The decision of whether or not to raise venture capital can be one of the most consequential on a founder’s journey. The choice you make can put your company on a particular path, and that path isn’t for everyone.
The venture-backed path can lead your company to become the next unicorn. You’ll have plenty of capital to spend, numerous funding rounds, and a mandate to pursue rapid growth. But in return, you might find yourself surrendering control of your company and making some very tough choices if not everything goes according to plan.
The other option is bootstrapping, which means financing the business from personal capital and profits. Taking this path allows you to retain complete control over your company and its growth, but that can mean competing with well-funded businesses and always keeping your eye on the bottom line.
Of course, there are other options for founders beyond these two paths, most notably growth equity and selling your business. In this article we’ll discuss what to consider before pursuing VC funding, and other sources of capital you can opt for instead.
Is VC funding for you? 4 factors to consider
For many early-stage startups, the decision to seek venture capital is a simple one: outside investors are often the only way to get seed financing before revenue starts coming in. But startups aren’t the only companies that can receive venture capital funding.
VC investors often approach profitable, established companies with offers of adding capital to fund rapid growth. These companies have no need for external capital, but offers from VC can be enticing.
Whether you’re a founder of a startup or of an established business, it’s important to consider four factors before proceeding with VC funding. These can be broken down into internal and external factors.
Internal factors:
- How much risk are you willing to tolerate?
- How much control are you willing to surrender?
External factors:
- Does your business model require upfront investment?
- How are your competitors being funded?
How much risk are you comfortable with?
Venture capitalists invest in several startups and keep a diversified portfolio. They only need one of their ventures to become a unicorn in order for their fund to succeed. As a result, they’re more willing to amp up the risk and push their companies to grow at all costs.
Think of it this way: As a venture capitalist, you might be investing in anywhere from 50-100 companies at the same time. Because your portfolio is so diversified, you’re more prepared to amplify the risk on each of these ventures because only one needs to make it in order for your VC fund to succeed. If 5080 companies fail and you get that one success story, you’ve done good.
As a founder, on the other hand, you only have the one company. If you take extreme risks based on VC advice, and your company fails, you’re the one who faces the consequences. Venture capitalists will still have other companies that they can continue backing.
Another key risk aspect is that VC investors have more legal protection than founders in terms of liquidation preference. This defines who gets paid first when a company is acquired or liquidated (e.g. in case of bankruptcy). To reduce their investment risk, venture capitalists usually ensure they get paid before founders and employees. This means that, in case of liquidation, you will only receive the amount left over after VCs have been paid. In some cases, you may end up receiving little or no money even if your startup is successful.
These are two major scenarios you need to consider before approaching VC funding. Ask yourself how much risk you’re willing to tolerate and be aware that, in some cases, you may exit your company with little pay-off. There’s a balancing act at play here: your company is unlikely to become a unicorn without venture-backed funding, but VC funding can also increase the chances of your company going bust.
How much control are you willing to surrender?
You may be thinking: if my VC investor suggests risky growth strategies I can speak out against them. However, there’s a chance that you won’t have enough control left in your company to vote against them. This is because venture capitalists can exert control over your company even if you maintain more than 50% ownership.
How does this work?
VC investors can influence your company in two ways:
- Through privileges granted to preferred stockholders (called protective provisions)
- By having a seat on your company’s board
When VCs invest in your company, they get preferred stock while founders usually hold common stock. Investors will almost always negotiate to become preferred stockholders in order to have special privileges which grant them the right to veto decisions that could affect their investment. This means that a venture capitalist can block your decisions even if they own just 5% of your overall stock.
With these significant minority protection rights, VCs can exert power and control over company issues like:
- Liquidation events (e.g. selling, merger, or dissolution)
- Changing the company’s charter or bylaws (e.g. changing the number of directors)
- Changing the amount of authorized common or preferred stock
- Issuing new classes of stock that has rights equal to or better than existing preferred stock
- Redeeming or buying preferred or common stock
- Hiring or firing key executives
- Buying assets
- Significant changes to business strategy
In some cases where you might end up owning a minority share in your company after several funding rounds, VC can also result in a smaller exit for you as a founder. For example, if you bootstrapped your company and exited with $100m owning 100%, you’re better off than taking VC funding and exiting at $300m with just a 20% stake in the business.
