Entering the world of entrepreneurship financing can be like visiting a foreign country, full of unfamiliar customs and terminology. This article serves as a guide to demystify the topic and aid you in understanding some of the basics of startup financing. This overview covers a wide range of subjects under the startup financing umbrella; read the related articles to gain a deeper understanding of particular topics.
The article begins with a brief description of the diverse types of financing and investors, then walks through the general startup financing timeline, including seed funding, early and late stage financing, and possible exits. Because the implications of funding can be so far-reaching and complex, this overview concludes by highlighting some important negotiation considerations.
Types of Financing
Startups can be funded either through debt, equity or a combination of the two. However, many of the funding sources utilized by larger companies, such as bank loans, bond issuances, and stock market flotations, are difficult or impossible for startups to access. As the number of young companies has proliferated over the past half-century or so, a financing ecosystem uniquely tailored to the needs of these nascent companies has formed, matching investor risk appetites with startup financing needs.
The most common form of startup financing involves selling an ownership stake in the company in exchange for a capital contribution. These equity investments fall into one of two classifications: common stock or preferred stock. Other financing options routinely used by startups include venture debt financing and bootstrapping.
Each share of common stock represents a proportional share of a company’s ownership. Common stockholders have a subordinate claim to the excess profits of a firm, meaning they are the last to receive payment in the event of bankruptcy. If the company performs well, common stockholders may experience the greatest return, but if the company performs poorly, common stockholders could lose their entire investment. In the context of startup investing, the ownership stake of a company’s founders and employees typically takes the form of common stock.
Like common stock, preferred stock also represents partial ownership in a firm, but it includes additional investor protection. During bankruptcy, preferred stockholders are paid out in full before any liquidation proceeds are given to common stockholders. Preferred stockholders also benefit from favorable dividend provisions. Nearly all venture capital investors (see Types of Investors below) require preferred stock in exchange for their investment. These preferred shares often convert to common stock at the time of a successful exit, such as an acquisition or IPO (see Financing Timeline).
Venture debt firms specialize in loaning money to companies with a higher risk profile than those accepted by commercial lenders. Venture debt loans operate much like traditional loans, with a principal amount to be repaid at the maturation date and a specified amount of interest accruing every fiscal period. Because of the higher risk profile of venture debt clients, the interest rates are often much higher than for those taking out traditional loans. Lending agreements often grant the venture debt firms a small equity stake, called a “kicker,” which enables the lender to participate in the borrower’s potential upside. One common type of financing provided by venture debt firms are bridge loans, which are short term loans that temporarily fund companies until they can secure a different source of financing.
Whether by choice or out of necessity, some founders create companies with very little outside financing in a process known as bootstrapping. Founders employing this strategy initially finance their companies using their personal resources and hard work, often referred to as “sweat equity.” Bootstrapped startups must achieve profitability quickly so that the money generated from the regular business operations can be used to pay expenses and fund growth initiatives. After achieving a certain level of success without external financing, most bootstrapped startups eventually tap into the early-stage venture capital market. With a more proven business model, founders of these companies have an easier time raising funds.
Types of Investors
So-called angel investors are individuals who invest at the earliest stages of a company’s life cycle. Often, these angel investors are successful entrepreneurs themselves who enjoy giving back to the startup community. Angel investors serve as key advisors to young companies as they make strategic decisions. Since angels invest so early in the financing lifecycle, they typically take on much higher levels of risk compared to later-stage investors.
Venture capitalists (VCs) are firms solely dedicated to investing in promising, young companies. VCs often provide the first substantial amounts of capital to startup companies. VCs search for promising companies to which they can provide equity capital in hopes of propelling growth. Venture capitalists are financially motivated—the VC invests, the company grows, and the VC makes a handsome profit when they sell their ownership interest in an IPO or acquisition. Because an investment in an early-stage startup is quite risky, VCs diversify their investments across many startups. Most portfolio companies fail, but a few startups grow enough to offset the losses incurred on the unprofitable investments and still provide an attractive total portfolio return.
Also known as corporate venture firms, strategic investors are established companies whose primary business is not investing. These investors are usually large corporations that hope to expand or protect their core business by investing in smaller firms, often ones with disruptive or complementary products or technology. Some strategic investors eventually acquire their investees, but receiving an equity investment does not guarantee that the corporation will extend an acquisition offer.
Crowdfunding is a relatively new form of raising capital, but one that could substantially change the startup financing landscape in the future. Crowdfunding, related to crowdsourcing, democratizes financing by allowing individuals to invest their personal assets in causes of their choice. Although crowdfunding campaigns through websites like Kickstarter usually provide much smaller amounts of capital compared to the other investing sources discussed in this article, crowdsourcing funds can be enough to help a company develop a proof of concept or start an initial batch of production.
