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Venture capital is a major source of growth for small and medium-sized enterprises. It helps them to fund their business, at the cost of providing higher returns on equity or taking an ownership stake in companies that would otherwise struggle to invest internally. In many ways it’s a win-win situation for investors and entrepreneurs alike, but how does venture capital work? And what are some disadvantages?
Ten Benefits of Venture Capital
Raising venture capital has many benefits, and for fast-growing companies looking to expand rapidly, it may be the only choice. In addition to money, venture capital companies provide advice and make connections to prospective partners, team members, and future financing rounds. It may also help you hire more easily and lower your total risk.
The following are 10 benefits of raising venture capital for a startup:
1. Raise Huge Sums of Money
Many startup loans are restricted to $5 million, and qualifying for one may be tough. Venture money, on the other hand, may range from $100,000 for a seed-stage company to more than $25 million for more established companies in big markets. Startups also have a proclivity to raise venture capital many times, enabling them to access huge sums of money that would otherwise be unavailable.
2. Risk Management Assistance
Bringing on venture funding helps startup entrepreneurs handle the risk that comes with starting a business. Startups are more likely to avoid significant problems if they have an experienced staff overseeing their development and operations. Although the failure rate for businesses remains around 20% in the first year, having someone to turn to for guidance when faced with a difficult circumstance may increase the chances of making the right choice.
3. Payments are not required on a monthly basis.
A venture capital firm will invest in your company in exchange for stock in the company. This implies that, unlike small businesses and personal loans, your company will not be required to make monthly payments. This frees up money for your company, enabling you to reinvest instead of paying interest by enhancing goods, employing more people, or expanding operations.
4. No Personal Assets Must Be Pledged
In the vast majority of instances, you will not be required to contribute extra personal assets to the expansion of your company. While many startup financing alternatives require founders to put their houses up as collateral or use their 401(k) to cover beginning expenses, most venture capital agreements exclude the founder’s personal assets.
5. Experienced leadership and guidance
After exiting their companies, many successful startup founders become partners at venture capital firms. They often have prior expertise growing a business, resolving day-to-day and bigger issues, and tracking financial results. They are frequently skilled in assisting startups and sit on the boards of as many as 10 at a time, even if they do not have a startup background. As a result, they may be significant leadership resources for the businesses in which they invest.
“Experienced investors often act as strategic advisors to the management teams of their portfolio businesses. That guidance and mentoring may be helpful in helping entrepreneurs make important strategic choices or avoid frequent errors, especially when the management team is relatively new.”
— Baker Donelson’s Emerging Companies Team Chair, Chris Sloan
6. Networking Opportunities
When you’re focused on your company, you don’t always have time to network with individuals who can assist you in growing it. A venture capital firm’s partners may spend up to half of their time developing their network to help the businesses they invest in. This network can assist you in forming new collaborations, expanding your customer base, hiring key personnel, and raising future rounds of financing.
7. Opportunities for collaboration
When you receive venture capital financing, you’re receiving “smart money,” as it’s also known. This implies that the money you get comes with the additional advantage of the venture capital firm’s experience. To get your business on the correct track to development and success, you’ll often collaborate with firm partners, other startup owners who have received financing, and specialists from both of their networks.
8. Help with hiring
The team you need to launch a business and the team you need to scale it are not the same, and venture capital companies may assist you to hire essential individuals to help you scale. Furthermore, many prospective workers may see a venture-backed company as less risky than a conventional startup with no financing, making it simpler to hire skilled and diverse staff.
“Venture companies typically have a network of successful entrepreneurs and executives they’ve previously supported, as well as an understanding of which recruiters can help you find and attract excellent individuals. We also assist in the selling of candidates for important jobs as part of the recruiting process.”
— Bill Baumel, Managing Director of Ohio Innovation Fund, a venture capital company
9. More Publicity & Exposure
Most VC companies have a public relations team and media connections, and it’s in their best interests to get your company noticed. Being connected with a company may give it a lot of credibilities, particularly for entrepreneurs who haven’t created any other successful businesses. Increased visibility may attract the attention of prospective workers, customers, partners, and other venture capital companies looking to raise money.
“If a venture capital fund’s ‘brand’ is well-known, it may attract other funds and people who think the well-known fund has a track record of high success and don’t want to lose out on the chance.”
