Financing Foibles: Barriers To Traditional Venture Capital

11/30/2017 09:42 am ET
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From finding a building to obtaining equipment to putting together a productive team, every element of a successful startup requires funding. Unless and until you can find someone to finance you, there’s no way to get your business off the ground. Traditionally, new businesses have relied on venture capital for their early financing. But this funding method doesn't work for many kinds of firms, even when those firms have promising plans for success. Only by recognizing the gaps left by traditional venture capital and finding new methods to fill those gaps can we provide effective funding for all new businesses.

Limit 1: Narrow Expertise

To make profitable investments in startups and small businesses, financiers must learn as much as possible about new companies and the industries they plan to operate in. Considering the sheer number of different types of businesses, it’s not possible for most venture capital firms to consider all businesses in all industries. Instead, they pick one or two industries and learn everything they can about them. They then consider potential ventures only from those specific industries, excluding all others.

While this method allows venture capitalists to pick safer and more promising investments, it makes it harder for new companies to find such capitalists in the first place. Not only do new business owners have to make sure that a venture capital firm serves their industry before they make their pitch, but certain industries have little support from venture capitalists to begin with. If financiers consider an industry to be mature or declining, they often refuse to fund any startups in it. As a result, many businesses that have the potential to be highly profitable never get off the ground.

In order to provide funding to businesses in underserved industries, it’s necessary to move beyond the narrow expertise of venture capital firms. Funding platforms like DropDeck are making this easier by storing and organizing vast amounts of information on each startup. Even if financiers don’t know much about a particular industry, they can look at new businesses’ profiles on the platform and learn all they need to know about whether it will be profitable. And because this information is stored in a blockchain, financiers can be confident that it is accurate, even if they don’t know how to assess it independently. As a result, businesses of all industries will be able to more easily find capital sources that are willing to fund them, even if they are from mature or declining fields.

Limit 2: Pitching & Prejudice

If a company is able to find financiers who serve their industry, the next step in the traditional venture capital process is to convince those capitalists that their specific businesses are worth funding. Often, this involves speaking directly to those who own or control the fund, explaining their business plans and all the specific features that will help them succeed. Venture capitalists can then weigh the merits and risks of the startup and decide whether it is worth funding.

In theory, venture capitalists should make their funding decision solely on the basis of how promising a business venture is. But in practice, many financiers take into account other factors that should have no role in investment, such as:

  • Race- Venture capitalists are not immune to racial and ethnic prejudice, and sometimes favor certain groups whom they associate with business success. In Western societies, this typically means that Asian and white entrepreneurs have an easier time getting funding than black, Latino, and indigenous entrepreneurs.
  • Gender- Financiers often give more funding to businesses that are managed or owned by men than to those where women play a leading role.
  • Region- Venture capitalists frequently favor businesses in locations that they associate more with economic growth. A business in California, for example, might have an easier time getting funding than one in West Virginia, even if they have the same potential.

While prejudice is a deep-seated problem that humanity is still struggling to solve, platforms like DropDeck may be able to limit its influence on startup financing. By connecting entrepreneurs to as many potential financiers as possible, such platforms increase the chance that they will find a patron who judges them based on their business potential, rather than their gender or skin color. The platforms also publish large amounts of detailed, specific information available about each company, and organize that information to emphasize the factors that are most important in determining if a business will succeed. As a result, financiers can be as objective as possible in deciding whether to fund a company, leaving little room for prejudice.

Limit 3: Risk & Uncertainty

Even when entrepreneurs find venture capitalists who are willing to fund them, there is still a risk that the financiers will back out at the last minute. Perhaps they change their minds about the quality of the business, or they were simply being dishonest about their desire to provide funding in the first place. Faced with this risk, many new businesses use their funding cautiously, limiting their potential for early growth.

Platforms like DropDeck minimize this risk by taking contract fulfillment out of the financiers' hands. Through smart contracts, or contracts that are programmed to enforce themselves, the platforms automatically transfer the financier’s money to the startup. Then when the startup generates profits or royalties, the contract gives the financier their rightful portion. As a result, both startups and financiers can be confident that they will receive what they were promised.

Business funding is always changing, with new methods being developed to address the limits of venture capital. By studying DropDeck and other innovative solutions, you can catch a glimpse of the future of financing.

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