When you start a business, it’s obvious that you need to raise money to finance your venture. And one great way to do this is through startup funding rounds. But how do these rounds work? In this post, we’ll guide you through the different types of startup funding rounds and how they work. So, if you’re looking for information on startup funding rounds, read on!
The Evolution of the Startup Ecosystem
It seems every day there is some new round of funding and some new massive amount of money that has been raised. But for those uninitiated in the world of venture capital, the many rounds and kinds of funding that are a part of the startup system can be confusing.
If the back-to-back startup funding announcements make you want to start something of your own or simply make you want to understand what in the world is going on, you need to be aware of how startup funding rounds work, how it starts, and what are the important stages that define it.
Funding and where it comes from can often determine the direction that a startup takes, which is why it is essential to understand exactly what is happening in a country like America, where the startup culture seems to be thriving.
Different Types of Startup Funding Rounds
There are different types of startup funding rounds that are raised at different stages of a startup’s life. These rounds come as pre-seed, seed, Series-A, Series-B, Series-C, and beyond.
The rounds which are venture capital funded but are not categorized as any series are called venture rounds. The funding in each subsequent round is higher than the previous one and is raised during various stages of a startup’s growth journey.
Funding in these rounds starts coming from founders and their friends and family, eventually leading to the participation of big venture capital firms if the startup can make it big on growth.
Essentially, you start very small like with any business. Your dad gives you a loan, you ask your friends for small contributions, someone says they’ll make an investment and you get started.
Then, maybe when you start seeing signs of the idea or the company growing, professional investors seem interested in the idea and make offers to give you funding in exchange for equity in the company.
These investors are who we call venture capitalists – they look out for good ideas and invest in them at an early stage for a minority stake.
Normally, they don’t get involved in the workings of a startup which means they simply evaluate the founders and the team and determine whether a startup can put its money where its mouth is and turn profitable.
If they do manage to become profitable, then the venture capitalist gets their initial investment back and also a steady stream of profit.
Let’s Get Into the Basics
Before we get into the details, it is necessary to understand who exactly is investing in these startups. Yes, as has been mentioned, initially the absolute initial stage is friends and families.
However, the main investors that any startup wishes to attract are venture capitalists. There are two kinds of venture capitalists, either individual angel investors or venture capitalists firms.
In the case of angel investors, they are private venture capitalists operating on their own – lone wolves. Venture capital investment firms are different. These are usually collaborations where several investors pool their money to invest in different startups, except the firm hires someone to manage this money.
This person can be hired separately or can be one of the investors, or the decisions can be made in collaboration as well. It all depends on how that firm wants to structure itself.
Firms don’t generally invest in high-risk companies, and it is usually angel investors that take the plunge with more high-risk ventures. However, investing in any startup is risky by nature as you are investing not just in an idea, but also in the people leading that idea and the team they are hiring.
This risk is taken because the venture capitalists know that while these companies could fail if they do make it, the returns would be massive. While these startups are very high risk, they also have very high returns.
Consider this as the ideation stage of the startup. You have an idea and you want to carry out research, formulate a plan and start building the product around it.
The startup is just taking off the ground and funding can come from the founders’ capital and funds from friends and family. Many angel investors are the source of funding at this stage. On the other hand, VC firms have also started funds to invest in startups at the pre-seed stage.
Since it is just the beginning, startups usually do not have solid data to present and investors are betting on the founders, the team, the product, and the market to make the investment decision.
The investment size is also small since the idea is to invest in developing the product and carrying out the research. Pre-seed funders take anywhere between 10-25% equity at this stage.
Since this is the concept stage, the size of funding is very small compared to the later stage rounds, usually running in tens of thousands or some cases hundreds of thousands of dollars.
The business idea has moved on from the concept stage to product development and testing the viability of the business model. Investments at this stage are usually small coming from angel investors and seed-stage VCs.
Many incubators and accelerators also invest at this stage, putting in small amounts in the startup. The average investment size is usually small, running into a few million dollars. But after the pandemic, we are seeing the seed funding rounds fetching investments running in tens of millions of dollars.
At the seed stage, since the product is still in the testing stage, there is no solid trajectory of growth for investors to make an investment decision. Investors are again taking the risk with their bets on the founders and the idea. The funding is usually spent on developing the product, recruiting the talent, and getting the initial traction.
Series-A is the financing round raised when the startup has managed to get the product off the ground and has a dedicated user base and revenue coming in. Series-A rounds are raised to further consolidate the strategy for long-term growth and earn profits.
In general, very few startups make it to Series A rounds. Globally as well, startups which generate investor interest following the seed round are small in number. That is because not all startups can become a hit in the market after their launch.
The world’s top VC firms such as Kleiner Perkins, Sequoia Capital, and Andreessen Horowitz have usually invested in startups during the Series-A rounds. Angel investor participation in Series-A rounds is also not uncommon and early investors also follow on to maintain their shareholding in the startup.
Series-B financing rounds are mostly about bringing stability to the business. The startup has built a dedicated user base, the product is optimized for the market and the idea now is to expand the scale to a bigger level.
Series-B funding rounds run in tens of millions of dollars, and in some cases, hundreds of millions, depending on the market. The startup at this stage is focused on spending to capture the market through sales and advertisement. Of course, product iterations are ongoing always, but the basic product is already optimized for the market.
The same sort of investors, late-stage institutional VCs, and angels, are also participating in the Series-B rounds with large cheques coming in this time. The round is usually led by a single institutional investor, or co-led by two or three big investors. Earlier investors may also follow on and some may think about exiting.
Series-C and Beyond
These are the serious rounds raised when the startup has reached a high level of growth and the idea still is to consolidate further. Big funding comes in during this round which can be utilized to introduce new products or services, scale into new geographies, and carry out strategic acquisitions.
By the time Series-C is reached, founders’ and early investors’ shares have increased considerably in value and set the stage for an exit. Since the value of the company at these stages is high, exits will reap lucrative returns.
Series-C funding can be followed by Series-D and Series-E, or even Series-F in some cases, all focused on raising funds to consolidate as market leaders by eliminating competition, scaling into new geographies, setting the ground for an IPO, or achieving some other key performance indicator (KPI) set by the startup for itself.
Investors which participate in these rounds are the prominent VCs who inspect the business in and out.
Sometimes startups need interim funds to make it to the next planned round. In these instances, a bridge round is raised to fund the requirements to make it to the next round. Startups can sometimes miscalculate their funding requirements and raise less in a round.
Contrarily, they might spend more than planned, in which case they will need some interim investment to fund their requirement, but only to make it to the next funding round. These rounds, known as bridge rounds, then simply act as a bridge between two funding rounds.
In conclusion, startups add to a major part of the economy but they are also complex, so understanding how they work is an important first step to understanding how they affect our world. We hope this article answers all of your startup funding questions! Stay tuned for more.