Venture Capital (VC) is a common component of the capital stack for early-stage and high-growth businesses. It is often used when a company must invest large sums of money to build a complex product or target a broad customer base. Like all equity finance, it involves selling a portion of a company's equity in return for capital, resulting in dilution for founders and other seed investors.
VC investments have been growing consistently over the last two decades (as seen below in PitchBook’s Q3 2021 Venture Monitor), providing capital to companies that have gone on to be significant parts of our everyday lives (Amazon, Netflix, Google). But also in B2B products which work in the background that a consumer does not see (Hubspot, Salesforce, and Stripe).
The main advantages of equity financing are a) the size of investment is usually large compared to the size of the company and b) that there is no obligation to make repayments out of cashflow, as the VC investment looks to get exceptional returns through a sale of the company or IPO. However, with significant equity raises comes a loss of control, preferential rights for the VC investors, and potential conflict over strategy.
The most significant area of caution is that VC strategy is a high risk /high reward. VC investors take bets on the company getting to scale, and only a portion of their investments will work out. So those that do not work out will have spent all the invested money and have set their company up for a difficult future. The Corporate Finance Institute analysis of Andreessen Horowitz Investments show that for every 200 investments made, only 15 are deemed to be a success. As for those not in the 15, below are a couple of things to be wary of:
-VCs get their money back first, often leaving founders with little or no payout after many years of work. Even if there is a profit on a sale, the VC may have a preferential return (or hurdle) which must be hit before founders get paid.
-By taking on VC investment, you are setting your business up to be highly loss-making for the foreseeable future. If it doesn’t work out, there is a big gap to close to get to a breakeven or more sustainable point, which will involve layoffs, expense cutting, and other difficult items for the business to survive.
Key Questions to Ask Before Going the Venture Capital Route:
1. What is the track record of companies the VC has invested in?
2. What percentage of the fund is this investment?
3. Do you typically take board seats?
4. What are the reporting requirements?
5. How do they add value (outside of the investment)?
6. How do you handle potentially competitive situations?
7. What does the diligence process look like?
8. How far into the fund’s life is the investment coming?
9. What preferential rights will the VC have over other investors or founders?
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