— Kevin Pollard, Tulane University’s A.B. Freeman School of Business professor
10. Fundraising Assistance for Future Rounds
Venture capital companies want to see your business obtain more money at a greater value. They may be able to connect you with other venture capital companies that may help you at a later stage and offer more financing. VC companies often retain the right to participate in subsequent rounds of financing and frequently contribute more money as the company develops. 
Disadvantages
It’s tough to relinquish full control of your business, but it’s a necessary element of obtaining venture money. Obtaining financing is similarly difficult. You’ll need to pass a due diligence procedure and have a member of the venture capital company sit on your board of directors to monitor your activities, in addition to sustaining growth.
The following are the 10 drawbacks of raising venture financing for a startup:
1. The Founder’s Share in the Company Is Reduced
You’ll need to dilute your equity to issue additional shares to your investors while raising a financing round. Many businesses outgrow their original investment and need subsequent rounds of funding from venture capital firms. Founders lose majority ownership of their business, as well as the control and decision-making authority that comes with being a majority shareholder, as a consequence of this process. Founders may reduce this risk by just raising the funds they need.
2. Finding investors may be time-consuming
When all financing options have been explored and the money is required for expansion, startups realize it’s time to seek venture capital. However, fundraising may take months and should not be done at the expense of running the business. Founders give themselves enough time to both continue to develop the business and collect enough money to keep growing by beginning the process before they need it.
3. Funding is scarce and difficult to come by.
Only around 5,000 venture capital transactions were done in the United States in 2018, according to a study by the National Venture Capital Association. Almost 3,000 of these businesses have previously received venture capital funding. According to venture capitalists, for every three or four businesses they finance, they get around 1,000 ideas.
An incubator or accelerator is one option for companies looking for their first round of financing. They often offer up to $150,000 in financing as well as a three-month boot camp to prepare businesses for development and future rounds of funding. Angel financing is another option for startups looking for smaller sums of money with more flexible conditions.
4. The overall cost of financing is high.
When compared to taking out a loan, giving up equity in your business may seem to be a bargain. The cost of equity, on the other hand, is only recognized when the company is sold. Venture capitalists provide much more than just money, such as guidance and connections. However, this is not a choice to be taken lightly, particularly if there are other financing options.
Two companies, for example, each need $1 million and are valued at $10 million. The first firm takes out a 10-year SBA loan for startups at 10% interest, while the second raises $1 million for 10% ownership. If both businesses sell for $100 million after ten years, the first company’s founders will have paid $600,000 in interest and kept ownership, while the second company will have lost $10 million in profits from the sale owing to equity dilution.
5. Formal reporting structure
You’ll be obliged to establish a board of directors and a more strict organizational structure if you get venture capital financing. Both promote the company’s development and openness, allowing it to expand. This may restrict the company’s flexibility and limit the amount of influence the founders have. It is, nevertheless, advantageous to a quickly expanding business.
This structure is imposed by venture capital companies to supervise the business and identify any issues. Problems arise more rapidly as a result of quicker development, and they must be addressed before they spiral out of control. Because of the enhanced levels of reporting and openness, this structure provides confidence to venture capital firms.
6. Extensive due diligence
Because they are investing money from outside sources, venture capital partners must screen companies. There are two phases to this. The first step involves evaluating your technology and business fundamentals to see whether there is a market and if the company can be expanded. They undertake a more comprehensive examination of your team’s history, as well as the startup’s financial and legal situation, in the second stage.
Despite the fact that this procedure may take months, it is advantageous to the companies that go through it. It is considerably simpler to fix issues if they are identified and addressed early in the startup’s development. Because many problems have already been examined and addressed, future rounds of financing will be easier as well.
7. The company is expected to expand and grow quickly
Venture capital companies require your company to increase in value on its path to being bought or listed on a public stock market in order to receive a return on its investment. Knowing that the company has to get there may add to the already tremendous strain that entrepreneurs are under. There are, however, methods for entrepreneurs to cope with their anxiety.
Founders may ensure that their objectives are aligned and benefit from the knowledge of others by interacting with other founders and their investors. Founders should also be aware of how to reduce their burden by delegating when necessary, allowing them to concentrate their time and attention on the most important aspects of the company.
