It’s rare that you’ll see me post an article from another website on this blog. But I read this and thought it was important. It’s also a topic I don’t know very much about. Small business venture capital. This is being reprinted with permission from Peter Ireland.
With my first business, HydroSport, I worked at least 2 jobs for about 10 years to fund it. If I had known then how much time and money it would take I don’t think I would have done it. It would have been way too overwhelming. But once I was about half way into it there was really no turning back. You get to a certain point where you just have too much time and money invested to give up.
Throughout the whole process I kept wishing a guardian angel investor would come along and save me. But that never happened. Now after reading this article by Peter Ireland, maybe I was on the right path after all and didn’t know it.
Small business venture capital
Are you really sure that you want to go this route? Most entrepreneurs who pursue small business venture capital don’t qualify. They merely end up wasting a lot of time and energy in a futile endeavor.
It gets worse, a venture capital firm will in most cases fire the founder and founding team within months of an early financing round. The Wall Street Journal pointed this out in a article by Barnaby Federer from September 30th, 2002:
them after a few drinks, they’ll say, ‘We replace the CEO’ “,
he said. And that, he indicated, does not vary
with the economic climate.
Venture capital can be a tremendous boon to a tiny fraction of the companies pursuing it. But in the vast majority of cases it presents the entrepreneur with a “Faustian Bargain”. Venture capital brings with it tremendous meddling and pressure from venture capitalists. In this day and age they typically lack both the operating and industry depth of their predecessors. The effect of this on fledgling ventures is loss of control by the entrepreneur. Which then frequently leads to bad–and sometimes fatal–business decisions being made.
10 drawbacks of small business venture capital
Here are ten drawbacks of venture capital for the entrepreneur to mull over before making a decision to pursue it.
- The decision to chase venture capital is often a tempting distraction. From the much more complex and important entrepreneurial tasks of creating something to sell and persuading someone to buy it. The pursuit of venture capital is sometimes a means by which to postpone the day of reckoning when the marketplace finally decides if the idea will fly.
- Venture capitalists behave like sheep investing only in whatever industry happens to be the flavor of the month. Everyone else need not apply.
- Rookie entrepreneurs talking to venture capitalists expose their ideas to increased risk. They cannot distinguish between genuine interest and mere “brain-sucking” to uncover corporate secrets.
- Once negotiations begin venture capitalists will typically stall in order to push cash short companies to the brink of bankruptcy. This is a way of extracting additional equity and concessions at the last moment.
- Terms demanded by greedy venture capitalists frequently work to erode and ultimately destroy the founding team’s commitment to building a successful company.
- With the first dollar of venture capital accepted the entrepreneur’s control slips away to 28-year-old MBA wonder-boys with shallow of operating experience.
- As soon as venture capitalists become involved the founder’s role shifts. From critical company building functions to preparing reports. Attending endless meetings. Writing memos. And hand-holding impatient and/or meddlesome investors.
- An infusion of capital often shifts the founding team’s focus away from selling to spending money in an effort to placate venture capitalists. They often confuse bulking-up staff and assets with real growth.
- Venture capital brings with it tremendous pressure to create a liquidity event. This frequently results in bad decisions being made to launch products too early or enter into the wrong markets.
- The venture capitalist’s knee-jerk response to every problem is to fire the founders and evade any personal responsibility for bad decisions.
Why venture capital is bad
Here’s a bonus 11th reason why venture capital is bad. It is by far the most expensive money an entrepreneur can ever tap into. Let’s do the math to see why this is. Suppose you and a venture capitalist agree to a “pre-money” valuation of $1 million for your start-up. The venture capitalist then invests $1 million for 50% of the equity. After the investment, the company is said to have a “post-money” valuation of $2 million. Being 50/50 partners sounds acceptable, right?
Three years later the company is sold to a Fortune 500 corporation for $5 million. Do you and the venture capitalist each get $2.5 million from the proceeds? Not on your Nellie! The venture capitalist will have a so-called “liquidation preference” built into the original investment agreement. This allows him to first take out 2 to 5 (or more) times his principal before anyone else sees a penny. So, let’s say that in this example he takes out $3 million (i.e., a “3X liquidation preference”), plus any accrued dividends on his preferred stock. After exercising the liquidation preference and cashing in his dividends only $1 million is left. You, the founder, and your team, will then split this remaining money on a 50/50 basis with the venture capitalist.
This is a simplified example of what happens.In real life the founder and her team would probably receive far less than even the $500,000 due to all the fine print clauses.
Is it worth it?
The good news is that there is a wealth of research that supports that anyone wishing to build a company for the long term will be better off by not utilizing venture capital. As a result savvy entrepreneurs devise startup strategies that allow them to focus on generating cash flow instead of chasing venture capital. Naive “entrepreneurial wanna-bees” have a philosophy which can be summed up as, “Give me X million dollars or this idea is dead!”.
If your entrepreneurial goal is a company “built to last” it’s usually best to forgo venture capital. If your goal is a company “built to flip” for a fast buck use venture capital if it is available to you.
Peter Ireland, is an entrepreneur, former CEO of a public company, and angel investor.
Copyrights 1996-2003 Peter Ireland
There’s more than one way to fund a startup and venture capital is just one of them. Throughout this blog I’ll do more research into different ways to find money for your ideas. Sometimes I feel like I did it the hard way. But I own my business free and clear 100%, make all of my own decisions, and own the IP. I don’t have anyone standing over my shoulder telling me how to run it. And I’ve learned so much by having to do everything myself.