Securing appropriate finance is one of the first and most fundamental steps when starting up a new enterprise. The funding you obtain will need to meet the requirements of your business, including covering the set-up stage, your operations and any additional fees you may undertake to launch your company.
Venture capital (often shortened to VC) is just one of many solutions that your business may utilise to get the equity they need. VC firms pool investment from private sources to raise funds for your business in exchange for shares. Their aim is for your company to offer them a good return on investment.
Venture capital is an excellent fit for many early-stage, pre-revenue businesses – particularly those deemed too risky by traditional lenders. It also supports SMEs as they navigate the initial stages of development.
If you are considering venture capital as a finance option, it is crucial to know its advantages and disadvantages. This blog outlines the pros and cons to help you decipher whether VC is the correct route for you.
- The advantages
- The disadvantages
- Alternative options for your business
- How to tell if venture capital is right for you
The advantages
Venture capital offers significant rewards to early-stage businesses that can secure it. We’ve listed the most prominent.
There’s substantial funding to be gained
The most apparent advantage of venture capital is the amount of funding a business may receive.
As VC firms work by pooling investments from many sources, it collates to a considerable sum of money. As a result, your enterprise could benefit from a large injection of capital, meaning you are less likely to need to seek funding from elsewhere.
These funds tend to be given in tranches over a set period rather than all upfront. This will be welcomed by some early-stage companies, which means you have continual financial support to allow your company to grow.
VC is open to risk
Venture capital is aimed primarily at early-stage businesses that are seeking finance. While traditional lenders, such as banks, tend to be risk-averse with these companies – who have little or no financial track record – venture capitalists are much more open to the risk.
If you have high growth potential and struggle to raise finance elsewhere, it may be worth considering VC instead. This also works if your start-up idea could be deemed high-risk.
While VCs are open to risk, the risk needs to translate to high reward. They will expect a very healthy rate of return on their investment – usually of at least 25% – so you will need to ensure your offering is commercially viable. Even if your business idea is slightly controversial or disruptive, it is vital that you are confident of achieving success.
You’ll get hands-on support
Another attractive benefit of venture capital is that, alongside funding, it offers an additional layer of practical support for entrepreneurs.
Venture capitalists investing in your company will be eager to receive a good rate of return on their investment. Due to this, they are happy to work with you to make your enterprise as successful and profitable as possible.
VC firms offer support in the shape of operational guidance, access to resources and introductions to helpful industry contacts and networks. This means that it’s not just your finances that benefit, but also areas such as HR, logistics, sales, marketing, etc.
This help is often significant in the first stages of development of a start-up, allowing you to build strong foundations that will come in handy across the lifespan of your company.
There are no repayments
Many enterprises fear being burdened with monthly repayments after taking out a loan. These regular payments strain finances, with positive cash flow needed to ensure every instalment is met.
As venture capital uses equity investment, the need for monthly repayment is removed. Instead, you offer shares in your business. As your company grows and becomes profitable, shareholders will receive their returns as dividends from these profits, without the need to part with cash you do not have.
This alleviates the pressure while allowing VCs to get their money back only when you have achieved success. However, VCs may also look to split their investment between equity and loan notes (which will pay back an interest rate over the course of the loan), so be sure to clarify this in the early stages of your discussions.
It’s a long-term solution
Venture capital is a long-term financial solution, with most VC firms planning an exit five to seven years later. Doing so gives your business an excellent chance to grow, offering them better returns in line with your increased revenue.
This means you will enjoy years of financial and practical assistance from your venture capital. If you are looking for long-term support, VCs will enable you to grow and optimise your operations to ensure extended success.
No assets are required
Another advantage of venture capital is that no assets are required to be utilised as security against the funding. This is particularly useful for start-ups that have not yet acquired significant equipment or stock for their operations. It includes personal assets that may be requested in other funding agreements.
With no requirement for assets, more companies will be eligible for finance, and there is no risk of your equipment being seized or your personal wealth being affected.
You will access more opportunities
As we’ve already mentioned, venture capitalists are invested in your success as it dictates the return on the investment they receive. Due to this, they will provide you with enhanced opportunities that lead to high business performance.
Examples of opportunities include networking, collaborations with other companies, recruitment support and leadership training. It could also lead to publicity as the VC firm may put you forward as a good news story for local and industry press outlets, which will drive awareness.
By embracing these opportunities, you will strengthen the foundations of your start-up and guarantee your chances of a successful launch and long-term success.
There’s the possibility of future funding rounds
When you receive VC finance, it doesn’t need to stop there.
Many VC firms want you to raise finance in future funding rounds as it increases their returns (especially as your company valuation grows). Some will work with you to create a funding strategy and put you in touch with financers who will help.
As a result, you will generate higher sums of funding across the lifecycle of your business, enabling you to continually tap into finance to achieve your goals and improve value.
The disadvantages
Although eligible businesses will receive high-level advantages from venture capital, there are considerations you should make to determine if it’s right for you. These are the most significant.
It’s hard to get approved
One of the biggest challenges associated with venture capital is receiving approval. At some firms, the chance of getting approved is reportedly as low as 0.05%.
