For any startup, finance is a key issue. Attracting financing is not an easy task due to the high risk factor and the complex process of launching startups. There is also another problem — finding the right way to work with investors interested in your project.
Knowing how investment rounds are divided and what requirements for startups should be met can help greatly. At each stage, money is attracted for clearly defined tasks, but there are also some limits to financing. Why else is funding divided into rounds? Because it gives investors a clear understanding of what stage a particular startup is at and what tasks it is currently solving.
In this article, we will talk about each of the rounds in detail, including its tasks, opportunities, and “pitfalls”.
First, it is good to know what venture capital means. Venture capital is money from private investment funds or companies for the development of startups in their very early stages. A venture capitalist receives an equity stake in the company being funded. Venture fund holders often invest in startups at the idea level, if it looks promising to them, hoping for big profits in the future.
The distinguishing feature of venture capital investments is the high degree of risk. CB Insights has found that “70% of upstart tech companies fail — usually around 20 months after first raising financing (with around $1.3M in total funding closed).” However, the profit from one successful transaction can cover the losses of dozens of failures.
The main task of a venture investor is to find a company that can become the next new Facebook or Amazon in the future. A company that can grow into a large corporation from a small startup, with a $10K stake, can earn the investor $1 million as a result. That’s what makes venture investments the most profitable, but at the same time, the most risky.
As a rule, the period of venture investment is 7-10 years. After that, investors sell their shares in the company on exchanges or to strategic buyers. Most investment funds operate in the homeland of venture capital investments — the United States. About 1000 venture funds operate here, most of them are concentrated in Silicon Valley. The most famous are Andreessen Horowitz, Sequoia Capital, Accel Partners, Google Ventures, to name a few.
To understand how venture investment works, you need to know that each startup goes through certain development levels, with each development level associated with an investment stage. Conventionally, there are several defined stages: pre-seed, seed, Series A, B, and C. We’ll focus on each major stage in more detail below. However, some companies can go on to Series D and Series E funding rounds as well.
The first stage is a pre-seed funding round. In this primary phase, founders invest their own resources to start a business, including funds from FFF (Family, Friends, Fools). This is when the money for your idea comes from your family members, friends, or “fools”. The word “Fools” is used figuratively and refers to people with little or no investment experience. They may not understand the risks associated with such initial funding. Also, founders may look for options to get grant financing or funds from private investors (Business Angels) who have expertise in their industry.
The main tasks of pre-seed funding are to test the hypotheses of a business idea, select an activity vector, and turn the hypothesis into a product. In a typical pre-seed round, the founding team receives a small investment to achieve one or more of the milestones needed before “true” seed investment. At this stage, investors are, more often than not, investing in the team, rather than the product itself. For instance, if you or your co-founders have worked in a large company at a senior level, or already have experience in launching successful startups (not necessarily successful ones, but with good prospects), they will invest in your idea much more willingly. The main questions at this stage are: do I trust this person with my money and do they have a good understanding of the business they are dealing with? It is also possible that the initial product concept will completely alter after the MVP release, with a sharp change in direction at this stage of launching your startup.
According to the WSGR Entrepreneurs Report, the average amount raised for pre-seed loans globally amounted to $0.45 million in the first quarter of 2020. In general, the usual funding amount of pre-seed startups is less than $1 million.
The most common “pre-seed” investors are the founders themselves. The process is also called ‘bootstrapping’ - which means financing a company with your own money, without attracting external investment. Borrowing from friends and family can be another funding resource here. Meanwhile, other options for startups in the preseeding stage include small business loans, crowdfunding, grant financing, and sometimes accelerator programs.
At the pre-seed stage, startups are evaluated according to a kind of checklist, or scoresheet. Let’s take look at the key factors that influence the decision-making process:
Team — Creating a startup is an energy-consuming process. There might be other barriers such as lack of money and constant pressure, but having a good, reliable team will give you a better chance of implementing your idea
Saleable Idea — ‘Selling’ your idea for a new product or business is all about how you present it, justify it and backup your words with solid, dependable business data.
