Financing a startup can be a long, complicated process. If you’re funding your business and don’t have a clue about the investment and process, don’t fret. We’ve broken down every step of the process and what it means for your ownership, to make learning about it as easy as pie. Read on for more info, or jump-to our infographic to see startup funding explained with pie.
While you may typically think of funding as something that’s done all at once, it’s actually often a process that happens in stages as a business grows. The early rounds will typically be financed your savings, family, and loans, while later rounds involve venture capitalists and hedge funds.
Startup Funding Stages
A startup may collect money from hundreds of investors while it raises multiple rounds of capital, however, there are several generally accepted stages to funding a business.
Start With a Great Idea
It may seem obvious — but it’s important to note that the best way to ensure funding is with a solid idea, and knowing how to present it well. In your first few funding stages, you won’t have much performance data or positive financials to show your potential investors, which means that your idea and character must motivate investors to come on board. So even if you’re pitching your friends and family, do your research. Create a pitch deck, demonstrate your understanding of the market, and show you have the skills necessary to lead a business towards success. You wouldn’t bake a pie without a recipe, and you certainly can’t start a business without a plan.
Bring in Your Co-Founder
While many people do start their business solo, it’s you’ll likely need a sous chef. Startups with two co-founders rather than one raise on average 30% more capital. Whether you need someone who compliments your skillset to take on tasks or someone who shares your vision to bounce ideas off of — bringing on a co-founder is a common next step. Not only does this mean that you’ll have someone to help out with the work, you’ll also be able to pool resources. However, this will likely mean your ownership of the business is cut in half.
This is also the time that many companies set aside a portion of their equity as an option pool. An option pool is a reserved stake in the company for future employees, also used to attract talent who bet that it will one day be worth much more. So now, you and your partner will own about a third of the company, while another third will be set aside.
Begin With Pre-Seed Funding
Often before even launching your business the first major stage of funding is the pre-seed funding. Now’s the time to put your brilliant pitch to use on friends and family, or secure an angel investor if you’re lucky. You won’t get rich off of this funding since the average funding amount is less than a million dollars, but this will allow you to make critical hires for operations or invest in a space to work. Like preheating the oven before baking, your business won’t be off the ground yet, but the heat has definitely been turned up.
Now, what about your slice of the pie? A typical angel investor will want between 10% and 15% of your company equity post-valuation, or after they place a value on your company. This means that your shares will be diluted by the amount that they contribute.
This round isn’t mandatory. Some business owners elect to skip this in favor of a small business loan or bootstrapping their funding. While you will have to pay back a small business loan, you don’t have to give up equity in your company at these early stages, and since the average small business loan amount is $633,000, it can be a great option for the first round of funding.
Raise Seed Funding
The next step is a slightly larger funding round, that makes it possible for you to pull all the moving parts together. Now is when venture capitalist funds, accelerators, and additional angel investors will become interested, investing an average amount of $1.7 million. However, you’ll sacrifice some equity again. Depending on your source of funding, you could end up giving away anywhere from 10–25%.
While your slice of the pie may be smaller, with a company valuation around $3 million, your piece of pie will be worth a lot more.
Seed funding will allow you to make more hires to bring operations up to speed, run tests to assure market fit, and start development on your product. Some businesses will conduct multiple rounds of seed funding before moving on to the next step because it allows for more flexibility to pivot and find the right market fit before scaling. It’s necessary to bring all of the parts necessary for your business together, like mixing the ingredients for a pie.
Launch Series A Funding
While every funding stage until this point has relied on your business’s potential, series A round funding is secured by showing traction with positive market tests, increasing revenue, and how well previous rounds of funding have been invested. This is the first time your business is actually coming together — like a pie ready to bake.
Venture capitalists, private equity firms, hedge funds, and super angel investors will get a taste for how your business will actually do. And if they like what you’ve done, investments in this round average $10.5 million. Businesses may opt for equity crowdfunding rather than finding investors at this stage, especially if they struggle to attract the interest of large investors.
