Should you seek investor funding for your startup? Knowing the pros and cons of investors is essential before making this critical decision. Venture capital can provide not only financial resources but also valuable networks and expertise that accelerate growth. However, accepting investor money might not always mean good news.
Below are the tradeoffs and dilemmas that startup founders face when taking on investors. We’ll explore the benefits and complications of working with venture capital (VC) firms—investors who provide capital in exchange for equity. In particular, we’ll explore the most severe risk of all to control-oriented founders: fully losing control of the company at the hands of a VC-dominated board.
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Benefits of VC Funding
According to The Founder’s Dilemmas by Noam Wasserman, the majority of startups eventually bring in VCs, but there are pros and cons of investors having a place on your startup team. A VC’s fundamental objective lies in maximizing returns, not just on your venture but across their entire portfolio of investments. Thus, they’re vested in seeing your startup succeed over the long haul.
Bringing VCs on board doesn’t offer just monetary benefits, writes Wasserman. One vital advantage is that VCs provide access to new networks that can present opportunities for your business. When VCs invest in a company, they typically introduce its founders to their extensive professional connections, including other companies in their portfolio, industry experts, potential clients, and talented job candidates. These introductions often happen through formal networking events hosted by the VC firm, direct personal referrals, or by leveraging the VC’s reputation to open doors that would otherwise remain closed.
Many top-tier VCs also maintain talent recruitment teams dedicated to helping their portfolio companies find key employees. In addition, the VC’s experience can offer invaluable guidance on personnel, operations, marketing, and other non-financial aspects of your business.
(Shortform note: Although Wasserman writes that VC funding can unlock new opportunities, there’s actually a risk to startups in raising too much money. When startups raise excessive capital early on, they typically develop high burn rates (the pace at which a company spends its cash reserves) and become less capital-efficient, making sustainable scaling more difficult. Moreover, companies that secure seed funding at inflated valuations can get saddled with unrealistic performance expectations—and when they don’t meet those lofty expectations, it complicates future fundraising efforts.)
The Risks of VC Funding
Despite the benefits of VC funding, Wasserman writes that taking on VC funding can be risky, especially if you’re a control-oriented founder. One significant concern is the potential loss of control for the founder-CEO. If founders give away equity in their pursuit of funding, that equity translates into voting shares, board seats, and a say in the company’s strategic and operational decisions. Although this exchange aids in company growth and success, it may restrict the founder’s power and affect how they steer the company’s direction.
Furthermore, some VCs may challenge the CEO’s role if they suspect the CEO will become a future barrier to their control or success. Experienced VCs have ideas about how a successful business should run, and if they perceive the existing leadership as a potential hindrance, they may push for a change. Indeed, writes Wasserman, the progression and success of startups often involves the passing of control from the original founder-CEO to the board or an externally recruited CEO. More often than not, these changes are initiated by the board of directors or investors who seek managerial experience and expertise which they find lacking in the founder-CEO.
Reid Hoffman, the author of Blitzscaling, spends part of his time as a venture capitalist. His advice for entrepreneurs corroborates Wasserman’s warnings about VCs taking control and making big changes. Hoffman advises being aware of the incentives venture capitalists have to push the “take huge risks, move fast at all costs” narrative, and how these incentives might conflict with yours as a founder:
- VCs need outsized returns on a few companies to make up most of the returns of their entire portfolio. They’d prefer for each company to go for broke than to be conservative – for a VC, it’s ok for 9 companies to fail if 1 is a blockbuster. In contrast, you only have your one company, and another company’s success is little consolation when yours fails.
- VCs need to deploy large amounts of capital if they raise large funds (e.g., if they raise a $1B fund, they can’t write $1MM checks). For you, raising more capital may not be worth the dilution and liquidation preferences if you can’t effectively deploy the capital.
- VCs raise funds with a limited lifetime (usually 10 years with extensions) and need to get liquidity for their equity in your company during that time (sell stock, IPO, acquisition). They therefore want to push for fast growth and exit sooner. If you prefer a longer time horizon or want to stay private forever, your interests may conflict.
In many cases, VC performs a valuable function when the stars align. In a superb case like Facebook, everyone’s incentives were aligned—the business actually needs capital to grow in a winner-take-all market, the strategy thesis is correct, the business effectively deploys capital, and the company explodes in value.
In the most punishing case of venture capitalism problems, your market doesn’t have huge returns of scale or winner-take-all dynamics, you raised too much capital to burn on strategies that don’t return, and liquidation preferences for investors sap your returns on exit. In an alternate universe, you might have built a more sustainable, meaningfully successful company and pocketed more returns.
| Protect Yourself From Investor Takeovers Business history is rich with stories of founders who find themselves ousted from their own companies, as happened to Elon Musk at PayPal, Travis Kalanik at Uber, and Jack Dorsey at Twitter (now X). Founders can, however, take steps to protect themselves. One protective measure is to maintain a majority of voting shares in your company. If you hold onto more than 50% of the voting shares, it’s much harder for VCs or other investors to force decisions without your approval. In addition, you can make founder seats irrevocable, which guarantees your involvement in the company at some level even if you lose your board majority. Finally, you can implement term limits for board seats, which enables you to replace hostile or uncooperative board members once their terms expire. On the other hand, as Feld and Mendelson write in Venture Deals, venture loans are an alternative to VC funding that can offer greater flexibility for founders concerned about sacrificing equity. They write that the terms of venture loans are often negotiable and can be tailored to suit the specific needs of your business. For instance, you might negotiate a flexible repayment schedule that would let you make smaller repayments in the early stages when your startup is still finding its feet, with larger payments coming due once you’re more established and generating higher revenue. |
Explore the Pros and Cons of Investors in Startups Further
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