MVP — Minimum Viable Product is something that can be sold and the customer will be satisfied. Read more about MVP in our separate article How to Build a Minimum Viable Product (MVP)
Capacious market — Startups are risky investments and sometimes they fail even after having received the money. This happens if the profit a startup can make is too small
Confirmed demand — The most popular reason why startups do not survive is a product that no one wants or needs. The sooner the team realizes that people are willing to pay for the value provided (or MVP), the better their chances of success are.
The second stage of investing usually stimulates the substantial growth of a startup. At this stage, a startup already has not only a team and a product, but also one or more sales channels. The task of a startup at this stage is to scale the business through these cost-effective channels with the help of new investments. It includes both team expansion and product development, but the main task is to scale the business (quantity of customers, client segments, geography, and so on).
Funds are given not only for marketing, development, or other specific things. Primarily, money is given for scaling. This is when a team multiplies its sales volume, while not increasing the staff, or the costs of the company as a whole. With the help of investments, the global goal is to accelerate the company’s growth, so that it captures the largest possible market share in the shortest possible time.
Typically, a seed funding round produces up to $2 million for the startup in question. Some founders think that their companies only require seed funding for successful growth. Such companies may never participate in a Series A round. The majority of startups raising such investments are valued at somewhere between $3 million and $6 million.
Beyond friends and family, a major source of seed fundraising is an angel investor. Angel investors, also known as business angels, refer to high net worth individuals who invest in startups (usually at a very early stage of their development). They invest their free financial capital, often accompanied by accumulated knowledge, expert opinion, and contacts. Another great source is accelerator programs. Accelerators offer knowledge and contacts to help with business development. Also, some large corporations (e.g. Intel, Google, or FedEx) provide seed funding to promising startups that work on innovative technologies.
Raising this type of funding is one of the major accomplishments of a startup. In the seed round, a product and go-to-market strategy have already been built and developed. At this stage, it is important for investors to be sure that this is not an accidental success, but the result of effective business practice.
To convince an investor, startups should have developed a product prototype, tested the market, and readied investor interests needed for future financing rounds. Such steps require a significant amount of research and planning. In a nutshell, a seed funding presentation should demonstrate the unique value of the product, the startup’s achievements, and the reasons the founders are willing to push their concept further to the market.
There is a team, there is a product with verified sales channels, and there are significant amounts of money flowing into these channels. This is the stage of rapid growth. At this point, you can attract not only money but also expertise and connections, the so-called “smart money”, that can help your startup hit big. Usually, good startups in this phase can already choose who they would like to see on their list of investors. This point is important, since later-stage investors may be reluctant to fund a startup that has “weak” investors on board. In attracting round A investments, companies can raise funds from $500 thousand. The main goals include the organization of mass production or 24/7/365 service work with the recruitment of a full-fledged team. Generally, Series A funding gives a startup several years to develop its products, team, and begin implementation of its go-to-market strategy.
According to the Fundz startup database, just in the U.S., the average amount of Series A investment has grown steadily over the years and is currently at around $15.5 million as of July 2020. It is estimated that around 700-750 Series A deals will take place in 2020. Based on the average Series A startup valuation in 2019, Series A startups have an average pre-cash valuation of $22 million.
While most startups before this stage have generated only passing interest on the part of large investors, Series A funding creates competition between funds. As stated in PitchBook Data, some of the biggest Series A investors in software startups include New Enterprise Associates (NEA), Andreessen Horowitz, Accel Partners, Bessemer Venture Partners, Sequoia Capital, Greycroft Partners, GGV Capital, and many others.
To start with and to set specific goals for your team, you can join an accelerator. For example, if you want to increase revenue five times or to find a channel for attracting new customers. It is about processes that take much longer without accelerators. Accelerator programs offer knowledge and contacts that will help you develop the business, attract investments and give access to a large community of mentors and experts. They will also help you quickly identify and correct mistakes in your business building processes. In addition, having access to an accelerator is a kind of “quality mark” for startups.
