The Pros and Cons of Venture Capital for Founders
- What the benefits and downsides of venture capital are
- What founders should know about private equity
- Why founders should consider hiring an investment bank
How you fund your business is a serious point of consideration and shouldn’t be taken lightly.
At some point, whether or not to pursue VC funding will cross the minds of most software or internet founders. When money is tight and you’re excited about growth, the venture capital route can be an attractive option.
Before you decide to pursue venture capital, make sure you’re aware of the pros and cons, as well as your viable alternatives.
The Pros of Venture Capital
The benefits of funding your business via venture capital include:
- A bigger balance sheet
- The possibility to grow faster
- An experienced partner
- Access to alternative capital
- An improved ability to recruit
- An opportunity to professionalize
A bigger balance sheet
The most obvious benefit of VC funding is access to more capital on your balance sheet.
Founders who bootstrap their business (by necessity or by choice) are constantly faced with questions of how to allocate resources throughout the organization. A VC fundraising event can effectively change the discussions of resource allocation from "this or this" to "this and this."
The possibility to grow faster
As a bootstrapped founder, you have significant resource limitations. You can’t spend more than you make or your company will go belly up. An infusion of VC capital can remove these resource limitations, giving a company the potential to accelerate growth.
In many cases, a VC-backed company (per the recommendation of their investor) will use negative cash-flow as a growth mechanism—burning capital early to accelerate growth with the hope that size translates to profitability in the future.
An experienced partner
Experienced VC partners have invested in and worked with a wide array of companies. As such, they can be a valuable resource to assist with strategic decisions and even leverage their network to help you succeed.
You should note, however, that not all partners are created equal. While a VC firm might adamantly pitch the value of their partnership, you should talk to some of the firm’s other portfolio companies to verify how involved the firm/partner tends to be aftering closing the transaction.
Access to alternative capital
Due to a lack of reputation, bootstrapped founders will find that access to alternative capital like loans or revolving lines of credit will be more limited. For an unproven company, credit is usually lower and terms less favorable.
VC-backed companies, on the other hand, find that these issues disappear, due to the VC firm’s high credit-worthiness. The VC firm can often even introduce the founder to potential lenders.
An improved ability to recruit
People like to work for companies that seemingly have big brands. Venture-backed companies tend to have the perception of being a bigger/better business with extensive resources, making recruiting easier. An investor could also help you recruit from their own network.
An opportunity to professionalize
An investor joining your board will have the effect of professionalizing the executive aspects of your business. Many founders see this change as a positive, since a new partner on your board creates pressure to get organized.
The Cons of Venture Capital
The good doesn’t come without the bad. Some important downsides of venture capital include:
- An amplified risk profile
- Greater expectations
- A loss of control
- Someone to answer to
Each time you raise VC money, your share of ownership in the company will decrease. While a smaller portion of a bigger pie may not seem like a bad deal, a few questions you should ask yourself include:
- How big can the pie reasonably get?
- What’s the probability of reaching that significant size?
- Which is bigger: all of a small pie or a fraction of a big pie?
An important aspect of dilution is that it rarely just happens once. Because aggressive VC investors encourage their founders to grow cash-flow negative, when the money runs out, founders have to run another investment round to stay alive, further diluting the founder’s ownership.
(On a related note, each fundraising round will pull a significant amount of a founder’s time and attention away from running the business.)
An amplified risk profile
Bringing on a VC partner does not equate to "business as usual, but with more money." Your partner is going to want to ratchet up the risk on the business.
By design, VC firms invest in a wide portfolio of companies in the hope that at least one or two of them take off to cover the loss of the remaining companies. For this approach to work, VC firms encourage their portfolio companies to employ more aggressive strategies that could make or break the company.
In many cases, a founder could have a strong financial outcome without taking on the additional risk. But because of the divergence of economic interests, VCs would rather push the company to the breaking point, in many cases placing a founder’s financial interests in jeopardy.
When you started your business as a founder, the amount of cash you had to put in was likely relatively small. So for you, every dollar of revenue you add is like adding another dollar in enterprise value (or a multiple of that).
Investors, on the other hand, enter a business at a much higher cost basis and therefore have much higher expectations for the business. As a result, they may place a lot of unwelcome pressure on you to increase risk and hit your targets.
That unwelcome pressure will hold until your company either 1) takes off or 2) falls apart. If your company falls apart, the VC fund will likely go dormant and offer only perfunctory support.
A loss of control
Many founders assume that maintaining a majority ownership means maintaining full control over key business decisions. But VC investors are experts at protecting their minority interests and aren’t going to hand over a big check without some protections.
Even if you maintain a majority share, minority protections written into your investment and operating agreement can reduce both your control of the business as well as your economic outcome in the event of a liquidation event.
For example, depending on the security structure, an investor could own a 20-30% stake in the company but receive 60% of an economic outcome. Other protections could give the investor the right to:
- Block strategic decisions in the business
- Block a potential sale of the business
- Force a sale of the business
- Fire your CEO
Is VC Right for You?
While venture capital is good for some, it’s not good for everyone. Here are some signals that VC might not be right for you:
You’re hoping for some liquidity. Because VC firms are hoping for massive outcomes and usually invest in early-stage companies, they are loath to pay any liquidity out to founders. If you’re hoping to extract some money out of the business, then VC isn't right for you.
You’re averse to risk. If you’re more concerned about protecting what you’ve built than making a BIG bet, VC isn’t right for you.
Your market size doesn’t support multiple capital raises. Because the VC route results in significant dilution, your market opportunity has to be large to justify handing out shares of the company. If the size of your market has a short ceiling, then VC isn’t right for you.
Private Equity: A Viable Alternative to Venture Capital
An alternative path we see founders pursue to great success is a minority or majority recapitalization via private equity.
A private equity firm’s focus is to invest in companies that have a proven track record, then help those companies expand. Unlike VC firms, PE firms are fully open to giving liquidity to founders and are more risk averse because they expect a return from most of the companies they invest in. PE partners tend to be more involved post-transaction.
Of course, the private equity route requires you to achieve a minimum threshold of business execution to attract an investment. But if you already have a proven thesis and a successful company, then private equity can be the right path to:
- Raise capital to grow your business
- Take some chips off the table
- Grow your business without excessive risk or dilution
- Partner with an investment firm who is fully aligned with the success of the business
The Importance of Hiring an Advisor
But like VC, private equity isn’t without its pros and cons. Private equity partners have accumulated decades of experience running transactions with companies like yours, and are therefore expert at structuring the transaction in their favor.
As a founder, your focus should be on running your business, not trying to manage relationships with seasoned investors. Hiring an expert M&A advisor to guide you through the transaction process is your best move to achieve an optimal outcome.