February 26, 2020

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by: Jonathan Hung

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Tags: Startup Funding

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Categories: Angel Investor, Startup Funding

Startup Funding Stages Explained

If you’ve recently created a startup or are thinking about forming one, then congratulations, you’ve made a decision that will forever transform your life in so many unexpectedly positive ways. The world of startups is fun, inspiring, and filled with some of the best stories imaginable. However, there are also many concepts associated with startups – particularly with regards to funding – that may not be very clear to people new to the scene. You may have read terms like “angel investing” or “series A” funding. These refer to startup funding stages. Each business goes through phases of financing as the company grows.

While these stages may seem initially confusing, they are conceptually quite simple once you look into them more. If you’ve founded a startup or you’re looking to do so in the future, here’s a guide to all the startup funding stages of which you’ll need to be aware!

 

Table of Contents:

Friends, Family, And Self-Funding: The Absolute Beginning Of The Startup Funding Stages

Before anyone is willing to invest in you, typically, businesses receive their very first initial seed capital from friends, family, … or the founders’ bank accounts. It is usually quite challenging to convince investors to invest in something that doesn’t exist. To get your company off the ground, develop the business plan, and so forth, you’ll typically need funds from a close source that knows you well.

At the very beginning, the initial investment tends to be quite small. You might receive a $20,000 check from a friend or put $50,000 of your own money in the business. The objective at the “first formation” stage is to get everything in place so you can start your business and start developing a prototype.

Angel Investments: The Next Phase Of Funding

Once you have a business that is operational and showing potential (that is, you’ve assembled a fantastic team and have some real numbers to back up your idea), then the next stage usually involves seeking out angel investors. Typically, startups in this phase have valuations of approximately $3-5 million. They are launching a product and building traction. Startups in this phase are expanding rapidly.

Angel investors tend to be accredited investors that are investing their own money into businesses and ideas they love. Angel investors are typically looking to invest in exchange for equity and a seat on the board. For startups, having the right angel investor backing them can make the difference between success and failure. The experience, knowledge, and advice that an angel investor provides are often invaluable during a startup’s early years. Therefore, angel investing is often about more than the money – it’s about the time and commitment of the “angel” to the vision and people behind it.

Typically, at this stage, entrepreneurs seek out angel investors. There are many groups and meetups where entrepreneurs can go to pitch their business to a group of potential investors. Usually, it’s best to go to meetups, where the investors have familiarity with your particular area of expertise. Angel investors tend to want to be more hands-on with these investments than later funding stages.

At this level, companies typically raise less than $500,000. Sometimes an angel investment might be as little as $20,000, and sometimes it might be more. There are no rules or regulations on how much or how little of an investment anyone can do.

Note that sometimes people turn to crowd-funding or micro VCs instead of angel investors at this stage. Both have their place and can be beneficial but they also have downsides.

Micro-VCs tend to have costs and levels of due diligence that can eat time and money for the startup.

Crowdfunding is an interesting idea, but many people find that the level of marketing necessary to make crowdfunding work is cost-prohibitive. The best use of crowdfunding is to “Top-off” your funding round. If you’re already raising money and have a few investments in you round but can’t seem to close the gap in your target funding then crowdfunding might work for you.

The reason is simple, crowdfunding attracts micro investors that are very new to startup investing and actually tend to be risk-averse. When they see that you already have a great deal of the funding round secured by other (presumably more experienced investors) then it reduces their anxiety and they are more willing to invest in your funding round.

One excellent angel investment was Peter Thiel’s investment of $500,000 in Mark Zuckerberg’s company, Facebook. He made this investment in exchange for 10.2% of the company and a seat on the board. Eight years later, he sold part of his stock in the company for $638 million when Facebook went public.

Series A Funding

This round usually represents the first round of real venture capital funding (although sometimes Series A dollars come from accelerators or angel investors that have lots of money that they want to invest). At this point, the startup has an established record of excelling in some particular metric. Maybe they have significant traction, or they are already making a healthy profit. The business has unique characteristics that make it probable to succeed moving forward. Companies at this level have valuations around the $15-30 million mark, although some may be higher.

While previous rounds care a little bit about profit, Series A funding cares substantially about that aspect. It’s crucial at this stage to have a business model and plan that will generate long-term profit. You don’t need to be making a profit tomorrow, but you do need to have a plan for it in the future. Otherwise, VCs will balk at the notion of funding your startup.

Series A funding is all about starting to scale. The seed money should have established the business model, enabled you to hire key people, and let you figure out the products that you want to offer. Once you hit Series A, you’re asking investors to help your business start to scale in terms of users and revenue. Because of the focus on scale, Series A is the first of the startup funding stages where investors are evaluating your business’ finances and metrics. In previous rounds, investors typically are assessing your team or your idea.

At the Series A level, startups also typically provide preferred stock instead of equity. The reason VCs like the preferred stocks is that it takes precedence over common stock in the event of bankruptcy. Startups in this phase need the capability, therefore, to issue preferred stock.