To qualify for a Series A funding round, a network of contacts with potential business partners should be well-nurtured. Concentrate on the people that you’ve already built in-depth relationships with. Building lasting business relationships won’t happen overnight, since you must show your business is trustworthy and capable. Ideally, meeting with potential investors takes place as early as possible, to give them an idea of your future business goals.
As you continue to prove that you are trustworthy and the fact that your business is meeting important milestones, you’ll find that it’s easier to attract the investors your business needs. In a nutshell, the following factors may influence the evaluation of a startup’s value at this stage:
proof of project concept;
development progress made with seed capital;
quality of work of project managers;
perceived level of risk.
At this stage, a startup project has already been on the market for some time. A Series B round is needed to further scale the business, increase competitiveness, capture a larger market share. The goal of this stage of startup financing is to become a profitable project. Investment risk is lower, therefore the amount of financing is higher than in Series A.
As stated in Investopedia, the average capital raised in a Series B round is averaging $32 million in 2020. When we talk about a Series B company, it usually needs $2-10 million worth of investments to enter global markets.
A strategic investor is a large company operating in the same or associated, industry, which is interested in acquiring a controlling stake. The list of the top Series B investors includes Google Ventures, Kleiner Perkins Caufield & Byers, Khosla Ventures, New Enterprise Associates, General Catalyst Partners, etc.
Usually, a company should show some great achievements in its Series A round before Series B funding rounds can occur. Here, the value of a startup is estimated based on the following:
comparing company performance with other competitors;
assets (e.g., in terms of intellectual property, etc.).
Regarding this type of funding, venture investors usually participate in financing when a project has proven its sustainability and success in the market. A startup participates in Series C when it plans to take on an even larger market share. It may want to purchase or develop more products/services, (which may include buying a competitor). In round C, a company increases its shares in the business and begins to make substantial profits. It is in this round that a company becomes profitable and capable of independent development without further support.
Further rounds are also possible if there is a growing need for a significant increase in production or the potential to sell a company to a strategic investor. Many companies remain at the Series C stage and only a few of them reach round D, which involves preparing a company for an initial public offering (IPO) or selling to a strategic investor.
The average Series C funding amount in the U.S. has reached $59 million in 2020. Generally, Series C funding is between $30 and $100 million settling on an average round of $50 million. The evaluation of Series C companies is often between $100 million and $120 million. However, companies can be worth much more.
Some of the most common investors in Series C funding are late-stage venture capitalists (VC), Hedge funds and Investment Banks. It can also be private equity firms that invest in startups or businesses through shares or ownership in that company.
Traditional bank loans can be a valuable financing option during this growth phase if you can secure favorable terms. Banks usually provide startup loans with the lowest interest rates. Also, they do not receive company shares. However, be ready for an in-depth application process that requires a strong credit history.
When approaching Series C, the strategy here will likely be different from the previous rounds. As we mentioned, the average funding amount is around $50 million. That means that such startups are usually established and successful companies in their later stages of development. Previous investors may be keen to further invest in Series C, but the remainder will have to be filled by other investors. The assessment at this stage is not based on expectations, but rather on accurate data. Investors estimate how many clients such a company has, what income it has, and what are the current and expected growth rates.
In this article, we have described the main startup funding rounds. Dividing startups by investment rounds gives us an idea of where in the business cycle they are and with what dynamics startups are developing. Not all startups go through each of the rounds and often rounds are combined or intermediate ones allocated.
As you can see, there is no shortage of funding options when it comes to developing a startup. Detailed research is required at each stage of development. Make sure decisions are made according to your company’s specific needs, aligned with your goals as an entrepreneur, and that provide the best chance of future success. Whatever type of financing you choose for yourself, make sure you have a plan for the return of funds invested. Choose what works best for your company.
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