commitment, which can make it difficult for founders to attend various networking functions. Venture capital firms often have an impressive network of suppliers, other investors, and potential customers that founders can leverage to help grow their business.
5.) Provides Your Business With Large Amounts of Funding
Simply put, venture capital firms have access to impressive amounts of funding.
Other forms of financing, such as small business loans, are not only difficult to obtain but also don’t usually surpass a few hundred thousand dollars. Data from the Federal Small Business Loan survey reported the average small business loan amounted to just $52,158 in Q4 of 2021.
Venture capital, on the other hand, can reach upwards of $30 million for founders who can demonstrate the potential of their business.
A great example of a startup raising large amounts of capital is the popular ride-hailing app Uber, which raised over $1.5 billion in venture capital funding before going public.
6.) Validation
When a venture capital firm decides to invest in a company, they’re essentially giving its stamp of approval and expressing confidence in the company’s prospects for success.
The validation that comes with VC funding can help a company build credibility, secure additional funding, and increase its visibility within its industry.
7.) Increases Chances of Company Success
VC funding comes with much more than just a loan.
Sure, money is important for fast-growing startups, but what’s even more valuable is having a team of seasoned professionals founders can turn to when making difficult decisions.
Venture capital firms work with the companies they invest in to help oversee growth initiatives and ensure operations are scaled efficiently. This helps early-stage companies avoid many of the common mistakes associated with building a business and drastically increases their chances of success.
8.) Personal Assets Aren’t Used for Collateral
Generally speaking, VC funding doesn’t require founders to assign their personal assets as collateral.
This means founders can focus on growing their businesses without the added worry of potentially losing their assets.
Disadvantages of Venture Capital
1.) High Expectations
Venture capitalists expect to see a return on their investment by supporting a startup’s growth and appreciation in value. This may involve the company being acquired by another firm or going public through an initial public offering (IPO). The pressure to achieve these outcomes can be intense for founders.
One way for business owners to manage the stress of meeting these high expectations is to communicate regularly with other founders and investors. Sharing insights and learning from the experiences of others can help founders gain perspective and make more informed decisions.
2.) Underperforming Businesses Can Lose Their Funding
Founders who don’t perform well or engage in behavior that is detrimental to the company may risk losing their funding. Actions like failing to maximize shareholder value or poor financial management may encourage venture capitalists to pull their funding completely.
To reduce the risk of losing their capital, founders should be open to advice from their board of directors and communicate frequently with investors.
3.) Funds Aren’t Released All at Once
Venture capitalists usually provide funding to startups based on predetermined milestones. These milestones are tailored to the specific needs of the business and may include metrics such as reaching a certain level of revenue growth, attaining a specific number of customers, or capturing a defined percentage of market share.
Receiving capital in stages can help a business prioritize its goals, however, companies that need a large influx of cash quickly may struggle with an incremental funding process.
4.) Founders Give up Equity in their Business
One of the biggest disadvantages of venture capital stems from how VC deals are structured.
Typical VC deals involve founders giving up partial ownership of their company in exchange for venture capital.
Giving up ownership of one’s company is never easy and reduces the potential reward if a founder’s business ever becomes successful. Founders may also have to raise capital from more than one investor, meaning they’ll have to relinquish further equity in exchange for additional funding.
5.) Finding Investors Can be a Time-Consuming Process
Pursuing venture capital funding can be a time-consuming and distracting process. Continuously pitching business plans and completing various rounds of due diligence is a demanding and stressful undertaking that can suck up significant amounts of time and resources.
In addition, the injection of funding from venture capitalists may also bring with it an influx of opinions and demands from investors. Founders may feel pressure to please their new business partners and shift their focus away from what is best for the business.
6.) Comprehensive Due Diligence
Venture capital funds conduct a thorough screening process, known as due diligence when evaluating potential investments. This gives VC firms a chance to vet their potential investment opportunities and ensure the information they’ve been provided is accurate.
While the due diligence process can seem time-consuming and a distraction to growing a business, there is immense value for founders who can complete the process.
More specifically, due diligence typically entails VC firms asking business owners difficult questions and raising issues with their growth strategy. Founders who can answer a VC firm’s questions will be better equipped to grow their business and find securing additional funding in the future much easier.
7.) Founders’ Freedom is Reduced
If you receive venture capital investment, you’re essentially bringing in new business partners.
This means setting up a more formalized reporting structure and at times, taking the advice of your new partners.
This could be a problem for founders who want to have complete freedom in how they manage their business and could potentially be a sticking point to developing a healthy relationship.
8.) Successfully Earning VC Funding is Extremely Difficult
Obtaining funding from VC firms can be a challenging process, as only a small fraction of startups (0.05%) are successful in securing this type of funding.
With stiff competition and a limited amount of venture funding to go around, not every promising startup will be successful in raising the capital their business needs.
What Kinds of Companies Receive VC Funding?
Venture capital funding is typically provided to early-stage or fast-growing companies. These businesses are usually technology focused, however, can operate in a variety of different industries like healthcare, consumer goods, and many others.
Further, these businesses have usually reached an inflection point with their growth and require additional financing to expand. VC firms tend to look for startup companies that are first movers into an untapped market or are disrupting traditional industries through new and innovative products.
In general, companies that receive venture capital funding are expected to have a clear vision for the future, a solid business model, a strong management team, and most importantly, the potential to generate significant returns for their investors.
Alternatives to Venture Capital
SBA loans
The Small Business Administration (SBA) offers loan guarantees of up to $5 million for loans originated by accredited lenders. To be eligible for these loans, you’ll need to have a credit score above 680 and will be required to set up a monthly payment plan.
These loans come with repayment terms of up to 10 years for working capital and competitive interest rates. Unlike venture capital funding, SBA startup loans don’t require founders to give up equity in their company.
Revenue-based financing
Revenue-based financing, also known as royalty-based financing, can be a good alternative to venture capital funding. In this type of financing, investors receive a percentage of the business’s gross revenue regularly until a predetermined amount has been paid back. This predetermined amount can vary dramatically, however, the average amount is usually three to five times the original investment.
Unlike traditional loans, there is no interest charged on top of the balance and no fixed payments. Instead, payments are based on the performance of the business.
This means payments to the investor will vary based on the growth of the business, which can be beneficial for startups that don’t have consistent monthly revenue.
Angel investors
Angel investors are individuals who invest in a startup before it’s ready for venture capital funding. The amount these angels invest can vary dramatically, with some investments totaling less than $10,000 and others surpassing $150,000. Some angel investors look to pool their money with other angels so they can invest larger sums into faster-growing businesses.
Additionally, where venture capital usually takes an active role in helping an entrepreneur build their business, angel investors don’t typically get involved in the day-to-day operations. It is a good idea for any new investor to familiarize themselves with the difference between angel investors vs. venture capitalist.
How to Decide if Venture Capital is Right for You
Truth be told, VC financing isn’t right for every startup and business owner. Some businesses just aren’t ready to receive a large influx of capital, and some entrepreneurs don’t want to relinquish control of their company to someone else.
The good news is, there are plenty of options for entrepreneurs trying to secure funding, as well as venture capitalists looking to invest.
Hopefully, after reading more about the advantages and disadvantages of venture capital, you’ll be able to make a more informed decision on whether or not venture capital financing is right for you.