A startup requires a lot more than just a brilliant concept. It requires a substantial amount of time, discipline, commitment, and, most crucially, funds. A 2016 survey by the British Business Bank reveals that over sixty percent of businesses require external investment rounds in order to establish themselves. The definition of a financing round relates to the rounds of investment through which businesses or startups raise funds. As a business demonstrates an increased likelihood of success with its proof of concept and a growing client base, its valuation will climb over different rounds of funding. However, the valuation varies in each round, depending on many factors. Understanding these aspects will help startups plan their milestones and move accordingly.
In this article, we’ll share important details pertaining to different rounds of fundraising. We’ll share some traits that distinguish each round, and also provide a review of its impact on the startup.
Equity vs Debt
A funding round, also known as series funding or venture round, refers to the efforts made by firms, primarily startups, to expand their business. They do this by taking funds from investors in exchange for equity. In general, getting debt-based financing is hard for startups, due to limited tangible assets. Moreover, it also increases the risk factor because of high leverage ratios. Instead of debt, equity financing is considered more meaningful for startups. Many startups undergo several rounds of fundraising to scale their business. In the process, startups might be propelled to significant valuations, which creates wealth for both investors and the startup.
Startups generally require more capital than their founders can provide for marketing, product development, and scaling the team. In exchange for an investor’s financial contribution, they give up a portion of their equity. This is known as equity financing and signifies that the investor is a co-owner of the company. Unlike a loan, the investor might lose all of their money if the business fails.
Different Rounds of Financing
There are several stages of a company that may require capital injection. In general, each stage is associated with a different funding round, having a designated identity. A basic list of different funding rounds with scale is shared below:
- Pre-Seed Funding: Up to $1 Million
- Seed or angel round of funding: $1 Million To $4 Million
- “A” round or Series A financing: $4 Million To $15 Million
- “B” round or Series B financing: $15 Million To $40 Million
- “C” round or Series C financing: $40Million To $100 Million
It’s important to note that the funding a startup raises may not always fall within the range mentioned above. While this is the most commonly observed range in the market, it may vary according to the needs of a startup, stages of investment or different market factors.
Each designated round gives venture capitalists and other institutional investors information on risk level and growth, with varying valuation for each round. Notably, the majority of investors, particularly private equity investors, prefer convertible preferred stock for the successive stages of startup funding. The key reason an investor would choose convertible preferred stock is due to the hybrid nature of the product, which falls between debt and equity. In addition to dividends, a holder of convertible preferred stock will be paid together with creditors before common shareholders if the firm fails and is liquidated. It is similar to protecting one’s equity investment from risk.
Characteristics of a Financing Round
Before digging deeper into the mechanics of the funding round, let’s identify some of the major players in the various fundraising rounds and their associated interests. Firstly, there are startup founders seeking finance for their ventures. They are primarily concerned with getting startup operations up and going. In addition, the entrepreneur seeks strategic investors who can expedite the company’s growth to the targeted ranks relative to the competitors.
Secondly, there are investors that not only believe in the spirit of entrepreneurship but are also prepared to invest in startups despite the inherent financial risk. The investors also expect that the firm will achieve long-term success and a return on investment commensurate with the amount invested.
For investment, the investor will often receive a portion of the firm’s ownership. If the company expands and generates profits, the investor will receive dividends. In addition to founders and entrepreneurs, business analysts, accountants, attorneys, and investment bankers also play a part in a funding deal. By reviewing the company’s financial records, accountants will confirm the company’s financial health. On the other hand, investment bankers will determine the company’s worth based on a variety of elements, including cash flow and capital, among others.
Attorneys verify that every legal need is met during the transaction. The business analyst will aid investors in doing extensive due diligence and background checks, which might take months. They will also examine the legitimacy of the business plan, pitch deck, and recommended company strategy. This phase determines the amount of capital an investor is willing to commit in a business.
Types of Funding Rounds
To have a better understanding of how different rounds of financing operate, we will examine each allocated round in-depth to see what each stage entails. The details of each funding round is shared below:
Pre-Seed Funding
At this moment, there is no functional prototype, simply a vision. With the founders’ personal funds, the founding team gets in action. It is the early round of investment, and only once the concept gets more structure and a working prototype is developed, the entrepreneur or founding members would often seek for further finance from family and close friends. This round of fundraising can go up to $1 Million.
The money raised will assist the entrepreneur(s) in product development to ensure a commercially viable product.. These funds may also be used for other activities like registering the business, ensuring compliance with other legislative requirements, etc.
In general, in this stage, the entrepreneur has to rely only on his or her own funds as opposed to outside financing. The team is considered to be bootstrapping since they are attempting to build a business using personal funds or the operational income of the new business.
Seed funding or Angel round
Seed capital is the initial money investment from an external source into a startup. This is the first official round of equity financing. At this point, it is usual for angel investors with a risk tolerance to donate modest amounts, often from $1 Million to $4 Million. Seed investment is a vital step that initiates the transformation of a prototype into a revenue-generating business model for a startup.
The “seed” investment may be compared to planting a tree, though. The seed is the product that the angel investor is funding, and the soil is the market. The seed (product) will develop into a tree if the soil (market) has sufficient nutrients (enough initial financing and a good business plan) (Successful brand).
Angel investors are often wealthy and rich individuals with a high net worth, typically retired executives or entrepreneurs. The phrase “Angel investor” originated in the Broadway theatres, when affluent individuals gave money to help with shows.