Incubators & Accelerators
Incubators and accelerators are organizations that offer specialized programs that create an environment conducive to a startup’s success. Named after the medical apparatus that provides a safe, controlled environment for babies, incubators provide an affordable and collaborative work setting where entrepreneurs can work side by side for extended periods of time. Incubators take little to no equity in the companies they sponsor because they are funded by outside institutions like universities and governments. Although not technically investors, incubators can still provide invaluable operational and developmental support to a fledgling startup.
Accelerators, meanwhile, provide an intensive development program during the span of a few months, with the goal of preparing startup companies to receive venture capital funding. In exchange for their services, accelerators usually require the opportunity to purchase an equity stake in the companies that participate.
Private equity firms specialize in purchasing, managing, and eventually selling privately-held companies. Late-stage startups often sell their businesses to private equity firms as an alternative to an IPO. In addition to buying entire companies, private equity firms also acquire smaller equity stakes in late-stage companies through an investing strategy known as growth equity. Unlike venture capitalists who invest very early in the financing timeline, private equity investors focus on more established companies that need additional capital to further expand their operations.
Mutual Funds, Hedge Funds, & Other Investors
Mutual funds and hedge funds pool together large sums of money and invest across a wide variety of stocks, bonds, and other assets in hopes of making a large overall return for their investors. Other institutions like sovereign wealth funds, which act as investment vehicles for a nation’s surplus, have also been attracted to the high-return potential of startup financing. These capital providers are more risk-averse than venture capitalists and typically only invest in relatively mature companies.
For more information about the investors discussed in this section, see our Types of Startup Investors article.
Startup to Exit: Timeline of an IPO
The following steps display the traditional financing stages that new ventures pass through as they grow: seed funding, early-stage equity, late-stage equity, and exit. However, each company’s path is unique. How long a company stays in each stage or whether it even passes through each stage varies greatly depending on the startup’s circumstances.
A startup’s initial capital sources are termed seed financing. The name seed denotes both the young status of the company’s operations as well as its potential for growth. Most seed financing occurs before a company has profits, revenues, or even products. Angel investors, family members, and close friends are the primary financial sponsors of companies in this stage. At this phase in a company’s development, investors exhibit higher amounts of risk tolerance. Due to the difficulties of entrepreneurship, the overwhelming majority of seed investments fail. Seed financing often comes in the form of small investments made through informal agreements. Entrepreneurs seeking seed financing primarily hope to secure enough cash to jumpstart the business.
Early-stage Equity: Series A/B
After a company’s operations have grown or its technology has developed into a more marketable product, the startup’s financial needs grow larger than what seed investors can comfortably provide. Venture capitalists specializing in early-stage companies become the primary sources of capital in this phase. The financing process in this stage looks very different from seed fundraising since companies are now working with professional investors. Venture capitalists formalize financing arrangements through extensive legal documentation, assign a concrete valuation to the startup, and offer large investment amounts. The first venture capital investment, or “round,” raised by a company is called Series A, with each subsequent round being named after the next letter of the alphabet. (Series B is the second equity round, then Series C, and so on.)
Late-stage Equity: Series C/D…and Beyond
Investors with a much lower risk appetite become more active in the later stages of the financing process because investors perceive less risk in companies with a track record of growth and success. Late-stage companies attract investments from larger venture capital funds as well as other investors like hedge funds, mutual funds, and private equity firms. Usually only very successful companies will secure late-stage equity rounds while their less successful peers will fail to gain traction with investors. Due to increased valuations, businesses in this phase of the investing timeline can raise much larger amounts of capital while giving up less ownership in the company (see Valuation, Dilution sections below). Late-stage investors receive a much smaller return compared to successful investors in the earlier stages, but they have the added assurance that the investee is more likely to experience an exit in the future.
Exits: IPO or Acquisition
Investors eventually desire to liquidate their holdings to capture the return generated by their investments. Such opportunities are called exits or liquidity events. Sophisticated financiers always enter an investment with a clear exit strategy in mind. For startup investors, the two opportunities for successful exits are through an initial public offering (IPO) or an acquisition.
In an IPO, the company sells shares of its common stock to the public. While there are many benefits to an IPO, stockholders primarily benefit from the liquidity that such an event provides. Any stockholders in the company, including investors, founders, and employees, can eventually sell their shares on the stock market after the IPO. An acquisition offers similar liquidity benefits, but typically requires the existing ownership group to sacrifice all ownership and control in the company when the deal closes. Common acquirers include private equity firms and large corporations.
The amount of capital a company raises in each funding round varies greatly depending on the business’s unique situation. Some important factors that influence the size of an investment include the current market conditions, the ownership interest granted to the investor, as well as the company’s industry, management team, and business model.
