The Pros and Cons of Venture Capital Funding

To raise VC funding or not. This is a delicate question that looms in any startup founder's mind. A decision of so much consequence that has the potential to make (or break) your startup. Raising VC funding is a double-edged sword. Becoming a VC-backed startup gives you access to a number of privileges: access to capital, expertise and guidance, networking opportunities and credibility. But, in return for these benefits, you agree to embark on a stellar corporate growth curve, dilute your ownership stake and  sacrifice some control over your company.

In this article, we will explore how to decide if VC funding is the right fit for your company. We will weigh the pros and cons of securing funding from VCs and explore the  alternative options to scaling your startup.

Which startups are suitable VC Investments?

To answer this question, let’s backtrack a little and ponder about how VCs actually think about investing in a startup. The following chart is the Capital Market Line: it plots asset classes by their risk and return profile. Treasuries and government bonds are generally considered the safest of all, but they come with a lower return. Publicly traded securities like stocks and corporate bonds are somewhere in the middle. Private equity, which is where startups fall into, is the asset class that generally promises the highest returns, but only attainable by assuming the elevated risk that comes with it.

Here is a mental model to keep in mind: as you progress along the capital market line, the probability distribution of returns becomes wider. Low risk investments offer lower returns and the variance in returns is likely to be small. Higher risk investments offer higher returns, but the variance in returns is higher. This is especially true for startups, which are on the far right of the graph: the probability of both scoring a home run and of going bust is higher.

Venture capital is inherently “go big or go home”. Statistically, the return distribution of VCs follows a power law: a few select investments typically make up the majority of the returns. VCs will make an investment if they think that the startup has the potential to generate outsized return and compensate for the potential losses from other investments. This strategy reflects the most probable fate of early stage ventures: that most will likely fail and only a few will make it. Odds are not on their side when making investments in this area, so VCs often go out of their way to maximize the performance of their portfolio of startups.

As such, practically many new businesses are not fit for VC funding. Naturally, a VC-backed startup needs to possess the following characteristics: massive market potential coupled with a highly scalable business model, which facilitates exceptionally high growth rates within a short period of time. 

One of the key metrics is Total Addressable Market (abbreviated as TAM). A more specific figure is Serviceable Obtainable Market (SOM), which is the market share your startup will be able to win considering competition and market specifics. These serve as a proxy to the size of opportunity your business is going after, which is expected to convert into the top line of your startup. Hence it is helpful to first determine how big a market you are after and be mindful when coming up with the number.

VC funds (run by General Partners or GPs) have a certain time horizon in which they need to exit their investments to return the capital to their investors (Limited Partners or LPs). To achieve this, VCs always invest with an exit strategy in mind. It is therefore an implicit commitment on the part of the startup to provide one for them. This may come in the form of selling their stakes to the public via an IPO, selling to another company (being acquired) or selling to another VC or PE firm (secondary sale). The time frame may vary for each VC, but typically is between 5-7 years. Failure to achieve good results in terms of exits may affect the VC’s reputation and the viability of raising capital in the future.

In accepting the funding from VCs, you must be willing to exert effort so as to live up to the expectations of your VC partner. VCs expect your startup to achieve a certain ambitious target within a number of years. As a consequence of their fund structure, they are incentivised to push for an exit after a 4 to 7 year holding period, even if your startup still has ample room for growth.

Pros and Cons of VC Funding

Taking VC money can come with many benefits, but also various downsides. VCs have funded revolutionary enterprises of the present day that might never be where they are today had they not been funded. When you strike an agreement with your VC to raise venture capital, in addition to the injection of fresh capital to grow your company, your VC is going to offer you value besides their investment. This can be in the form of product expertise, market entry, introductions to potential suppliers or customers and introductions to other investors for your next round. 

Partnering up with an excellent VC firm can be like standing on the shoulders of giants. You stand higher up the ground, your vision is extended farther beyond and your foundation becomes stronger. Other stakeholders like suppliers and employees may take your startup more seriously, because you have also earned the credibility of being associated with a reputable VC firm.

