Why Profitable Businesses Seek Venture Capital
While some argue that venture capital (VC) funding is primarily for early-stage companies looking to accelerate into new products, geographies, or hiring, there are other compelling reasons why profitable businesses might seek outside funding. One significant reason lies in the ability to cash out for hard work and preserve business stability through strategic cash management.
Key Reasons for Profitable Companies to Seek Funding
Profitable businesses often choose to raise venture capital (VC) or other forms of external funding from private equity (PE), hedge funds, or other investors. Besides accelerating product development and geographic expansion, one major benefit is that it allows management and founders to partially or fully cash out before an initial public offering (IPO) or other unpredictable situations arise. This is because IPOs have become more challenging due to the Sarbanes-Oxley Act and other market factors. A sale to a private equity firm or through a management buyout (MBO) can provide a liquidation event that rewards management for their hard work and allows them to invest for the future.
Case Study: Founders Selling Shares to an Investor
Consider the case of two founders of a company that has been bootstrapped for seven years. They have managed to pay themselves modest salaries and bonuses while running the company profitably, being diligent in managing their cash flow. To ensure they don't run out of cash in a soft quarter or emergency situation, a venture capital firm, Acme VC, can come in and invest $20 million into the company at a $50 million post-money valuation. This investment includes $15 million for the company's balance sheet, $2 million for each of the founders, and $1 million for other employees or early angel investors.
Now that each founder has $2 million in cash, they can buy a house in a safe neighborhood with good schools. Additionally, they retain 60% of their original stakes, meaning they've retained a substantial portion of their ownership for a profitable company that now has an additional $15 million to invest in growth. This mix of accelerating business growth and allowing management to cash out partially is often seen in management buyouts (MBOs), which are more common in the PE sector.
Other Motivations for Raising Capital
There are various other reasons why a profitable business might raise capital. Some companies might not be cash flow positive and run out of cash from time to time. Others need more money to grow faster, whether to catch up to or keep pace with competitors. Still, others want to raise capital for a rainy day to ensure they are prepared for potential future challenges.
Timing is Everything: Raising When the Market is Fertile
A particularly strategic rationale for raising capital is to do so when the market is robust and valuations are high. For example, companies might choose to raise money now, before a major global crisis like the outbreak of a significant pandemic, a geopolitical upheaval, or a socio-economic event that could cause investment capital to dry up. This timing allows businesses to maximize their funding at peak valuations.
Expanding Into New Markets and Developing New Products
Lastly, raising capital can help businesses in their research and development (RD) efforts and expand into new, growing markets. This can provide significant long-term benefits and growth opportunities. Companies can use the funds to develop new products, explore international markets, or invest in cutting-edge technologies that can give them a competitive edge.
Caveats and Considerations
It's essential to note that raises are often motivated by both good and bad reasons. While external funding can provide the necessary resources for growth and stability, it also comes with its own set of complexities, such as giving up equity and potentially restructuring. Thus, companies and management need to carefully consider all aspects before embarking on a fundraising journey.
Final Notes
This article provides insights into why profitable businesses may choose to raise venture capital, with a focus on key reasons beyond traditional acceleration of growth. The factors discussed include cash flow management, cashouts for founders, market conditions, and strategic growth opportunities. These considerations can help businesses make informed decisions about their fundraising strategy.