Based on conversations with an experienced fund investor, VCs have historically clustered the majority of their investments into similarly-sized amounts based on the company’s development. However, the fund investor also mentioned that since the dot-com bust in the early 2000’s, the venture capital industry has shifted away from this approach. The figures listed below indicate the typical size of an investment at different funding stages prior to the dot-com bubble. Although these numbers are no longer reflective of how much a “typical” startup will receive at any given stage in the financing timeline, they provide important context for founders looking to raise VC investment.
Variation in deal sizes has increased markedly in recent times compared to the numbers listed above. Some companies will still follow the fundraising pattern detailed in the chart, but more and more investors are willing to be flexible on the size of the investment depending on the company’s needs and potential. For example, a biomedical startup called Seven Bridges raised $45 million in its Series A round, while 3D modeling startup SpaceClaim totaled only $5 million in Series D funding.
For more information about the various phases of startup financing, see our article entitled The Stages of Startup Financing.
Although the main elements of each type of financing are relatively standardized, the exact provisions of each agreement must be negotiated on a case by case basis. The discussion below addresses some of the most important aspects of negotiations between investors and founders.
Since the total amount of ownership in a company will always be fixed at 100%, each additional equity financing round provided by new investors decreases how much of the company is owned by the existing shareholders. The term dilution refers to this decrease in an investor’s ownership percentage. Founders naturally want to avoid diluting their equity percentage in the company they created. However, some dilution is necessary to receive startup financing. According to an experienced fund investor, many founders unwisely pass up fantastic opportunities to partner with top-tiered VC firms due to unrealistic expectations about ownership.
Determining how much dilution to accept at each stage of the financing timeline is difficult and founders routinely reach different conclusions based on their startups’ unique circumstances. In general, founders experience the most dilution in the seed and early-stage rounds with later funding having less of an impact on ownership percentages due to increased valuations. The previously mentioned fund investor’s advice to founders confronted with dilution decisions is to carefully study the implications of a proposed agreement and then consult with trusted advisors that have previous startup financing experience. For more information on dilution, please see our article Dilution and Stock Option Pools.
As the name suggests, a valuation is the amount that an individual or investing group believes a company is worth. Although everyone can have a different view on a company’s value, actual investment at a specified valuation level validates the approximate range of a company’s true value. At the end of the day, a company, like any other investment, is only worth what someone is willing to pay for it. Existing investors seek to grow the company valuation as much as possible because their respective equity ownership also appreciates in value.
The more a company’s valuation grows, the more financing the company can secure for the same level of dilution (see below). Suppose two firms want to buy a 25% ownership stake in a startup, but Investor A values the company at $100 million while Investor B values it at only $50 million. The startup would double the amount of capital ($25m v. $12.5m) raised by accepting Investor A’s offer. Valuations are determined based on expectations surrounding the company’s future growth. A more thorough analysis of valuation is addressed in other articles, but founders should familiarize themselves with the basics of corporate valuation and the associated implications for startup companies.
Corporate governance refers to the rules and processes by which a company is directed and involves the board of directors’ supervision of the management team. At formation, strategic decision-making authority for a startup rests entirely with the founding management team. As the company passes through successive rounds of fundraising, more and more invested stakeholders desire management oversight.
Venture capitalists take on significant financial risks given the early nature of their investments and demand certain safeguards as a means of protecting their investments. The venture capital firm leading an early-stage funding round typically negotiates for a seat on the investee’s board of directors as well as special approval rights for important strategic decisions. Some founders are surprised to discover that corporate governance provisions related to financing rounds may restrict their management decision-making liberty.
Investors, employees and founders may experience hardship when large amounts of wealth are tied up in the privately-held stock of the startup. Shares of a startup’s stock, however valuable, cannot be sold easily and converted into cash. The earlier the stockholder gains possession of the shares, the more acute the problem is because the individual must wait longer for the company to experience a liquidity event. Many founders have large sums of wealth that are completely inaccessible for personal expenditures.
In a process referred to as “taking money off the table,” existing shareholders can sometimes liquidate a portion of their holdings by selling shares to investors interested in acquiring a larger stake in the company. In theory, this technique offers a simple solution to the liquidity dilemma, but shareholders often struggle to find interested buyers and negotiate a mutually-acceptable price. In summary, both startup investors and founders should be aware of the challenges inherent in owning large amounts of privately-held stock.
A thorough understanding of the startup financing process will help you make better decisions regarding the future of your company. Each of the topics discussed in this article is an essential part of financing that can have significant impacts on your business. After all, most startups live or die based on their ability to obtain financing.
- Fund of funds are organizations that make investments in other investment organizations instead of investing directly in bonds, stocks, or other securities. For example, a fund of funds may invest its entire portfolio in venture capital funds, hedge funds, or private equity funds. These other funds then make investments in the securities of individual companies and distribute returns to the fund of funds investor.