Venture capital (VC) is a form of financing that is tailored specifically for high-growth startups. VC firms will invest money in a startup in exchange for an equity stake in the company. However, they are not like traditional investors. Here’s why.
Is a Venture Capital Right for My Startup?
VCs take a large amount of risk by betting on early-stage companies, so they require large returns. The rate of return that a venture capitalist is looking for on an investment varies depending on the stage of the company, the industry and the level of risk involved. However, VCs generally are looking for a return of 10 to 20 times the original investment within a period of five to seven years.
This means that if venture capitalists invest $1 million in a startup, they would expect to see a return of $10 million to $20 million within that time span. This may seem like a high bar, but it reflects the fact that VC investments are typically high-risk, high-reward, and that many startups fail to achieve significant growth or profitability.
Simply due to the economics of VCs, only a tiny fraction of hyper-growth companies will ever be considered. If you read the startup press, it may feel like every company is raising VC funding; that’s not an accurate representation of reality. According to the National Venture Capital Association, less than 1% of businesses receive VC funding. Even in 2021, which was a record-high year for VCs, the $150 billion in total U.S. VC funding was only around 13,000 companies.
The truth is that a vast majority of startups don’t raise VC money. The question is whether VCs are right for your company. This article will shed some light on that question.
Advantages of Venture Capitals for Startups
VC funding can be a game-changer for startups, providing them with access to a range of benefits that can help accelerate growth and increase their chances of success.
- Accelerate growth. One of the primary advantages of VC funding is the ability to accelerate growth. With VC funding, startups can often secure larger amounts of money compared to other sources, such as loans or grants. This funding can be used to hire additional staff, expand marketing efforts, develop new products, and invest in research and development. With this increased financial capacity, startups can grow at a faster pace, increasing their market share and competitive advantage.
- Guidance. VCs often have deep expertise in your industry and have seen how the industry has transformed over the years. So, they can provide guidance and expertise to startups. Many VC firms have experienced professionals who can offer advice on product development, marketing strategy, financial management and legal compliance. This guidance can be invaluable for startups that are still figuring out product market fit, their business model and growth strategy. By leveraging the expertise of VC investors, startups can avoid costly mistakes and make smarter decisions that will benefit the company in the long run.
- Connections. Another advantage of working with venture capitalists is that they often have extensive networks within the industry. This can be helpful for startups looking to make connections with potential partners, customers or investors. VC firms can introduce startups to key players in the industry and help them build relationships that can lead to growth opportunities. These connections can be especially valuable for startups that are still building their reputation and trying to establish themselves in the market. It’s also helpful during fundraising because VCs may bring in other interested investors.
- Prestige. VC funding can provide startups with a sense of prestige and validation. When a startup secures VC funding, it sends a signal to the market that the company has potential and is worthy of investment. This can help attract additional customers, partners, employees and investors, further accelerating growth. In addition, having a VC investor on board can help startups build credibility and establish themselves as a serious player in the market.
At its best, VC funding can take a good team with a good product and supercharge growth. Since VCs are taking an equity stake in the company, they have a vested interest in seeing it succeed. This alignment of interests can help ensure that both parties are working toward the same goal: building a successful company.
Disadvantages of Venture Capital for Startups
VCs are a popular form of financing for startups. However, it’s not without its drawbacks. Below, we’ll discuss some of the disadvantages of VCs that founders should consider before deciding to pursue this type of funding.
- Loss of control. One of the biggest disadvantages of VCs is the loss of control that founders may experience. In each round of funding, the founders give up more control for two reasons. First, the preferences attached to the shares in each round of funding tend to give those investors more control than the last round. Second, the lead investor for each round generally joins the board of directors. So, let’s assume you started with a board of two founders and you added a board member in your Seed, Series A and Series B rounds. After the close of that Series B, the investors not only have a large block of the shares in the company with higher preferences than the founder/employee shares, but they also now have a majority control of the board. This means that the investors may have a say in major decisions, such as funding, hiring, setting strategic direction or even selling the company. It also means they could choose to fire the founders.
- Pressure to grow quickly. One disadvantage of VCs is the pressure to grow quickly. VC firms seek high-growth companies, creating a sole focus on rapid “hockey stick” user growth curves. However, this sole focus on profitability has its trade-offs, including company culture. It leads to short-term thinking and decision-making focused solely on achieving a certain milestone before the next round of funding, rather than building a sustainable business model.
Startups receiving funding from VCs are expected to use that money to grow users to generate returns for their investors. However, VCs typically invest in startups with high-growth potential, which means that those startups often need to raise more capital to continue expanding their operations and developing their products. This can lead to a cycle where startups are constantly in fundraising mode, trying to secure the next round of funding to continue operating and growing. Because founders need to continue to show hyper-growth, they make bigger promises to VCs in each round of funding. It’s like getting on a treadmill at a jog, just holding the increase speed button. This cycle is known as the “VC Treadmill.”
- Misalignment of incentives. Another potential disadvantage of VC is the misalignment of incentives between the founders and the investors. While founders may be focused on building a sustainable business that aligns with their long-term vision, investors may be more interested in seeing a quick return on their investment. This can create tension between the two parties and may lead to conflict down the line.
