The pros & cons of working with professional investors

By: Odysseas Papadimitriou

The continuing maturation of start-ups founded during the Great Recession-era entrepreneurship boom has kept venture capitalists quite busy thus far in 2013.  All together, 577 early-stage companies have received nearly $2 billion in first-time financing from venture capital firms through the first two quarters of the year, according to a joint study from PricewaterhouseCoopers and the National Venture Capital Association.

But despite this flurry of venture capital activity and the impressive amounts of money that entrepreneurs stand to glean from professional investors, one has to wonder if more advantageous funding sources are available.  Professional investors aren’t philanthropists, after all.  Major strings are attached to their open checkbooks, and doing the best thing for your business necessitates carefully evaluating the overall price tag in light of your company’s financial situation, industrial environment, and growth needs.

With that in mind, we’ll explore the pros and cons of working with professional investors below, leveraging insights from leading entrepreneurship experts in the process and ultimately providing a bottom-line recommendation for when it is and is not wise to swim with these sharks of the start-up world. 

Cons

While venture capital is “closely tied to the mythos of the entrepreneur,” Douglas Clark, CEO of the project portfolio management company Métier, told CardHub in a recent interview, “statistically, from any one entrepreneur’s reality, VC has a negligible role.”

Why?  Well, the vast majority of VC money and attention is focused on a very small number of companies that have ideas with truly significant profit potential.  “Who is the most worthy to create the next Excalibur app for glory and a G4?” Clark asks.  Even if your company is the answer, “The VC and the fund investors are the winners,” he says.  “Every once in a while, they take Arthur with them, but they control the sword.”

This analogy cuts to the quick of the professional investor-entrepreneur dynamic.  Professional investors throw money and ideas around, amassing investment stakes like lottery tickets, hoping to cash in on a big payday.  However, accepting their money necessitates following their rules, and that can require big-time sacrifices in terms of control, focus, and ultimate profitability.

The biggest disadvantages of dealing with professional investors can therefore be boiled down to the following:

• Diminished Managerial Control:  Not only can professional investors serve as an impediment to day-to-day efficiency, diverting your attention from company operations to investor management, but they’re also known to follow their own formulas for success, leverage their own industry contacts, and operate on their own timelines.  Such factors can be beneficial in certain situations, but they’re also a recipe for disaster if you’re an independent-minded owner with a particular strategic vision.  That’s one reason why “few founders survive at the top of VC-funded growth firms,” according to Dr. Todd Watkins, director of the Entrepreneurship and Microfinance programs at Lehigh University.

• Long-Term Cost:  Venture capital is widely considered to be the most expensive type of funding available to entrepreneurs, and not just because it requires ceding managerial control.  It also necessitates sacrificing a certain cut of all future profits, which can easily wind up dwarfing the funds reaped in the short-term if your company proves as successful as you and the professional investors in question believe it ultimately can be.  The question you therefore have to ask yourself is whether venture capital is truly a prerequisite for success or a luxury that you needn’t attempt to afford.

“Unfortunately, I think too many founders raise too much money without realizing the implications it will have down the road,” says Hemang Gadhia, CEO of Condaptive, Inc.  “The amount you raise can create unnecessary limitations on outcomes and I don’t think founders realize that. True story — my startup Condaptive turned down both seed and A rounds. We wound up selling the company for about $35MM. If we had taken money both of those rounds, we’d have to have sold for more than double that amount to put the same money in the founders’ pockets.”

Pros

Despite the clear downsides to accepting professional investments in your start-up, there is undoubtedly a reason why entrepreneurship and the world of venture capital are so closely linked.  In short, venture capitalists can provide:

• The Money Needed to Compete:  In certain industries, the monetary barriers to entry are extremely high, and without the necessary financial backing, even the most sophisticated companies are doomed from the start.  In other cases, promising companies have stalled due to a lack of liquidity.  The money that professional investors are able to provide can therefore serve as the oil needed for your company’s engine to operate smoothly.

“We ended up raising money because it is incredibly difficult to scale aggressively without the necessary resources,” says Eric Malawer, CEO of DeepMile Networks.  “It also proves difficult to think long term/strategically about the business when you have short term financial pressures. We also saw competitors with clearly inferior products beating us because we just couldn’t match their speed to market and PR/marketing/sales efforts.”

• Valuable Connections & Experience:  Networking is obviously essential to business success, particularly in the world of entrepreneurship where potential strategic partners and buyers are at a premium.  Well, professional investors basically network for a living and can therefore help connect you with the personnel necessary to maximize your company’s profit potential and ensure that you are getting a piece of the biggest pie possible.

Bottom Line

At the end of the day, the decision of whether or not to work with professional investors boils down to pure need.  If you can’t succeed without the deep pockets of venture capitalists, then you have no choice but to sacrifice control as well as a portion of your ultimate payday.  If you believe that it’s possible to grow your business without the help of professional investors, don’t climb into bed with them for publicity, status, or because you think the opportunity might not re-present itself in the future.  The stakes and the overall price tag are just too high.