The acquisition of capital is an essential part of any business strategy but what are the benefits and potential pitfalls of investment from venture capital?
To be successful, a business will need a certain amount of capital at its disposal. If you want to make more products, advertise to more people, expand your workforce or update equipment, you are going to need to secure yourself some financial capital.
Capital is the funds or resources that are loaned to a business when they are ready to attempt to take the next step in their journey. Sometimes being profitable is just not enough to allow a company to expand in a way that would that would allow them to take advantage of demand in a maximised way.
The acquisition of capital represents one of the more pronounced risks of running a business. Capital is there to be spent, but it is also there to produce results and to be repaid. But it also represents a supreme vote of confidence in the strength of a business, as it is not generally the case that people decide to loan money to someone they do not believe will be able to pay them back.
But how sound a strategy is actively seeking out an investment from a source of venture capital, and what are the benefits it can bestow and the harm it can inflict?
The Mechanism of Venture Capital
To really get to the bottom of whether or not trying to procure some venture capital is a beneficial thing for you to be doing; you are going to need to really understand how it works and the main desires that motivate it.
Most definitions of venture capital emphasise the fact that the funds being provided are almost universally being supplied to start-up companies, still in the early stages of their development. This means that the practice is based around the idea of maximising potential and minimising risk, and the potential is huge. One study claims that in 2010, venture capital backed businesses accounted for 11% of US private sector employment and 10% of all total US sales, while another argues that the empirical evidence seems to be point to a relationship between venture capital and innovation at the industry level.
Who are the main sources of venture capital?
While there are likely to be a few super wealthy individuals who want to go it alone, most venture capital funding will come from specialised funds. These funds act as a type of pooled investment vehicle for companies that may be considered to be too much of a risky proposition for banks and other sources of capital to take on.
This fund will usually be managed by a venture capital firm, who employ a workforce of people who have in-depth knowledge of certain business areas and industry types and try and spot trends and rate companies based on predictions of future performance. Different venture capital firms will focus on different industries or different kinds of companies, but the end goal is always the same: to provide funds to companies that are perceived to be ahead of the curve in order to profit from being an innovator or market leader.
Most funds will only fund companies that fall into one of the following categories:
- Companies who as yet have no set organisational structure or product range (often referred to as ‘Seed Capital’)
- Start-ups who have sample products and some semblance of a full time staff (these venture capital firms are often called ‘start-up incubators’)
- Companies in the first few years of their venture who are experiencing good sales but need capital in order to make significant efficiency or productivity gains ( Juniper networks received over $40 million from a group that included Siemens and Ericsson in 1997)
- Established companies who are looking to expand into new markets or product areas (such as NewVoiceMedia who secured $35 million in 2013 from Bessemer Venture Partners)
Where does the money come from?
A venture capitalist firm is not necessarily going to be made up of wealthy individuals who are pooling their resources together. Rather, the firm is likely to be charged with making investments on behalf of the companies and individuals that have provided resources for the fund.
Most funds have a fixed timescale for investment and the recoupment of loans, usually somewhere around 10 years. This timeframe means that there is an initial period of investment (3 to 5 years depending on the timeframe), followed by a period in which the focus is on management of the existing portfolio.
As for the actual source of the resources that each fund has at its disposal, that is a factor that depends on the nature of the individual fund, its focus and its scope. The pooled investments could come from companies, individuals or financial and investment institutions.
Why do people do it?
The main aim of providing venture capital to young companies for the firms and funds involved is to make a healthy return on their initial investment. Providing capital to companies who are about to undergo a significant push into new markets is an inherently risky proposition for investors, but the returns can be significant.
Securing capital from a venture firm can be more beneficial to a smaller company, because they may not be able to secure funding from banks and other lending institutions, and because the firm in question is likely to have a significant expertise in the area that the company operates in.
There is a famous saying that there is no such thing as a free lunch. While this may be true, venture capital represents a slightly different take on this famous piece of hard business reality.
In the venture capital world, lunches may not be free, but some people like to pay for people who are unable to afford one to eat on the proviso that should good times come, the person can buy them two lunches back.
There might be substantial benefits for you, but be under no illusion that they are seeking a return on their initial investment.
The Potential Benefits of Securing Venture Capital
The burning question at this point is still whether or not it is even worth a company’s time and effort to try and secure this type of funding.
There are so many variables flying around in any market, company structure or geographical region that it means that every company must consider their own position before going down this path. Is the kind of expansion offered by venture capital possible and sustainable in the long term or would slower, more managed growth be a better way of making sure the company had the expertise and experience that it needs in order to be the best it can be?
