The Great Recession has reinvigorated America’s entrepreneurial spirit. As the job market soured during the housing market crisis and ensuing economic swoon, business creation rates soared to record heights. We averaged fewer than 29 new start-ups per 100,000 people each month from 2000 to 2007 – when the unemployment rate averaged 5.0% – and that number rose to 33 start-ups per month from 2008 to 2011 – when joblessness climbed as high as 9.6%, according to data from the Bureau of Labor Statistics as well as the Kauffman Foundation.
When jobs weren’t as abundant, we took it upon ourselves to create our own. That’s certainly admirable, but the fact of the matter is that starting a business is the easy part. What’s hard is not only staying in business, but also growing and becoming profitable. Of all the businesses founded in 2008, only 74.4% survived two years, and even fewer – 62.4% – made it three, according to the Bureau of Labor Statistics.
Whether a company lives or dies depends in large part on how it’s financed. There are a number of financing options available to small business owners, from credit cards and small business loans to friends and venture capitalists. But which is best?
Much depends on the nature of one’s company and the credit landscape, but venture capital financing has become quite sexy in recent years as banks have tightened underwriting standards and the Istagrams of the world have struck gold. But does that necessarily mean it’s wise for small business owners to go after VC money?
To Venture or Not to Venture?
We conducted a little survey of CEOs and professors of entrepreneurship about the pros and cons of dipping one’s small business feet into the venture capitalist pool. And here’s what they had to say on the matter.
Why an Entrepreneur Should Take VC Money: “This question is a bit off. The question isn’t whether an entrepreneur should accept VC money or not, but what type of capital is available and when is it needed. The vast majority of entrepreneurs will never have access to VC because their ventures don’t fit the VC sweet spot. Specifically, VCs look for high tech, high growth potential ventures that are seeking to grow rapidly. Most VCs come in after the business has passed several milestones, such as built the product and generated some early sales. With that being said, entrepreneurs should accept VC money if:
- They are poised to grow rapidly and need significant capital to achieve that growth (usually greater than $2M).
- The VC has deep pockets meaning that the entrepreneur can go back to that VC to ideally lead future rounds
- The VC can add value beyond capital, most notably the “rolodex.” A better VC will have connections to potential hires, customers, suppliers, etc. The better VC will have experience advising and guiding entrepreneurial companies through rapid growth and a successful ‘harvest.’
- The entrepreneur and VC have good ‘chemistry’ and will be able to work together.”
Why an Entrepreneur Shouldn’t Take VC Money: “The short answer is the opposite of the above. The longer answer is that the entrepreneur:
- Doesn’t need the capital
- Has access to other, more appropriate sources
- The company has generated enough value so that taking the investment won’t lead to undo dilution.”
- Andrew Zacharakis - Professor, John H. Muller, Jr. Chair in Entrepreneurship, Babson College
Why an Entrepreneur Should Take VC Money: “An entrepreneur should accept VC when s/he has an opportunity for explosive growth, does not really want to manage the company when it takes off, when s/he does not mind having someone else call the shots so long as the growth and profitability goals are protected, and there are no viable financing alternatives available.”
Why an Entrepreneur Shouldn’t Take VC Money: “Should not take VC when the obverse holds, but especially– when retaining control of the venture is critically important, when there are goals besides maximizing near term returns that are essential to the entrepreneur, and when others s/he talks to says to stay away from the VC offering the deal.”
- Harry Sapienza – Professor, Curtis L. Carlson Chair in Entrepreneurial Studies, University of Minnesota – Twin Cities
Why an Entrepreneur Should Take VC Money:
- Help with growing the venture more quickly;
- It can greatly expand an entrepreneur’s network;
- Help with strategic decisions and adjusting business models;
- VCs represent external validation of the venture;
- Good exit advising.
Why an Entrepreneur Shouldn’t Take VC Money:
- The VC’s perspective can be more focused on the exit and not necessarily on the long-term good of the venture;
- The entrepreneurs usually have to give up sizeable equity to get the VCs to sign on;
- The advice that VCs offer the entrepreneurs that they fund has not been shown to consistently add value.
