Why do profitable companies raise venture capital

Venture capital: horsepower with a catch

Venture capital (VC) is the addictive substance of start-up founders in many ways. Many want it, the common motto is: “More is always better.” If it is used at the wrong time or in the wrong dose, it can end badly for the founding team.

While VC is by no means a new invention, the numbers of the last few years are remarkable: The global VC investment volume grew from 2010 to 2019 from just under 40 to 250 billion euros. While in 2010 the 300 million euro investment in “Better Place” (e-mobility start-up) was still the largest investment round of the year, the biggest deal in 2019 was the 3.2 billion euro investment in the data center operator Tenglong over ten times as big.

Without a doubt, many of the most successful start-ups would not exist without venture capital: Whether SpaceX, AirBnB or Alibaba - all of them relied on venture capitalists in their early days. In 2001, only one of the five most valuable companies was briefly VC-financed (Microsoft); in 2016, all five (Apple, Alphabet, Microsoft, Amazon and Facebook) were.

But does this apply to all start-ups? Is venture capital - and a lot of it - really the only way to successful entrepreneurship, or is it not quite as essential as the marketing of the growing VC industry would like to suggest?

Fast growth as a competitive advantage

The answer to these questions is complex and there are good reasons why most start-ups today choose the VC route: The motto is still “grow fast”. Especially with business models that are easy to copy (such as switching platforms like Uber), rapid growth is an indispensable means of success.

Anyone who, as a "first mover", is not able to book a large market share for himself at the beginning, finds himself with increasingly higher "customer acquisition costs", i.e. the price of a customer acquisition (one of the most frequently used key figures in the start-up world) , faced. As a result, many of these companies are not profitable for several years and therefore often require large sums of external capital, which is difficult to do without a VC.

The situation is similar with many high-tech companies in which years of research and large up-front investments are prerequisites for market entry. And even if the sums required are rarely as astronomical as with Elon Musk's SpaceX, external capital is also an important financial security for founders, which enables many of them to take the risk that comes with a start-up , enter into.

VC brings know-how to the company

In addition to the financial arguments, VC also has other advantages. Investors not only bring money, but also expertise, contacts, mentorship and start-up infrastructure. Venture capitalists were often successful founders themselves and act as mentors and sparring partners to assist in important decisions or to establish the right contacts.
Especially founding teams with the technical, but not business expertise and "first-
Time-Founders ”benefit from their many years of experience. Venture investors (usually called “venture capitalists” or “VCs” for short) see new business models every day and, through their knowledge and network, can help young companies to develop the product in the right direction in order to reach customers. In addition, many venture firms provide free office space, lawyers, and marketing experts.

VC as a status symbol

Last but not least, there is another, less pragmatic reason for venture capital: In Silicon Valley in particular, many founders define their success by the amount of the VC investment. Like the horsepower of cars, the sizes of the financing rounds are compared in discussions and are - in our opinion wrongly - representative of the business and thus personal success of the founders.

A recent example shows that this can turn out to be a miscalculation: The online streaming provider Quibi, which relied on a young audience and the use of smartphones, failed spectacularly after just six months despite 1.5 billion euros in capital. The biotech start-up Theranos and its infamous founder Elizabeth Holmes made it to even more unexpected fame: VC investors only got back just under four million of their 1.2 billion euros when Theranos turned out to be a major fraud, which not only a lot of money, but also destroyed several lives.

Own shares are falling

VC financing has disadvantages not only for financiers themselves, but also for founders. The (repeated) collection of capital leads to “dilution”, the ever-progressing surrender of company shares and the associated loss of control. This may seem small and easily bearable in the first round, but a recently published study shows that, on average, after the second round of financing, investors already have more voting rights than the entrepreneurs themselves. Only 30 to 50 percent of the founders are at the IPO Head of their company and even less in the case of a company acquisition.

Anecdotally, VCs tell us that just under a third of these departures are voluntary. While this loss of control does not have to go hand in hand with a financial or personal failure for the founders, it can be the case: When Zipcar was bought by Avis for 500 million euros, the founding couple only got a few hundred thousand euros.

Controversial point of risk

One of the reasons why the interests of founders and investors are often conflicting is based on the venture capital business model: venture capitalists speculate on making the majority of their profits with a very small proportion of their investments, usually three to five percent. VCs are not interested in generating “average” returns. On the contrary, VCs are willing to take high risk in each of their individual investments in order to multiply their money a hundredfold in one of their deals.
This does not apply to the founders themselves: while a particularly great courage to take risks is viable (and desirable) for the VC fund, as it has many start-up investments, a founder puts everything on one horse.

Bootstrapping in the garage

Not every business model and especially not every founder is forced to scale as quickly as possible. Some successful entrepreneurs recognized this early on: Even Bill Gates "bootstrapped" Microsoft for a long time, ie financed it himself, worked in the garage without pay and made a profit early on in order to reinvest it. It wasn't until late that he only collected a million US dollars and gave up five percent of the company for it. Some successful technology companies such as GoPro and Atlassian have built billion dollar companies with this strategy - without any risk capital. The secrets of their success are business models that are quickly profitable, but above all do not rely on growth above all else and run the company sparingly.

VCs simply bypasses a third financing option, which is particularly popular for established start-ups: institutional investors such as pension funds or large companies (“limited partners”, “LPs”) invest directly in start-ups. In this way, the LPs not only avoid the management fees of the VCs, but in many cases also gain the opportunity to work directly with up-and-coming start-ups in their industry.