What is Venture Capital and How to Know if VC Funding is a Good Idea for Your Startup
In the last several months there has been an increase in “supergiant” venture capital funding deals ($100 million or more) In August, Boston-based security firm Cybereason raised a $200 million Series E round. More famously, toward the end of last year’s bike and scooter-share company Lime raised $335 million in its Series C round. The examples go on and on. And, VC funds are on the rise overall in the United States, according to industry resource Crunchbase.
With these trends, it’s sometimes easy to overlook the fundamentals. What is venture capital? When is it a good fit for your startup? Do you need to be located in San Francisco or Silicon Valley to get it? (That answer is “no” by the way.) How do you know whether venture capital funds are better than, say, a traditional commercial loan or private equity?
It’s important to do your due diligence when it comes to VC firms, angel investors and the like. Making a mistake in this area can prove expensive for years to come. Some venture-funded companies have actually sought to part ways with their venture capital firms. You should make sure you’re familiar with the basics before diving into the venture capital pool, so let’s start with the most basic question:
What is venture capital?
Most successful technology companies follow a lifecycle pattern that starts with an idea. It then develops into a small-scale business model. Ideally, it then grows until it becomes a huge corporation.
Each stage of development has different associated risks, goals, and challenges. Different kinds of funding are appropriate for each level. What works for your early-stage company before you launch may not be ideal in a year. What works for your year-old company may be unsuitable for a 10-year-old company.
Venture capital is typically associated with high-risk, early stages of startup growth. These are the first years before the company exceeds $50 million in revenue. While some venture capitalists, or VCs, use convertible debt structures, most offer private equity funding. In other words, they give cash funding to early-stage startups that demonstrate the potential for high degrees of growth. These seed rounds, Series A rounds, and other forms of seed funding give some percentage of ownership to the VC. They then own stock (either common or preferred) until the company is sold.
When is it the right time to consider VC funding?
The short answer to this question is “When your company has its foundational legs firmly underneath it.” In my experience covering startups, it’s time for VC funding if you have a solid understanding of your product, your unique selling proposition, business plan, and customer. Founders I talk to say they try to achieve management team stability before connecting with VCs. You also should have a firm grasp of the type of VC you want to partner with. They’re not all the same.
In an ideal world, you’d like to be making money already. Don’t rush the process. Moving too quickly could put you on shaky footing right out of the gate. It’s better to take the time to establish your fundamentals and get clear on your brand and its story.
Why might venture capital be a bad idea?
There are some downsides to venture capital financing. Some entrepreneurs and executives even call it a “pact with the devil.” To be sure, you do give up some control in exchange for that cash infusion. That loss of power can lead to some unpleasant realities.
Many venture capitalists tend to emphasize “growth at all costs.” That makes sense for them. From the VC perspective, it’s a numbers game. The more investment opportunities they can fund and put on pace to grow quickly, the likelier they are to find the next unicorn.
However, it doesn’t make as much sense for the small business, necessarily. Scaling quickly can literally kill a startup. The VC can simply chalk up an expected loss and turn to other portfolio companies. You, however, have to turn off the lights and find something else to do.
Another disadvantage of all that high-pressure scaling is that you can find yourself not nearly as wealthy as you might have thought. Here’s why: at every round of funding, you’re giving up a little more control. Those VCs expect some ownership stake in the company, after all.
Ultimately, even if you do happen to snag that billion-dollar public offering, you might wind up with less cash than if you’d sold your smaller company for a smaller amount of money. Your interests don’t necessarily align completely with your VC funders. It’s easy to forget that when it seems like they’re cheering you on to glory.
Is venture capital investment right for your company?
Remember that your company has other options besides venture funds. For example, commercial loans remain a strong choice for companies that don’t wish to give up additional shares. But, these loans must be repaid on a recurring basis. However, for companies at the right stage of early growth who can partner with experienced institutional investors, VC funding might be the best path forward.
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