- Lowell Busenitz – Michael F. Price Chair in Entrepreneurship, Michael F. Price College of Business, University of Oklahoma
Why an Entrepreneur Should Take VC Money: “Most of the startup companies suffer from what we academicians refer to as “liability of newness.” This is due to executives’ limited strategic options and access to financial and human resources. Hence, it is not a coincidence to see many of them fail within the first couple of years of their founding. It is normal for entrepreneurs to reach out to angel investors, venture capitalists or equity funds to acquire some of these resources. First, VC’s provide financial resources. I believe that it is their primary purpose. Second, they provide the required human resources at the board level. VC’s have experienced and knowledgeable people working for them. This may be of interest to entrepreneurs.”
Why an Entrepreneur Shouldn’t Take VC Money: ”VCs are highly activist types of shareholders. They want to acquire large stakes in startups and possibly look for ways to take companies to IPO so that they can cash out their investment. Although most of them have a long-term approach, a possible early exit is highly likely for them. This may put extra pressure on the entrepreneurs. They may not like to be told what to do by the VC representatives who serve on their companies’ boards. In a way, entrepreneurs transfer some of the power they have in their own companies to an outsider.”
- Guclu Atinc, Assistant Professor of Management, College of Business and Public Administration, Drake University
Why an Entrepreneur Should Take VC Money: “When the terms are in the best interest of the entrepreneur over other alternatives that might include not getting funded. The ‘best interest’ of the entrepreneur includes financial and non-financial concerns with weights unique to the entrepreneur.”
Why an Entrepreneur Shouldn’t Take VC Money: “When the terms are not in the best interest of the entrepreneur over other alternatives that might include not getting funded.”
– Michael J. Schill – Associate Professor of Business Administration in the University of Virginia’s Darden School of Business.
Why an Entrepreneur Should Take VC Money: ”They should accept money from a VC if the entrepreneur and VC share the same strategic vision for the company, if the VC can bring more resources than funding, and if the terms are good (valuation, contractual terms, etc.), and if the firm needs the funding.”
Why an Entrepreneur Shouldn’t Take VC Money: ”The VC model is somewhat outdated. Business accelerators are replacing VCs as a funding model, especially for early stage financing. I would recommend that an entrepreneur consider applying for funding and advice from a business accelerator first, and consider seeking investment from a VC second.”
– Jon Eckhardt, Executive Director of the Weinert Center for Entrepreneurship at the University of Wisconsin School of Business.
Why an Entrepreneur Should Take VC Money: “It is all about ‘smart’ versus ‘dumb’ money. The key is accepting money from VC firms that can bring strategic partnerships, unique expertise and key management skills.”
Why an Entrepreneur Shouldn’t Take VC Money: “Loss of control. Diversion of original focus and intent of the venture (not always negative but often is in the founders minds). Necessity to give up significant ownership (often at a time when it is cheap).”
- Dr. Pat Dickson – Director of the Business and Enterprise Management degree program in the Schools of Business at Wake Forest University.
Why an Entrepreneur Should Take VC Money: “Fuels fast growth and upside potential; can bring mentors with tons of great advice; enables scale otherwise unachievable.”
Why an Entrepreneur Shouldn’t Take VC Money: “Most expensive type of capital; can bring mentors with tons of unwanted advice; rapid growth may not be desirable nor scaling possible; outside owners mean loss of control; few founders survive at the top of VC-funded growth firms.”
- Dr. Todd Watkins, Director of the Entrepreneurship and Microfinance programs in Lehigh University’s College of Business & Economics
Why an Entrepreneur Should Take VC Money: “Because the venture has a business model that takes a long time (at least a couple of years) to reach positive cash flow and that requires a large infusion of cash due to high capital and personnel budgets during early growth.”
Why an Entrepreneur Shouldn’t Take VC Money: “Entrepreneurs shouldn’t accept VC money just because they can! I have seen too many business models that are very promising that did not NEED VC money fail when they took the money even though they did not need it. They ended up flaming out while trying to grow too fast too quickly, while trying to satisfy the VC’s expectations.”