Accepting venture capital (VC) funding significantly alters the dynamics of business operation. Once you accept VC funding, you no longer operate independently; you are committed to achieving the substantial growth trajectory expected from a VC-backed startup. This includes regular reporting on your company’s performance to investors and often requiring their approval for major business decisions. Even if a VC holds only a minority stake, they can wield considerable influence through their board position, the protective provisions in your agreements, and their role in shaping future fundraising efforts.

Accepting VC investment also means relinquishing a portion of your equity. Through successive funding rounds, your ownership stake could be significantly diluted. Moreover, VCs often secure a liquidation preference, ensuring they are paid first during a sale or liquidation, which could leave minimal proceeds for the founders if the exit does not generate the expected returns.

The necessity to deliver quick financial returns can compel founders to prioritize short-term gains over the company’s long-term best interests, potentially leading to decisions that stray from the startup's original vision. Disparities between the goals of founders and investors might also generate conflicts, especially under challenging conditions or slower-than-expected growth.

Additionally, given that VCs usually aim to provide returns to their investors within a 5-10 year timeframe, they might pressure your startup towards an exit strategy, such as a sale or IPO, earlier than might be beneficial for your company.

While VC funding can elevate a startup to greater heights, it necessitates careful consideration of how it aligns with your long-term business objectives and personal vision for your enterprise

Does your startup really need VC funding?

In our previous discussion, we established that only certain types of startups are suitable for VC fundraising. However, it's crucial to recognize that not every startup that qualifies for VC funding should pursue it. It's beneficial to invert the problem and consider whether you can scale your startup using your own resources—this is known as bootstrapping. Unlike raising venture capital, bootstrapping allows you to retain full equity in your startup. Without the rigorous demands of VC-driven growth expectations, you maintain control over your startup’s operations and can progress at your own pace.

When evaluating the need for VC funding, consider these two critical factors:

Cash Reserves: Assess whether you have adequate financial resources to invest and sustain your company until it begins generating significant cash flows.

Market Dynamics: Determine if your business operates in a "winner-takes-all" market, where the dominant player enjoys substantial advantages.

Certain business models inherently require VC funding, especially when significant upfront capital investments are necessary. For example, if you run a SaaS startup, you may need to invest heavily in software development before any revenue can be generated. During this phase, substantial portions of your capital could be consumed by salaries for top talent and marketing efforts to build customer awareness.

Additionally, startups in markets characterized by network effects, such as marketplaces or community-based platforms, often face the "winner-takes-all" scenario. These business models benefit from the rapid formation and expansion of a network. Being the first mover can provide a critical competitive edge, akin to being the first person in a room and blocking the door to others. If this dynamic applies to your startup, securing venture funding might be essential to establish and maintain your market position.

In conclusion, while VC funding can propel a startup to rapid growth and market leadership, it is not always necessary or advisable. Evaluate your startup's specific needs, market conditions, and long-term goals to determine if venture capital is the right path for your business.

Conclusion

The decision to pursue venture capital funding is a pivotal one for any startup, carrying with it a spectrum of potential outcomes that can significantly shape the trajectory of the business. It's crucial for founders to weigh the benefits of access to capital, expertise, and networks against the realities of equity dilution, loss of control, and the pressures to meet high growth expectations. The right choice varies widely among startups, depending on factors such as market potential, competitive landscape, and the founder's vision for the company's growth and autonomy. Founders must undertake a thorough assessment, not only of their startup's readiness and suitability for VC investment but also of their personal readiness to navigate the journey that comes with it.

Raising venture capital is not the only path to success. The essence of the decision lies in understanding the unique needs and long-term objectives of the startup, coupled with a realistic appraisal of what VC funding entails. By making an informed choice, founders can steer their startups toward a future that not only embraces growth and innovation but also remains true to their original vision and values.

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At Alehar, we're deeply passionate about M&A and fundraising, equipping us with the expertise and extensive network needed to carry out transactions efficiently and represent the interests of our clients effectively. Our expertise is particularly valuable for transactions ranging from USD 3m to 200m, as we guide companies through every step of their M&A and fundraising journey (including both equity and debt transactions)