The Stages of Startup Financing

Long before completing an initial public offering (IPO), your startup company will likely need access to capital to grow its operations. The financing choices that you make along the journey from a fledgling startup to an IPO-ready company will have profound effects on ownership interests, strategic operations, and corporate governance. This article highlights the financing alternatives that your company will have at different stages of its development, beginning with an overview of the four phases of external financing.

Stages for Raising Outside Equity Investment

New ventures seeking external financing generally pass through four broad stages as they grow: Seed Funding, Early-Stage Equity Rounds, Late-Stage Equity Rounds, and Public Offering or Financial Sponsor-backed Exit. It is important to note that not all startups follow such a clear-cut pattern; each company’s financing path is unique and influenced by many factors including the prevailing macroeconomic conditions and the startup’s industry, strategy, leadership, network, and location. How long a company stays in each stage or whether it even passes through each stage varies greatly depending on the startup’s circumstances.

Seed Funding

A startup’s initial capital sources are categorized as 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 as founders are still formulating the business model and before the company has profits, revenues, or sometimes even functioning products. Entrepreneurs seeking seed financing primarily hope to secure enough cash to jumpstart the business. Some startups decide to supplement or replace seed financing by participating in accelerator or incubator programs. See our Types of Startup Investors article for more information about accelerators and incubators.

Since personal acquaintances can rarely support a startup’s financial needs, founders turn to wealthy individuals called angel investors for much larger amounts of capital. At this phase in a company’s development, investors assume high amounts of risk due to the uncertainty associated with the startup’s business operations. Instead of focusing on historical and short-term forecasted financial performance, seed investors invest based on their opinion of the startup’s potential. In making these early investments, angel investors take on more risk than any investors in later financing stages as most seed investments fail, despite their founders’ best efforts.

As previously stated, angel investors provide larger amounts of capital and require legal documentation to formalize the arrangement. Each individual angel usually commits between $10k and $100k, although some wealthy “super-angels” regularly contribute several times that amount. In aggregate, companies often look to raise between $500k and $750k from angel investors prior to a venture-backed equity funding round. Although founders, their family members, and their friends generally receive common stock, nearly all angel investments take the form of preferred stock or convertible debt.

In exchange for their investment, founders agree to allocate roughly 5 - 20% of the company to the new investors. While no founder desires unnecessary dilution, the timely cash and expertise provided by angels are often invaluable resources for a young company. One reason for the significant dilution in ownership is to compensate early-stage investors for the high levels of risk they bear.

Compared to the cumulative amount of financing raised prior to a public offering or acquisition, an angel investor’s contributions are miniscule. However, the advice and insight provided by angel investors can have a lasting effect on a startup’s growth. Additionally, a company’s ability to attract angel investments can be the difference between progressing to a Series A venture capital-backed equity round and running out of cash. Since most startups in the technology industry do not generate revenues or profits for the first several years of operations, these companies rely on outside investments to sustain themselves until reaching profitability.

Early-Stage Equity Rounds

As a startup company continues to grow, the investments needed to meet the company’s future aspirations often require an infusion of capital beyond angel investors’ capacity. Venture Capitalists (VCs) are among the few financing sources with sufficient capital and risk tolerance to make substantial investments in these young companies. Therefore, most capital in this stage comes from VCs specializing in early-stage investments. (See our Venture Capital article for more information about venture capital investors.)

The first VC investment, or “round,” raised by a company is called Series A, with each subsequent round using the next letter of the alphabet. (Series B is the second equity round, then Series C, and so on.) The amount of early-stage equity money invested in small startups varies greatly based on the company’s leadership team, product development, financial performance, industry, connections, and many other factors.

VCs only invest in companies with high-growth potential, but they make sizeable investments in startups matching this profile. Very few VC funds invest in quantities less than $500k and larger VC firms often have a much higher minimum threshold. VC firms often partner with one another in the same funding round to increase the amount of funding and to diversify risk. The investing group is called a syndicate, and the firm organizing the funding round is referred to as the lead investor.

VCs’ investing criteria are like those of angel investors because most unproven startups have yet to generate profits. Instead of focusing on financial results, VCs consider the strength of the underlying business model, management team, total addressable market, product design, strategic positioning, and inherent risks. Given the size of VC investments, VCs may receive dozens of pitches each week from entrepreneurs looking for funding. A startup’s management team should be aware of the intense competition for venture financing, with some estimates indicating that only one or two out of every hundred startups secure venture support.

