From seed to Series E: Understanding funding rounds
Capital is the lifeline of any business from start-ups to established, successful enterprises. But how do they gain access to capital?
Start-ups and pre-initial public offering (IPO) businesses generally raise money through a series of funding rounds. And the amount of money raised and its source is variable. Some businesses need initial and developmental seed capital while others need expansion financing. Or, some might require large, late-stage hedge fund, bank and private office investments.
So, for potential investors and founders looking to understand the entire process better, we’ve put together this guide. It lays out terms used during funding rounds as well as explaining how it all works.
How does funding work?
Finding money to start a business, develop and validate your product or service, generate revenue and fund growth varies at different business stages.
And depending on the funding round, the type of investor will vary, too.
Founders, family, friends or wealthy people often provide the initial capital to start a business and fund its concept and development. But large institutional investors will typically add needed capital later in the business’s life. This is often just before an IPO. That additional capital helps to expand new market growth, finance acquisitions and support the business’s overall value.
In exchange for this funding, investors may receive an ownership stake (i.e. equity) in the venture.
The amount of equity a potential investor might want for its investment usually varies at different funding stages. However, if your capital investment is coming from family and friends, it’s unlikely that they’ll expect an ownership stake in exchange for early investment in a start-up.
Venture capital firms and institutional investors will certainly expect an ownership stake. And it’s comparable to the funding round, the business’s metrics and the investment amount.
As you might expect, the funding amounts in start-ups and early stage businesses are much smaller than the investments in rapidly growing later-stage businesses on the verge of an IPO. However, the valuation of a start-up also changes because investors perform a new valuation at each funding round. Or in other words, their expectations change throughout the stages of a funding cycle.
Risk and return
Founders and friends often firmly believe an idea or business will succeed. They enthusiastically embrace the risk and reward ratio that comes with starting a business and investing seed capital. If anything, it’s exciting!
However, venture capital firms and institutional investors have different views of risk and return. They generally demand rigorous data and metrics to validate a business’s success and justify a potential investment.
So, you can expect any venture that evolves from an idea to a successful, publicly traded corporation to participate in several funding rounds. Most successful start-ups go through at least three funding rounds. Though a start-up with groundbreaking technology or veteran management with a successful track record might leapfrog the typical funding progression.
These are the terms people generally use during the start-up funding cycle:
Some businesses might require an additional round or two after Series C to achieve certain milestones before an IPO. Those additional funding rounds are known as Series D and Series E financing.
We’ll dig into each funding series and what it involves a bit later.
[Related: Choosing your North Star Metric]
Finding your potential investors
How does an entrepreneur find people or businesses willing to invest in a start-up? How does a start-up attract investors for much larger capital amounts later in the business’s life cycle?
Who invests at each stage?
Investors at a start-up’s earliest, pre-seed stage are usually very different from potential investors at a seed or Series A funding. Seed or Series A investors may differ from Series B or C investors.
Founders, friends, family members or single angel investors usually fund start-ups in the pre-seed stage. Some start-ups attempt to raise initial capital through crowdsourcing platforms.
At the seed or Series A funding stage, sophisticated angel investors or venture capital firms typically provide equity funding to promising start-ups. Other venture capital firms, hedge funds, private equity firms and investment banks might invest at the Series B or C stage.
Many venture capital firms will invest in any business with substantial potential. However, other firms focus on particular industry niches or technologies.
The bottomline is that knowing the investors in your space will help you find potential funding sources.
Industry knowledge, research and networking are critical to finding investors at any stage of funding. And leveraging professional contacts both in and out of your industry will lead to finding potential investors. And for the founders and management team, investing time into developing relationships with targeted potential investors could very well lead to funding.
No sophisticated investor writes a cheque at the first meeting. And the deeper the relationship, the fewer meetings and presentations a start-up will likely need to close a particular funding round.
However, for an early start-up, joining an incubator or accelerator can put founders in touch with potential investors already interested in working with promising young businesses. Incubators often mentor start-ups, and those relationships lead to opportunities to pitch potential investors for seed or Series A funding.
What’s more, finding opportunities to present the start-up’s business and product(s) at a demo day or an investor day is another way to land investors.
[Related: How to calculate opportunity cost]
How business valuation works
Valuation is the quantitative process of determining a business’s current or projected fair worth. So before any funding round, analysts working for the business, potential investors, or both, will determine a business’s valuation.
There are two main categories of valuation methods:
Absolute valuation models. This considers intrinsic business fundamentals such as revenue, profit, cash flow, dividends and growth to arrive at a valuation.
Relative valuation models. This compares the business’s metrics to those of similar businesses to reach a valuation.
These often don’t work well in valuing start-ups because start-ups have no financial history or might even be exploring or pioneering a field.
Indeed, pre-seed start-ups typically assign a hypothetical business valuation. But how do start-ups determine value in this case? At this stage, valuation is really what a start-up convinces an investor it’s worth.
At the seed or Series A stage, more data exists for valuation. The start-up has proof of concept and projected market potential. And it might have even made some sales or strategic relationships.
