Every company starts with an idea. But to transform your startup dream into a profitable business, you may need funding to help launch and ultimately grow your organization.
Though most businesses are financed with personal funds and bank loans, financing from venture capitalists remains the most common source of equity funding for startups with high growth potential, such as those in the tech industry. Whereas traditional debt financing requires you to repay a loan through payments and interest, capital from equity funding is acquired in exchange for shares of ownership or convertible notes that start off as debt and are later converted into company shares.
Equity financing is normally raised in stages and can be comprised of multiple rounds before you decide to sell your business or take it public. Within the larger venture capital (VC) industry, individual investors (also known as “angel investors”) and micro-VCs usually participate in early-stage investments (i.e. pre-seed, seed and Series A rounds), followed by mid-stage and late-stage VCs in Series B, C, D and so on rounds.
Now that you know the basics, let’s dive deeper into each stage to see where your business fits in.
Pre-seed funding is the initial stage of equity fundraising. This is the stage when your startup is developing its proof-of-concept or prototype with just a few employees (typically yourself and any other co-founders). Thus, it’s difficult for companies in the pre-market phase to attract small business loans from commercial banks, credit unions and other financial institutions since they lack proven success and/or assets for collateral.
Likewise, unless your company already has a proven track record, most mid- and late-stage venture capital firms won’t participate in funding rounds this early in your company’s lifecycle. Instead, pre-seed money will likely come from your own personal savings or your parents, relatives, friends or even angel investors.
Other sources of funding during this round may come from incubators, which are companies that dedicate small amounts of capital to vetted new businesses and accelerate startup development by providing office space, on-site mentoring and other support services to help them become financially viable.
The National Business Incubation Association (NBIA) estimates that there are over 1,250 business incubators in the United States alone. Y Combinator and Techstars are among some of the most well-known startup accelerators, but a simple Google search should help you find one in your region. You can also find lists of incubators on the NBIA and AngelList websites.
While the investment amounts during this funding stage are usually under $15,000, this capital is critical to getting your business off the ground. You may use pre-seed money to refine your business plan, create your website, build your company’s management team and purchase any other necessities required to kickstart operations. Keep in mind that, once you begin taking capital, you should have a business plan and legal structure in place to protect the legal rights of your startup’s employees and investors.
During this funding round, angel investors and early-stage VCs invest in your startup to help expand the development team and take additional steps towards product/market fit. As defined by Marc Andreessen, general partner at Andreessen Horowitz, product/market fit “means being in a good market with a product that can satisfy that market.”
In other words, seed financing is meant to support business activities focused on building and refining your product. Moreover, seed funding can also be used to hire additional product engineering and design talent, with the remainder allocated towards marketing and outreach activities.
Typically, angel investors will invest under $1 million during the seed stage. Angels are accredited investors with either a minimum personal net worth of $1 million or an annual income of at least $200,000. They’re generally a diverse group who’ve achieved their wealth through various means. Many tend to be former entrepreneurs or executives with previous experience starting and growing successful companies.
Angel investors typically provide smaller financing amounts than venture capital firms, but may still take a hands-on approach to their investments. Like venture capitalists, these investors may actively participate in the management of your company to ensure the profitability and security of their investment.
To find potential angel investors for seed funding, start by visiting online forums, such as AngelList and Gust. These sites provide platforms for startups to post their business ideas and meet investors looking to fund young companies.
Early-Stage (Series A and Series B Rounds)
Following the seed round, startups enter early-stage financing, or what’s commonly known as Series A. The name refers to the class of preferred stock investors receive in exchange for their investments.
During the Series A round, your startup will most likely have achieved or be approaching product/market fit. Investors will also be looking for a growing user/customer base and monetization of your product. The money invested at this stage, which could be upwards of tens of millions of dollars, is primarily focused on continued recruitment of employees—particularly in sales, marketing and customer support—and growing your customer base.
If your business needs more funding, then the equity funding process moves to the Series B round. The additional capital from investors often results in increased market share and revenue. Consequently, this capital is typically used for ramping up business activities, including marketing, product development, talent recruitment, etc.
As your company approaches the break-even point and shows signs of being able to achieve profitability, your chances of attracting additional rounds of funding increase as well.
Liquidity, IPO and Beyond
If your startup survives past the early funding stages, then you may find it necessary to raise larger amounts of capital in Series C, Series D and so forth. This growth stage is where your startup focuses almost exclusively on expanding the business by producing and shipping products, growing the number of paid subscriptions, increasing product inventories and boosting revenue.
Once your business reaches the growth stage, company founders, early employees and investors who own company shares or have stock options may be ready to cash out some or all of their stake. The growth stage is often geared towards a “liquidity event,” typically in the form of an acquisition or initial public offering (IPO), which provides an opportunity for shareholders to trade equity in exchange for cash.
Equity financing at this stage doesn’t necessarily stop at Series D; it can extend into multiple rounds of funding until your company reaches profitability and/or decides to sell or go public with an IPO.
The Equity Funding Process: An Ever-Changing Landscape
Equity funding patterns and investor expectations are likely to shift and evolve as more startups seek to grow into successful, long-term businesses. This is especially true during the pre-seed, seed and Series A funding rounds. If you’re beginning the equity funding process, it’s helpful to keep these factors in mind as you’re negotiating deal terms with early investors.