I regularly have conversations with entrepreneurs and shareholders who are thinking about raising capital or selling their company.  Some of these entrepreneurs are very sophisticated business people who understand business and finance. But, I also have conversations with founders who are new to the world of finance and harbor a few misconceptions.

A common misconception is the difference between private equity and venture capital investors. Private equity firms typically make control investments in mature companies with recurring revenue and proven management teams. Some private equity firms will make investments in exchange for less than 50% ownership of a company. But, that is not typical. When a PE firm invests in a company, they typically want to retain the management team. The PE investor may want the founder to continue working in the company for a time. But, often the founder’s motivation for selling is to fund his or her imminent retirement.  So, the selling founder will be free to use the proceeds of the sale as he or she sees fit.

By contrast, a VC firm typically makes a minority investment in a start up or emerging company.   If a VC sees enough upside in the company or its technology, the VC may invest in a company even before the company has revenue.

I occasionally hear founders and their partners talk about VC funding as if they will be cashing out.  This typically is not the case. Unlike a PE firm making a control investment in a mature but growing company, the VC is typically investing in a company that is experiencing a cash crunch. The VC alleviates the company’s cash flow issue by providing “growth capital” in the form of a combo of debt and equity. This growth capital typically must be used by the company to fund growth strategies such as research and development, product commercialization, or hiring necessary personnel. In other words, the VC investment doesn’t represent the ultimate pay day for the founders. The founders may be allowed to take some money off the table. But, the VC will require most of the funds to be applied to future growth initiatives.

VC money is expensive and will come with strings attached. Even though the VC will likely make a minority investment in a target company, it will likely include so many covenants in the debt instruments and other agreements that the VC will lock up effective control over the company. This isn’t an indictment of venture capital investors. But, founders and directors of companies must enter into negotiations with VC firms with their eyes wide open.

If you are considering taking on investors of any kind, give some real thought to whether you really need the capital and the string that inevitably are attached. Short of an outright sale to a private equity firm or corporate buyer, the founder won’t be able to take the money and run. Instead, they will continue working in the company, have their equity diluted, incur debt and be subject to an assortment of covenants and restrictions.   Suddenly, the entrepreneur is no longer working for him or herself, but working for the investors. On more than one occasion, I have seen clients flirt with venture capital investors only to conclude that they would be better off funding growth out of available cash flow.

Taking investor capital is often a prudent decision to fully fund the growth of an emerging company. VC firms may have more to offer than just cash. A good VC partner will also bring industry experience, financial know-how, and a network of customers. Just know what you are getting into when you are dealing with investors.

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