Before you consider VC funding, ask yourself whether you’d be willing to have less control over the decisions and direction of your company. If the thought of losing control over your company makes you feel queasy, you may be better off bootstrapping.
Does your business model require significant upfront investment?
For some founders, the decision of whether or not to pursue VC funding isn’t a question. There are certain business models that are extremely difficult to scale without external financing. In order to grow your company, you’ll need significant upfront investment that can often only be achieved through startup venture capital.
Business models of this type are typically characterized by:
- Long payback period of customer acquisition costs (even with high LTV/CAC)
- Network effects
- Large capital expenditure
One example of this kind of business model is an online marketplace (think AirBnB, Uber, Etsy, Fiverr). These businesses require a significant upfront investment in customer acquisition to attract buyers and sellers until there is a critical mass.
Another example is enterprise software (Slack, Salesforce, Airtable). These companies need to invest heavily in initial research & development in order to perfect their software. They also tend to have long sales cycles, meaning it can take weeks or months for clients to purchase the software. As a result, payback will occur in the future and you need to rely on funding to get you through the initial stages.
If your company follows one of these business models, VC funding may be necessary to help you build, grow, and scale your company to a stage where it’s successful. In that case, the payoff can be incredible. Companies like AirBnB, Uber, or Slack would have been impossible to scale and succeed without significant upfront investment backed by VCs.
How are your competitors funded?
This point is an important one to consider. You may have created a product that is equal to or even better than your competitors’ products. But with a bootstrapped business, it’ll be extremely difficult to compete if your venture-backed competitors start to invest heavily in sales & marketing or sell their products at a loss t to push you out from the market.
Well-funded companies can operate at a loss for a long time, and many large startups are notoriously unprofitable. This is especially an issue if there is little differentiation in your industry and competition is mostly based on price. Having well-funded competitors undercutting prices can make your bootstrapped startup go bust as you struggle to compete.
Take this example from Andrew Wilkinson, founder of Flow. In this Twitter thread, he discusses how his bootstrapped project management software struggled to compete with Asana after Asana raised $28M in venture capital.
Lesson: if your company is dealing with well-funded competitors, it may be worth pursuing VC if you want to survive.
Alternative funding methods to venture capital
Now that you have taken these four points into consideration, you may be thinking that VC is not for you. That’s OK – venture capital is only one way of funding ambitious growth plans. There are other ways to fund your company that may be more suitable and in line with your needs.
Venture Capital vs. Growth Equity
For certain companies, growth equity is a viable alternative to venture capital. If you take this route, you can bootstrap your business until you have a proven business model that’s ready to scale. You can then pursue investment from growth equity firms to drive further growth for your business.
The major differences between VC and growth equity are:
- Stage of company development: VC funding usually occurs early in a startup’s lifetime while growth equity firms target more established companies with a proven business model and customer base.
- Liquidity: Growth equity provides some level of liquidity to founders, making it a good step for those who are ready to take some chips off the table
- Involvement: Growth equity investors tend to be more involved with your business while VCs have a more hands-off approach.
- Profitability: Companies receiving growth equity are usually more likely to be profitable with a proven business model while venture capital can fund businesses that are operating at a loss.
- Control: Growth equity usually enables founders to grow their business faster while still maintaining significant control over operations and strategy.
- Risk level: Growth equity has less risk than venture capital, and terms usually balance benefits between founder and investor more than VC.
- Discretion: Unlike venture capital, companies will usually choose growth equity because they want to, not because they need to. More established companies are already on route to growth, and growth equity allows them to accelerate that further.
About Aventis Advisors
Aventis Advisors is an M&A advisor for software companies. We believe the world would be better off with fewer (but better quality) M&A deals done at the right moment for the company and its owners. Our goal is to provide honest, insight-driven advice, clearly laying out all the options for our clients – including the one to keep the status quo.
Get in touch with us to discuss how much your business could be worth and how the process looks.
