Venture capital: what startups should know

Venture capital is a form of private equity financing that investors provide to startups and small businesses with high growth potential. In return, these investors, known as venture capitalists, receive equity ownership in the company.

Venture capital firms adopt a strategic approach by injecting equity into startups, a resource acquired beforehand from institutional investors, family offices, or corporations. By doing so, these institutional investors actively participate in the venture capital fund, a model renowned for its potential for high returns, albeit accompanied by substantial risks.

VCs fund high-risk growth potentials

The primary purpose of venture capital is to fuel growth, innovation, and market expansion. In 2022 alone, global venture capital investments exceeded $500 billion, channeling support into a diverse array of startups, early-stage ventures, and growing companies.

The financial commitment from venture capital can vary widely, ranging from modest amounts, such as €100,000, to substantial sums extending into the hundreds of millions. In exchange for their financial backing, venture capitalists secure company shares, co-determination in decision-making processes, access to critical information, and certain control rights.

Venture capital means: loss of control and dilution

However, it's essential to note that aligning with venture capital often results in founders ceding a considerable degree of control over their own ventures. This relinquishment becomes particularly evident when contemplating significant events like an initial public offering (IPO) or a lucrative exit, where founders may face a higher cost of capital due to an increased company valuation.

Good to know: For large, established companies, equity funding takes place in the form of private equity financing, e.g. by institutional investors – but this is usually not relevant for startups. Since going public is not yet an option for young companies, we will focus on venture capital in the following when we talk about equity financing.

Funding stages in venture capital

Seed Stage

Purpose: Initial capital for idea validation, product development, and team building.

Investors: Founders, friends, family, and angel investors.

Early stage

Series A: Scaling operations after proving the business model.

Series B: Focused on expanding market reach and refining strategies.

Growth Stage

Series C and Beyond: Large-scale funding for market expansion, acquisitions, and scaling operations.

Later Stage

Return of Investment: Preparing a possible IPO or an exit.

Venture capital is the standard for most startups

Receiving funding from venture capital funds or business angels is part of the financing strategy for most startups. Although it is not the only way of financing, for most startups it is the best or even the only possible option, especially at an early stage.

How easy or difficult it is to find investors depends on various factors:

• the business model of the startup plays a role, but also the market in which it operates,
• its competition and
• the economic situation.

While successful startups were free to choose their investors in recent years, it has become much more difficult to raise fresh capital due to the current tense economic situation.

Pros and cons of venture capital

Venture capital is popular for a good reason. Those who find reputable, good fit investors and close an attractive deal with them at a good valuation, have several advantages at hand.

Pros regarding venture capital

• The investors’ expertise, industry knowledge and network have a positive effect on the development of their portfolio startups.
• Venture capital provides a substantial financial injection, allowing startups to scale operations, invest in research and development, expand their team, and penetrate new markets.
• It also helps startups to strengthen their external image: If they can present well-known investors with an excellent track record, they gain trust of potential customers and partners, and it becomes much easier to find good employees.
• VCs are typically experienced in navigating exit strategies, such as M&A or IPO. They provide startups with strategic guidance on the most favorable paths.

Cons regarding venture capital

However, financing through VCs or business angels has downsides, too.

• Many months can pass before a funding round is completed, and startups give away company shares and thus a lot of decision-making power in return for new capital.
• VCs conduct thorough due diligence, exposing all aspects of the business. This scrutiny can be time-consuming and resource-intensive for startups.
• Moreover, with the time, interest conflicts between a startup and its investors can occur. In any case, equity financing comes with a dilution of the company's shares – the more shares that are ceded, the greater the dilution, of course. Thus, it can happen that startup founders hold only 10 to 15 percent of their company's shares at the time of an IPO. The long term financial consequences of giving up many company shares are often underestimated.
• VCs have high expectations and demand accountability, which can lead to increased stress for founders and pressure to meet milestones.

Alternatives to venture capital

Startups have hardly any alternatives to equity financing before generating their first revenues. This changes when the first revenues are earned, because then other financing sources such as alternative debt funding or non-dilutive funding come into play. 

Such modern debt funding solutions give software companies with subscription models easy and fast access to capital by converting their future annual recurring revenue (ARR) in exchange for immediate upfront payments. In addition, debt financing is non-dilutive, which differentiates it from equity financing.

re:cap provides debt when a business needs it

re:cap offers such debt funding, allowing tech companies to convert up to 60 percent of their ARR into capital immediately and continuously. In this way, the method functions similarly to a line of credit, which startups can access whenever they need capital.

In the case of re:cap this means, that companies can draw as many fundings as their business needs. The financing line will be increased based on the growth of their business and therefore adapts over time.

Based on the capital needs and business plan, re:cap can provide software companies with different funding scenarios that help them to get money when they actually need it – without risking unnecessary capital costs due to overfunding.

Alternative financing or venture capital: which is better?

Modern debt funding with re:cap offers several advantages over venture capital.

• Startups do not dilute their shares and thus stay in control of their company.
• Instead of investing time and money into fundraising, reporting and due diligence, they can fully concentrate on growth.
• The time until a next venture capital round is to be concluded can also be extended, so that the equity round can take place on better terms based on the greater growth.
• In addition, SaaS companies can supplement or increase the size of an equity round with re:cap financing and thus save shares.

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So when is venture capital the right choice, and when should startups better rely on a debt alternative?

On the one hand, it depends on the phase the company is in. For those who are still at the very beginning, venture capital is a very good solution.

Debt or venture capital – it depends on the company's stage

However, as soon as they start generating revenues, it’s a different story.

Then the decision depends on what they need the funding for: If funding is to be invested in measures whose outcome and thus ROI is difficult to calculate today, such as the development of entirely new products, venture capital makes sense as growth capital.

If, on the other hand, startups with a SaaS business model and already generating revenues want to invest in measures with a clearly calculable ROI, such as marketing or sales activities, mergers & acquisitions or geographic expansions, re:cap is an attractive alternative. 

Combine both methods for capital diversity

The good thing is that both methods can be combined with each other (and with other forms of financing such as convertible loans too).

Startups, for example, start with venture capital and use it to finance expenses with outcomes that are difficult to plan. As soon as they achieve regular revenues, they supplement their capital with re:cap financing.

They can use it for expenses until the next funding round and always have money available when they need it, since re:cap works like a long-term financing line. re:cap is also suitable for short-term expenses - e.g., when acquiring another company or for urgent investments that accelerate growth (such as sales, marketing, new technologies).

More financing options for startups

Alternative debt funding can be a big win because it offers companies more choice and flexibility in their financial planning and capital stack without dependency on equity financing.

That's a huge advantage, especially in a volatile economic period like the current one. A financing with re:cap helps SaaS companies to act more calmly and to continue to focus fully on their business and growth.