Venture Capital vs. Other Funding Sources

Starting up a business is an exciting venture, yet one usually requires many financial resources. To many entrepreneurs, how to finance their startup is an important question. Though the popularity of venture capital has grown over the past years, it is not the only available option. This will discuss venture capital in comparison with other sources of funding so that entrepreneurs can make informed decisions on how to finance their businesses.

Understanding Venture Capital

Venture capital refers to a form of financing in private equity that is normally provided by venture capital firms or funds to both new start-ups and small businesses with extraordinary series of growth potential. VC firms invest in such companies in exchange for an equity or ownership stake in the business.

There are various stages involved in the venture capital process:

Seed funding: This initial phase enables the startup to validate the idea and prepare a prototype.
Series A, B, and C funding: Subsequent rounds for providing capital for growth, expansion, and scaling operations.
Exit: This is the last step where the VC firm sells out its stake, generally through an IPO or acquisition.

Not only is venture capital money, but more often than not, venture capitalists also bring in useful expertise, industry connections, and strategic guidance to get the company on the fast track to growth.

Traditional Funding Sources

Before going deeper into the details of venture capital, it would be appropriate to look at some of the traditional funding sources that have been used by entrepreneurs for several decades:

3.1 Bank Loans

Bank loans are perhaps the oldest means of financing a business. They take several forms, including:

Term loans: Lump sum borrowed with a fixed schedule of repayment
Lines of credit: Flexibility in borrowing up to a pre-agreed limit
SBA loans: Government-backed loans with preferential terms for small businesses

Pros of bank loans:

You get to fully own your company
Interest paid is tax-deductible
Predictable repayment schedules

Cons of bank loans:

Need collateral or a personal guarantee
Challenging to raise for start-ups with no track record
Only lend you as much as they think you can repay based on your creditworthiness

3.2 Angel Investors

Angel investors are usually wealthy individuals who in exchange for capital investment, take partial ownership of equity or convertible debt in a start-up business. They tend to invest during the early days of business development.

Pros of angel investors:

Can invest small portions of capital compared to VCs
They usually have industry experience and very useful contacts
Can be more patient than VCs in expecting a return on their investment

Disadvantages of angel investors:
May not have as much capital available to invest as VCs in follow-on rounds
Are generally less structured in their approach than VC firms
May have fewer contacts that can be called upon to bring in other investors

3.3 Crowdfunding

Crowdfunding is a way of raising smaller amounts from a larger number of people, usually using the internet. There are a few variants of crowdfunding:

Rewards-based: the backers receive products or perks in return for their support Equity-based: investors get to have shares in the company. Debt-based: the money is lent by supporters who expect it to be paid back with interest. Pros of Crowdfunding Able to validate interest for your product or service in the market. Can raise funds without giving up equity in rewards-based models Provides marketing exposure. Cons of Crowdfunding Success mostly relies on a compelling story or product to be generated.

Time-consuming with major marketing efforts required
Inadequate capital raised for bigger projects

Comparing Venture Capital to Other Funding Sources

Now that we have covered the various sources of funds, let us compare venture capital against these alternatives along some of the important dimensions:

4.1 Amount of Capital

In most cases, venture capital entails larger sums than their counterparts. Where bank loans and angel investors may be in the thousands or hundreds of thousands, VCs can put down millions or even tens of millions in a single round.

This will, therefore, make venture capital very attractive to high-growth and heavily capital-based start-ups, such as technology companies or biotechnology firms. In the case of small businesses or modest growth plans, though, the large sums offered by VCs might not be necessary or even deleterious if it leads to pressure for unrealistic growth.

4.2 Equity and Control

Probably the biggest difference between venture capital and all the other sources of funds concerns the equity and control issue. In a word, when you take on venture capital, you are selling part of your company. Hence, this will mean less ownership and, probably, less control over your business decisions.

On the other hand, bank loans do not dilute any ownership of your company. You still will have debt to pay, but you won’t have to share any control or future profits. Angel investors usually take smaller equity stakes than VCs and thus present a middle ground between full ownership and huge dilution.

While crowdfunding can preserve your equity with a rewards-based model, equity crowdfunding has the potential to dilute your ownership to some extent; however, it would generally be less than VC funding.