What are some of the disadvantages to taking venture capital?
Finding affordable financing for a start-up can be a challenge for small business owners. Banks are wary of loaning money to a business without a two-year track record, and raising funds from friends and family has an inherent limit. A venture capitalist, however, can provide a company with the capital necessary for start-up costs and other expenses associated with expansion projects. An individual or firm acting as a venture capitalist has the funds for investing in a new business and the financing acumen readily available to help companies in their infancy, but disadvantages run rampant. Although venture capital is a viable source of equity financing, business owners should be aware of the caveats that exist with this type of funding.
Forced Management Changes
One of the most common practices in venture capital equity financing is the generally unwanted additional management personnel infused into the company requesting funding assistance. Because a venture capitalist typically has a great deal of business prowess, there may be an assumption a member of his or her management team is needed on the ground at the financed company. This can be presented under the facade of needed support and industry experience, but usually a business owner does not want or need an additional person in management. For the majority of venture capital agreements, however, these management additions are a requirement to receiving funding.
Loss of Equity Stake
Venture capitalists are able to provide small and start-up businesses with much-needed capital because they have easy access to it. With such large sums of money exchanging hands, it is no surprise equity positions within companies that accept venture capital investing are drastically shifted. A venture capitalist requires a large equity stake in the company to which he or she is providing funding to safeguard his or her initial investment.
In addition to changes in management teams and equity stakes, receiving equity financing from a venture capitalist comes with more strings attached to the decision-making process. Business owners are typically required to consult with the venture capitalist individual or firm prior to making any decisions in capital spending, expansion and personnel changes. This can create tension between the business owner and the venture capitalist, as the funding person is most likely not working closely with the owner on day-to-day business operations.
Delays in Funding
Because venture capital investing involves a large amount of capital exchange, a venture capitalist may not be willing to extend all requested funding at the same time. This means business owners may have certain milestones to reach prior to receiving the financing they initially requested, which could put additional undue pressure on them. Delays in funding could also come by way of an extended vetting process of the start-up business asking for financing.
Although venture capital can be a viable means to obtaining necessary capital for start up or expansion, business owners need to be aware that venture capitalists assume a great deal of control within the business to protect their investments.
The capitalization of a business is one of the most important factors during the many life-cycle stages of a business. Too little cash and you will fail (run out of money), too expensive of cash (such as through high interest debt financing) and you can't service your debt and you fail. You also have private equity and venture capital financing that can be a combination of debt and/or equity financing. One of the issues with both of these for entrepeneurs is that you now have someone you report to (typically a board of directors type set up) and you many times have to give up control or much of the control.
Investopedia has a very good definition of what Venture capital is:
Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. For startups without access to capital markets, venture capital is an essential source of money. Risk is typically high for investors, but the downside for the startup is that these venture capitalists usually get a say in company decisions.
Venture capital is something that you should only use if you have a well thought out growth plan, succession plan or exit strategy - which most business owners don't have as I outline in this article on why Most Business Owners have No Succession Plan or Exit Strategy
Venture Capital (VC) can be both expensive in terms of loss of control and loss of equity, but it can have some valuable benefits:
- It may be the only capital available if you are not at a point for more traditional financing, and
- In addition to money, the VC may have some good resources for you in terms of technology, intellectual property, managemnet guidance or other collaborative resources.
So as a business owner, before seeking VC capital, I think it is important for you to review all available resrouces for cash/capital, have a business plan and know your future capital needs and know what your growth and exit startegy is to help you determine if a VC will be able to:
- Give you want you need,
- Allow you to retain an acceptible (to you) level of control,
- Allow you to continue to move forward with your plan and vision, and
- Allow you to get the ultimate benefit of what you are building (what is the ultimate payoff).
Venture capitalists provide funding to startup companies, typically technology companies, almost always companies that have a strong growth potential. On the positive side getting financing from a VC firm means that you can be in business. So what are the disadvantages?
1. It's expensive
VCs will take a large equity position in the company that they invest in. Right off the bat, as an entrepreneur you will have given away a lot of your equity. As the entrepreneur goes through additional rounds of funding, his or her stake will continue to get diluted. It will not be long before the VC owns more of the company than the entrepreneur
2. Loss of control
The financing will come with many strings. One of them is making decisions on almost everything that is not product related. The VC can enforce that by taking a majority of the seats on the board of directors, and by appointing key personnel to your company including the CEO, the CFO, and even the CTO. Often these outside hires will bring in critical skills that the original team may not have had. However the balance of power is definitely tilted to the VC. Oh, and each of these people get to have an equity stake in your company.
