How to Fund a Startup – Funding Stages and Financing Options
Each entrepreneur dreams of solving a big problem with their startup, but this always requires funding. Founders can kickstart the development of a product with their personal funds. However, financing requirements will increase as the need to expand the customer base and improve the solution grows. Each owner needs to understand the available types of financing options at each stage of the startup to identify the appropriate type of funding strategy and how to engage with potential investors.
So what are the different startup funding stages? How to identify the right type of investor? What are the financing options for startups? Let’s start with the basics.
What is Bootstrapping a.k.a. Pre-Seed Funding?
The pre seed funding stage usually requires a proof of concept or prototype. Entrepreneurs start by bootstrapping their business idea. Personal savings, credit cards, and a line of credit are often the first option as they enable startup founders to stay focused on product development (and its viability) without having to worry about fundraising.
Once personal finances are exhausted, the startup founder can explore small business loans, borrowing money from friends and family, an equity crowdfunding campaign or even a business incubator.
* A business incubator is an alternative source of help for early-stage entrepreneurs to speed up the development of the business idea. This support includes helping to build out a Minimum Viable Product (MVP) or access to mentorship and potential investors.
What is Seed Funding?
Seed Funding is intended to help a startup grow its idea in the early stages and attract further financing by covering the basic necessities of a business plan, initial operating expenses, cash flow and working capital requirements, product development, and market research.
At this stage, most venture capitalists or banks will not invest large sums of money without a Minimum Viable Product, especially if it is coming from a new unknown startup entrepreneur. Angel investors are the most common type of investors at this stage. Alternatively, some startups find themselves signing up with a startup accelerator.
What is an angel investor?
Angel investors are typically wealthy, experienced, private investors with the network and business experience, a higher risk appetite and the willingness to support an early stage, high potential startup by investing their personal finances in exchange for equity.
In comparison, venture capital firms comprise professional investors whose capital comes from individuals, pension funds, corporations, and foundations. They require more due diligence and do not invest in early-stage companies.
What is a startup accelerator?
Startup accelerators are an alternative seed funding option. Startups enter accelerator programs together with a pool of cohorts for a fixed period. These programs support early-stage, growth-driven startups by compressing an intense, immersive education process, and providing mentorship and financing.
How much funds can be raised with seed funding?
Seed capital raised can range between $10,000 to $2 million, depending on the company’s valuation. However, as there is no proven track record at this point to support the valuation of their business, entrepreneurs can use the below leading cost-effective indicators to gauge product-market fit and demand:
- an expression of interest for your product or idea on a crowdfunding platform;
- releasing an early version of the product to ascertain virality and engagement.
Typically, an early-stage company seeking seed funding is valued between $3 million to $6 million.
What is Series Funding?
Series funding comprises startup funding stages that follow one after another, with funding and the company valuation increasing at each round.
Series A Funding Round
Series A is the first venture capital funding for a startup. Entrepreneurs reach this stage only when they have sufficient traction in terms of revenue, customers, market share, or other key performance indicators (KPIs). The business model should also be developed at this stage, even if it hasn’t been proven yet. Any funds raised at this stage are expected to drive revenue.
How much money can be raised in a Series A funding round?
In a Series A round, companies are usually valued between $10 million to $15 million, which would typically enable the entrepreneur to raise funds of between $2 million to $15 million.
Entrepreneurs have to be prepared with startup financial models as they enter this round to support their company’s valuation.
A few points on Series A:
- Landing the first investor in your Series A is crucial. This first investor anchors and leads the Series A round. Other investors will usually follow once the first commits, but the same happens if the first investor should leave before the round closes.
- Many startups fail here. Even startups successful in their seed round have difficulties securing a Series A round, a.k.a. “Series A crunch.”
- Less than 50% of the startups funded continue onto the next stage of funding.
Series B Funding Round
By now, your startup is up and running. So, how do you cross the $10 million barrier?
A startup is ready for a Series B funding round only when it has identified a product/market fit and needs to expand its operations. Investors will need to know if you can increase the customer base and expand the team with the Series B funding raised. At this point, entrepreneurs can start to hire more team members with specialized skills instead of trying to do everything themselves.
Detailed financial modeling at this stage is not uncommon. So, be prepared with your startup financing model.
How much funds can be raised in a Series B round?
The Series B company valuation needs to be significantly higher, between $30 million to $60 million, for the startup to raise investments of between $7 million to $10 million.
Funding at this stage usually comes from VC firms that are interested in late-stage startups and/or the same investors in the previous round, who often reinvest to prevent dilution of their early investment.
Series C Funding Round
Business is good. Your solution to the problem has done well, and you are now ready to expand your market share, develop new products, and grow through acquisitions. So, are you ready to take it to the next level?
This is usually the last round of funding that a startup does before the entrepreneur moves towards their exit strategy of having an IPO or being acquired.
How much funds can be raised in a Series C round?
Series C companies are often valued above $100 million. Investment raised averages about $25 million and are based on detailed due diligence (financial, tax, HR, operational, and technical) by venture capital firms, private equity firms, banks, or hedge funds.
Historical Financial Statements (usually past three years) and detailed financial projections (for the next three years), together with free cash flow and working capital requirements,
Series D Funding Round
Although most companies finish raising money during the Series C round, sometimes a Series D round is done when:
- An investment boost is needed to increase their valuation before going public.
- Expectations were not met after Series C. As a result, the company is now raising funds based on a lower valuation compared to the earlier round, also known as a “down round.” Although this helps get the startup the investment it needs, it also devalues the perceived value, dilutes the founder’s shares, and erodes trust in the entrepreneur’s ability to deliver.
How much funds can be raised in a Series D round?
As few startups reach this funding stage, the amounts raised and valuations range widely.
What is Mezzanine Financing a.k.a. Bridge Loans?
A hybrid of load and equity financings, this prepares the startup for the final push to an exit. There is no requirement for hard collateral, but the interest rate is often higher than a traditional bank loan. Mezzanine investors usually ask for the right to convert to equity in the event of any loan default.
In an initial public offering (IPO), investment banks commit to raising capital for the company by selling an agreed-upon number of shares at an agreed-upon price. The shares are traded on the stock exchanges. Although IPOs are risky, investors can profit substantially if it goes well.
The End Game
The only difference between the different funding rounds is the level of demand the investors make on the entrepreneur, both at the point of funding and subsequently as an investor. It depends on the level of equity (and control) the entrepreneur is willing to trade for financing. Identifying the right type of funding required for your startup and the appropriate type of investor will also help you plan how to engage with potential investors. The right financing levels will help get your good idea started, keep your business going, and even cash out in the end with an IPO or sale.