Startup funding rounds explained
Fundraising has become the way to start up and fuel business development. We all hear the success stories of startups that raise tons in funding and scale ups that do Series B rounds of tens of millions. But everyone who has been there knows that it is not an easy task to get funding. Where should you start? Who can you turn to and what valuations should you think about? In the world of startups a lack of capital is one of the primary reasons that startups fail within the first few years. Learning the ins and outs of acquiring money and how to promote your company can help ensure to become a successful business. In this article we explain the different funding rounds for startups and how each funding round works.
What are startup funding rounds?
First we start with an explanation of what funding rounds are. Startup funding rounds are a series of investments that raise capital for a new business. The different rounds of funding operate in the same manner; investors offer cash in return for an equity stake in the business. Between the rounds investors can make different demands on the startup. It is very common for a company to start with a pre-seed round and continue with seed, Series A, B and then C funding rounds. Funds are offered by investors, usually Angel investors or Venture Capital firms. Each funding round serves as a stepping stone toward greater growth and will help the startup turn into a successful company.
Pre-seed funding, also known as pre-seed capital, occurs at the very beginning of a startup when founders usually invest with their own money. Other commonly used options are friends and family. In this stage the company normally does not yet have a product, staff or customers. It is just an idea that can go in all directions and that makes the risk of investing money big.
The goal of a pre-seed round is to get the idea off the ground and usually involves producing a prototype. Performance figures to base the amount of an investment are not available yet. The valuation of a startup in this phase is not very high. Typical pre-seed rounds range in size from 50.000 to 100.000 euros.
There was a time that the seed round was the first investment round, but due to the competitive playing field it is now in most cases the second round. The seed round is when investors provide funds before a startup becomes operational. In this stage startups have come to the point where pitches, business models and investment applications need to be solid.
Most of the time the investors in the seed stage are Angel investors or early stage Venture Capitalists. An Angel investor is someone with a large amount of capital who decides to invest in startups in exchange for a participation in the share capital of the future business. Most of the time they not only contribute money, but also experience, advice and a network. They help entrepreneurs successfully bring their idea to the market. These Angel investors fill in the gap between the small-scale financing provided by family and Venture Capitalists.
Seed funding investments can range from 10.000 to 2.000.000 euros.
Series A funding
In order to further optimize the product and the user base a startup may opt for Series A funding. Series A funding is used to generate more users and more revenue to scale up. In this round it is important to have a plan for developing a business model that generates profit for the long term. The company has more information available at this stage. For example in this phase it is common that the startup has a good idea of the LTV/CAC ration. Also, the amount of users and the churn rate, clients that go away, customer loyalty and are important KPIs that can be measured now.
In the Series-A funding rounds founders can rely on the somewhat bigger investors. Mostly there is one Venture Capitalist, or a few, involved that takes the lead. The Venture Capitalist who takes the lead acts as a key anchor that helps to draw in other investors. Angel investors also invest in this stage, but they tend to have much less influence than in the seed stage round. Due to large competition it is also happening that late stage VC’s are forced to step in a little earlier.
Other things that come to play a role now are option pools for employees and dilution of shares for the founders. An option pool consists of shares of stock reserved for employees. It is a way to attract new talented employees to a startup company. The creation of an option pool will commonly dilute the founders share in the company, because investors often insist on it. A founders interest should not be diluted more than a half to avoid lack of motivation.
The average Series A funding as of 2020 is 15.6 million.
Series B funding
Series B funding are appropriate for companies that are already past the development stage. Mostly they have a substantial user base and have proven to investors that they are prepared for succes on a larger scale. The companies that undergo a Series B round are well established, generate stable revenues and genrerally come with solid valuations of more than 10 million euros.
The Series B round is used to grow the company so that it can meet the levels of demand. Therefore, the emphasis in this phase will mainly be on the growth in the numbers of users and turnover. The capital raised can be used in various ways such as talent acquisition, developing new technologies, marketing or sales.
The Series B is often led by many of the same investors as the earlier round. But, there will be a new wave of other venture capitalists included that are specialized in later stage investing. Sometimes private equity firms that are specialized in later-stage investments will enter the financing round. The company usually sells preferred shares that do not provide its holders with voting rights.
The average capital raised in a Series B round is 33 million.
Series C funding
Startups that continue with Series C funding are already quite successful. Actually they are no longer start-ups at this point. The valuations in Series C rounds are based on hard data and not only on the expectations for future succes, as in the earlier funding rounds.
At this stage companies are looking for additional funding for example to expand to new markets or develop new products. The goal of investors is to receive more than double the amount of money back. The funding is focused on scaling the company and growing as quickly as possible. Often the goal of Series C funding rounds is to boost the valuation of the company in anticipation of an IPO.
In the Series C rounds more investors are involved. This make sense as the operation gets less risky and more data is available. Many investors from previous round will participate, but often this round attracts new players as well. The new players are different from previous rounds. Because of the lower risk in this phase, large financial institutions such as hedge funds and investment banks are also willing to play a role. So, prepare to work with the largest VC firms and corporate-level investors that are far more demanding.
Commonly a Series C round will be the last external equity funding. Sometimes companies go for Series D or E, but that doesn’t happen very often. Mostly, the amount of money that companies gain though Series C rounds is enough to continue and develop on a global scale. The companies that need a final push before an iPO will continue with a Series D funding.
Note that late investors will purchase shares at a higher price than the investors who injected money in the earlier stages of funding. The returns are also lower, but the risk associated with losing their investments will also be lower. Fundraising for startups requires a lot of time and a good strategy to reach the goal. Understanding the difference between the funding rounds and the type of investors will help you to raise the money. Establishing a startup is not an easy task and always comes with a risk. With a good strategy you might raise the amount of money you need and your idea gets a change to succeed in the sea of competition.