Stages of startup financing

Are you ready to raise money?

One of the biggest challenges faced by startups is raising enough money to fund working capital, research and development, and marketing requirements. How do you avoid spinning your wheels?

It helps to understand whether your company is actually ready to raise money. It is worthwhile to ask: is your immediate need really financial? Many startups have more pressing concerns than money: the need for stronger leadership, better product or service ideas, or broader market validation. Your ability to raise capital will be seriously hindered by weaknesses in these areas.

What are the key stages of funding?

Understanding the different stages of funding also helps founders to better anticipate the company’s needs and different potential investment sources. Bear in mind that the demarcation points between these stages can be somewhat arbitrary.

Seed stage

The earliest stage of financing is often referred to as seed capital. Seed capital is the first injection of capital into the company. This usually occurs at the idea stage, before a product or service has been developed. Seed capital is often used to help fund some of the initial research and development, such as the creation of a prototype or beta version of a product. Seed capital is usually provided by the founders, either from the direct investment of cash or through sweat equity (or both). Where the founders do not have sufficient capital to seed a company, they may be able to secure investment from friends, family, and/or angel investors. Raising seed financing has been made easier by investment platforms such as AngelList and non-equity crowdfunding platforms like Kickstarter and Indiegogo. Incubators and accelerators will also often invest at the seed stage. In addition, certain early-stage venture capital funds and other institutional investors may be willing to make investments at the Seed stage. Seed financing is typically accomplished through any of the following instruments (listed from simplest to more complex):

Common Stock: Often sold in “friends & family” financings, where the investors will agree to be on the same equity footing as the founders. Requires the company to set a valuation on the stock, and thus on the company itself.
Convertible Notes or SAFEs: Convertible notes or SAFEs allow the company, subject to certain qualifications, to avoid valuing the company equity at the time of the investment; the investment dollars are paid in to the company, but will only convert to equity on the completion of the next, qualified financing of the company.
Series Seed Preferred Stock: Sometimes used where institutional investors are participating in the seed round. Typically, a simple preferred stock providing for liquidation preference and limited protective provisions.

Series A round

The next stage of financing is sometimes referred to as the A round. At the A round stage, a company will typically have made significant progress in its product or service development and is beginning to engage customers in discussions for the testing or purchase of its products and services. At this stage, expenditures typically still far exceed revenues generated, and profitability may still be several years away. An A round financing for startups is usually provided by angel investors, some venture capitalists, and in some cases, strategic partners, customers and government agencies. Accelerators will sometimes invest at the A round stage. Usually, A rounds will involve the issuance of convertible preferred stock.

Later-stage venture capital financing

As the company matures and its products and services are brought to market, more of its funding will be devoted to the sale and marketing of its products and services. Venture capital funds and government agencies that focus on early stage investment opportunities and strategic partners (particularly larger distribution partners) are the typical sources of capital at this stage. As in the series A round stage, later stage venture capital financing usually involves the issuance of convertible preferred stock.

Expansion capital

The final stage of funding is known as expansion capital. At this stage, the company has a history of sales growth and, if not yet profitable, is on a course to sustainable profitability. If profitable, all of the company’s profits are being reinvested into the company, but additional capital is required to expand the business into new markets or new product lines. Sources of expansion capital include venture capitalists, banks and other commercial lenders, strategic partners, and the public markets through a public offering of shares. Private equity firms may also be interested in companies at this stage, and may be willing to provide founder liquidity as well as growth capital.

Questions? Email us at startups@dentons.com.