In addition to providing capital to finance future expansion, VCs often provide hands-on guidance to their startups. Experienced VC partners can assist management in scaling the business and solving other complex issues because they have already worked closely with companies that have faced similar challenges. To guide the company and protect their investment, the lead firm in each early-stage funding round typically places a representative on the startup’s board of directors.

Although VC investors assume less risk than angel investors, all early-stage equity rounds are inherently risky. A 2012 study by Harvard professor Shikhar Ghosh estimated that 75% of venture-backed companies fail to return investors’ initial capital contributions.

Late-Stage Equity Rounds

For maturing companies that have not been acquired, gone bankrupt, or filed an IPO, the financing landscape changes significantly after the second or third round of funding. As the company matures, its business model and products or services usually become more established and sophisticated. Although a company’s capital needs may be greater than ever before, the uncertainty surrounding its success has diminished significantly over time. As a result, the amount of capital raised in late-stage funding rounds tends to surpass that of the early-stage rounds.  Later-stage valuations¹ are generally larger as well, meaning that existing investors experience less dilution. Each company’s unique circumstances dictate how many funding rounds the company raises, with some startups securing Series F and G equity rounds and others stopping at Series C or sooner.

While early-stage investors act as trusted advisors who are critical to the operation’s success, late-stage companies are less dependent on an investor’s advice. Most such companies already have a proven business model and seek equity investment to scale their operations. The financing process becomes more transactional as the new investor’s primary function is to serve as a capital provider and market validator for the company rather than as a deeply-involved advising investor. By nature of the situation, a different set of investors meets the late-stage company’s needs.

Late stage venture funds along with other investors like sovereign wealth funds, mutual funds, and private equity (PE) firms, become much more active in this stage of the financing cycle. These investors contribute large amounts of capital to companies with exit opportunities (such as a public offering or an acquisition) on the near horizon, often within 3-5 years. When negotiating valuations, late-stage investors focus more on traditional financial metrics and potential exit opportunities.

Although some companies prefer to continually tap the same investors for all their funding needs, most companies receive funding from different investing groups over time. Spreading ownership across many investing groups can provide benefits to both the company and its investors. For example, the participation of outside investors in the fundraising process often leads to higher valuations and establishes a broader network of potential capital providers who can respond in the event of a financing emergency. Diversifying the company’s investor base also spreads risk across several investing groups, preventing one firm from having to shoulder all the losses associated with a struggling portfolio company. For more information about late-stage investors, read our Types of Startup Investors article.

Public Offering or Financial Sponsor-backed Exit

After successfully securing late-stage financing, companies usually begin preparations for a new financing structure. The reasons for pursuing a radically different financing arrangement are threefold. First, traditional startup investors no longer desire to invest in companies that have grown too large. Companies with late-stage financing typically operate at a scale that dwarfs the company’s size during its first few years. Angel investors, VCs, and other startup investors are experts in providing financing to young, growing companies, not large, established ones. After a company has grown too large, startup investors may not be able or willing to provide the scale of financing that a large company needs.

Second, previously inaccessible funding sources become viable options to raise financing. Startups often lack the size and financial health to satisfy the listing requirements in public markets. Larger, more established companies are more likely to meet the listing requirements and attract investor interest when issuing bond or equity securities through capital markets².

Third, maturing companies must search for a more permanent way to fund their operations instead of relying on the startup investors. Up to this point in the financing process, each of the company’s equity investors operated under the assumption that they would eventually sell their shares after the company had established itself. Investments from angel investors, VCs, and other investors are temporary holdings that these shareholders eventually desire to liquidate. From a shareholder’s perspective, opportunities to sell stock and capture investment returns are called exits or liquidity events.

The two primary methods that companies can use to restructure their financing and provide exit opportunities to their early investors are through an initial public offering (IPO) or a financial sponsor-backed exit. An IPO involves selling equity in the company to the public, while a financial sponsor-backed exit occurs when an outside entity purchases the company. The two most common types of financial sponsor-backed exits include corporate acquisitions by larger companies and leveraged buyouts³ (LBO) by PE firms. In an ideal scenario, companies can explore multiple alternatives and choose the most attractive option. However, pressures related to a company’s financial position and investors’ preferences for an accelerated exit may force the company to pursue a specific financing strategy before thoroughly exploring all possible alternatives.

