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Capital Structure: What Is It?

Disadvantages of Venture Capital

Receiving venture capital requires a certain amount of control over your company, despite the temptation of obtaining large quantities of money to expand and develop your organization. A member of the venture capital firm's board of directors will need to be on your board of directors to supervise your operations in addition to ensuring development.

1. Obtaining funding is challenging and rather scarce.

The National Venture Capital Association (NVCA) reported that just 5,000 venture capital agreements were completed in the US in 2020. Nearly 3,000 of these businesses have previously received venture money. Venture capitalists note that for every three or four firms they invest, they get around 1,000 ideas.

An incubator or accelerator is one option for entrepreneurs looking for their initial round of investment. They often provide up to $150,000 in cash along with a three-month crash training that gets businesses ready for expansion and next fundraising rounds. Additionally, for more flexible conditions and lower capital sums, startups could look into angel investment.

2. The total cost of financing is high.

Comparing the cost of giving up stock in your business versus borrowing money may seem reasonable. But the price of stock is only paid when the company is sold. In addition to funding, venture capital also offers assistance and introductions. But you shouldn't take the choice lightly, particularly if there are other financial options.

3. There Must Be a Formal Reporting Structure and Board of Directors

You will be compelled to establish a board of directors and a codified organizational structure when you get venture capital investment. Both help the business scale by promoting growth and openness. The company's flexibility may be restricted as a result, and the founders' level of influence may be diminished.

This framework is imposed by venture capital companies to oversee governance and aid in problem-solving. The necessity to address issues before they spiral out of control increases with a quicker rate of development. Due to the higher levels of reporting and openness, this structure also provides confidence to venture capital companies.

4. Reduction in Founder Ownership Stake

You must dilute your equity while raising a fundraising round in order to offer additional shares to your investors. Many businesses need further venture capital rounds because they exceed their first financing. As a consequence of this process, founders progressively lose ownership stakes in their business as well as control and decision-making authority. Founders may reduce this risk by just raising the appropriate amount.

5. Seeking investors may keep founders away from their company

When all other financing options have been explored and additional investment is required for expansion, startups decide it is time to pursue venture capital. Fundraising, which might take many months, shouldn't interfere with running the business. The founders give themselves enough time to operate the business and acquire sufficient funds to continue expanding by commencing the process before the need for finance becomes urgent.  

6. Thorough Due Diligence Is Necessary

Because they are investing money from outside sources, venture capital partners must vet businesses. There are two phases to this. Your technology and business foundations are first assessed to see whether there is a market and if the firm can be grown. The venture capital partners will next analyze the history of your team and the financial and legal standing of the business in greater detail.

Although this procedure might take many months, the businesses that go through it benefit from it. It is considerably simpler to fix issues if they are found and dealt with early on in a startup's development. Because many problems will have been examined and resolved, future fundraising rounds will be easier.

7. Rapid business growth is anticipated

Venture capital companies require your business to increase in value on its route to being purchased or being publicly sold on the stock market in order to recover their investment. The already intense strain that founders endure may sometimes be made worse by knowing that the firm must succeed.

There are strategies to control this tension, however. By talking with other founders and their investors, entrepreneurs may make sure that they are on the same page about their aims and can benefit from the experience of others. Additionally, they want to lessen their burden by delegating as needed. They will be able to concentrate their time and efforts on vital aspects of the company as a result.

8. Money Is Disbursed Based on Performance

As the business achieves certain milestones, the funds received from venture capital companies are eventually disbursed. Revenue, customer acquisition, and other indicators chosen by the venture capital company are among the business-specific objectives. If the aims are the only things pursued, this may divert founders, but it also increases economic success.

9. Unproductive Employees Risk Losing Their Job

Entrepreneurs who aren't performing risk losing their company. Founders are sometimes fired if they don't act in a way that optimizes shareholder value or if they irresponsibly spend company money on themselves while ignoring the firm. In order to reduce this risk, founders should follow their boards' recommendations and explain their plans and objectives often.

10. Negotiation Leverage Is Rare

When venture capital is the only available source of finance to suit their demands, many entrepreneurs turn to it. Rarely, a business has influence over the conditions because there are too many prospective investors, a situation known as being "oversubscribed." Most entrepreneurs won't, however, have much power beyond rejecting the offer. This may be avoided by beginning your search early for a venture capital company that is aware of your objectives and financial requirements.

Alternatives to Venture Capital

The ideal kind of finance for businesses that need to expand swiftly in return for ownership is venture capital. There are additional options to take into account if your business is still starting out and developing slowly:

Before a business is ready for venture financing, angel investors will often invest. They may spend more than $250,000, but they focus more on prospective growth than actual development. They are more accessible to businesses and provide many of the same advantages as a venture capital company without the framework.

Because entrepreneurs don't have to forfeit ownership, revenue-based funding may be a wonderful substitute for venture capital. Your payments are erratic and dependent on the amount of money the business makes, which is excellent for launching a product. Startups may benefit from speedy online applications and loan sums up to $3 million.

SBA loans: Up to $5 million in loans produced by lenders are guaranteed by the Small Business Administration. These loans offer several advantages, such as reasonable interest rates and payback lengths of 10 years for working capital, while requiring a credit score over 680 and monthly payments. SBA startup loans are a suitable substitute for venture funding since entrepreneurs are not required to give up ownership.

Bottom Line

The benefits and drawbacks of venture financing should be carefully considered before proceeding. Even if you may acquire a sizable amount of finance with no monthly payments, equity is sacrificed in the process. Additionally, you'll get suggestions and help for expanding your company, but you'll also have to give up some of your power in the process.