- Dr. Jeff Cornwall, Director of the Center for Entrepreneurship at Belmont University
Why an Entrepreneur Should Take VC Money: “Quite honestly I do not recommend that entrepreneurs go immediately to the venture community for seed or early stage funding. However, there are some circumstances where raising a large some of capital is required in order to compete in certain industries. There are also times where very large, audacious ideas require raising a substantial amount of capital in order to build the product and the business. Elon Musk’s Tesla Motors is an example. Some renewable energy companies, biotech and telecommunications companies may also require large sums of working capital as well. There are many instances (e.g., software apps) where the cost to build a ‘minimum viable product’ (MVP) is quite inexpensive and, at least at the start, should be done with minimal capital. … While it can bring signaling, hiring and strategy benefits, venture capital comes with it share of risks, dilution and loss of control.”
Why an Entrepreneur Shouldn’t Take VC Money: “Most simply don’t need it. Too many entrepreneurs view raising venture capital as an end in itself. They place too much emphasis on the signaling benefits of raising capital and think short-term rather than long-term about issues of control, dilution and strategic direction of the business. An abundance of capital tends to dull the mind. There is the tendency to hire too fast, pursue too many un-validated ideas, and spend on non-strategic elements of the business. Using one’s own capital first and essentially being capital constrained in the early going is not necessarily a bad thing. There is a natural need to focus more narrowly, develop and test hypothesis, harness resources intelligently before building the product. It is not too different from artists or musicians who do their best work when they have the least resources. Focus is critical in the early stages of company development.”
- Angelo Santinelli, Adjunct Professor of Entrepreneurship at Babson College
Why an Entrepreneur Should Take VC Money: “To scale more quickly and to access expertise that investors can provide in growing the company and getting it ready for an exit event such as a sale or IPO. If you want a small piece of a big pie, go VC.”
Why an Entrepreneur Shouldn’t Take VC Money: ” If you want to remain involved in growing a company you might not want to be subject to an exit event for the investors to harvest their returns. So, if you are more interested in building a company than in the financial returns that come with an exit, try not to take VC investment.
If you are a controlling person and don’t like authority, don’t take VC money, but be willing to live with the lesser investment in growing and scaling the company. However, be sure you have the discipline to do things that will get you cash flow.”
- Terry Blum, Director of Georgia Tech’s Institute for Leadership and Entrepreneurship
“We work primarily with student start-ups. These students, like many entrepreneurs utilize “family, friends and fools” for funding in the earliest stage(s) of their venture. This includes their own funds too. The next step is more likely to be an Angel Investor or sources like a Business Incubator or a Business Competition in their area. Once the concept is proven, it is determined to be a high growth-high tech venture and they have initial funding, then the entrepreneur may be poised to seek VC funding.”
- Julie Messing, Instructor and the Director of the Center for Entrepreneurship and Business Innovation at Kent State University
Why an Entrepreneur Should Take VC Money: “If your company is in a sector where VCs have had proven track records, such as IT or healthcare, VCs could potentially do a lot more for you than the money. They will make introductions to business partners, help you hire key personnel, and help you get more funding down the road. If you have very ambitious growth goals in a niche that is expected to grow exponentially in the near future, you are likely to want VC money to achieve your goal because winners will likely emerge quickly and be VC-funded in that niche.
Also, VCs will trust you the more experience you have had as an entrepreneur and they will treat you better. So if you want to be a serial entrepreneur and be in the game for a long time, at some point you need to take the plunge and establish yourself in the VC world.”
Why an Entrepreneur Shouldn’t Take VC Money: “If your company is too small or young, and/or need too little capital, chances are VCs will either be uninterested, or the terms it offers will be prohibitively dilutive. If you want to grow slowly and retain control of the company for a long time, VC may not be the best match for you and there’s nothing wrong with that at all.”
- Ayako Yasuda, Associate Professor of Management at the University of California, Davis
Why an Entrepreneur Should Take VC Money: “If they want to become an instant national company. But the trouble with that is if they can’t become one, they’ve basically lost their idea because the VCs will kick them out. So there is high risk attached to that, and they are kind of gambling on an all-or-nothing basis. The people outside Silicon Valley didn’t seem to have that gambler’s attitude.
I’ve been keeping a database of billion-dollar entrepreneurs for four years, and I have close to 90 of them. Most of the billion-dollar entrepreneurs in Silicon Valley used venture capital. Most of the billion-dollar entrepreneurs outside of Silicon Valley did not use venture capital.
