Venture Capital (VC) has emerged as a form of private equity funding that is generally provided to start-ups and companies at the nascent stage. VC, a popular term in the 21st century economic landscape, is often offered to firms that show significant growth potential and revenue creation, thus generating potential high returns.
“Entities offering VC invest in a company until it attains a significant position and then exits the same. In an ideal scenario, investors infuse capital into a company for two years and earn returns on it for the next five years. Expected returns can be as high as 10x of the invested capital,” explained Groww.
Venture capital is generally offered by venture capital firms, investment banks and high-net-worth individuals (they are often referred to as Angel Investors). Venture capital firms often create VC funds (a pool of money collected from other investors, companies, or funds), apart from investing from their own pockets to show commitment to their clients.
Venture capitalists have established themselves as investors who pump their money into early-stage companies having promising futures. A venture capitalist can be a sole investor or a group of investors who come together through investment firms.
How Things Work
Venture capital only comes into play when a small business owner/start-up leader is looking to expand his/her business. Opting for funding through venture capitalists is a good option, as the move helps the entrepreneur to encash his/her business, financial and legal expertise which is usually required during business expansion.
“A venture capitalist brings in a lot of expertise, knowledge, and networking along with his capital investment. You can utilise their guidance to build your own network, promote your business with their direction and ultimately make it reach bigger heights,” Groww remarked further.
Venture capital can be classified like Seed Funding, Start-up Capital, Series A, Expansion Funding, Late-Stage Funding and Bridge Funding.
Once again, the article makes it crystal clear that when we talk about venture capital, we are strictly talking about a funding source generally accessed by small, medium and start-up kinds of ventures. Also, companies eligible for VCs are the ones providing high returns along with a high risk. VCs, as investments, help to commercialise a new entrepreneur’s idea on a particular product/service.
Even though VCs are long-term investments, where the returns can be realised after 5-10 years, the investors can disinvest in a company if the latter shows promising turnover. This is to ensure more capital gets fused in that business, rather than generating profits.
Here Are The Pros
Venture capital often helps new entrepreneurs gather business expertise. The investors come with significant experience to help the owners in decision-making, especially human resource and financial management.
Entrepreneurs are also not obligated to repay the invested sum. Even if the company fails, it will not be liable for repayment.
Owing to their expertise and network, venture capital providers can help build industry connections for business owners. This comes in handy in terms of marketing and promotion. Also, VC investors seek to infuse more capital into a company to increase its valuation. To do that, they can bring in other investors at later stages. In some cases, the additional rounds of funding in the future are reserved by the investing entity itself.
Venture capital can supply the necessary funding for small businesses to upgrade or integrate new technology in their operational ecosystems, which can assist them to remain competitive.
What Are The Cons?
As per Maximilian Fleitmann, former CEO of BaseTemplates, Only 0.05% of start-ups successfully raise money from venture capitalist firms. That is 1 in 2000! A funding round can be a lengthy process (sometimes over nine months) as venture capitalist firms will conduct due diligence on the applicant’s business to ensure the partnership is suitable. The criteria usually consist of the total addressable market, the commercial potential of the business’ services/products, management team’s strength, and whether the rewards outweigh the risks.
“Venture capitalist firms will want to see your business plan and financial forecasts. In these, you need to show the value of your enterprise and make the growth potential clear to see,” Fleitmann commented. Another issue for a new entrepreneur, while availing VCs is, giving up part of his/her business.
“This is one of the most debated elements of venture capital investment. It might not sound that bad to start with because, as we mentioned earlier, start-ups benefit from networks and guidance. However, companies very quickly outgrow their initial funding. This means they have to raise more rounds from VC firms, which also means giving up more equity. Therefore, in the process, the founders will gradually lose more equity in their own company,” Fleitmann explained further.
The move only results in reduced control and power to make decisions. Bringing in more shareholders also brings in more opinions on how the business leader should run his/her business. Also, some stakeholders will have a lot of involvement others will choose not to, which can lead to obstacles in the business’ growth.
Some venture capital firms can ask for anywhere between 10 to even 80% of the business’ equity, and due to that, even if the entrepreneur starts earning profits, a significant percentage will go to the investors.
Another risk factor is the venture capitalists’ appetite for receiving a return on their investments, as they are putting the money into the business with no guarantee that it will give them their capital back. So, from day one, start-ups will face the pressure to grow as quickly as possible and be on their way to going public/getting acquired. However, the business needs its own sweet time to develop its services and products.
Here, the “the quicker, the better” approach may end up hurting the entrepreneur if his/her product is not ready for the market. Another challenge is to find a venture capitalist firm, which will align with the start-up’s goals. However, if the task gets accomplished, it only helps the company, in terms of dealing with the “the quicker, the better” approach.
Another con is “distraction.” The business leader often gets distracted by the thought of applying for venture capital funding and pitching business plans to investors, rather than getting the products and services ready and customised as per the market demands. Also, the injection of cash also means an infusion of opinions. Ideas, demands, and queries from investors can sometimes distract the entrepreneur from his/her goals.
“It is easy for your judgement to be clouded by money and allow for your goals to change when others are factored in. Of course, this doesn’t happen to every company that gets venture capital funding, but it is just something to be aware of,” Fleitmann concluded.