In the traditional financing process, a company progresses from seed funding to early-stage financing and late-stage funding before arriving at a profitable exit. However, many companies do not experience such a clearly defined financing timeline. Acquisition offers can appear at any stage of a company’s lifecycle, although most founders and investors plan for a later exit that allows the startup ample time to increase its valuation. Founders and investors should carefully analyze each financing opportunity that arises because an unexpected offer may produce an outcome or liquidity event that is superior to the company’s original strategy.

Although an in-depth discussion of the advantages of an IPO are beyond the scope of this article (see IPO Advantages and Disadvantages), many founders value the additional publicity and independent control that public companies enjoy. Deciding to go public also has several disadvantages, including a costly IPO process (see The Costs of Going Public), additional regulatory requirements, and increased shareholder pressure for quarterly performance. Due to these difficulties, acquisitions (whether by corporations or PE firms) are much more common than IPOs among startup companies. According to a study of over 15,000 startups that raised VC financing between 2003 and 2013, TechCrunch found that 16 times more companies were acquired than went public.

Via an LBO, companies can avoid the downsides of being a public company while enjoying the financial support of a well-funded sponsor. For example, some PE-backed companies find it easier to make long-term strategic changes away from the constant scrutiny of Wall Street analysts. Some of the risks associated with an LBO-path include taking on high amounts of leverage and having misaligned objectives with the PE-backer. Some founders may desire to focus exclusively on revenue growth, while PE firms typically emphasize increasing the firm’s EBITDA, a key measure of profitability used in valuations.

In a corporate acquisition, the target company often benefits from the resources and expertise of a large industry player that can bring the business to new heights. Despite this benefit, acquired companies often face many post-acquisition hurdles when integrating with the acquiring company. Acquired companies usually lose their independent decision-making power and often struggle to maintain their culture and identity. Mergers and acquisitions come in various forms but corporate acquirers often view the target company using one of the following classifications, ordered from lowest to highest by valuation: 1) acquihires, 2) technology purchases, 3) business acquisitions, or 4) strategic asset acquisitions.

1. Acquihire – In an acquihire, a large corporation wants to retain the target company’s employees without necessarily continuing its product or pursuing its founders’ vision. Acquihires usually imply low valuations because the buyer only desires the employees under contract and sees little value in the company’s technology or business model.
2. Technology purchases – Technology purchases occur when the acquirer sees value in the target’s intellectual property, not just its employees. As a result, technology purchases generally feature a higher valuation than acquihires.
3. Business acquisition – A business acquisition values the target as a stand-alone company not just a collection of a few prized assets and usually exhibits higher valuations than acquihires or technology purchases. The valuation considers the company to have more value as a complete entity than simply the sum of its individual assets. The gap between the valuation of the overall company and that of its individual assets often relates to resources not listed as assets on a company’s balance sheet, such as brand awareness, workplace culture, operational expertise, industry experience, and network connections.
4. Strategic acquisition - Strategic asset acquisitions describe companies that can command tremendous valuations due to their importance within a market segment. For example, Instagram had such a unique combination of technology, scale, leadership, and execution that several corporate buyers bid against each other until Facebook acquired the company for $1 billion in 2012, despite Instagram’s failure to ever record a single dollar of revenue.

When evaluating whether to pursue an IPO-, corporate acquisition-, or buyout-focused financing path, management should consider their vision for the future of the company and their involvement therein. Founders who want to maintain control of the company after an exit may be able to structure an IPO so that newly issued classes of stock have fewer voting rights or float only a minority stake in the company. In a corporate acquisition, founders generally sacrifice all ownership and control in the company, although they may be able to negotiate special arrangements into the terms of the deal. When considering corporate acquisition or LBO offers, founders may also inquire about and negotiate concessions around the new ownership group’s plans for the company and its employees after the acquisition is complete.

A company’s size also influences what financing options are available. Although exceptions exist, most companies with less than $100 million in revenue will be unable to garner enough investor demand for an initial public offering. Meanwhile, corporate acquirers often seek to limit their acquisitions to targets with less than $50 million in revenue due to limited financial resources and the difficulty of integrating two large companies.

