Advantages and Disadvantage of VC Funding - Explained
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What are the Advantages and Disadvantages of Seeking Venture Capital?
There are many advantages and disadvantages to pursuing venture capital investment. The disadvantages are such that, if possible, most entrepreneurs prefer to grow organically. That is, they prefer to grow with personal investment, outside debt, and company revenue. Below we discuss the generally accepted benefits and detriments of accept venture capital.
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Advantages of Seeking Venture Capital
Only startups are susceptible to venture capital investment. Investors want a company that is going to achieve rapid growth by employing the funds invested. If the company cannot generate the necessary growth funds from personal investment, loans, or operational revenue, venture capital is a good option. Remember, the ultimate goal is for the company to be more valuable. If one dollar of venture investment has the ability to create more than one dollar of value, it is a smart decision to employ the capital.
Venture investors generally take part in the high-level decision-making of the company receiving the investment capital. VCs often have diverse backgrounds and experiences. Their expertise as directors or advisors can be very valuable to the company.
Venture capitalists generally have a number of industry connections. That is, they know people with expertise in areas relevant to the startup. The VC can seek advice or guidance from these individuals. In some cases, the startup will form an advisory board and invite these knowledgeable individuals to serve as members. The network is also useful when the startup needs particular professional services, such as accounting, legal work, engineering work, etc.
Nobody wants to feel like a failure. Often, entrepreneurs refuse to take action for fear of the consequences. Having professional business people to collaborate in a decision can provide the confidence necessary to make risky calls. Also, if the action fails, the entrepreneur is not solely to blame.
Disadvantages of Seeking Venture Capital
Venture capitalists want preferred stock in the corporation. This means that the company will generally have to reorganize as a Delaware corporation. It will amend and restate the articles of incorporation and approve new bylaws. This will allow the company to appropriately issue the preferred stock (generally convertible participating shares) that investors require.
The venture capital investment process generally includes a negotiation and due diligence period. During the negotiation period, the VC firm will employ the services of an attorney to draft the necessary documents. In some cases, the startup will also hire an attorney to assist in the negotiation. Once a rough deal is cobbled together, the VC firm will require a period for conducting due diligence on the target company. This requires legal, accounting, and operational assessments of the firm by outside professionals. These services are quite costly and are paid for by the startup from the investment capital.
Loss of Control
Investors are the new owners of the company. They demand rights commensurate with those of an owner. In fact, they generally demand special rights superior to those of the entrepreneurs. For example, investors will generally demand voting rights, board seats, information rights, registration rights, and other specific approval rights for major company actions (such as seeking more investment or selling the company).
Bringing on investors diminishes the ownership percentage of existing owners. Further, the protections generally afforded investors puts them at an advantage to the entrepreneur in the event of future investment. Basically, investors generally require anti-dilution protection. This means that future investment in the company erodes the percentage of ownership of non-preferred shareholders more than those of preferred shareholders. So, the entrepreneur loses a larger ownership percentage than the VC investors in the event of future investments.