In any event, start-ups can derive valuations at any stage from multiple factors. These include:
Proprietary technology or other barriers to entry
Existing revenue and customers
As a guide, seed stage valuations tend to range from USD2 million to USD10 million.
Start-up funding stages
Let’s explore the stages of start-up funding.
The earliest stage of start-up funding is called ‘pre-seed’. As the term implies, the business is just getting started.
A business’s founders, friends and family members usually provide pre-seed funding. But as we learned before, they often don’t make investments in exchange for equity at this stage because the founders provide the money.
So depending on the nature of the business and initial start-up costs, the duration of this funding stage can vary. Pre-seed funding amounts can range from a few thousand to hundreds of thousands of dollars.
Seed funding is the first official equity funding stage. Seed funding provides financing to complete your product or develop a concept, conduct market research and hire important personnel onto your team.
Start-ups often use seed funding to build a founding management team to complete the projects stated above.
Ideally, the amount raised at this stage will make the start-up profitable. But a more realistic funding goal should be to raise as much money to get to the next ‘fundable’ milestone. This is typically 12 to 18 months down the road.
Potential investors at the seed funding stage include founders (again), angel investors, incubators and venture capital firms. At this stage, investors want equity in exchange for their investment.
The seed funding environment is more dynamic and complex than in the pre-seed environment. Many new venture capital firms, sometimes called ‘super angels’ or ‘micro-venture capitalists’, target very early stage businesses for investment.
And similar to pre-seed funding, the amount of money raised during the seed stage varies widely. It will generally range from a few hundred thousand dollars to USD2 million. However, the amount of seed funding has increased in recent years due to flush venture capital firms and increased investor interest.
Series A funding
The Series A funding stage follows the seed stage. At this stage, the start-up has proof of its concept and should have a sound business model predicting long-term profits.
Investors in the Series A funding stage are usually traditional venture capital firms, although equity crowdfunding recently has been filling a funding gap at this stage.
Many start-ups that obtain seed funding fail to get Series A funding. Only about one in every three startups will go on to Series A and so forth. So, in a Series A raise, it’s not uncommon for a single venture capital firm to be an ‘anchor’ investor.
The thinking goes that once a start-up has secured its first major investor in Series A, other investors will follow.
Business valuation in Series A funding can range in the tens of millions of dollars. Though some ‘unicorns’ might be valued at a much higher level in Series A because of pioneering technology, a rapidly developing customer base, a ‘rock star’ founding team or a combination of the three.
Consider 2021 — the average Series A funding was USD10 million. Businesses typically seek to raise anywhere between USD2 million to USD15 million in Series A funding.
Series B funding
Businesses seeking Series B funding have products and are generating revenue. They’ve achieved enough milestones that their valuations reflect their work. And now they want to elevate their businesses past the initial development stage into the growth stage.
Series B businesses have developed large user or customer bases and have proved to investors that the venture can succeed on a large scale. You can expect businesses with Series B money to hire more talent and fill out product development, quality, sales, advertising and customer support teams.
In 2019, the average Series B business valuation was USD58 million. And the average Series B investment was $32 million per business.
Series B investors could involve many of the same participants as those in Series A, including key anchor investors. But Series B funding often brings other venture investors that specialise in later-stage financing, specifically when a start-up’s prospects are clearer.
However, there is still risk to investors at this stage because a start-up that has exceeded in a smaller market might not succeed in a larger market or a new market.
Series C funding and beyond
A Series C business is already successful — it should have brand or name recognition, an established customer base, strong revenue streams and healthy growth prospects.
However, the business might need another funding round in preparation for an IPO or an acquisition. It also might want to expand into new markets or develop new products.
Although Series C is usually a start-up’s last funding stage, some businesses seek additional funding rounds in a push to complete unfinished goals from Series C funding or to boost valuation before an IPO.
So, because a Series C business has proven its success, it will have a higher valuation. In 2019, the average Series C investment was USD55 million. The average valuation for Series C businesses is USD115 million.
In addition to the Series B funding stage investors, Series C investors could include hedge funds, investment banks, private equity firms, other institutional investors and private family offices.
These late-stage investors typically invest large sums of money in a Series C financing round, sometimes in the hundreds of millions of dollars. And they often expect to at least double their investment.
What investors look for
Investors in start-ups have different expectations at different funding stages.
At the seed stage, potential investors consider the viability of business or product concept, technological innovation and the people behind a new venture. Seed investors might demand large equity stakes at this stage, given the risk inherent in a new venture or the lack of other financing available to the founders.
Series A investors want more than a great idea. They expect proof of concept and a rigorous strategic plan to monetise that great idea. Furthermore, they may consider factors such as any past sales, risk, current growth rate and target market size.
Series B and Series C investors expect a well-established business with a strong customer base and scalability.
In the Series B pitch, investors expect to review management’s detailed plans for using the Series B funds to boost product development and customer teams, expand sales reach, and invest in people and infrastructure needed to satisfy the demands of rapid growth.
Series C investors also expect a successful business with proven metrics. And they’ll typically invest large sums before an IPO or other liquidation event.
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