Venture capital (VC) firms invested $132.1 billion in private companies last year, a record level by deal value, according to a report from Pitchbook and the National Venture Capital Association.
Each round or "series" of private financing raised is publicized and celebrated as if the company achieved a feat of mammoth proportions. However, if you're one of these companies' founders, venture capital and private equity (PE) are typically more cause for pause than celebration. I have never been the victim of venture capital or private equity--I believe I am a largely unbiased observer. My bias, if any, errs towards entrepreneurs.
Why do you start a company? If it is simply to make money, then using venture capital may be a good idea on rare occasions. Most people I know start a business for the freedom it gets them, for their ability to express themselves and to create. Venture capital carries a few less-than-subtle footnotes that make it deadly if these are part of your goals:
1. The costs are extremely high.
The rate or imputed rate of interest on venture debt, which often complements equity investments, is usually tremendously high--around 20 percent. If venture capitalists were in the consumer lending business, they would be in jail for usury. The cost of the financing is hidden by "preferred stock," which is largely a "heads I win and tails you lose" deal in favor of investors against entrepreneurs.
The venture firm gets the benefit of common stock-- they own a part or percentage of your company-- and an imputed interest rate--a rate of interest on the money on which they lend. They're killing two birds with one stone where you are the bird.
If the company dies or fizzles, the venture firm gets their principal plus their interest, and they get paid first in a liquidation or sale. If the company soars, then they get to convert their stake into common stock and enjoy the benefits of ownership. Founders, who are typically a bit optimistic, don't understand that the magic of compound interest is working against them.
2. To real entrepreneurs who stake everything, VC guys are a complete personality mismatch.
Venture capitalists are well-educated but, most often, they are not entrepreneurs themselves and they don't have nearly the same skin in the game. They are masked with the charm of years of training through their MBAs (I have one too) and calm and reasonable manners. Don't be fooled. Most entrepreneurs, the creators, would not want to be stuck simply going up an elevator with them from the first floor to the second floor.
3. You lose control of your company.
In the most ironic of fates, venture firms, who have the worst interest rates, have been very effective at conning an unknowing public into believing that they represent a win of some sorts. This would be like you celebrating that you just got a mortgage for the house you want to buy. Sure, it is great that you got the house--now you must pay your loan back.
Borrowing money is necessary in cases but borrowing at 20 percent is not a win. Now, suppose, you not only borrowed money at an extraordinarily high interest rate but because you did so, you now could not do with your home what you wanted. This is venture or private equity capital--look at the fine print in the 100-page document you will sign--all my claims here are right there in their own documents.
As an important note, and in the interest of being a little kinder and completely accurate, there is a time to look at PE and venture financing. These conditions are precise and rare. If you cannot get money anywhere else and that money is truly necessary to achieve your business goals (in the case where you have carefully defined the word "necessary"), the venture market might be for you.
Nevertheless, be wary when looking at venture capital. The pitches are disguised in phrases like "would you rather own 10 percent of a billion-dollar company or 100 percent of a 1-million-dollar company?"--a false negative argument.
I have run a tech company--a company in which I was a majority owner, for a good reason. You started a business to have freedom and create things. Don't give it away to a bunch of MBAs who have never created anything or, in many cases, never done a day of real work in their lives. There needs to be more education around capital raising for entrepreneurs, and now is a good time to start.