Thus, those companies present high risks, but the potential for exponential growth. Therefore, venture capitalists look for startups that can bring a high ROI and high valuation multiples.
That’s because of the set of investments venture capitalists make; only a few will succeed. Therefore, they have to place more bets to make the system work in their favor.
In the end, the venture capitalist makes money (the so-called exit) by either reselling the stake in the company at a much larger valuation or with the IPO of the company they invested in.
When that happens, venture capitalists make substantial returns for their partners. Indeed, the venture capital firm is usually comprised by a group of partners which raised capital from another group of limited partners to invest for them.
The limited partners (or LPs) can be either large institutions or wealthy individuals looking for high returns.
Before we get to the advantage and disadvantages of taking venture capital money, let’s first understand the explicit and hidden incentives that drive venture capital firms. Indeed, at the end, taking venture capital money is mostly about interests alignment.
And if those interests do not converge, that is when probably it might be not a good idea to take that money.
Understand the venture capital incentives
To understand how venture capital works, we need to look at the two resources that they allocate:
- and money
Time, because VCs funds, compared to other models, where financial resources are endowed, do contribute to the growth of the firm they invest in. This contribution can come in several ways, from assistance in hiring to providing guidance, or also having a VC on the board.
On the other hand, VCs provide capital for funding the scale of those startups.
Why is it important to understand the two essential resources? Well, while capital might be a relatively scalable resource, assuming VCs can bring in continuously limited partners.
Time is not. Indeed, VCs usually run out of capacity in managing a certain number of investments as those investments need to be also managed and supported.
And in general, VCs look for a return anywhere between 3-10 years, depending on the market condition, startup growth and more.
Which means they also look for 10-30x ROI in a 5-10 year timeframe.
Therefore, a few aspects we can highlight so far:
- venture capital have limited time resources to allocate due to the fact they can only manage a certain number of investments (as they provide several forms of support to startups);
- they look for extremely high returns (10-30x in the lifespan of the investment);
- those returns can happen anywhere between 3-10 years depending on several conditions (this means in this period VCs will ask for aggressive growth)
Let’s look now at the advantages and disadvantages of getting VCs’ money.
Advantages of VC money
Some of the key advantages can be summarized in a few key points:
- Guidance and expertise: usually VCs don’t bring just cash on the table but also the expertise of the team and partners part of the fund, which is one of the primary advantages of getting VCs’ money.
- Rapid Growth: if you’re looking for rapid growth, VCs will look for the same thing. Thus, you’ll both be aligned in terms of objective, which makes it easier to make this sort of agreement work.
- Connections: VCs will introduce you to the right people to unlock growth potential, which is another undeniable advantage.
- Hiring: the VC investing in your company can also help you find the right people to form your team and scale.
- Additional support: in some cases, VCs support can also come in other areas that are important to grow smoothly, which include legal, tax, and accounting matters.
For all these reasons, VC money makes sense. Let’s see when it doesn’t.
Disadvantages of VC money
There are two significant disadvantages in taking VC money:
- Loss of control and ownership: this is by far the most significant disadvantage as if you let VC in it means you need to be ready to give up some or a good part of the control. Therefore, you won’t be the only one in charge of the company’s vision and mission, but you’ll need to share that with the VC.
- While it is legitimate for VC to ask a high ROI for a risky startup which business model still needs to be proved viable. A very High ROI and an excessive push on growth might break things up. Remember that, companies, like products, might have a lifecycle and forcing too much on growth might well make the company implode.
When does it make sense to take venture capital money?
In a post entitled “The only thing that matters,” venture capitalist Marc Andreessen explained:
The only thing that matters is getting to product/market fit.
Product/market fit means being in a good market with a product that can satisfy that market.
How do you assess whether you passed through this product/market fit stage?
Marc Andreessen explained:
You can always feel when product/market fit isn’t happening.The customers aren’t quite getting value out of the product, word of mouth isn’t spreading, usage isn’t growing that fast, press reviews are kind of “blah”, the sales cycle takes too long, and lots of deals never close.
Therefore, there is no single way to measure that, but as Andreessen emphasized:
And you can always feel product/market fit when it’s happening.The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck’s.
And he highlighted something that would stick as a paradigm in the startup world for years to come:
Lots of startups fail before product/market fit ever happens.
As he explained to me:
This is (when to take VC money), of course, going to be a function of the kind of business model and product that you have. If you can bootstrap, if you can go all the way to product market fit and then raise money, you maintain the most control in your company. You have a lot of say in where the company goes from that point on.
And he continued:
In an ideal world, and it’s not just me, even the venture capitals and other angel investors will give you the same advice. The best ideal time to raise your big round of funding would be as you cross product-market fit.
Once you have product-market fit, some success is guaranteed. The question is how big can it get?
Thus, if you were in the condition to bootstrap – grow with your resources, or with a profitable business model – your company is in a perfect place to be.
You can decide whether to move to the next stage (scale), thus take VC money. Or keep growing organically.
And he also highlighted:
If you were doing something that required capital investment upfront, this is where VC makes sense, but there is now, increasingly so, a very mature market of other investors that play in that space.
Those would be super angels or angel investors that understand that you still haven’t reached product-market fit and you are going to be learning and pivoting and course correcting, and they tend to be more patient for those types of things.
What questions to ask before taking venture capital money?
Therefore before taking VC money, I would ask the following questions:
- can I validate the idea without external resources?
- Is the product technically complex that it requires additional resources to develop?
- Do I need money to scale?
- Am I ready to give up part of the control of my business?
In short, if you are a control freak, and you want to keep your vision of the company intact, VC money might not be the best option. If you’re willing to give up some control in exchange for money and expertise that might make sense.
In other cases, if you managed to bootstrap your way to product/market fit you might be in a good position as VC will want you. Thus, you will be able to negotiate better deals.
In the case in which you need a long term perspective to grow your business and still be in charge of angel investing or “super angels” might be a better option.
In all the other cases, bootstrapping is the way to go!
Other business resources:
- What Is a Business Model? 30 Successful Types of Business Models You Need to Know
- The Complete Guide To Business Development
- Business Strategy: Definition, Examples, And Case Studies
- What Is a Business Model Canvas? Business Model Canvas Explained
- Blitzscaling Business Model Innovation Canvas In A Nutshell
- What Is a Value Proposition? Value Proposition Canvas Explained
- What Is a Lean Startup Canvas? Lean Startup Canvas Explained
- What Is Market Segmentation? the Ultimate Guide to Market Segmentation
- Marketing Strategy: Definition, Types, And Examples
- Marketing vs. Sales: How to Use Sales Processes to Grow Your Business
- How To Write A Mission Statement
- What is Growth Hacking?
- Growth Hacking Canvas: A Glance At The Tools To Generate Growth Ideas
- Distribution Channels: Types, Functions, And Examples