One of the major difficulties that small businesses and new start-ups face is obtaining funding. In our contemporary society and with the use of technology, new firms have access to a plethora of fund sources. These include using the Internet for crowd-funding or even peer-to-peer lending. However, these sources are often uncertain as the firms do not know how much funding they will get with these methods. This means, that those start-ups often find themselves having to find funding from venture capitalists. The venture capital market plays a significant role in providing capital to a wide variety of enterprises. Although there are multiple benefits, new business owners need to be aware of the risks they are taking when engaging with venture capital firms.
So why accept the funding?
The first benefit of securing funding from a Venture Capitalist is that the business owner is not taking a loan. Therefore, the costs of operation will not include interest payments.
Apart from the financial safety, engaging with a venture capital firm may bring additional benefits. Inexperienced entrepreneurs stand to gain a great deal from venture capitalists’ wealth of start-up experience; they can gain insights on what to expect at various stages, what to worry about and what not to, and on how they are progressing. Tapping into this expertise can prove to be tremendously valuable in terms of business decisions or even human resource management, as the VC will help with the recruitment of top talents to maximize the productivity of the business. Being able to make better and informed decisions in these key areas, will be crucial for the growth of the firm. Moreover, if the owners have little experience in running a business and lack the knowledge to make informed decisions, the investors, holding a significant share of the equity, will be able to step in and have a say in how the business should run. This can be extremely valuable considering venture capitalists have extensive knowledge and experience in starting a business and how best to expand.
One striking example of a small project backed by venture capital firms to become a global success is Google. It started as a project from two doctoral students who later gained backing by Venture Capitalist firm Sequoia Capital and Kleiner, Perkins, Caufield and Byers (KPCB). The business received $25 million, as the investors were confident about the potential growth of the business, at a time when the Internet was booming. In 2001, on Sequoia Capital’s advice, Google founders hired the company’s first CEO, Eric Schmidt who remained the head of the firm until 2010. During this decade, we can see how much Google grew in terms of revenue (as seen in figure 1,) starting at nearly $70 million in 2001, to almost $25 billion in 2010.
But should small businesses be wary?
Of course! As a small business, turning to venture capital firms for a source of funding can prove to be a double-edged sword. So when opting for venture capital funds, instead of paying back as a loan repayment scheme, owners of the business will have to give up a significant part of their equity. According to Hellman (1998), this process will then allow “venture capital firms to hold effective control over the board, typically through a voting majority, and sometimes through explicit contractual agreements”. This means that the investors will effectively be significant shareholders of the company, subsequently, profits will also have to be distributed accordingly.
Due to this, the investors then become shareholders in the company. The size of their investment could determine how much influence they have on company decisions.
For example, if the investors have 20% to 50% of the shares, they have significant influence over the decisions, which means they can voice their opinion and influence decisions. However, if they have more than 50% of the shares, then the owners of the business lose management control, which means they often assume more direct control by changing management and are sometimes willing to take over day-to-day operations themselves. Although this is to guarantee the company’s headway, it can generate serious internal problems between the owners and the investors’ team. A telling statistic is that after 4/5 years from investment, more than half of the founder CEO’s are replaced!
Company owners who have been ousted from their own businesses include Steve Jobs with Apple, and Sandy Lerner, co-founder of Cisco. Lerner is no longer part of the company after losing control to a management group led by its early investor, Sequoia Capital’s Don Valentine. Cisco’s CEO, John Morgridge saw Lerner as the weak link of the firm, and it became clear that they shared different aspirations for the company. Subsequently, the board of directors decided to side with the CEO and let go of the founders.
So should you accept the investment in your business?
From a small firm, looking to get capital from venture capitalists point of view, having recourse to such funds will be beneficial for the business. Not only will the investors provide adequate financing, but also the support needed to help grow the business, by seeking new talents to perform the jobs, as well as give invaluable advice to better manage the business, which was the case for the current world-leading tech company, Google.
However, you also have to keep in mind that in order to access all these services, your control over the operations will be diluted because the investors will also have stakes in the business, via a percentage of the shares, which in turn, means that you partially lose ownership of the company. However, it is possible to mitigate against these setbacks, primarily through an agreement on the terms and conditions, prior to starting the funding of the business.
So, the short answer is yes! Accept funding, grow your company, but be careful that you’ll still be the person in charge, making the decisions!