Once again, you may have to give up anywhere between 15–50% of your equity, but the additional funding will allow you to open up additional channels for sales and marketing to grow your business further.
Move on to Series B Funding
By now, your business should be showing strong signs of success and growth. You should have a clear market and generate consistent revenue. Series B funding is typically used to scale your business in order to meet increasing demand, expand your operations into new markets, or to buy out another business. Investors are usually late-stage venture capitalists looking for a slightly more secure investment that can still provide returns. If you secure investing at this stage, you could expect funds of around $24.9 Million. The average equity in exchange is 15–30%.
Receiving Series B funding can also require far more analysis and scrutiny than previous rounds, as the business should be fully fleshed out, and operating on a large scale. If you were just baking a pie before, now you’re baking dozens.
Raise Series C and Beyond
At this stage, your business will be a much less risky investment, and therefore more attractive to a new set of investors: private equity firms and investment bankers.
With average investments at this stage of around $50 million, with average equity given to investors at around businesses typically use this money to expand their operations globally, or acquire competitors. Series C funds can also be used to increase a company’s valuation before the IPO.
Launch an Initial Public Offering (IPO)
Though a company can keep raising series funding through rounds D, E, and onwards, it’s around after the series C funding that they are large and stable enough to go public. Until a company creates an Initial Public Offering, they are entirely privately held, and cannot offer shares to the general public. While the investors are shareholders, their shares can’t be easily liquidated, because they cannot be sold. While you may be holding a slice of pie, it isn’t worth anything until others can buy and sell it. With an IPO, a company can now sell shares to the general public, raise funds, and increase the value of their company.
To do this, companies will hire an investment bank to be their underwriters in the IPO. First, the Securities and Exchange Commission (SEC) will assess the company and its financials to ensure that it is legitimate. Once the company receives approval, the bank will then buy the stock from the company, and be in charge of distributing the stock among a first round of investors. The bank makes their money by collecting the difference between the purchase price of the stock and what they sell it for. The general public is not usually involved at this stage until the stock is listed in an exchange like NYSE or NASDAQ.
Once a company goes public, financial data will be made publicly available and the company will be required to hold annual shareholders meetings. The value of your company is no longer determined by an investor’s valuation, it’s determined by the trust and judgment of the public at large.
How Funding Works
Every time you offer equity in exchange for funding, all existing shares in the company experience dilution. When dilution occurs due to new funding, it’s essentially like cutting the pie into more slices. With the new funds, you have a smaller slice — but it’s worth more.
For example, say you currently own 50% of your company, and an investor values your business at $1,000,000, and wants to invest $100,000. To calculate the dilution, you first have to find the value of your company after the investment, which is the post-money valuation. In this case it’s $1,100,000. Then you divide their investment by the post money valuation:
$100,000/1,100,000 = 9.1%
9.1% is how much equity that investor will get. This is also the percentage that each shareholder’s equity will be diluted.
To calculate your new equity find 9.1% of the original share (4.55) and then subtract that from the share: (50 – 4.55) = 45.45%
While the investment will probably raise the company’s valuation and enable it to grow, owning less of your company will mean that your ownership decreases each time you take an equity investment, which is common practice. For example, Bill Gates only owns 4% of Microsoft. For some, this isn’t a bad thing. Some business owners leverage insights from angel and venture capitalists who can help steer their business towards success.
Other Ways to Fund a Business
Not every business will become worth billions of dollars — and you may not even want it to. For small business owners, there are plenty of options available to finance their company that don’t involve multiple seed rounds or equity investors.
77% of small businesses rely on personal savings, and only .05% of small businesses raise venture capital. If you’re like the average small business owner who only requires $10,000 in startup funds, you may not need more than a small business loan to get off the ground and turning a profit. Bootstrapping, borrowing from friends and family, and crowdfunding are popular options that don’t require you to give up control of your business.
We went ahead and summarized everything you need to know about startup funding in our infographic below:
Credits: Meredith Wood Founding Editor and VP at Fundera