8. Funds are released based on performance
Venture capital funds are distributed in stages when the company achieves specific milestones. These are business-specific, but they include revenue targets, customer acquisition objectives, and other criteria set by the venture capital company. These objectives, as well as any conflicts, should be discussed with the board. If the goals are the only thing on the founders’ minds, it may be distracting, but it also leads to higher company success.
Ted Chan, CEO of CareDash, explains how he collaborates with his board of directors’ venture capital partners:
“Given the amount invested, there’s a definite amount of money and a direction set from the start in terms of how to utilize it and what the objectives are. VCs, in my experience and those of my friends, are less concerned with how you spend your money and more concerned with the value you provide. My board asks excellent questions and has helped me reign in spending, but it also allows me to take chances or explore paths that I understand better based on my experience.”
9. It’s Possible for Founders to Lose Their Business
Underperforming founders risk losing their companies. Founders are often let go if they do not engage in conduct that promotes shareholder value, or if they are irresponsible and spend company money for personal gain while ignoring the firm. To reduce this risk, entrepreneurs should listen to their board of directors and communicate regularly about their strategies and objectives.
10. Limited negotiation leverage
Most companies seek venture financing only if it is the only way to fulfill their financial requirements. When there are too many investors interested (known as being oversubscribed), the company has negotiating power over the conditions. However, apart from rejecting the sale, most companies will have little power. This may be minimized by beginning your search for a venture capital company that knows your objectives and financing requirements as early as possible.
Who Is a Good Candidate for Venture Capital?
Founders utilize venture capital financing to grow their businesses. Venture capital financing may help founders who haven’t scaled before or who require specialized guidance and connections in a new sector to grow. Venture capital may also be a fantastic source of financing if the company needs several rounds of funding in the millions of dollars for expansion or is in an unexplored expanding market.
The following are examples of situations when venture capital investment is appropriate:
- Founders with no prior experience growing a business: Venture capital partners have grown hundreds of businesses, making them a valuable source of information and expertise. In addition to the money, founders with limited experience growing may benefit from this resource.
- Startups that are experiencing rapid growth and need to scale: Getting venture capital financing may help you expand your operations if your company is currently expanding rapidly. You can decrease the number of pain points in your startup and keep up with demand while preserving or increasing the quality of your product by doing so.
- Founders who need several multimillion-dollar financing rounds: One of the few sources of financing that may provide several million dollars over many years is venture capital. Some companies need a lot of money, particularly if they want to keep acquiring customers even if they aren’t profitable yet.
- Startups in fast-expanding unexplored markets: In a flourishing industry, startups often find themselves as one of the few rivals. Traditional bankers are unlikely to lend to companies based on a trend, but venture capital firms would. This money may help companies expand and try to grab a big portion of a rising market.
- Founders in need of particular sector knowledge and connections: If your company is entering a new area with which you are unfamiliar, the appropriate venture capital firm may make all the difference. The company has a far better chance of success by avoiding errors by utilizing their expertise and contacts.
Startups with significant growth potential in fast-growing areas are the strongest candidates for venture financing. They may provide significant sums of money over a long period of time, as well as experience in scaling and specialized sectors. However, not every company is scalable right once, and until they are, entrepreneurs may seek financing from sources other than venture capital.
Frequently Asked Questions (FAQs)
What other kinds of venture capital are there?
Seed, growth, and acquisition funding are all specialties of venture capital companies. Seed money is usually used to build a team and be ready for a growth round. The expansion round is used to expand an established business. Finally, acquisition finance is typically obtained to fund the procedure prior to an acquisition or an IPO.
What is the purpose of venture capital?
By investing in high-risk companies with growth potential, venture capital fills a vacuum left by conventional finance. Founders often utilize it to expand their businesses, attract a wider audience, and improve their products or services. It’s also utilized to finance companies that are getting ready to sell or go public.
What are the papers needed for venture capital?
A business plan that contains information about your team, organization and financing requirements is usually required when pitching a venture capital firm.
Conclusion
It’s critical to weigh the benefits and drawbacks of venture capital before seeking funds as an entrepreneur. Although you may receive a big sum of money with no monthly payments, it comes at a cost in terms of equity. You’ll also get help developing your company, but you’ll have to relinquish some authority in the process.
