Startup Funding

What is Startup Funding?

Startup funding can be complex as there are many stages. However, it's important to note that many startups require external financing early on to grow, and understanding the funding stages is crucial for both venture capitalists and entrepreneurs. 

This article will focus mostly on equity funding sources from startups to IPO. 

Most companies in their early stages require some kind of external financing. For example, business financing can either come from debt or equity. However, startup financing is a little different and typically comes from equity.

When a startup raises equity capital, that means it is exchanging shares (ownership) for cash that will be used to fund the expansion of the business. The startup's stage and performance will affect the stage of funding the company is at and how effective its fundraising is.

Why is there a focus on equity financing? That is because it's difficult for startups (especially with low or negative EBIT) to get loans or take on significant debt. 

Since their historic finances indicate, there is insufficient pre-interest income to cover interest payments that would arise from a loan. There is the additional risk of not being repaid the principal.

There is, however, an exception for mezzanine financing and bridge loans which we will discuss in the article. 

Mezzanine finance is an option for businesses that need to provide warranties with their debt to attract lenders, while bridge loans also have special conditions that make them great for new ventures.

If you are interested in the venture capital space and want to learn more, don't forget to check out our venture capital course!

Startups and their investors

Startups are businesses in their initial stages of operation or occasionally pre-operation. Their costs are usually quite high relative to their revenue, if there is revenue. Because of these factors, they often seek aid in financing their businesses.

Startups can, however, grow very quickly with the right mix of market conditions, management, and financing, which is why they are of interest to certain investors.

Who would be willing to invest in such companies? After all, many of these businesses are pre-profit, and since shares are purchased privately, your equity stake is illiquid.

Due to the high growth potential of many startups, sophisticated investors (groups and individuals) might consider this asset class lucrative. This is where venture capitalists, angel investors, and early-stage PE firms come in.

Each investor group typically partakes in a different stage(s) of the funding process. The stages of funding consist of 

1. Pre-seed funding 
2. Seed funding
3. Series A, B, C
4. Series D and potentially beyond
5. Mezzanine financing
6. IPO

Startup Funding First Stage: Pre-seed funding

Pre-seed funding (a.k.a. bootstrapping) is the earliest stage of funding for a business. This also occurs at the earliest stages of the business itself.

Although technically considered equity funding, this round of funding may not come with the formal exchange of equity for capital. For this reason, it may not be included when discussing future completed funding rounds.

Sometimes the capital is given as a grant or loan, while other times, it may just be a gesture of goodwill, hoping but not obliging the entrepreneur to pay them back in the future. 

It is possible to exchange equity at this point, but uncommon. Agreements can be informal as they are between friends, family, and entrepreneurs.

Businesses at this stage may range between a $10,000 and $100,000 valuation. Funding is on an as-needed basis.

Companies doing pre-seed funding are just starting their operations. Startups are often doing various activities at this stage, including:

• Developing a business plan
• Market feasibility study
• Technical feasibility study
• Financial feasibility analysis

This stage of funding often does not include institutional capital. Instead, bootstrapping usually requires most of the funds to come from the owners. External funding can also come from friends, family, and supporters of the entrepreneur(s).

Seed funding

Seed funding is the first official round of funding. As a result, the outcomes of seed funding may vary. While some businesses may only need this round to have ample cash to run their business, others may use this as the first of many equity funding rounds.

Companies seeking seed funding can be valued between $100,000 to $6 million. These businesses are often still in their earliest stages and can be pre-operation. 

The business

As in pre-seed funding, this round aims to aid in the various feasibility studies needed to start a business. It may also help create an MVP (minimum viable product) or proof of concept.

At this stage of the business, startups are:

• About to launch their product
• Recruiting key employees
• Developing a product to market
• Seeking funding to keep operations going till revenue starts

This round of funding may seek to raise between $10,000 and $2 million. As the funding requirements can vary widely, the source of the funds may also vary.

Who are the investors?

As with many rounds, this will depend on a few factors. Geography, local demographics, size of the funding goal, minimum investment, and the type of business all play a part in which kind of investors may become attracted or allowed to invest in the business.

In some cases, for more simple types of equity-raising rounds and businesses, with smaller needs, many of the funders might overlap with those in pre-seed funding. Friends, family, supporters, and the owners will use their funds to keep operations going. 

The startup may need to seek accredited investors in more complex financing rounds, with more significant minimum investments, etc. With a strong business plan and market research, startups might consider contacting angel investors or potentially micro VCs.

