When a startup is facing the constraints of limited capital, many entrepreneurs consider venture capital funds (VCs) as a potential solution. Armed with a vision, proof of concept and a high rate of revenue growth, the founders believe the only thing standing in their way is a lack of cash to grow the business. A venture capital fund can certainly help founders realize the potential through rapid growth. However, there are times when investing in a venture capital fund can be harmful and even devastating. Before you think about raising capital, here are five things most entrepreneurs do not understand about the risks associated with raising capital:
1. Your Startup Is Not Ready For Rapid Growth
Most funds will expect you to immediately invest the money raised. Most recruitment rounds assign the company 18 to 24 months of activity. You might think you understand your sales model; after all you would not have reached that point without actual sales. However, when you double or triple your marketing activity in three to six months, you will find out very quickly whether your model is really ready.
The most pessimistic scenario occurs when you invest a lot of money in the sales process, but additional sales are not growing fast enough. If you do not receive at least $1 of revenue growth from every $1 of investment, you have a problem.
2. You Work According To The Investor’s Schedule And Not According To Your Schedule
A typical venture capital fund that raises money from investors, insurance companies and family offices does so over a period of 10 years. Therefore, the fund has about a decade to repay all its investments or reap the returns to pay back to investors.
An average venture capital fund recently recruited will incur capital for the first five years and reap the returns for the next five years. The fund will be under more pressure to return the capital to investors as it approaches the 10-year mark and this pressure can be directed directly at you.
The most common scenario is that the fund will force the sale of the company earlier than you want to meet the fund’s investment objectives. When the VC decides it’s time to sell, there isn’t much to do.
An example of this dynamic is when the Sequoia Fund forced Zappos’s CEO to sell the company to Amazon and not go to IPO despite the fact that the company’s sales were $1 billion and $40 million in EBITDA.
3. You Can’t Get Along With Your New Boss
One of the biggest changes that entrepreneurs fail to anticipate is the impact of a professional investor on their ability to run the company. Venture investors almost always change the company’s management structure to give themselves additional seats on the board. It is not uncommon for a fund to hold two seats out of five.
As CEO, you are going to be accountable to the board of directors. For many entrepreneurs, this is a new experience because by the time they are hired they have done pretty much what they want, without formal oversight.
Would prefer to work with a more tolerant partner & assistant or with a loan officer from a bank? It’s all centered on numbers, leaving no room for mistakes and hesitations to take bold steps? These are the moments when you realize you should have verified your VC more closely before closing a deal.
A partner (foundation) that is less than ideal can ruin your life for a good few years. When you raise venture capital, you have to understand that money is a commodity. What really matters is what you get in addition to the money. Does your new investor bring you industry expertise or special connections to marketing channels? Is the VC able to spend the right amount of time thinking about the company to make a difference or is your company one of the 20 boards where the VC sits?
What’s important: Can your VC contribute to creating a positive culture on the board? The quality of your board meetings is directly related to the board culture. A positive culture is one in which members – including the founder / CEO – are free to express their views and highlight challenges and opportunities. When the board atmosphere is positive, members focus on listening and adding value to the conversation. In the event of a negative atmosphere, members try to maximize personal benefit rather than universal benefit.
4. The VC Only Wants A Grand Slam
Being a venture capitalist is a tough business. Out of 10 investments made, one or two must have high enough profitability to cover the losses from the other investments that fail to meet expectations. 90-95 percent of venture capital funded startups do not reach the stated forecasts. Therefore, venture capital funds are going to push each and every one of their portfolio managers to the max. Medium growth does not provide investors with the returns they need to maintain their jobs at the VC, so there is little incentive for them to take anything other than an all-or-nothing strategy to any company.
The only way to hurt the Grand Slam is to push portfolio companies to maximum volatility.
So, what does that mean? Here’s a scenario: In your first year with your VC, you managed to increase revenue by 40%, but it’s not close to the 150% you have forecasted in your business plan. You think that, since you only have cash for nine months, the smart thing to do is reduce your cash burning rate and keep growing at 40%. Your VC, on the other hand, tells you to increase the rate of cash burning to increase sales growth and to increase the likelihood that you can raise additional funding. Although you know that the company is very likely to remain cash free and not ready for the next round of funding, there isn’t much else you can do.
If you need to achieve a growth rate above 100 percent and reach another round of funding, you’ve done your part. If you fail to reach your goals, your VC will try to reduce the damage and focus on the rest of their portfolio companies.
5. You’re Risking Your Capital
When venture capitalists invest in your company, they create a pattern of investing with preferred stock. This type of stock gives all kinds of fund preferences, including the dilution issue. It determines how much money should be returned to the fund, before you and the other investors get one penny from the venture.
For example, your company has raised about $10 million from a venture capital fund. The fund noted in the contract that it would receive twice as much back before the other shareholders would receive their return. That means you have to fund $20 million before you see a dime.
If hit a Grand Slam and sell the company for $100 million, you are in good shape; the fund will receive $20 million first and you can share $80 million with the other shareholders. But if you’re forced to sell the company for $18 million, guess what? Your fund will receive all $18 million, and you will receive nothing. Unfortunately, this is the more likely of the two outcomes for companies that raise funds from VCs.