Before giving you any financial support, VC firms will conduct thorough due diligence to check that you are suitable. As their main objective is getting a return on investment, they will need to see proof that you will provide this return. Criteria they review include the opportunity for growth, the commercial potential of your products or services, the strength of your operations and management team and whether the possible rewards outweigh the risks associated with your business.
They will need to see your business plan, financial forecasts, and other relevant supporting documents as part of their due diligence. You must provide these and ensure your enterprise’s value is evident – which means inputting time and effort into creating sufficient documentation to win funding.
You need to give up equity
The nature of venture capital means you must give away company shares. For some entrepreneurs, this is a challenging thought.
Depending on your development stage, firms may ask for between 10% and 80% stakes. You must offer a generous amount of equity to these investors. There are mechanisms that will allow for you to regain shares in the business as it grows when you meet agreed milestones that could be worth exploring.
Another concern about bringing shareholders into your company is that you are essentially incorporating more opinions about the running of it. Depending on your shareholders, they may have varying levels of involvement. Sometimes, you will need to seek sign-off from these stakeholders on your business decisions, which could lead to obstacles and challenges.
If you prefer not to involve outside sources or want to keep your profit in the company, external shareholders – such as venture capitalists – could prove tricky.
It’s not a quick fix
While the long-term timeframe associated with venture capital will be a plus for some early-stage businesses, it may deter others. Venture capital is not necessarily the best solution if you are looking for a quick fix or short-term funding, such as to plug a gap in your financials.
When signing up with VC, you must be prepared to give away shares in your company. You will welcome regular input from stakeholders and will also be unable to increase your share of the ownership of your business unless you have agreed on a rachet methodology with the VC in advance. This creates the opportunity to reacquire shares in your business if you meet pre-agreed milestones and goals.
Funds will also be given on a staged basis, rather than all upfront – so this isn’t suitable for entrepreneurs wanting sizeable sums instantly.
It’s expensive
As there are no repayments to worry about, many may believe that venture capital is cost-effective. However, the actual cost of equity will not become apparent until the sale of your business.
When you give away equity in your company, you suffer share dilution. Your shareholders have the right to proceeds from the sale of the business. You will walk away with a reduced figure, albeit greater than if you had not received the investment in most cases.
That is not to mention that share of the company dividends that investors will be entitled to during the lifespan of your company, again taking money away from you and your company. This is why people often say debt is cheaper than equity.
VC is not a decision to be made lightly, and you must contemplate the long-term repercussions.
There’s pressure to grow
A VC firm will support your business with the expectation it will provide a favourable return on investment. There is pressure on your company to fulfil these expectations by performing well and achieving the intended growth goals.
If you underperform, there’s a risk that shareholders could vote to replace you, so you end up losing your business.
The best way to manage the pressure is to regularly communicate with investors to ensure you are clear on their objectives and following an appropriate course to achieve them.
You need the right structure in place
If you are accepted for venture capital funding, you must set up a formal reporting structure and a board of directors. Doing so makes governance of the business and its performance easier, meaning the VC firm will be alerted to any issues ahead of time and resolve them.
However, these structures impede a company’s flexibility and relinquish the founders’ control. You must be willing to abide by these structures for the long-term – if you can’t, it’s unlikely that VC will suit you.
It’s hard to negotiate
Another potential disadvantage of VC is that there is little room for negotiation. Start-ups typically have a weaker position: they need funding to achieve their goals, are inexperienced, and might be out of other options.
If you have multiple investors interested, you may have some leverage – but this is a rare scenario. You need to agree to the terms given or reject the deal, which could see you lose out on funding altogether.
Taking the time to research VC firms and find one best suited to your needs will reduce the chance of complications and enable you to get a deal that you’re satisfied with.
Alternative options for your business
Venture capital is just one of the options available for early-stage ventures. If you aren’t sure it’s right for you, consider these alternative avenues:
- Angel investment – where individuals with personal wealth invest in your business in exchange for equity. They tend to offer similar rewards to VC, but there is less need for a rigid structure, making it more attractive to some companies. They are also more readily available than VC funding.
- Crowdfunding – where multiple people fund your company, creating a larger pool of finance. Doing so may see them receive equity in your business, though alternative incentives exist. Expect to have an engaging marketing campaign if you want to attract funders.
- Debt funding – although commonly associated with bank loans, the debt market is increasingly innovative with solutions to fit many companies, including P2P loans or alternative lenders. Debt is also ideal if you’re keen to avoid giving up equity.
A commercial finance specialist will discuss other options and help uncover your company’s best route.
How to tell if venture capital is right for you
There is plenty to consider before going down the route of venture capital. While it may be a high-reward, high-value source of funding and additional support for even risky ventures, it also takes effort to get approved and will not be ideal for every business.
As with any form of finance, you must take stock of your requirements and ensure that venture capital adequately addresses them.
If you need assistance in deciding whether venture capital could be suitable for you or seeking alternative solutions for your enterprise, our team of advisors are here to help.
With the experience working from working with SMEs, we provide support in securing the best funding for your needs and connecting you with funders who will help.