In essence, these experts have the resources and motivation to deliver market insights and a good business plan for the success of the companies. Angel investors assume the risk of investing in startups for a variety of reasons. Many Angel investors get involved because they have been entrepreneurs before, and want to give back by aiding aspiring entrepreneurs.
In simple terms, they are either intelligent entrepreneurs or company executives who are interested in investing in the next generation of entrepreneurs. Their involvement in startups always played a crucial role in creating the startup ecosystem, and set the stage for future to come.
“A” round or Series A financing
At this level, a proof of concept confirming the viability of the company model has generated both revenues and profits. This is the second equity funding round. It is, however, the first significant round of company funding by private equity companies or venture capitalists. Angel investors made the initial investment in stock. Prior to investment, the value is based on the progress made with seed funding, the quality of the executive team, the market share, and the dangers associated.
In general A-round funding, the firm seeks to expand operations or production in response to rising demand. The investment from private equity or venture capital firms may easily reach from $4 million to $15 million. Obtaining financing at this point is an early indication of the confidence that the startup is moving in the right direction and that the business is worth pursuing. However, substantial investments generate substantial demand.
The startup will have to issue additional shares to investors. The amount of responsibility is increased by the investors’ expectation that milestones would be met. The investor may bring on more personnel in order to safeguard their investment and promote quicker growth. Additionally, angel investors may invest at this level but will have less impact than during the initial investment phase.
Notably, fewer than fifty percent of entrepreneurs from seed stage are able to secure Series A investment from private equity or venture capital firms, as they typically fail to attract investors. Being able to secure Series A funding is significant proof that the startup is poised for growth, and holds huge potential in the future.
“B” round or Series B financing
At this point, the firm is deemed to have graduated from the startup or development phase, and extra capital is intended to propel it to the next level. Companies that have completed seed and Series A fundraising rounds have often already gained a major market share, met the targets specified by investors, and are prepared to scale.
Here, the B series is generally meant to place efforts for scaling discovery, which entails building a strong marketing strategy, recruiting extra quality staff, establishing a solid customer support system, purchasing necessary tools, etc. At this time, the firm is also highly regarded and may attract investments somewhere between $15 Million To $40 Million. The objective of financing in this case is to achieve operational break even, or if possible, generate profits.
The valuation in this round is based on the company’s performance relative to its competitors and the industry as a whole, its revenue projections, and relevant market factors. Usually, Venture Capitalists or Private Equity Investors are involved in these rounds of funding.
“C” round or Series C financing
When it comes to marketing its products in a certain geographical market, the organisation has achieved great success and displayed keen commercial acumen at this point. Companies that have achieved this stage of fundraising have often built a large client base, several income streams, and stable growth.
Existing investors gain confidence that the firm should venture into new markets, produce new products, or even purchase other companies to obtain a competitive edge based on business research and well-crafted business plans. For the firm to reach its aim, the third round of equity financing, Series C capital, is required.
At this time, the company’s valuation is based on actual performance, not projections. Based on the numbers, it may be able to attract funds in the range of $40 – $100 Million. This substantial capital is a result of the company’s demonstrated success with its business plan. In addition, the playing field is less dangerous and there are more investors, such as hedge funds, investment banks, private equity firms, and large secondary market organisations.
Typically, a company’s demand for external equity capital will be limited after Series C rounds, but it will continue to expand globally. Alternatively, many of these firms may use Series C capital to increase their valuation in preparation of an IPO. Additionally, this phase may provide an exit option for investors seeking to liquidate their stake.
However, it’s not necessary for every startup to attain such a lucrative scenario only after Series C funding. Many startups might have to go for many rounds of funding, depending on their requirements, and their ability to find success in the market. The number of rounds might vary depending on the startup’s end goal, market scenario, investor’s expectations, and many other factors.
Every funding round provides a significant advantage to the startup, but there are a few drawbacks too. Let’s have a look at pros and cons of getting funds for a startup:
Merits of fundraising
- In addition to financial resources, venture capitalists support entrepreneurs with mentoring and counsel. This expert advice facilitates improved decision-making, and helps startups stay ahead of the competition.
- A startup benefits from attorneys and accountants employed by investors, who will assist in the company’s rapid growth.
- Typically, venture capitalists and private equity organisations have a well-established network that a company might utilise to accelerate its business.
- In contrast to debt financing, equity financing does not need collateral or monthly payments. It prevents loss of working capital for the startup.
- Capability to attract more capital based on company prospects compared to debt financing.
Demerits of fundraising
- Loss of business control, since every investment involves an equity transaction, which will lead to investor’s influence in crucial decisions.
- Distribute dividends deriving from the successful execution of one’s concept to other investors.
- Finding a qualified investor and completing the necessary documentation might take months, delaying the commencement of expected operations.
- Not appropriate for family-owned enterprises that have no intention of selling shares to raise further financing.
- Potential for conflict when shareholders have different expectations for the firm.
These are a few of the important merits and demerits of fundraising. However, the list isn’t exhaustive. Startups might encounter many new benefits and issues as they go forward in their fundraising journey.
Conclusion
At each point of their entrepreneurial journey, entrepreneurs may expand their firm thanks to the funding available at different stages of the startup. This scaling process enables them to determine where their startup stands right now, and identify investors who would invest in them to aid in their growth. Remember that firms must be developed enough to qualify for a given investment round in order to get money. Entrepreneurs may determine where their startup is based on their progress. Founders can use this frame of reference to understand their own progress and approach investors who are best fit for their startup.
