Companies and businesses need finance to operate. Some companies have affluent owners that provide them with this finance. Others can raise finance through their existing shareholders. Similarly, some companies can also generate funds from the public. However, small companies and startups usually don’t have these facilities. For these companies, obtaining finance is a substantial challenge.
The most critical issue for small companies and startups is the lack of security they provide. Investing in these companies is highly risky. Most investors usually do not want to take these risks. However, some entities may support these companies for a high cost. One of these includes venture capital firms or venture capitalists.
In this article, we cover the advantages and disadvances of venture capital. Before jumping into the detailed advantages and disadvances, let go through some basic definition venture capital and how it works. So let get started!
What is Venture Capital?
Venture capital is a type of equity financing that is available to small companies and startups. In this type of finance, an entity known as a venture capitalist invests in a company’s equity. Usually, these entities include financial institutions known as venture capitalist firms. These firms obtain a minority stake in a company. However, they only invest in companies that have significant growth potential.
Venture capital is finance for a company, like any other type of finance. It is a type of private equity. However, it is available to startups or small companies rather than established companies. Usually, venture capital includes investments in monetary form. However, some venture capitalists also bring networks or expertise that is critical to a company’s success.
Venture capitalists usually include affluent individuals that pool their money into a venture capital firm. However, it may also contain investment banks and other financial institutions. These entities can bear high risks due to their resources. However, they also expect significant returns in exchange. For that, they usually identify companies that they deem to have high growth potential.
Overall, venture capital is a type of equity finance that comes from venture capitalists. This finance is available to startups and small companies rather than established ones. However, these companies must illustrate a high growth potential for them to receive the finance. Although it is risky for the investors, it can provide significant growth if the underlying company takes off.
How does Venture Capital work?
Venture capital starts with several affluent individuals coming together and forming a venture capital firm. These individuals pool their funds together to invest in various other companies. Some venture capitalists may also include investment banks or other financial institutions. Mostly, however, venture capital comes from venture capital firms.
Once established, these entities identify a company in which they can invest. This process involves several steps. However, the most primary requirement is for the company to be a startup or small company. These companies must also have a high growth potential in the future. If a company does not meet these criteria, it will not qualify to receive any capital.
Once venture capitalists identify a company with high growth potential, they will invest in it. Usually, this process involves acquiring a minority stake in the company. This way, venture capitalists become the company’s shareholders while the company receives finance to operate. Some venture capitalists also provide other resources to the company. The resources may include network, expertise, management, etc.
Venture capitalists wait for the company to grow and their shares to appreciate. Usually, venture capital firms operate on a 10-year time frame. During these years, the venture capitalists will take part in the underlying company’s management decision-making. This way, they can ensure the company performs in their best interest.
Once the company grows to a certain level, the venture capitalists will dispose of their equity. By doing so, they can make a significant profit on the transaction. Sometimes, however, the company may also underperform. The venture capitalist will end up bearing significant losses from it. Usually, the rate of failure is higher than success. However, once a company becomes successful, the profits from the transaction will exceed any losses.
What are the advantages and disadvantages of Venture Capital?
Venture capital can have significant advantages for small businesses and startups. For some companies, it may be the only option to get finance. However, it can also bring in several disadvantages. Some of these benefits and drawbacks may come from specific venture capitalists. Others may, however, be inevitable.
Advantages of Venture Capital
Venture capital can provide several advantages to companies. Some of these include the following.
Provision of capital
Venture capital can provide companies with a significant amount of capital. Some venture capitalists may limit this capital to a specific amount. However, others are more lenient in the finance they provide to companies. Furthermore, some companies can receive several rounds of venture capital funding. This way, they can get substantial amounts of finance.
Risk management
Venture capitalists ensure the underlying company does not suffer due to significant issues. Therefore, they help companies with managing their risks. Venture capitalists also have expertise from other ventures, further enhancing the process. With the expertise and services venture capitalists provide, the rate of failure becomes significantly lower for startups.
No security necessary
One of the most critical issues for startups is the lack of resources to provide as collateral. Usually, these companies require assets to offer as security, which they don’t have. However, venture capital does not entail any security from the underlying company. Therefore, companies can enjoy additional finance without pledging their assets.
Networking and collaboration opportunities
Venture capitalists have access to a wide range of resources. These include the networks and expertise they provide. When a company joins a venture capital network, it also receives access to these resources through the venture capitalist. Therefore, it presents companies with significant networking and collaboration opportunities that other finance sources don’t.
Disadvantages of Venture Capital
Venture capital can also introduce some challenges or disadvantages, some of which are below.
Dilution of ownership
Venture capital fundings bring in an issue that is prevalent with equity finance. It dilutes a company’s ownership. Usually, for small companies and startups, it means the founders have reduced ownership. Sometimes, venture capital may also require them to lose control over a company’s operations. If so, it can have a significant impact on the company’s operations.
Limited opportunities
While venture capital can provide companies with significant benefits, it is significantly scarce. On top of that, startups have to face substantial competition to get finance through venture capital. It makes it more challenging for companies to obtain this source of finance. The ratio for companies that receive venture capital from total applications is 0.4% or even less.
High costs
Venture capital is a type of equity finance, which has a higher cost compared to debt finance. The cost of equity is higher when it comes to the finance obtained through venture capital. Companies may get compensated for it through the expertise and networking that venture capitalists provide. However, it is for companies to decide whether the additional cost is worth these features.
Additional pressure
When venture capitalists invest in a company, they believe it to have high growth potential. This factor introduces additional pressure on companies to scale and rapidly grow. Some companies may not progress as expected and be considered a failure. They will also not receive additional support even though they grow.
Conclusion
Venture capital is a type of equity finance provided by venture capitalist firms, investment banks, or other financial institutions. It is one of the best sources of finance available to startups and small businesses. However, it may also come with higher costs. There are several advantages and disadvantages of venture capital, some of which are listed above.