If venture capital is going to be suited to your company, there are some real, measurable benefits that it can bring:
The first and most obvious benefit is the quick injection of liquid capital into your business, which can mean you quickly begin to expand your business right away
It is also worth stressing that this is not a loan, so it is not likely that there will be repayment schedules that are as stringent
The boost to the legitimacy of your business that can come if a well-respected venture capital firm decides to invest some money into your company
The venture capital firm is itself likely to be an incredible resource when it comes to expertise, business connections and networking opportunities (many venture capital agreements feature a member of a firm being appointed as an honouree member of your company’s board)
As we have seen above, venture capital is pretty closely associated with job creation, which means that you can really begin to shore up the knowledge base of your company
Venture capital is not going to work if you do not have a strong foundation to pour these extra resources into. It can give more oomph to what you already have and can help you bring in more people and infrastructure around that central idea, but venture capitalists are unlikely to be helping you come up with ideas or assisting in the day to day organisation of your company.
The Potential Risks of Venture Capital
As with any business investment, there is a large amount of potential risk for both the investor and the beneficiary. Aside from the obvious risk of failing to make substantial expansions and being burdened with a large amount of debt, the introduction of venture capital itself can sometimes do more harm than good for a company.
Examples of these kinds of negative effects are:
The funding terms inserted into the venture capital agreement such as a presence on the board or restrictions on what direction the company can use the money to take, might begin to change the existing management structure of the company in significant ways. Many companies face problems when the preferences of investors seem to take preference over those of established, long term team members
Similar to the point above, the insertion of venture capitalists into the mix may have the effect of lowering the return for the company founders
One of the main strengths of smaller and younger companies is flexibility and the ability to institute major changes relatively easily. This ability may be lost (or at least significantly curtailed) when your company becomes locked into an investor-beneficiary relationship
The venture capitalists may be pushed by their investment timeframe to begin to pull out and focus on getting their money back, whether or not the timing is right with regards to your company’s performance
In some cases, where a company is underperforming to a large degree, you will see the repayment of debt being prioritised over the continued survival of the company at a lower level of performance
The point to remember with venture capital is that the money is not being given to you without a number of very large strings attach. For many business owners, it comes down to an issue of power, and how much you are willing to give away in order to secure funding.
How to Go About Trying to Secure Venture Capital
Securing venture capital is not an option that is going to be presented to every company, so if you think that you would benefit from an injection of liquid capital there are certain ways that you are going to have to make yourself visible in amongst the crowd.
There are steps that you need to take so that your company is as attractive a proposition as possible, but you are also going to need to go to the right places and talk to the right people.
Things you need to do
You may have potential oozing out of every pore, but unless your business is optimised in certain ways there is not a lot that venture capital is going to do for you. You are going to need to:
Have a unique central idea and be in an industry that is not easy to break into (high barriers to entry). Venture capitalists want to fund great companies, but not great companies that anyone with an internet connection can then start replicating
Have an interesting value proposition that will compel people to engage with your company in a way that is scalable
Demonstrate that there is a market to be had, and that it has potential to grow in the future
Make sure you have a team with expertise and market knowledge
If you can show any potential investors that you have a good product or service in a profitable marketplace with a capable team behind you, they are much more likely to throw their resources behind you.
Places you need to go
The next thing you are going to need to do is to get yourself to a venture capital event. There will be different event rosters for different countries and different industries, so you are going to have to do a little bit of research. Attending these events can be expensive in terms of time and resources so try to make sure that you pick your event wisely.
Some examples of venture capital events in the US and the UK should help give you an idea of what it is you are looking for.
People you need to speak to
You could also potentially tailor your approach specifically towards trying to woo influential individuals within the venture capital scene. This approach is going to require a serious amount of research, networking and targeted promotion. These individuals are likely to be extremely busy and focused on a number of other ongoing investments already, so your pitch is going to have to be perfect.
A key part of this process is making sure that you are targeting the right individual and the right firm. Do they have a history of success in investing in companies like yours, in your geographical area? Also, what have the return on investment criteria (are you going to be able to expand sustainably if you have to satisfy a 40% annual rate of return for investors?) on these previous deals been and how active is their investment style?
Grabbing the attention of your chosen firm and securing yourself an introduction are not going to be easy. You are going to have to get yourself out and about, and really highlight the benefits of your business model and your plan for world domination. If you do manage to secure some time, you are going to need to get to the point quickly.
While securing some venture capital funding can be a great boost to a young, fledgling company who is eager to start opening doors and showing people what they can do, it is important that the company is in the right kind of shape before the funding comes in. If you pour money into a bloated and inefficient system you are just going to emphasise the pre-existing bottle necks and black holes.
But if your company is in great shape and has masses of potential, you could find that these funds are eager to help you out.