The Double-Edged Sword of Venture Capital

By: Brian Cashin, Editor-in-Chief

Venture capital is a buzzword in this era of startup culture and of innovations in boosting business growth trajectories, but few associate this term with any of the less favorable implications which it may entail. Venture capital is indeed crucial to broadly facilitating business expansion and sophistication, but the entrance of venture capital into a small business scene can potentially alter the fundamental workings and purpose of fledgling firms. Many of the most successful startups turn down venture capital offers and achieve long-term growth that surpasses that of firms which accept such offers, and some argue that dreams and business ideals are most genuine and most sustainable when venture capital is not involved.

The purpose of venture capital presupposes that the primary aim of a business is expansion and development.While this is usually true, the entrance of venture capital into a small business scenario may entail some heavy-handed implications. One of the unique advantages of a modern day startup company is its direct access to a wealth of informational resources via the internet and a full freedom to pursue its founding purpose, interests, and ideologies unbridled by corporate hierarchies or shareholder restraints. Small startup firms are fairly easy to manage and are highly conducive to retaining central emphases upon creativity and imaginativeness in their business practices, but eventually the need to turn a profit and to meet budgetary demands makes itself felt. The necessity of establishing a robust business presence in the modern world of highly technologically competitive markets endows venture capital with a potency which is more difficult to ignore than it has been in earlier eras, when expensive technologies were not as ubiquitously integral to heightened paces of innovation. [3]

In this way, there exists a sense that venture capital is potentially contradictory to the fundamental spirit of nascent businesses, especially tech startups. The tech startup world is set apart from many other industries of the modern service-oriented U.S. economy by the fact that the creative work of technology startup firms is not necessarily characterized by the money-exchanging distributive work of companies such as financial firms and of many venture capitalists. Typical tech firms actually create altogether new products for public use rather than generate profits from performing intermediary and advisory services. [5] One of the most pronounced criticisms of the detractors of Wall Street-affiliated business fields is that the mere exchange and manipulation of money, while necessary and useful, creates nothing tangible that can persist as a newfound asset to society. Thus, when financial firms like investment banks and hedge funds reap immense profits, it is not readily apparent that such means of profit-making have inherent creativity or substance.

Of course, financial investment professionals are undeniably valuable to society in many ways, but the argument that a venture capitalist can in some instances become a vulture capitalist (an investor who uses monetary might to take control of a firm and then garner undue profits and authoritative decision-making power at the expense of the firm’s founders, inventors, and/or original structure) has been proven over the past several years to be, at least in part, valid (for example, in the case of Zappos being sold to Amazon at the behest of Sequoia Capital in 2010). [4] Critics of venture capital contend that the entrance of venture capital into the financial affairs of a startup firm is the equivalent of tainting the promise and innovation of emerging startup culture with the impropriety of the less-admirable aspects of Wall Street conventions.

Before venture capitalists even enter the fold, the process required to generate and secure investor interest is the first threat to company solvency. Startups are beset with tasks and obstacles which require tremendous effort to overcome, and even minor diversions from the fundamental work of running a business that occur during the early lifetime of a startup can be fatal to the long-run health of the company. Startup founders and inventors who are brilliant within the realm of their company’s field of work may be far less than stellar in promoting their firm to venture capitalists. Consequently, the countless hours of travelling, creating pitch and presentation materials, and scheduling meetings that are entailed by the process of seeking venture capital might cause a previously successful startup to veer toward disaster due to the decreased time commitment of its workers in directly managing company operations. [1] Also, since the time required to build relationships with potential investors could otherwise be spent on building and strengthening a customer base for the business, the venture capital search process might act as a distraction that could cause a company to neglect the very source of its profits which it is seeking to expand.

The enthusiasms, motivations, and expectations of venture capitalists can typically be indifferent, or even alien, to those of the founders of the firms in which they invest. Not surpringly, venture capitalists and startup founders often evaluate the parameters of progress and success quite differently, but in many situations the venture capitalists, by controlling the larger part of the financial footing of the company, prevail when such disagreements about maximizing success arise. One of the most immediate effects of a venture capital deal for the receiving company is the speedy expansion in the scale of the business, a potentially disruptive experience given that the founders of the receiving company may have overseen much more modest, manageable business growth up until that given point in time. This surge in growth, which is necessary to enable venture capitalists to obtain an assured return on their investment, is only successful if revenue rises enough to meet the scale of the growth, an occurrence which does not always take place. In the most unfortunate case, such a flux in the growth of a company as spurred on by the entrance of venture capital into the scenario can actually bring financial ruin to the previoulsy stable firm if the company’s growth extends far beyond what its profits can sustain. [4]

It is often difficut for a small business to meet the expectations of venture capitalists, much less exceed them. The founders of a firm may boot strap funding for their incipient business (i.e. fund their business costs with their own money and/or the operating revenues of the company) and be satisfied with modest gains in profit and the slow down periods in growth which occur, but venture capitalists cannot be successful with the same mild-mannered approach toward building a business. [2] Venture capitalists normally have less of a reason to hold the same level of personal confidence and attachment in regard to an unseasoned firm as do founders and inventors, and the only indisputable confidence builder for a venture capitalist is tangible profit. Startup companies which receive venture capital can only thrive if investor interests and founder interests are balanced such as to allow for long-term profits and sufficient short-term success, but investors will expect, or require, that their advice be followed. This expectation is not contingent upon whether or not the advice is wise, and founders and inventors can be bound to follow the terms of shareholder agreements even when they can foresee that doing so is contrary to their hopes and dreams for the firm. [3] Business relationships can become prickly once venture capital needs to be accounted for, and it can become a mutual nightmare for startup founders and investors alike when neither side of the table can executive the affairs of an emerging company as it sees fit.

Startup success comes in many shapes and sizes by way of any number of strategies and funding structures. Venture capital would not exist if it were never economically successful, and the demonstrations of the failure of venture capital are counterbalanced by testaments to the behemoth success which this mode of funding can, and frequently does, deliver to a firm (like Apple Inc.).

In essence, venture capital is indeed a double-edged sword: whether or not that sword is too sharp for comfort is up to each company to decide for itself.

 

[1] Forrest, Conner. “The dark side of venture capital: Five things startups need to know”. March 10, 2014. Accessed March 14, 2017. http://www.techrepublic.com/article/the-dark-side-of-venture-capital-five-things-startups-need-to-know/

[2] Holley, David. “Starting a Medtech Company? Try Skipping Venture Capital, VCs Say.” February 14, 2017. Accessed March 14, 2017. http://www.xconomy.com/texas/2017/02/14/starting-a-medtech-company-try-skipping-venture-capital-vcs-say/#

[3] Mullins, John. “VC Funding Can Be Bad For Your Start-Up.” August 4, 2014. Accessed March 14, 2017. https://hbr.org/2014/08/vc-funding-can-be-bad-for-your-start-up

 [4] Robinson, Adam. “5 Ways Venture Capital Can Steal Your Dream.”  January 24, 2017. Accessed March 14, 2017. https://www.entrepreneur.com/article/286097

[5] Roose, Kevin. Young Money. (New York: Hachette, 2014), 245-252.

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