Funding is one of the prior and major consideration that an entrepreneur must consider when embarking on a venture. Venture capital funding or Venture Capitalist as popularly known is amongst the many options that one may consider when looking for a funding. Financial backing is a vital vehicle for driving a business towards the goal, and venture capital has been a key player filling the void between funding sources, particularly ideal for early-stage businesses.
It is essential for business professionals or even beginners to have a thorough idea about what does venture capital offers, its advantages and disadvantages when seeking this option. This blog covers a comprehensive discussion on the pros and cons of venture capital and the working mechanism, to help interested and aspiring entrepreneurs have informed access to the capital and funding they need.
Defining Venture Capital Funding
Capital Venture is a type of private equity funding typically offered to small businesses or startups with high growth potential by Venture Capital firms or well-off individual investors. This concept took birth in the 20th century and became significantly prominent in the US post World-War II era. Fast-forward to today's time, it is still a vital vehicle that drives innovation and invention in the US economy. The concept has evolved dramatically with the technological boom. Venture Capital today is playing a significant role in pushing growth across sectors and has become a global phenomenon with several firms making investments across sectors like Healthcare, technology and Renewable energy.
In simple words, venture capital is where investors or financial institutions funds companies at their early stage to help materialise their growth objectives. They make investments in exchange for an equity from the company. While the goal of such financing is to help companies become profitable and generate good returns of investment, it is a risky initiative for investors. As it is an investment without guaranteed success, and the possibility of failure looming large, investors typically acquires equity and board position in the company with the target to steer and enhance the success parameter of the business.
Pros and Cons of Venture Capital Funding
Venture capital offers several benefits and advantages to business professionals, as it provides not just finance, but also chances for networking. Let us look into the Pros of venture capital in detail.
Pros of Venture Capital Funding
Access to substantial funding: Business equals money. You need money to fuel your business to gain more money and growth. Venture capital provide startups or small businesses with large amount of capital which may be impossible to get in the traditional loan methods. VC funding provides business entrepreneurs the launchpad to their plans and focus on building their business with a support system backing them.
Networking Opportunities: Networking is a double-edged sword that takes entrepreneurs a long way. In a venture capital funding approach, investors pools money from various sources through their network, thus keeping them well-connected. Thus, entrepreneurs can take the advantage of tapping into their networks of successful investors and entrepreneurs. The associates involved in the business will also invest their time and foster new relationships and amplify their network to aid their companies. Startups do not have many resources in terms of managing networking and relationships. Hence, leveraging VC funding will aid in accessing an extensive network and forming partnerships, building a strong client base and optimizing future prospects for future funding.
Shares in Place of Repayment: Venture capital investment comes without the burden of monthly repayment, unlike other business loans that require repayment. Instead of repayments, VC investors ask for shares in the business. Upon the success and growth of the business, investors sell off the shares at a cost higher than the initial amount.
Quicker Growth: Businesses tend to grow and expand faster with VC's growth-enabling support and resources. Start-ups and small businesses have higher chances of swinging their business with venture capital support behind them. Outpacing competitors and achieving a defendable market share requires quick growth.
Expert Mentorship and Hands-on Support: This is one of the biggest and unmatched advantages of the Venture Capital. The expert mentorship and hands-on support that businesses get apart from the capital investment help them in transforming ideas into full-fledged business. Businesses receive an added layer of support from experts and successful entrepreneurs.
Cons of Venture Capital Funding
Let us identify some of the pitfalls and downsides of venture capital funding
High Standards: Startups often fail to raise money from the capital received from venture capital investors. This is one of the biggest challenges. Raising funds can be time-consuming, sometimes over nine months, as investors make diligent efforts in ensuring the suitability of the partnership. This is to ensure that they get great ROI from their hard-earned money. There are certain standards that businesses must ensure, including business products and services commercial potential, addressable market, strength of management team, and measuring risks and rewards, etc.
Loss of Shares: This is another biggest disadvantage of VC funding. Businesses often outgrow their initial funding, leading to needing more rounds of VC firms, entailing losing more equity to investors. This consequently leads to the founder of the company losing more share in their own company. Additionally, they will have lesser control and power in their own business, with more and more shareholders coming into the business with more and more opinions on running the business.
Pressure on growth: With no promise of repayment yet the need to fulfil the business goal, companies may be pushed too far and quick. Startups can feel pressured to scale as soon as possible and be well on their track to getting acquired or going public. Although, the faster, the better, it can bring harmful effects for businesses that are unable to fulfil customers demand or for those not ready for the market.
Chances of getting deviated in the process: Getting more and more investors on board means throwing more and more ideas and pitching them to various firms and individual investors. The efforts of injecting ideas and catering to potential investor's queries may keep you off-tack from the business goals. There are high chances that businesses may forget their main goal in the process of pleasing investors. It's essential for businesses to be wary of their judgements getting clouded by the quest for money.
How does Venture Capital Works? The Working Mechanisms of Venture Capital
Entrepreneurs can better navigate the beneficial factors of venture capital funding and mitigate risks associated with it, and amplify the potential rewards if they have a proper and in-depth understanding of how a venture capital functions. Often, entrepreneurs are misguided by the thought that investors are seeking for good ideas. VC Firms and investors are rather on the lookout for competent managers in specific industry segments.
VC firms and investors, in order to provide finances and support, look for the following parameters:
- The individual's skills, reputation and potential incentives to the VC firms
- The potential of selling oneself
- Position of the individual (CEO, CFO, VP)
- Number of qualified individuals for the position in the high-growth industry
- Risk-taking willingness and ability
So how does one go about the VC funding process? Let's identify the step-by-step process of how VC funding works.
Finding the right funding partner: The first step of the process is to find the right investor. Entrepreneurs seek out investors and VC firms with track records for investing in their specific industry. Finding the right investor involves pitching business ideas and networking with potential investors.
Pitching the business Idea: The next step after finding the right investor is to present the business ideas and plans effectively over a presentation using pitch deck. The presentation typically includes clear explanation and introduction of the company, the business model and plans, product or services and market opportunity.
Investor's due diligence: If an investor or the VC firm is up for the business, they will conduct due diligence by reviewing the company's business model, their market position, financials and risks. This step is necessary for verifying the feasibility and growth potential of the business idea or startup.
Term Sheet Negotiation: If the investors or firm decides to move forward, they present a term sheet to the entrepreneur. It is a document that outlines the investment terms and conditions, amount of money, rights and obligations, equity, valuation, etc.
Investment: On both parties agreeing to the terms, the firms then provide finances/funding to the business. The funds are usually disbursed in stages, known in the business term as Tranches.
Post Investment Support: VC firms or investors not only gives financial support, but they back the business by providing guidance, strategies and networking opportunities to the business. They also take the company's board member seats.
Exit Strategy: This is a crucial aspect of the VC funding and investment. VC firms seek for their ROI within 5 to 10 years. The exit strategy can be in the form of a merger, sale of the company or an IPO (Initial Public Offering).
Venture Capital funding supports business in four typical stages:
- Seed Stage : Developing prototype, conducting market research and establishment of founding team.
- Early Stage: The company has a revenue generating product or service
- Growth Stage : Companies have a proven business model and seeking further expansion.
- Pre-IPO/Late Stage: businesses prepare for an IPO.
We have covered the pros and cons of Venture capital funding and its working mechanism. Having in-depth knowledge will help in navigating VC funding effectively.
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