Venture Capital Advantages and Disadvantages
Sep 20, 2022
Founders must face and overcome many obstacles when founding or growing a business. In some industries and business models, scaling up requires more resources than a business can quickly generate on its own, making the availability of cash to invest in the organization a common limiting constraint.
Securing outside capital for hiring great talent, accelerating product development, and ramping up sales and marketing efforts can indeed jumpstart a business’s growth. Venture capital financing is a common way to secure that capital. But understanding venture capital advantages and disadvantages is critical for deciding how to fund your business strategy.
What Is Venture Capital?
Venture capital (VC) is a type of financing that firms or funds provide to small, early-stage, high-growth companies with exceptional long-term growth potential.
What kinds of companies receive VC funding?
Venture capitalists are typically looking for companies that can offer a return on their investment of 3x to 10x or more, depending on the investment stage. To achieve these returns, venture capitalists generally invest in companies with high potential growth and a large total addressable market (TAM). Because not all companies a venture firm selects will be winners, this generally translates to an overall portfolio internal rate of return (IRR) of 20% to 35%.
VC funding recipients are often smaller, newer companies. These businesses typically can’t easily access traditional funding from IPOs (public capital markets), bank loans, or other debt instruments.
The economics of venture funding
Venture funds are typically funded by a group of limited partners (LPs) that range from previously successful investors and entrepreneurs to insurance companies and other financial institutions like universities and state retirement systems.
Investments are made through either equity or convertible securities. Equity investments give the VC firm ownership in the form of stock. Convertible securities are debt instruments that can be converted into equity later, typically when the company raises additional financing.
Why Venture Capital? Advantages of Accepting VC Money
Weighing the pros and cons of venture capital is essential for deciding if it’s right for your company. Although there are disadvantages, which we’ll get to later, venture financing typically comes with tangible benefits.
Access to VC financiers’ experience and knowledge
VCs often possess vast technical and managerial expertise. One of the most common venture capital benefits is that it gives startup companies access to resources beyond money.
Through other companies in their portfolio or companies they’ve built and worked with, venture capitalists often possess vast experiences that can help your business succeed. For example, a VC might have worked with a company in the same industry as yours, allowing them to provide insights into the market.
VCs have a vested interest in your business succeeding. When you succeed, they succeed (and make money). They are willing to share experience to keep your business moving in the right direction and ensure you have access to the right experts.
Connections
VC firms typically have an extensive network of industry contacts they can introduce you to, which can help you get your foot in the door with customers, partners, and suppliers. For example, a VC might introduce you to an experienced CEO who can help take your business to the next level.
A study by Gompers and Lerner found that VC-backed companies were three times more likely to receive follow-on financing than non-VC-backed companies. This is likely because VCs want to invest in companies that have already proven themselves successful and have a higher chance of achieving even more success in the future.
Resources
In addition to connections, VC firms also have access to resources that can help your business grow. For example, some VC firms have in-house legal, finance, and human resources expertise. This can save you the time and money of hiring outside consultants or building an internal team.
Some VC firms even enjoy access to office space and equipment that startups can use. This can be a considerable advantage for early-stage companies trying to keep their costs low.
Venture capital is an essential source of financing for startup companies. Venture capitalists provide not only funding but also expertise, networks, and resources. The advantages of venture capital can help your business succeed.
Disadvantages of Venture Capital
Venture capital is not without its disadvantages. Along with the advantages above, here are some potential drawbacks to consider before taking VC money.
High stakes
One of the most significant disadvantages of venture capital is that it comes with high stakes. Venture capitalists aren’t content to invest money without control. They typically want a considerable equity stake and a seat on the company’s board of directors in exchange for their investment.
They have a say in how your company is run and expect a return on their investment within a few years. This can be difficult for founders who are used to having complete control over their business and can lead to conflict between the VCs and the founder, especially if the VCs have different goals for the company.
Dilution of ownership
VC financing can be dilutive to the founder’s ownership stake in the company. This is because VCs typically invest through equity, meaning they own a portion of the company. Although this can be difficult for founders who are used to owning 100% of their business, dilution is not always bad. It can be beneficial, as it allows the founder to raise capital without giving up control of the company.
If you’re not comfortable giving up a significant equity stake in your company, venture capital might
not be the right financing option for you.
High pressure to deliver results
Another disadvantage of venture capital is that it can be high-pressure. This is because VCs typically want a return on their investment within a few years. This can pressure the founder to grow the company quickly, which may lead to shortcuts and cut corners and can be detrimental to the long-term success of the company.
It’s important to remember that not all VCs are the same. Some are more patient than others and are willing to give you more time to grow your business. Before taking VC money, it’s crucial to research and ensure you’re partnering with a VC firm that’s aligned with your goals and will give you the time you need to achieve them.
How to Decide If Venture Capital Is Right for You
Although the disadvantages of venture capital financing can be significant, they should be weighed against the valuable advantages, such as access to expertise, networks, and resources.
Ultimately, it’s up to you as a founder to weigh the advantages and disadvantages of venture capital investment in your business. If you’re uncomfortable with high stakes and pressure to deliver results, VC may not be the right choice for you. On the other hand, if you’re willing to give up some control and tap into additional expertise and resources, venture capital financing could be a great way to finance and grow your business.