Venture Capitals vs. Federal Funding: Which is the Best Funding Option for Your Startup?

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As a startup founder, securing funding is one of the biggest challenges you will face. While Angel Investors and Venture Capital firms continue to be a prime choice for tech companies, one that many startups overlook is federal funding opportunities.

Federal grants are non-repayable funds that are given to businesses by the government for research and commercialization purposes.

In the last 10 years, the federal government has increased funding for research and development (R&D) — investing $179.5 billion in FY 2021

Venture capitalists are typically experienced private investors who have a keen eye for identifying promising startups with a high potential for success. They offer more than just funding; they provide access to a network of resources and expertise to help startups grow and achieve their goals. Their investment also serves as validation for your startup’s potential, which can be invaluable when seeking additional funding or partnerships. However, taking money from venture capitalists means giving up a portion of your ownership and decision-making control, which may not be ideal for some founders. The median and average level of VC ownership at the exit was 53% and 50% respectively. In other words, by the time of exit, VC will likely own half your business. (Crunchbase)

In contrast, Federal Funding is more stable and predictable. Companies can receive federal money with no strings attached. When a government awards you a grant, it does not take any ownership in your company, and you don’t have to pay interest rates or return the funds. Federal funding also can provide legitimacy and credibility to your startup, making it easier to attract other investors. However, the process of obtaining federal funding can be lengthy and competitive, and the requirements and regulations can be stringent.

In this article, we will explore the differences between these two funding options to determine which is the best fit for your startup.

Pros and Cons of Venture Capitalists

One of the most significant advantages of working with venture capitalists is access to their network of resources and expertise. They can provide guidance on various aspects of your startup, from product development to marketing and sales. Additionally, venture capitalists can offer connections to potential partners, customers, and other investors, which can be invaluable for startups looking to grow quickly.

Another benefit of working with venture capitalists is the validation they provide. By investing in your startup, they are essentially saying that they believe in your vision and potential for success. This can be a significant boost to your startup’s reputation and make it easier to attract additional investment in the future.

However, there are some drawbacks to working with venture capitalists. The most significant disadvantage is the loss of ownership and control. Venture capitalists typically require a significant equity stake in exchange for their investment. When you bring on VCs, you’re also sharing decision-making power with them, which means they get the right to say how you run your business. This can lead to conflicts around the direction of the company and the allocation of resources.

Historically, VCs and Angel Investors focus on specific industry sectors. From 2010–2021 83% of the VC deals went towards the sectors such as software, internet, telecommunications, and healthcare that comprise. All other industry sectors combine for only 17% of the total funds VC invests in seed and angel stage deals. VCs are also focused on only a few states, with most flowing to California and Massachusetts.

Another potential drawback of working with venture capitalists is the pressure to achieve rapid growth and profitability. Venture capitalists invest in startups with the expectation of a high return on their investment, typically within a few years. This can create a sense of urgency and pressure to achieve growth quickly, which may not always be feasible or sustainable.

Despite recent positive changes in the direction to improve diversity in VC funding, historically underrepresented founders continue to be underfunded by VC firms.

According to the latest Crunchbase data Black startup founders in the United States raised around $264 million out of the total $33.6 billion in venture capital allocated in Q4 2022. That’s an uptick from the $178 million — or 0.43% — the group raised in Q3.

Pros and Cons of Federal Funding

Federal funding can provide a significant amount of money, which can be used to cover research and development costs, hire employees, or purchase equipment. For example, Small Business Innovation Research Program (SBIR) federal funding program is the largest source of non-dilutive capital for US-based small businesses that provides the incentive to profit from its commercialization. Through the SBIR Phases (read more about SBIR Phases) companies are able to raise ~2 million in non-dilutive funding towards R&D and commercialization.

Federal funding does not require repayment or equity. The government takes zero equity in your company. This means that you can retain full ownership and control of your startup, management, and intellectual property which is essential for founders.

Federal funding also can provide stability and legitimacy to your startup. Federal agencies typically award funding based on the potential impact that your startup can have on society, rather than the potential for a financial return. This means that federal funding can be an excellent option for startups working on solutions to social or environmental problems.

Another advantage of Federal funding is that they cover broader technology sectors including manufacturing, defense, energy, and the environment, all key to growing America’s economy. Currently, all 12 federal agencies are participating in the SBIR program and are required to set aside at least 3.2% of their extramural R&D funds for the SBIR program.

Two agencies accounted for more than three-fourths of total SBIR funding in FY2019: the Department of Defense (DOD) ($1.533 billion, 48%) and HHS ($988.0 million, 31%). The next three highest SBIR funding agencies (DOE, NSF, and NASA) together accounted for almost 19%. The remaining agencies accounted for about 2%. See Figure 1.

Figure 1

However, obtaining federal funding can be a challenging and competitive process. The application process can be lengthy and complex which requires technical skills and knowledge to prepare and submit applications. It might take up to 8 months to submit the application and get any results on it. (Read How To Successfully Navigate SBIR Application Process)

Also, the Program’s requirements and regulations can be stringent. Additionally, once you receive federal funding, you will be subject to regular reporting and auditing requirements, which can be time-consuming and costly.

All those factors can make founders not consider applying for federal funding as the right option to go with.

Which Funding Option is the Best for Your Startup?

The best funding option for your startup will depend on your unique circumstances and goals. If you are looking for access to resources, expertise, and connections, venture capitalists may be the right choice for you. However, if you are an early—stage company that needs sustainable cash injection to complete R&D federal funding may be a better fit.

It is essential to consider the long-term implications of each funding option. If you work with venture capitalists, you will need to be prepared to give up a portion of your ownership and control. If you choose the federal funding pathway you will need to put a lot of time and effort to secure the funds.

Ultimately, the best way to determine which funding option is right for your startup is to do your research and weigh the pros and cons carefully. Also, consider getting guidance on the available federal funding opportunities to see if there are actual programs that can be a good fit for you.

How Venture Capitals and Federal Grants Can Work Together

While federal grants and VC funding may seem like competing options, they can work together to support your company’s growth. Startups that have secured federal grants may be more attractive to VCs as they have demonstrated their ability to secure funding and execute research and development projects. Additionally, startups that have secured VC funding may be more attractive to federal grant programs as they have demonstrated their ability to attract private investment.

In fact, some VCs actively seek out startups that have already received federal grants, as this can be a sign of the startup’s potential for success.

Securing funding is a critical step in bringing your innovative ideas to life. Venture capitalists and federal funding are two of the most popular funding options for startups, each with its own advantages and disadvantages. It is essential to weigh the pros and cons carefully and choose the funding option that is the best fit for your unique circumstances and goals.

Regardless of which funding option you choose, it is essential to prepare your startup carefully and develop a compelling pitch that showcases your vision and potential for success.

If you’re an early or growth-stage company looking for SBIR funding, schedule a call with an iFund Lab advisor today to learn more about available grants and eligibility criteria. Send a call request at funding@ifundlab.com