3. You will be the last to be paid
The term sheets from the VC will specify how the VC and the entrepreneur get paid. The VC gets paid for his time and advice all along the way through dividends, while the entrepreneur will usually collect a salary.
When the company reaches its exit point (ie it gets sold or it goes public), everyone looks forward to getting paid. For runaway successes, there is enough to go around.
In the likely case that the company does not become a runaway success, the VC will get paid first as per the term sheets. If there is money leftover, the entrepreneur will then get paid.
VCs perform an essential function of funding startup companies. They are high risk investments, and as such they should bring a high return. Clearly VCs should get paid for the risks that they take and the know-how that they contribute.
However, for entrepreneurs who have other sources of funding, it is worth pondering the disadvantages of VCs.
Some of the potential disadvantages I have heard from my founder/entrepreneur clients are the following:
- Giving up equity in your company
- Having the venture firm take a board seat on your company
- Having to answer to investors who don't fully grasp your business
- When taking additional rounds of funding your will lose more equity and dilute your current investors
- Possibly being pushed out of your company at some point.
Although there are certainly potential disadvantages, there are also plenty of advantages. Do your homework!
Great question. And since you asked it, I won't bore you with the history and background of venture capital. I will, however, base my comments on the larger issue of the disadvantages of taking private equity (or private investments).
First, giving up equity can be a very expensive way to fund a business. The problem is, it doesn't seem so at the time, right? If you need $100,000 and someone gives it to you for 20% of your business, it can seem like a gift from the heavens. Until the business takes off, largely as a result of your hard work, solid ideas and compelling vision. Until you "buy out" your partner (if she is willing to be bought out - you can't really force them to do so) you will give her 20% of any distributions and, if you sell your business for $5MM, you will give her $1MM. A loan is usually a lot less expensive and if you still owed $50,000 on the original loan ($100,000) when you sold the business, you would pay off the loan. So first, you have to ask: what is my end game?
Second, a lot of private equity investors or opportunistic (they want the return) but not very helpful. The more reputable V.C. firms will provide something more than just money. They will frequently have the relationships needed for your idea to launch! In this case, giving up some equity can be worthwhile as now your business might be sold for $10MM and not $5MM. You'll still give up $2MM, but because of their help you will pocket $4MM more than in our first example. Here's the rule I give my clients who own a business: never take private money without first having confidence in the investor's ability to help you grow beyond your abilities. And then, legally formalize these expectations so that you have an "out" if they are not performing as agreed/expected.
Third, by receiving private equity money you are essentially take on partners (shareholders in a corporation or unit holders in an LLC). And let's face it, partners can be powerfully helpful or problematically harmful to your vision. Most of the time, they are a pain in the ... well, you know. Even the most minority shareholder has legally defined rights and can create headaches for those attempting to grow the business. They want a return on their money while you want to grow the company. For example, in a family owned business the non-active family members can be so insistent on receiving a quarterly dividend from the enterprise that it hinders the ability to re-invest in the machinery, equipment, property, employees, etc. necessary to grow.
I'm sure that others will have additional comments to make. If you think it would be helpful to talk about this, let me know. You can reach me at email@example.com.
If not, then best of luck to you as you work through this important issue.
All the best-
Like a lot of things in life, for every pro, there's a con. Venture capital is a perfect example. As for disadvantages, among the many are:
- Ownership is diminished - Venture capital firms will negotiate hard to get as much ownership of the company as they can per dollar of investment. You have to be willing to negotiate hard in response.
- Oversight - While it can and often does instill good discipline into the company, for an entrepreneur used to running the show, it can be frustrating to have people that you report to....and who can put the ixnay on some of your decisions.
- Culture - As you take on venture capital, you'll probably bring in more people to the company. These new additions will change the vibe of the company. It may be a good change....but it may not. You'll have to play those cards as they're dealt.
- Vision - With new partners, while everyone may go into the relationship with the same goals, the dynamics of business can and probably will create opportunities for "mis-alignment" between the partners. Pure majority voting control helps you to easily manage that issue, but majority voting may not be in the cards. If that's true, then you'll need to manage your relationships with the other voters to keep the majority vision in line with yours. For some, this is envigorating. For others, it's exhausting.
Best of luck!