Costs and Benefits of Taking Venture Capital Funding

To begin, I will direct you to a study done by Wells Fargo entitled “How Much Money Does it Take to Start a Small Business?”. The study found that the average small business needed only $10,000 to launch their venture, an amount easily attainable via bootstrap financing, without giving away any equity in your company. In fact, the Wells Fargo survey shows that 73 percent of entrepreneurs funded their startups primarily with personal savings. This indicates that you really don’t need a lot of money to start a small business, and the money you do need is probably within your personal reach, through personal savings or credit cards.

Of course, when considering delaying your involvement with outside investors and self-funding your venture, you must consider the risks and rewards of each option. By foregoing outside investment, you retain all of the equity, and thus all of the control, in your venture. Any venture capitalist will require a substantial chunk of equity to compensate them for risking their cash in your venture. They’ll also want to bring on a managing partner (or management team) to help run the company. When you accept money from a venture capitalist, the company is no longer just yours, so don’t expect it to run as such. This shift in control alone is a compelling reason for many entrepreneurs to self-fund.

However, by accepting outside funding and compensating the investors with equity, which doesn’t cost you anything (today at least, but we’re coming to that), you greatly decrease your personal cost of failure. Now you have divided the risk up between yourself and your outside investors, meaning if your venture fails, the loss is spread between you and your investors, sometimes cushioning the blow to you personally. However, be aware that some venture capitalists require preferred equity, meaning that they get paid before you in the event of liquidation, often leaving you without any way to recoup what you had invested in the business.

When I wrote that compensating investors with equity didn’t cost you anything, I was lying. While it may be easy today to say, “Sure, Mr. VC-man, you can have X% of my company” in exchange for a check with lots of zeros, there’s a good chance it will come back to bite you later. Remember that your equity is not only your control over the business; it’s also your claim to its assets in event of a liquidation or (preferably, and most lucratively) an acquisition. When considering any offer that involves a change in equity balance, you have to consider the future cost. Right now, your equity isn’t worth much, which is exactly why investors want it. By investing in your company, they’re expecting that equity to increase in value enough to not only recoup their investment, but earn a hefty return as well.

So let’s pretend that you accept $1 million in exchange for 33% of your new company. It probably seems like you got an awesome deal – $1 million for a piece of paper! It’s like printing money! However, now lets pretend that through wise investments and excellent management, you grow your company and a year later receive a buyout offer of $10 million. Now instead of pocketing $10 million, you’re keeping $6.66 million, and giving the other $3.33 million to your early investor. So, if you do the math, you’ve effectively taken a $1 million loan at 333% interest! So it turns out that paper equity contract cost something after all. I realize I’m oversimplifying here, but it definitely illustrates the point.

However, my above analysis is probably overly cynical. You got much more than a loan when you accepted venture capital money. That excellent growth you experienced was probably due in part to the experienced entrepreneur or venture capitalist on your board that came along with your funding. You also got $1 million at a time when no sane bank would have loaned you that kind of money. You probably couldn’t have gotten your business off the ground without venture capital dollars. So by no means am I trying to paint venture capital in a negative light. Venture capital makes entrepreneurship possible and drives our economy; many of today’s most successful companies wouldn’t exist without it. I’m merely trying to instill the value of the equity in your new venture, and encourage everyone to explore all options when raising cash for your venture.

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  • Excellent article; however, even if you sold your business for 10 million dollars and walked away with 6 million with the right investment you are still set for life. Personally, with my experience with Venture Capital it is extremely hard to find the right investors especially when it comes to long term. I would suggest to avoid some of the cons discussed in this article make sure you have a good business plan with reliable numbers as that will give you an idea what your equity is really worth.

Bill D'Alessandro