The Advantages and Disadvantages of Venture Capital
To create and grow a successful business, you’ll need careful planning, smart strategies and adequate funding. Planning and strategizing can be accomplished in-house, but even entrepreneurs with great ideas often need to look to outside sources for adequate financing. Businesses with innovative products and services may offer a lot of potential for growth and profit, but without a proven track record and lots of collateral, they can run into roadblocks when seeking financing from traditional sources like banks. Venture capital, funds provided by wealthy private investors or venture capital firms, has both advantages and disadvantages that both parties should carefully consider.
For startups and new businesses with significant potential for growth, venture capital can provide a vital source of money to grow quickly. For example, let’s say you have a new business idea with a ready-made and eager market to buy it. What you don’t have is the money necessary to develop that idea into a product you can sell to that market, at least not before competitors can. In this situation, venture capital might allow you to quickly create and expand the business, gaining market share and brand recognition before competitors can beat you to the sale. Because venture capital is not a loan, it’s categorized as equity in the company instead of debt carried by the company. Thus, the company doesn’t have to repay the funds. Additionally, as the business grows, its value tends to increase, so venture capital can end up making the original owner's stake in the company even more valuable.
Venture capital investments mean exchanging a slice of ownership in the company for money. That means the owner of the company is no longer the only person in charge or able to make decisions about the company’s direction. For some entrepreneurs, this can be a difficult trade to make and live with, especially if a disagreement arises with the venture capital investor. And it’s not unusual for venture funding agreements to lead eventually to such disagreements. Often, venture capitalists have a greater tolerance for risk and wind up pushing for rapid expansion into new markets or areas, whereas the original owner may prefer a slower approach to growth. Venture capital investors may also push for a quicker exit from the market than the original owner is willing to consider, either through acquisition by a larger company or through an initial public offering.
For savvy, experienced investors, venture capital is often an attractive strategy. It offers the potential for impressive returns on the original amount invested, and if the investment pays off, the status and rewards that come from having “picked a winner.” Venture capital investors often seek out innovative start-up companies, particularly in the high-tech industry. These companies can realize dramatic business expansions, sometimes in just a short amount of time. A successful venture capital investment could result in returns that far exceed industry averages. Even smart traditional investments, such as purchasing stock in large, successful companies, or buying real estate in healthy markets, can pale in comparison to a significant venture capital investment in a successful tech start-up.
The primary drawback of venture capital for investors is the significant risk that accompanies that potential for significant reward. Potential is no guarantee of success, and a huge payoff is not the favored outcome, statistically speaking. Even experienced venture capital investors can make a mistake, and even the strongest business ideas can fall victim to unfortunate developments. Poor business decisions, fundamental flaws in a business model, changes in economic conditions and competition may impede growth even with ample funding. If a company fails despite attracting venture capital, investors could lose most if not all of their investment.