- Prestige doesn’t matter. Some founders may be attracted to VC funding because of the prestige it brings. However, this is a pure vanity metric. Who’s on your cap table is way less important for long-term success than whether your customers love your product. It’s important to remember that raising VC money doesn’t guarantee success. In fact, many startups fail even after raising significant amounts of VC funding. Simply having a VC investor on board doesn’t automatically make a startup successful.
- Raising VC takes the focus off the business. Finally, raising VC can be a time-consuming process that takes the focus off the business. Startups may need to spend months pitching their ideas to multiple firms before securing funding. This can divert resources away from other important activities like product development and customer research. In addition, the due diligence process required by most VC firms can be time-consuming and may require founders to take their eye off the ball in terms of day-to-day operations.
While VCs can provide startups with access to significant amounts of capital and expertise, they have potential drawbacks. Founders should carefully weigh the pros and cons before deciding whether VC funding is the right choice for their startups.
VCs are looking exclusively for “unicorns,” a term used to describe a privately held startup company that has reached a valuation of over $1 billion. The term was coined by venture capitalist Aileen Lee in 2013 to describe the rareness of such companies, much like the rarity of mythical unicorns. Most companies, even most great companies, are not unicorns.
You can build an incredible company without ever becoming a unicorn. Below are two other startup models.
While unicorns are focused on rapid user growth and scaling to achieve a high valuation, zebras prioritize profitability as well as social responsibility and ethical business practices. Zebras are viewed as more grounded and practical than unicorns, and are often seen as a more realistic and achievable goal for startups.
Unicorns are often associated with fast growth and high risk. They are focused on achieving a massive market share and disrupting existing industries, with the aim of becoming the next big thing. Unicorns are typically venture-backed startups that have raised significant amounts of capital to fuel their growth. They prioritize rapid expansion and often prioritize user acquisition over profitability. As a result, unicorns are often unprofitable for several years, with the hope that they will eventually dominate their market and generate significant returns for their investors.
Zebra companies, on the other hand, are focused on creating sustainable and ethical business models that address social and environmental issues. They prioritize building long-term relationships with customers, employees and other stakeholders, rather than achieving rapid growth at all costs. Zebra companies are often bootstrapped or funded by impact investors who prioritize social and environmental returns alongside financial returns. They prioritize profitability and measure success not just by financial metrics, but also by their impact on society and the environment.
Silicon Valley Small Business
Another powerful business model is the Silicon Valley Small Business, the SV-SB, as described by Anu Atluru. It is a hybrid of sorts. It intertwines small business values and discipline with big tech know-how and ambition.
- High caliber founders. Founding teams may seem similar to those of a “traditional” Silicon Valley startup, but they possess unique characteristics. They have skills, ethos and playbooks that are native to Silicon Valley. However, they tend to include more solopreneurs and studios (along with LLCs instead of C-corps). Founding teams value autonomy and flexibility, and envision a range of potentially good outcomes rather than binary, all-or-nothing scenarios.
- Low headcount. Teams remain small and move quickly as long as possible. They generally have 20 or fewer employees (often fewer than 10). A skilled team of 20 or less can create leverage and punch above its weight. Once a startup gets larger than this, they are forced to operate much slower, with more bureaucracy and less alignment,
- Prioritize efficient growth. SV-SBs don’t just seek to build “lifestyle” businesses or modest passive income streams. They want to scale as quickly and efficiently as possible. But they want to do so profitably, not on the backs of “free” VC money. Their desire and often their know-how to scale sets them apart from traditional small businesses, and their focus on lean and profitable growth can distinguish them from unicorns.
- Bootstrapped. They aim to bootstrap profitability instead of relying on VCs. They are familiar with VC funding but aren’t swayed by the potential status, signal or stability. They may raise the equivalent of friends and family or a pre-seed round, but not much more. They look for capital-efficient businesses and prioritize profit, alongside growth from the outset. With less money going in, there’s a lower bar for financial return. Additionally, “success” doesn’t require a billion-dollar exit. Making millions is a win (and thousands keep the team afloat).
Financing Alternatives for Startups
While VC funding can provide startups with access to significant amounts of capital and expertise, there are other options to consider:
- Bootstrapping. Bootstrapping involves using your own personal savings or revenue generated by your business to fund its growth. This approach can be challenging, but it can also offer greater control over the company’s direction and may be more sustainable in the long run.
- Angel Investors. Angel investors are high net worth individuals who invest in startups in exchange for equity. While angel investors may not provide as much funding as VC firms, they can still offer valuable expertise and connections within their industry.
- Small Business Loans. Small business loans from banks or other lenders can provide startups with access to capital without giving up equity. While these loans may come with higher interest rates than VC funding, when used wisely, they can provide the right growth capital at the right time.
By considering these financing alternatives, you can find the right option for your startup’s needs and goals. Keep in mind that each option comes with its own advantages and disadvantages, so be sure to weigh your options carefully with your legal counsel.
Founders may believe that VC money is a panacea for all company issues, but it can actually amplify business errors and destroy an otherwise good company. VCs have expectations that don’t make sense for most companies.
When considering funding options for your company, you have a choice. You and your co-founders can choose to build the type of business you want, whether it’s a unicorn, a zebra, a Silicon Valley small business or something entirely different.
If you’re looking for legal counsel to help weigh these options, feel free to reach out to us here.