Investment into U.S. venture-backed companies dropped 20% to $6.6 billion in the fourth quarter of 2013 compared to a year earlier, according to Dow Jones VentureSource, and was down 15% to $29.7 billion for all of 2012. As the venture capital industry evolves, the funding landscape for startups has become more challenging. However, some different sources of funding are becoming more accessible to young companies that have endured the pure startup phase and show promise. Along with traditional venture capital funds, corporate investors, private equity firms and hedge funds are providing institutional investment. There are potential advantages and disadvantages to each of these financing sources. We’ve listed some of these advantages and disadvantages below.
Traditional Venture Capital Funds
• Many of these funds, through their experience and connections, can add value to a company that goes well beyond the amount of money invested. In addition to providing strategic guidance, well-known funds can open many doors to potential customers, investors, and other resources.
• These investors will typically want liquidity within a fixed time horizon.
• These investors may be reluctant to assign the higher valuations that some other categories of investors may assign (particularly hedge funds).
• Some of the “lower tier” funds have been unsuccessful; as a result, they are unable to invest in subsequent rounds or provide the non-financial support that has been a hallmark of traditional venture capital funds.
Corporate Venture Capital Investors
Many large corporations have established successful venture capital operations, using their investments to keep up on new developments and emerging talent in their industries.
• As with traditional venture capital funds, corporate investors can add value through their deep industry knowledge and contacts.
• A corporate investor’s name alone may open doors to potential customers and other opportunities.
• Some of these investors do not have fixed time horizons, and unlike traditional venture capital funds they do not have to return funds to their limited partner investors. This can also make them more open to a range of investment structures and more unusual situations.
• Because these investors often sell products in, and invest in, a single industry, there may be conflicts of interest between the investor and the companies in which they invest, or between two or more companies in which they are invested.
Private Equity Funds and Hedge Funds
Having become aware of the high returns that some venture capital funds have earned in the past, a growing number of private equity funds, hedge funds, and similar investors have entered the venture capital game. This is not a new phenomenon, but it is starting to make an impact on startups.
• These investors often use higher valuations when making their investments, yielding higher investment proceeds or less dilution for existing investors than lower valuations would bring.
• These investors may have strong financial contacts which may be useful if the company will go public or seek other non-venture capital financing.
• Some of these investors are comfortable with a “buy and hold” strategy and may have a relatively long investment horizon.
• These investors may be more comfortable holding publicly traded securities than are traditional venture investors, so these investors may retain an investment in a company after a public offering, stabilizing the company’s investor base.
• Some of these investors are not used to investing in emerging companies. When there are setbacks – as there often are at emerging companies – these investors may become unsupportive.
• The higher valuations some of these investors are paying can put increased pressure on a company to rapidly achieve a certain valuation or liquidity event, sometimes at the expense of the company’s long-term development.
Impact on Startups Seeking Funding
A company seeking funding should explore alternatives from multiple sources, and get the advice of multiple advisors before deciding to accept any investment. There isn’t a single type of investor that’s best for every situation. In our experience, the type of investor that’s best for a given company depends on many factors.
With new institutional options, as well as crowdsourcing options emerging due to changes in the regulation of angel investors — including the rise of sites like Kickstarter (the subject of a future article) — startups have more options than before, and more issues to consider. Before deciding to move forward with an investor, you should get as much advice as you can from those with significant experience, and from a wide range of sources, including successful startups, serial entrepreneurs, business advisors and attorneys who have worked through many types of deals.