(For more information about exit opportunities see our Alternatives to an IPO article.)

Bootstrapping: An Alternative to Early-Stage Financing

Although most successful startups receive outside equity investment as described earlier in this article, some founders are unwilling or unable to secure seed and early-stage funding. These founders must instead rely on company-generated cash flows, personal savings for financing, and supportive friends and family to grow the company. Commonly called “bootstrapping,” this method requires little external investment and instead strives to optimize the company’s existing resources, however limited they may be. Most successful “bootstrapped” companies share certain characteristics, such as austere financial discipline, a resourceful management team, and a compelling long-term vision.

Although most bootstrapped companies typically rely on personal savings and contributions from friends and family for financing, many startups have recently turned to crowdfunding as another source of capital. Crowdfunding enables startups to collect small online donations from the mass public. Most crowdfunding websites are rewards-based platforms where individuals contribute money towards the development of the startup’s product or service. Once the startup completes development, the donor receives the finished product or service. To clarify, these crowdfunding donors are not investors; they are customers who pay upfront for the future delivery of a product or service. Since the crowdfunding market is relatively new, dramatic changes to the competitive landscape and the regulatory environment may be on the horizon.

Seed financing from personal acquaintances often comes in the form of small investments made through informal agreements. Founders should take precautions to ensure that all arrangements involving investment securities, like common stock, preferred stock, and convertible debt, satisfy the SEC’s regulatory requirements. In most circumstances, private companies are prohibited from issuing investment securities to individual investors. However, the SEC details some exceptions to this restriction in Rules 504, 505 and 506 of Regulation D, the SEC’s authoritative pronouncement on the subject. Rule 506, the most commonly used exception, allows startups to issue unlimited amounts of securities to “accredited investors” who meet either the specified personal net worth requirement or the annual income requirement. Failing to abide by SEC regulations can bring severe legal consequences that can hamper a startup’s ability to raise future funding.

Typically, bootstrapped companies start with some initial investment of personal resources that creates a self-sustaining business fueled by customer sales. Working with suppliers to negotiate trade credit or factoring receivables are two methods founders and management teams use to optimize a startup’s cash flow. Eventually, most bootstrapped companies seek investment from VC firms or banks for additional financial resources. However, by forgoing seed and early-stage financing, the initial investors avoid large-scale dilution in their equity stakes.

Deciding Whether to Bootstrap or use Seed Financing

The first major financing decision that founders must make is whether to finance their startup through bootstrapping. As with all financing considerations, bootstrapping has several advantages and disadvantages. While the following paragraphs address important factors to consider, remember that seed financing is only an alternative if you can attract interested investors. Most founders who bootstrap their companies are forced to so because they do not have any other financing alternatives. Conversely, most founders who can raise outside equity eagerly accept the funding. Regardless of whether you have a “choice” between seed financing and self-financing, carefully consider the following information to better understand the profound consequences that financing decisions can have on your company.

Advantages of Bootstrapping

The three primary advantages of bootstrapping a company are 1) decreased dilution, 2) greater decision-making power, and 3) increased financial discipline.

A significant reason why many founders consciously forgo early-stage financing is to preserve their equity ownership in the company. Most startup founders who accept external financing experience significant dilution during the initial growth stages. In a study of 71 technology companies from 2011-2015, the data and analytics platform Craft found that median ownership percentage of the founding team was 15% at the IPO date. The unique circumstances and financing choices of different companies often lead to even more extreme outcomes. Consider the contrasting examples of Atlassian and Pandora. Having avoided venture-capital funding altogether, Atlassian’s two founders owned 75% of the company at the IPO date. Meanwhile, Pandora raised over $64 million from VCs, diluting the combined ownership percentage of the three founders to a mere 2% at the IPO date. (See our Dilution and Stock Option Pools article to learn more about how equity financing can change your ownership percentage.)

In addition to reducing dilution, bootstrapping allows founders to exert greater control over their companies. Most early-stage investors demand a board seat to advise the company and protect their investment. Although venture-capital advisors often add value to startups, differing philosophies between board members, founders, and management can create destructive conflicts. Founders who forgo external funds have more freedom to pursue their personal vision for the company and quickly make strategic adjustments. Greater financial flexibility is another component of the founder’s increased control via bootstrapping. A profitable, cash-generating, bootstrapped company is self-sustaining—its founding team is not desperate for investor money and can negotiate from a position of strength when securing external financing.