Silicon valley VCs seem to have found the magic formula. Four percent of venture capitalists earn two-thirds of the IPO profits in the industry, and IPO profits are the highest profits. So about 50 VCs seem to know what they’re doing. The rest of them are all pretenders and living on fees, obviously. The 50 do well because they need home runs. They need the billion-dollar companies. They need the billion-dollar entrepreneurs, and those billion-dollar entrepreneurs exist only in Silicon Valley — the ones that have used venture capital. So it becomes one of those things where if you’re in Silicon valley you can find these billion-dollar entrepreneurs and billion-dollar potential and get a great return. If you’re not in Silicon valley, you know the question of what comes first – the chicken or the egg, in this case it’s well settled I think based on the data I’m seeing. It is not money that creates billion-dollar companies; it’s billion-dollar companies that attract capital. The entrepreneurs seem to have all gone to Silicon valley that can do these kinds of things.
The timing of when they [take VC money], that’s the other interesting part. All of [the billion-dollar entrepreneurs] started within 1-5 years of when an emerging industry started. And this has been true for the last 35 years. This is really the key issue. When an emerging industry starts, you have all kinds of new opportunities and they create new business ideas that can grow. Right now, for the last 12,13 years other than Internet 2.0 — which is the social networking — there haven’t been any major emerging industries that have created any home runs, which is why the VCs are basically sucking wind. If you look at their returns, they have been stinking to high heaven. … They proved that they can’t just create something in the middle of nothing. They need to have an industry to back them up.
Why Silicon Valley? That’s an interesting question because Silicon Valley, Minnesota and Boston were the three big centers of venture capital in the ’70s. By the last decade, Minnesota was nowhere and it is less than 1% right now; it’s miserable. Boston doesn’t seem to have done all that great, although if you talk to people in Boston they’ll give you staggered names. But in the overall scheme of things, I didn’t see too many VC-funded billion-dollar entrepreneurs in Boston. Silicon Valley has them all, and the reason for that is one that should be debated. But I think the key question is can anyone duplicate it, and to me it’s like, OK lets start a new company to duplicate Toyota. It’s not that simple and not that many people can do it. But hey, if you give me billions, what the hell I’ll risk your money and I’ll try it and pay me fees on top of that — which is what the Silicon valley game is. And whose money are they wasting? The pension fund money. And so this becomes a deeper question about how do we get this growth.”
- Dileep Rao, Clinical Professor of Entrepreneurship at Florida International University and a former venture capitalist
Why an Entrepreneur Shouldn’t Take VC Money: “My advice to students and entrepreneurs is don’t bother seeking VC. It’s a West Coast phenomenon with a limited amount of activity around Boston, Austin, and New York.
We just don’t see any VC in the Tampa Bay area. There’s some angel activity, but it’s pretty limited. The “VC” funds we have in Florida tend to operate more as small investment bankers only doing deals in revenue generating companies looking for capital for growth. In the 7 years I’ve been involved in startups in the TB area, I’ve only seen a handful of VC deals in pre-revenue ventures.”
- Sean lux, Assistant Professor at the University of South Florida’s Center for Entrepreneurship
“We’ve lived both sides. We bootstrapped for the first few years. When you need to make payroll – you cut through the BS and need to prove you can get clients to pay you money. It teaches you a toughness and discipline – even a ruthlessness – many early funded companies don’t have. You appreciate raising money is not “success” like a lot of people believe. Building a sustainable, profitable business is success.Now the flip side…
We ended up raising money because it is incredibly difficult to scale aggressively without the necessary resources. It also proves difficult to think long term/strategically about the business when you have short term financial pressures. We also saw competitors with clearly inferior products beating us because we just couldn’t match their speed to market and pr/marketing/sales efforts.”
- Eric Malawer, CEO of DeepMile Networks
“Unfortunately, I think too many founders raise too much money without realizing the implications it will have down the road. The amount you raise can create unnecessary limitations on outcomes and I don’t think founders realize that. True story — my startup Condaptive turned down both seed and A rounds. We wound up selling the company for about $35MM. If we had taken money both of those rounds, we’d have to have sold for more than double that amount to put the same money in the founders’ pockets.”
- Hemang Gadhia, CEO of Condaptive, Inc.
