Venture Capital: What is the Price of Freedom?

Entrepreneurs love being their own bosses. They want to build a company that fits the mission and vision that got them started in the first place. Following one’s passion is very satisfying and, if done right, can make a founder rich. But building a dream is demanding, with endless hours of work and no vacations.

Perhaps the biggest challenge entrepreneurs face is raising capital. It’s a trade-off between getting crucial funding and maintaining control of the company. So, when it comes to balancing the need for capital with the need to maintain a startup’s direction, the question is: what is the price of freedom?

The Dangers of Venture Capital

Raising capital is one of the most important responsibilities of a CEO. Capital is the oxygen that keeps small businesses alive and helps them grow.

So many startups have been conditioned to think venture capital (VC) is the best source of funding - mainly because historically there were no real alternatives. While VCs have deep pockets, strategic connections and valuable experience growing companies, many of the dangers of raising capital from VCs have not been clearly explained to entrepreneurs. As Basecamp CEO Jason Fried put it: “Venture capital money kills more businesses than it helps.”

These are the key areas where venture deals can often negatively impact a startup’s potential.

Valuation

A company’s valuation is central to its ability to raise money. It’s a complex, though highly imprecise, calculation that usually ends up being a back-of-the-envelope exercise for startup founders, who often use approximations like how competitors or similar companies valued themselves.

On the other side, VCs run models and calculations using company data and external information from databases to arrive at their own valuation. Most of the time, setting a valuation then becomes a negotiation between the entrepreneur and the investor, where companies often have to accept a valuation lower than what they believe they are worth in order to access capital.

Terms

Sometimes the terms are more important to VCs than the valuation, as terms can significantly modify the share price in the investor’s benefit down the road. Terms can include control provisions, such as board seats and rights that protect the investor from adverse conditions like dilution. In a recent webinar with a company I work with called StartEngine, I noted, “a VC has a timeframe, a very concentrated position [of control over the startup], and very often has an oversized say at the board level”.

When startup founders concede on terms, it can come back to bite them. VCs can wield their authority to demote or entirely remove founders from the companies they started! Investors often fire the founders and raise additional capital with terms that bury the founders’ and employees’ common shares and render them almost worthless, in what is known as a recapitalization (or “recap”) event.

This can be a disaster for entrepreneurs, who see their dreams shattered and years of nonstop work go to waste. Former Spinner founder Josh Fesler furnishes a cautionary tale of how he fought to prevent one of his VC-investor board members from ousting him, and ultimately led the company to a $320M acquisition. Harvard Business Review has also discussed the negative impact of VCs removing founders, finding that “almost 40% of all CEOs are gone within three rounds of VC investment.”

Expectations

VCs need their portfolio companies to grow really big, really fast to hopefully generate outsized returns that make up for the large majority of losses in a VC’s portfolio (even top VC firms like Andreessen Horowitz only see about 8% of their investments succeed). That’s why taking VC money immediately puts pressure on startups to achieve an exit scenario.

This means many startups that could be successful with a slow-and-steady approach are forced to grow too fast. Also, many companies that could be happily profitable at a certain valuation and income level are forced to grow to unsustainable levels.

Equity Crowdfunding - Another Alternative

With the advent of equity crowdfunding, there is now a viable alternative to venture capital that offers its own benefits. Equity crowdfunding allows entrepreneurs to raise capital directly from the general public in exchange for debt or equity, usually with perks for investors to incentivize their participation, on platforms like StartEngine.

This means startups can raise substantial amounts of money at a valuation they are comfortable with, without giving up control or having to agree to adverse terms. With greater control of the company, they’re under less pressure to provide returns outside their own timeframe.

They’re also able to amass an army of hundreds, if not thousands, of investors - rather than a few dozen through VC - that will serve as champions for the company’s growth. And, startups can always be raising, to keep themselves continually funded, rather than raising capital in fits and starts.

But, like raising through venture capital, equity crowdfunding has its own share of downsides: 

1. Founders must dedicate a great deal of time and effort to managing their equity crowdfunding efforts.
2. Founders must invest in marketing and advertising their campaigns to attract potential investors - usually about 10% to 15% of the amount raised.
3. Crowdfunding platforms typically charge fees of about 7% of all money raised.
4. There is no guarantee a campaign will be successful, though historically about 70% of campaigns raising on StartEngine’s platform have reached their funding goal.

Combining platform fees with marketing and advertising costs, startups can end up giving back about 20% of the amount they raise via equity crowdfunding - a small price to pay for freedom, in my mind.

Conclusion

Dozens of companies have raised over $1M on StartEngine in industries as wide-ranging as solar energy, travel, apparel, food and beverage, and many more. These companies hail from all over the country (and even several international companies with US-based operations), with founders of diverse backgrounds. In fact, Hacker Noon raised on StartEngine too.

Both venture capital and equity crowdfunding have their pros and cons. But I believe freedom is worth more than the 20% cost of capital often associated with equity crowdfunding. If you agree, you can apply to start raising money on StartEngine today.

This testimonial may not be representative of the experience of other customers. This testimonial is no guarantee of future performance or success. Kevin O'Leary is a paid spokesperson for StartEngine. View the details here: https://www.startengine.com/17b