A final and often overlooked advantage of bootstrapping is financial discipline. Without the support of external financing, a startup must rely on its internally generated cash flows to cover expenses and fund future investments. Founders who bootstrap their companies instill a culture of profitability and frugality that stands in stark contrast to the spendthrift behavior many startups exhibit after closing a large funding round. A company that learns financial discipline from inception will be more resilient during financial hardships and will likely be more efficient in the long run.

Although a risky strategy, successfully bootstrapping a company can be an incredibly lucrative financing approach for founders. Examples of founders who successfully bootstrapped their companies include: Michael Dell (Dell Technologies), Mark Zuckerberg (Facebook), Steve Jobs (Apple), Larry Ellison (Oracle), and Bill Gates (Microsoft), all of whom became billionaires because they maintained meaningful ownership as their businesses grew to maturity.

Advantages of Seed Investment

The three main advantages of accepting seed funding instead of bootstrapping are 1) decreased financial risk, 2) increased growth, and 3) mentoring opportunities.

With the aid of external funding, companies lower the risk of having insufficient funds. Traditional funding sources are often willing to provide financing when a startup prospers, but are hesitant to do so when it struggles. Unexpected events like a downturn in the economy can not only disrupt a startup’s financial plan but also erode financiers’ overall willingness to invest. After accepting seed investment, a company can shore up its short-term financial reserves, which serve as a buffer to protect the company against a financing emergency. Bootstrapped companies usually lack even minimal financial reserves, leaving them exposed to additional operational and financial risks. Founders should consider their personal risk tolerance and objectively analyze the worst-case scenarios before deciding to accept the additional risk associated with bootstrapping a company.

Financing choices during a company’s formative years have strategic implications, too. A startup with a mission-critical, time-sensitive goal, such as capturing a market or developing new technology before the competition, will have an advantage if it can raise additional financing. Receiving timely outside investment can help drive speed to market⁴, which often determines which startups will win and which ones will fail. Simply put, bootstrapped companies almost always experience slower growth in the short term compared to venture-backed competitors. An exception to this rule would be a startup with an independently-wealthy founder who can bankroll the company.

A third advantage to seed funding is that the startups have opportunities to benefit from the wealth of knowledge, experience, and connections that angel and VC investors offer. Once an equity round is complete, investors have an inherent interest in helping the startup succeed. Founders can rely on these investors to warn them of potential pitfalls and to inform them of new growth opportunities. By acting as trusted advisors, experienced investors can guide their investees towards growth and profitability based on their past involvement with other startups. Although all startups can place influential advisors on their board of directors, companies that accept seed fundraising have access to the talents and skills of a financially aligned group of important mentors.

Due to the importance of investors’ capital and mentoring, most successful startups accept external financing as soon as possible. Although the prior section listed several high-profile examples of founders who bootstrapped their companies, they are the exception rather than the rule. A much more common route to achieving large-scale success is through seed financing.

Conclusion

Financing is one of the most important factors in a startup’s survival. At different stages in a company’s development, alternative financing choices are available. In a company’s initial stages, founders can choose to either bootstrap their company or actively pursue seed funding. If successful, startups may then seek early-stage financing and possibly late-stage financing. At any time throughout the process, the company may field acquisition offers that could trigger a significant change to the financing structure. Still other companies patiently pursue the path towards an IPO to gain access to public capital markets. Altogether, startup financing offers myriad alternative paths as you try to structure the most advantageous financing for your company.

Resources Consulted

• Blog by Fred Wilson (Co-Founder of Union Square Ventures)
• Forbes, Why 99.95% Of Entrepreneurs Should Stop Wasting Time Seeking Venture Capital
• Wall Street Journal, What You Need to Know to Become an Angel Investor
• TechCrunch, Here’s how likely your startup is to get acquired at any stage
• Madrona Venture Group, How VC-to-PE Buyouts Can Change Market Dynamics for Later-Stage, VC-backed Companies
• TechCrunch, Facebook Buys Instagram For $1 Billion, Turns Budding Rival Into Its Standalone Photo App
• Term Sheets and Valuations by Alex Wilmerding
• The Entrepreneurial Bible to Venture Capital by Andrew Romans