Typically at this stage, and depending on the business needs, angel investors are the most likely individuals and groups to be interested, as they have larger risk appetites. However, in exchange for their valued capital, they will require a formal equity stake in the business.

Series A funding

Series A funding for many firms will be the first round of institutional financing. Firms in this stage must have moved beyond just an idea and should now have a solid plan to execute and monetize the business.

Since less than 10% of companies receiving seed funding can secure their series A financing goals, this is a crucial step in further growing the business. 

For the greatest chance of success, statistics indicate that joining an accelerator program is the right move at this stage. Accelerators make up about 10% of series A financing rounds, but they can be exclusive. All the more reason to ensure a great business plan is in place.

As mentioned, investors are now looking for more than just an idea. In the pre-seed funding round, the financing may have been used to create an MVP. At this stage, the startup should be able to demonstrate its MVP, or if not, it should be perfecting it.

As of late, business valuations are starting to be positively skewed. This is due to the increased valuations caused by a frenzy of VC deals in recent years. As a result, some companies are achieving unicorn status in their series A.

The business

At this stage, the business needs to start establishing stronger KPIs.

1. Revenue figures
2. Client base size
3. Client base satisfaction rates
4. And more

Specifically, entrepreneurs need to consider how they will make money and grow the business.

In terms of making money, entrepreneurs should consider how they will start to monetize their product or service at this stage. Furthermore, they need to establish a long-term business plan which outlines how the business will maintain profitability.

In terms of scaling the business, there are two key aspects or strategies to consider:

1. Should the business focus on its current market, and how can it capture more of this market?
2. Should the business consider expanding into new markets? Which markets can it expand into, and how can it expand?

At this stage of funding, the business should focus on the following:

• Revising the business model
• Creating and retaining a team for the venture
• Raise enough to cover financial losses caused by the startup phase
• Further product/service development
• Plan or initiation of scaling the venture
• Operation optimization

These firms raise between $2-15 million to meet their needs, but this has also started to skew recently. Increased valuations and "mega" financing rounds are changing the VC landscape, but the range we mention is most likely what would be observed in this financing round. 

However, the average firm as of mid-2022 is valued at $23 million, and the typical valuation range is between $10-30 million.

Who are the investors?

The investors of series A funding rounds are looking for ideas that have an execution plan or have even begun executing their business plan. If there is proof that the concept can be monetized, the venture becomes an even stronger candidate for funding.

Some angel investors still consider investing at this stage, but series A funding is largely dominated by well-known venture capital funds such as:

• Tiger Global
• Sequoia Capital
• IDG Capital
• Index Ventures
• GV (formerly Google Ventures)

At this stage, it is very helpful to gain a large firm's funding initially. Although not necessary, many entrepreneurs find it easier to raise capital when mentioning a larger VC fund has already invested in their series A. This firm is called the "anchor" firm.

As mentioned, series A funding can be quite difficult, as investors are not looking at a company with a long track record yet. Firms having trouble raising capital might consider equity crowdfunding from a company such as Equivesto.

Crowdfunding options open the table to a larger variety of investors, including those who are not accredited, investors. These exempt market dealers allow regular investors to participate in funding rounds as early as series A funding.

Series B funding

Series B funding is similar to series A in many respects. Many of the same tips also apply to entrepreneurs. However, there are still a few key differences.

The Business

The business will be at a different stage than in its A round. In this equity funding round, the venture should be past the development stage and looking at ways to grow the business. 

The business needs to cover the costs of the following:

• Business development
• Increasing sales volumes
• Improve, develop, and implement marketing plans
• Improving technology
• Acquiring more new talent

These businesses are typically valued at $30 - $60 million. The median valuation sits at about $40 million.

This round of funding seeks to raise about $30 million, but the mean and media are fairly far apart for similar reasons as series A. The median amount raised as of late is $26 million, and the mean is around $33 million.

Who are the investors?

The investors in this round of funding are quite similar to those in the A round, although you will rarely encounter angel investors at this stage. Typically the process for acquiring investors is also quite similar.

In this stage, you will come across mostly VC firms, and one anchor firm will often be used to help further the fundraising goal. There will, however, be the addition of some late-stage VCs at this point.

Late-stage VC funds are looking to analyze what has happened to the business between series A and now. In addition, they want to see what the venture has accomplished, which can help analyze the business prospects.

Series C funding

This is the final funding stage for many firms before other options, such as IPO, are considered. The reason is that this funding stage can be anywhere from tens to hundreds of millions, and the businesses are somewhat established now.

