What is venture capital – pros and cons

How does venture capital work and how will a private equity firm provide funds to your business?

Differing from popular belief, venture capital only plays a tiny role in basic innovation funding. In 1997, venture capitalists invested more than $10 billion, yet only $600 million, or 6%, went to companies. Furthermore, it is estimated that R&D (Research & Development) accounted for less than $1 billion of the total venture capital pool. The vast majority of that money went to follow-up funding for projects that were started with significantly more money from governments ($63 billion) and corporations ($133 billion).

The next stage of the innovation life cycle—the period in a company's life when it begins to commercialize its innovation—is when venture capital plays an essential role.

Venture capital is not long-term funding. The objective is to invest in a company's balance sheet and infrastructure until it reaches size and credibility that allows it to be sold to a corporation or provided liquidity via institutional public-equity markets. In essence, a venture capitalist invests in an entrepreneur's idea, develops it for a certain time, and then exits with the help of an investment banker.

The structure and norms of capital markets have created a niche for venture capital. There are typically no alternative institutions to turn to when someone has an idea or a new technology. Usury regulations limit the amount of interest that banks can charge on loans, and the risks that come with starting a business usually justify higher rates than the law allows. As a result, financiers will only finance a new business if there are hard assets against which the debt may be secured. Many start-ups have little hard assets in today's information-based economy.

What are the different types of venture capital investments?

Seed capital. At this point, your company should have a working sample product and ideally interest from potential customers. At this stage, funding is also scarce. It usually covers the hiring of extra key management, conducting additional market research, and finalizing the product or service before launching it into the market.

Early-stage funding. You've gotten your company off the ground, hired a management team, and sales are expanding two to three years into your business. At this level, VC funding may be able to assist you in increasing sales to the break-even point, improving productivity, or increasing the efficiency of your company.

Late-stage capital. Your company has established sales and revenue at this point, and you have a second level of management in place. You might need money to expand your capacity, ramp up your marketing, or boost your working capital.

What are the advantages of venture capital?

1. Huge sums of money can be raised

Many startup loans are limited to $5 million, and qualifying for one might be challenging. Venture funding, on the other hand, can range from $100,000 for a seed-stage business to more than $25 million for more established startups in huge markets. Startups also have a proclivity to raise venture capital multiple times, allowing them to access significant sums of money that would otherwise be unavailable.

2. Payments are not required monthly

A venture capital firm will invest in your company in exchange for shares in the company. This implies that, unlike small businesses and personal loans, your company will not be required to make monthly payments. This frees up funds for your company, allowing you to reinvest instead of paying interest by upgrading products, hiring more people, or expanding operations.

3. There will probably be more publicity & exposure

Most VC companies have a public relations team and media contacts, and it's in their best interests to get your startup noticed. Being affiliated with a company can give it a lot of credibility, especially for entrepreneurs who haven't developed any other successful businesses. Increased visibility may attract the attention of potential workers, customers, partners, and other venture capital companies looking to raise funds.

What are the disadvantages of venture capital?

1. The founder's share in the company is reduced

You'll need to reduce your equity share when raising a funding round. Many businesses outgrow their original funding and require further rounds of funding from venture capital firms. Founders lose majority ownership of their company, as well as the control and decision-making power that comes with being a majority shareholder, as a result of this process. Founders can reduce this risk by just raising the funds they require.

2. The overall cost of financing is high

When compared to taking out a loan, giving up equity in your firm may appear to be a bargain. The cost of equity, on the other hand, is only realized when the company is sold. Venture capitalists offer much more than just money, such as advice and introductions. However, they also have high expectations on the return of their invested capital.

3. It's possible for founders to lose their business

Under performing founders risk losing their companies. Founders are frequently let go if they do not engage in activity that optimizes shareholder value, or if they are careless and utilize company cash for personal gain while neglecting the business. To reduce this risk, founders should listen to their board of directors and communicate frequently about their strategies and objectives.

Are there any alternative options to venture capital?

Debt

You borrow money from a lender.

Advantages: After you return your loan, your relationship with the lender ends. You don’t give away equity.

Disadvantages: If you are unable to make payments, the lender may force you to file for bankruptcy.

Angel Investors

People who spend a portion of their fortune in businesses rather than stocks, real estate, or other investments. They usually write cheques ranging from $10 to $200,000.

Advantages: They have the advantage of filling the gap between FF and VC funding.

Disadvantages: There are a lot of angels who aren't very sophisticated.

Use Of Crowdsourcing

A platform that allows a group of individuals to “back” your firm. Each fundraising is usually limited to $1 million.

Advantages: The ability to raise funds from present or future consumers and the ability to use crowdsourcing as a marketing campaign.

Disadvantages: Investors are put off by packed cap tables, which make it impossible to negotiate.