Venture Capital Funding
Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves.
Venture capitalists generally:
- Finance new and rapidly growing companies;
- Purchase equity securities;
- Assist in the development of new products or services;
- Add value to the company through active participation;
- Take higher risks with the expectation of higher rewards;
- Have a long-term orientation
When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company.
Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. Going forward, they actively work with the company’s management by contributing their experience and business savvy gained from helping other companies with similar growth challenges.
The advantage of venture capital investment is that you get money that enables you to expand your business and obtain market share before someone beats you to it. Venture capital is not a loan that needs to be repaid; rather, venture capitalists (VCs) invest their money in exchange for equity (an ownership share) in your company. VCs get their cash out only when your business is acquired by another company or “goes public,” that is, when its shares can be publicly traded on a stock exchange.
The disadvantage is that you are no longer the sole owner of your company and may lose control. Moreover, a VC may move your company towards an Initial Public Offering (IPO) of publicly traded shares faster than might be best for the long-term health of the business.
In general, the earlier the stage where you receive funding, the more you have to give up. A few VC companies or “angel investors” might invest in what is not yet a real operating business but just a concept. For $500,000, they might take a 60% ownership in the company, and put in their own management team. If they decide that this can become a viable business (“proof of concept”), they might fund the company for another $5 million, taking yet more equity. By the second round of financing, the original business owner might retain only a 5% to 10% ownership.
What are the Pros and Cons in having Venture Capital Funding as a partner?
- Financial strength for global competition
- Share buy-back opportunity
- Easier to get listed on a stock exchange
- No conflict of interest
- VC network can enhance the company’s business
- VC’s provide experience, advice, and mentoring. They are objective, helpful with networking and hiring the right people. They add credibility and prestige to your business, share the risks, and help eventually to sell the business.
- Lose part of the ownership
- Cannot manage the company as a family-run business
The risk of working with a VC may be their concern is more for a profitable and mandatory exit, compared to your concern for your employees and customers. You loose independence to manage your business and the VC’s may have the right to fire you and your management team. It can be a full-time job to manage the venture capitalists that are funding your business.
Venture capitalists usually ask for:
- Anti-dilution protection. If the company’s stock price goes down any time in the future, they get additional stock for free.
- Dividends. In addition to stock, they get a guaranteed rate of return.
- Liquidation preferences. VCs get their principal and dividends back before anyone else gets a penny.
- Participating preferred. They get to double dip—they first get their investment plus dividends, then the value of their stock.
- Mandatory redemption. This requires the company to buy their stock back by a certain date, establishing a deadline for an exit event.
- Demand registration rights. The VCs can force the company to file a registration statement with the Securities and Exchange Commission to initiate an initial public offering—another way of forcing an exit event.
- Approval rights. The VCs must approve any new financings and have the right to participate.
- Reps and warranties. You’ll also have to accept personal liability for representations you’ve made about key aspects of the company. They will have the right to sue you for all you own if you forgot to give them any bad news.
There are no easy choices. If you have orders for your product with a sufficient gross margin, commercial finance companies may be your best choice. If you need to develop your product and lack the capital to fund your business to develop the product, market your brand and receive orders, venture capitalists can be the best thing that ever happened to your company. If you commit to a commercial finance company, you can terminate the contractual relationship. If you commit to a venture capitalist, the exit strategy is in their domain.
“Make a mint” If someone is making a mint, they are making a lot of money.
“Feel the pinch” If someone is short of money or feeling restricted in some other way, they are feeling the pinch.
Recommended Books on Whether Venture Capital Funding is Right for Your Startup
- Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist
- The Business of Venture Capital: Insights from Leading Practitioners on the Art of Raising a Fund, Deal Structuring, Value Creation, and Exit Strategies (Wiley Finance)
- Mastering the VC Game: A Venture Capital Insider Reveals How to Get from Start-up to IPO on Your Terms
- THE ENTREPRENEURIAL BIBLE TO VENTURE CAPITAL: Inside Secrets from the Leaders in the Startup Game
- Venture Capitalists at Work: How VCs Identify and Build Billion-Dollar Successes
About the Author:
- What Makes You Eligible for Venture Capital?
- Other People’s Money (OPM): Equity Style
- 5 Strategies to Raise Capital for a Small Business
- Can Your Small Business Attract Venture Capital Financing?
- How to Raise Money to Start a Business