The Business

As mentioned, businesses at this stage are somewhat established in their market. This often follows a period of great success for the venture, and there is now an established track record for the KPIs.

Businesses are seeking funding for the following reasons:

• Expand the line of product and/or service offerings
• Expand into new markets
• Funding may be used to acquire another firm

At this stage, the business is seeking funds to grow what is already a successful business. There are a few good uses of funds, including the above, but here's why they would take these actions.

There may be an opportunity for vertical or horizontal acquisition to improve market presence, pricing control, develop synergies, or increase revenue. For example, perhaps starting another venture in a new market via strategic alliance, joint venture, or M&A activity.

If there is a business that could develop major synergies with the venture, this could increase future valuation significantly. Or if there is a major competitor, then acquisition can be a great way to improve the firm's market share.

The point is that the business is earning revenue at this round. As a result, the firm is seeking a series C with the primary concern of pumping capital into the business to accelerate growth.

Most companies in this funding stage can be valued at up to $120 million, but the more established and successful the firm has been in the past can vastly change the upper limit of its valuation. As a result, the median valuation was around $68 million as of early 2022.

Funding at this stage can also depend on the success of the company. The mean and median funding as of early 2022 is about $59 million and $53 million, respectively.

Who are the investors?

This is where the interest opens up significantly regarding the variety of potential investors. 

Investors could include:

• Hedge funds
• Private equity firms
• Investment banks
• Other large secondary market investors

As the firm has now progressed into being a significant corporation at this stage and has seen a significant amount of success up until this stage, it warrants consideration by these larger firms. 

Since there is an established track record and some fundamentals to analyze, these firms are now more comfortable deploying their valuable capital into this corporation in exchange for an equity stake.

Series D funding and beyond

A venture would not often seek D or beyond in funding rounds. However, some corporations still consider and execute rounds D, E, and even F rounds of funding from time to time.

Potential reasons for this may include investment opportunities and not meeting full funding needs in round C.

Regarding investment opportunities, those with equity stakes will want to ensure the company receives the best valuation at IPO. If there is a good investment opportunity (i.e., an acquisition, investment in tech, etc.), then this may be a cause to do some late-stage raising of funds.

If those funds can accelerate the business's growth fast enough, it can help create a stronger track record before going public.

Conversely, a venture may not have received the funding it hoped for in the C round. For this reason, and partially the previous, the owners may seek to raise capital to strengthen the company before exiting.

This benefits the current shareholders by strengthening the business and satisfying the potential market demand for more business shares.

The main takeaway is that a company may continue with several rounds of funding after the C round, as needed, to strengthen the company.

Mezzanine financing and bridge loans

This is one of the latest stages of financing before an IPO. Mezzanine financing typically involves a combination of debt and equity, such as convertibles being offered to strengthen the company further.

An example of how this would function is if a company fails to make its interest payments (defaults) and is forced into bankruptcy, the debtholders will be able to take ownership of the company by converting the debt they hold into equity.

The debt comes with what is known as warrants, and this feature increases the value of the debt securities attached. Because of this feature and the increased security value, the company can seek more favorable terms on its rates and other terms of debt.

On the other hand, bridge loans are short-term loans used by the company to make short-term investments close to IPO. The loans and interest will be paid back with the proceeds of the IPO.

Funds are used for similar purposes as in the C round, improving market share, expanding into new markets, etc. 

At this stage, funding is most commonly sourced from PE firms, but some firms with relationships to the company might also provide mezzanine finance or bridge loans.

IPO

This is the final stage of funding for the corporation, where it goes from private to public. Then, finally, the IPO (initial public offering) is where shares are offered to the public for the first time on a public exchange. But there are a few keys here. 

With regards to the early funders, many will take this opportunity to exit the company. As it is outside the scope of many VC and PE firms to trade in public securities, the IPO is the perfect opportunity to harvest the capital gains from their investment. 

The corporation itself will have to be prepared for all the compliance requirements for its IPO. They will also have to prepare to be audited regularly and prepare financial records and pro forma statements for investors indefinitely.

There is also virtually no limit to seeking further funding at this stage. Although the IPO or unseasoned offering is a special time for the organization, outside of regulations and the board of directors, there is little in the way of issuing further equity in exchange for capital.

Many corporations at this stage are profitable and have some performance record, opening the door for retail investors, asset managers with either client or corporate portfolios, and portfolio managers to become involved in the company.

At this stage, controlling capital structure also becomes easier for some corporations to control as public markets are a great place to issue either additional debt or equity securities.

Researched and authored by Brandon Fausto | LinkedIn

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