It used to be a popular misconception that
venture capital funds only invested in companies that had traction and have
proven products. Obviously, that misconception has changed with the large
number of risky investments in startups. With the considerable amount of
resources and advice available on how to pitch to VC’s, there still is a lackof understanding on how the industry really works.
Innovation has been the key driver of
competitiveness within an industry. However, to bring innovative ideas to life
requires more than just talent to succeed. As innovative ideas are considered
risky for traditional banks to invest in, many entrepreneurs turn to the
venture capitalists to bring their ideas to reality.
Venture capital has become an important
source of funds for innovative and risky startups that may have a potential for
high returns. A venture capitalist invests in a potential company in the hopes
that their investment could give them a higher rate of return for themselves in
a shorter amount of time.
Due to the risky nature of the investment,
the venture capitalist spreads their risk over multiple prospects. This way,
they minimize the risk of losing their money in one company and make it back
from the one startup that makes it big.
Some characteristics of a VC firm are:
Investing in risky ventures with potential for high returns: VCs usually invest in unproven and innovative ideas which
traditional financial institutions avoid. For that investment, they expect a
ROI that is higher than usual. In general, they look for a rate o return that
is within the range of 25 to 40 percent.
Hands on experience of an industry: VCs
have prior experience and contacts which gives them an expertise in better
management of the funds deployed. Not only do venture capitalists provide
funding, they also provide a network and expertise that can help their
investment grow. They can provide technical, marketing and strategic support.
Raises funds from several sources: There
is a misconception that venture capitalists are rich individuals who are
partnered together to invest in companies. Many VCs are not necessarily rich
and almost always manage the funds on behalf of others. They raise financing
from institutions such as other investment funds, pension funds, endowment
funds, in addition to other successful individuals.
Diversify their portfolio: As mentioned
earlier, VCs reduce their risk by developing a portfolio of companies instead
of investing their entire fund into one company.
Short-term exits: As high ROI is
important for any VC, they always make an investment with an eye for the
short-term future. They determine whether they can see a return from their
investment within 3-7 years. Their exits can range from getting bought out by a
larger company, or taking the company public or even selling it to a private
equity fund.
Advantages
of Venture Capital Investments
As a entrepreneurs, you may want to
consider funding that range from few hundred thousand to a few million.
Normally, you require this funding to grow your company by hiring more
employees or the ability to do research and development. When faced with these
situations there are many advantages of using a VC.
These include:
- Securing a larger amount of money than you could from a commercial lender or government lender, turning your shares into more money in a shorter time frame. VCs normally make a decision in investing much faster than traditional financial institutions.
- They share the financial risk in expanding your small business.
- You can get specific experience from different kinds of VC firms, such as those specializing in early stage (startups) businesses or late stage (fully developed) companies.
Some Cons of Venture Capital Funds
Even though a VC firm can review your
business and identify a lot of value in your company, it can be a disadvantage
to accept VC funding. Some cons are:
- Losing your majority equity share to investors who are not passionate about your company.
- Possibility of surrendering managerial control to a VC firm
- Risking that a VC firm will take your company to a quick exit before it’s ready.
- Losing competitive advantage in an industry by sharing privileged information about your business model to others.
Before choosing to work with venture
capitalists, ensure that the pros outweigh the cons. The best position for a
venture firm to be in is to have a substantial equity stake in a company. A VC
earns their fees based on a percentage of the profits they create for their
investors.
As the startup business owner you need to
be realistic with your available equity stakes in terms of what you're willing
to part with and the valuation of your company. It's important to find that
balance and understand that first offers should not be generally accepted.
