What are the Dangers of Venture Capital Financing?
Venture capital is money given to a startup in the belief that the company has a good chance of becoming profitable. This money is a lifeline to entrepreneurs who don't have access to sufficient bank funding or a cash influx from a public offering. It's not free money, however. Investors get a high return. To buttress their risk, venture capitalists often provide management and strategic counsel. Therein lies the dangers for both businesses and investors.
Dangers for the Entrepreneur
Who's the boss? As a startup entrepreneur, you probably went into business to run your own ship. Well, with venture capital, you may work a few more days as deputy than captain. The VC investors are a like a board of directors to whom you report. They can veto decisions you make, control how you distribute stock and approve any new financing you get. They can also fire you.
Not a shared passion. Investors are in it for the money. They have portfolios to manage, so you'll have to forgive them for not sharing your passion of saving the world with the next gret social enterprise. They'll be gone with the return comes in.
Managing more conflict than money. VC firms often co-invest with other VC firms to lower their risk in investing in companies. On the other hand, having multiple investors improves your chances of a success: a three-fold chord is not quickly broken. But, inevitably differences of opinion will emerge among your investors, who may also have more on their agenda, such as getting their nephew Bob a job or getting a tax write-off. Your job as a business owner will involve as much "managing up" as managing the day-to-day affairs of your startup.
Dangers for the Venture Capitalist
Risky investment. The VC firms that backed companies like Microsoft and Google during their formative yields were paid handsomely for the risk they took. But like the fine print in weight-loss advertisements, your result may vary. More businesses fail than succeed. The chance that your firm will pick more losing startups than winning one is great. Moreover, once you're in, the only way out of a partnership is through the sale of the company or an initial public offering. Your stake is locked. Many spread their risk by investing instead in portfolios than span multiple startups but an independent or corporate VC are more likely to be in the riskier relationship.
Excess valuation. New technology companies in particular are often priced well above their worth. Eventually the bubble bursts, and your VC firm may still be entrenched in the operation of the company, such as through its board. Your firm takes the chance that you might get significantly lower returns than if you had chosen an alternative investment.
Lawsuits. Even if a business fails, venture capitalists can be named in lawsuits against a company. For example, one famous case stems from a travel guide company that went belly up but long after,minority stock owners were suing the company and its investors for negligent misrepresentation and breach of fiduciary duties. This is a common area of concern for venture capitalists who also have to answer to investors within their funds. Claims of fraud, breach of contract and complaints with the Securities and Exchange Commission are unfortunately common.