“Statistically, from any one entrepreneur’s reality, VC has a negligible role. One in 400 get funded, and at best, only one of those three embiggens. We keep talking about VC, however, because it’s so closely tied to the mythos of the entrepreneur. The term sheet is the entrepreneur’s sword in the stone. Who is the most worthy to create the next Excalibur app for glory and a G4? The VC and the fund investors are the winners. Every once in a while, they take Arthur with them, but they control the sword. Do the math, on the x of amount funded to the y of number of entrepreneurs, VC skews the normal distribution to the fat tail of big money flowing to a very precious few. When I talk to young entrepreneurs, I tell them to be Jabba. Know you business, and ensure everyone knows you are serious. Surround yourself in experts and trusted lieutenants, and be strong of will to resist all mind tricks.
VC is right for a handful of ideas. I wish I could invent the light saber. I would visit Sand Hill post haste. Sadly, the noise of VC is vastly louder than what 99.9% of entrepreneur should hear.”
- Douglas Clark, CEO of Métier
“I have been on both sides of the table during my career. There are many obvious pluses to raising venture capital. I thought I would share a couple of perhaps lesser known pitfalls:
Warped incentives around exit strategy. This relates to the situation where one or more of the investment funds gets into a ‘swing for the fences’ mode because their portfolio is doing poorly and therefore, even with a good solid exit on your company, they will not achieve returns sufficient to raise another fund. In such a scenario, they have the incentive to push a company that is successfully chugging along to grow in unnatural ways — even when it’s clear to others the characteristics of your business are not likely to be compatible their growth plan. After all, an otherwise attractive exit (one that would make money for the founders and other investors) will be a drop in the bucket for the distressed portfolio. And because the partners in that poorly performing fund are in a position where they will receive no carried interest on the portfolio – absent achieving a moonshot return – they may view themselves as playing with house money.
More sophisticated poker players. With institutional investors (as opposed to individual backers), it can be harder to tell what they are really thinking. There are conversations with their partners and their LPs behind the scenes and wildcards, such as the process they go through to raise a fund from their LPs, that can affect the positions they take. Take, for example, the situation where the company has fallen somewhat short of its plan, needs to raise a follow on round and the existing investors seem to be taking a long time to circle commitments. This could be the result of extended diligence, distraction with other holdings in their portfolio, or any number of legitimate factors. Or it could be because the VC funds are running low on dry powder they have reserved for follow-on rounds and/or the partner on the deal is having a hard time selling his colleagues on re-upping. Or perhaps they have lost confidence in the company and are just trying to turn over additional cards on the chance that a surprising positive development happens. In this last case, what you perceive as fundraising activity might include an element of going through the motions for legal reasons. As a company’s dwindling cash brings it near the ‘zone of insolvency,’ the directors have an obligation to more strongly represent the interests of creditors and this can create liability if they don’t adequately fulfill the obligation. However, as long as there is apparently substantive conversation about raising the round (and therefore some reasonable probability that it will close), they have a defensible position (Note: I’m not a lawyer, so consult an expert on the implications of the zone of insolvency and related actions). I’ve heard of more than one situation where a venture-backed company was promised a cash infusion only to find the cavalry never arrived. This can make the wind-down process quite stressful for the team. Perhaps this is the source of the venture capital riddle: ‘How do you know that a company going out of business was venture backed? There are no skid marks at the edge of the cliff.’
Both of these scenarios illustrate some of the subplots that could be going on behind the scenes, perhaps entirely unbeknownst to the CEO or management team.”
- Chris Bolster, Co-Founder and Managing Partner of PublicRelay
There’s obviously no black or white answer when it comes to how wise it is for small business owners to work with venture capital firms (if there was, this article would have been a lot shorter!). But the prevailing thought seems to be that while VC financing does have its benefits in terms of connections and quick legitimacy, it also has significant drawbacks – such as loss of control and high costs – that outweigh the perks in most cases. Most of the aforementioned experts said they would approach the decision with that mindset if they were to launch a new business today.
Perhaps that’s for the best, considering the current state of the venture capital market. It’s shrinking. In Q1 2011, 49 firms raised $8.1 billion. In Q1 2013, 35 firms raised $4.1. There’s simply less pie to go around these days and a less competitive market to operate in (for start-ups of course, pie futures are optimistic).