Facebook’s Series A round was for $12.7 million from Accel Partners, a VC firm. That deal valued Facebook at $98 million. A representative from the VC firm joined the board of directors. Therefore, by the end of the Series A round, Facebook had three board members – Zuckerberg, Thiel, and Breyer of Accel Partners.

Series B Funding

Series B funding is a logical extension of the previous startup funding stages. At this point, your business is scaling upwards. Your business model has been in place for quite a while, and there’s significant traction. Now the startup is looking to scale, and its sights are starting to focus on a potential IPO. At this point, the startup is looking for funding exclusively from venture capitalists. Companies at this level frequently have valuations around $60 million. They’re not massive, but they’re rapidly expanding, and they have significant history and data to back that up.

Startups might think of Series B as a “bigger” Series A round. This round of the startup funding stages tends to be the most challenging for startups because the focus is taking the business to the next level. You’ve found the right team, you’ve found your market niche, and now this money is to make it big. Therefore, there is significant scrutiny of the startup because, at this stage, the funds should be starting to propel the business towards an IPO.

Series B also has significant investment levels. VCs often invest many millions into a business. Series B investments have an average contribution of $32 million and frequently value the company between $30-$60 million.

Series C Funding

Series C funding is very different than Series A and B. At this point, the startup must have a fully developed product and user base. It must have used the funds from the previous startup funding stages wisely to build a user base and financial structure that would be amicable to an IPO. Series C investments are to give the company a further push towards a buyout or an IPO.

Interestingly, there is quite a bit of capital at this stage. VCs, banks, investment companies, and other entities want to invest in stable businesses to take them to IPO. At this point, the startup has established a proven track record and already has a significant market share. However, some startups don’t make it to this stage because they don’t attain the market share, valuation, and traction necessary to support an IPO in the future.

Typically, Series C investments range from $50-60 million with company valuations around $120 million.

Series D, E, F, And So On

Once a business has a Series C investment, they can either go for an IPO or buyout. If they’re not ready for an IPO, then they will typically continue to raise money with future startup funding stages. These rounds are Series D, E, F, and so on. There is no limit, technically, to how many funding rounds a startup might have. Twitter, for example, had four stages (up to G) of funding stages after it received Series C funding.

However, the basic premise of each of these funding stages remains the same. The company should be seeking an eventual IPO or buyout, and each of these rounds should be targeting that goal. If the startup becomes stagnant, then they won’t receive additional startup funding stages.

Initial Public Offering (IPO)

The IPO is the last and final round of funding for startups! At this phase, the company offers corporate shares to the public for the first time. Banks, individuals, and investors from all over the world can buy a piece of the business.

Startups at this phase are no longer “startups,” but instead, they are companies that are probably household names. Facebook, Twitter, and Snapchat have all gone through official IPOs, and most people would not consider them to be startups but rather mature established companies.

Companies tend to raise hundreds of millions or even billions in this phase. Facebook was an outlier, having received a massive $16 billion with its IPO. Twitter raised $2.1 billion with theirs. Companies have equally substantial valuations that are in billions as well.

After IPO, the startup has achieved what very few companies ever do – become a ticker symbol on a significant stock exchange!

Conclusion

Since each of these startup funding stages follows a natural progression, let’s quickly recap what a typical startup goes through. Let’s follow Startup Co. through pre-seed money to IPO!

Alice and Bob form Startup Co., each contributing $20,000 in funds to the business. Alice and Bob own 50% of the company each. They incorporate, put together an idea, a prototype, and begin to assemble a small team. They work out any partnerships and legal issues as well to ensure they have a rock-solid foundation.

At this point, they’re ready to look for an angel investor. An angel investor will look at the team and what it has accomplished so far. Since, in our hypothetical example, Alice and Bob have a fantastic team and an excellent prototype, the angel investor decides to put in some money. They put an investment of $200,000 into it in exchange for 20% of the business and a seat on the board. Bob and Alice now own 40% each.

Startup Co. achieves success! They develop the product, bring it to the market, and people love it. The revenue and user base numbers are growing substantially. They show it to a Series A venture capital firm who, after a successful pitch, is ready to write them a check for $15 million. In exchange, they take 25% of the company in the form of preferred shares. Bob and Alice now own 30% each.

With that Series A money, Startup Co. expands and continues to grow. It’s an established product with a road to profitability. Now is the time to focus on market share and scaling up. During this round, there are Series B VCs that, combined, give Startup Co. $30 million. In exchange, they take 33% of the company (a little high, but it makes the math more manageable). Our two founders, Bob and Alice, now own 20% each for a combined stake of 40% of the business.

Next up is Series C. After scaling up, it’s clear that Startup Co. is going to be a resounding success. During this round, Series C investors put in $50 million in exchange for about 25% of the business. Bob and Alice own 15% each, or 30% combined.

With so much success, Startup Co. is a candidate to be on the stock market. The last of the startup funding stages is the IPO one. At this point, they offer 50% of their company with a valuation of $1 billion. This round raises $500,000,000 in cash. Bob and Alice each own 7.5%, which is now worth $75 million apiece.

Not bad off of a $20,000 initial investment!