Let's say you have an idea for a business. It's a solid idea that solves an immediate tension in an industry. It's an idea that, given the proper circumstances, can fill a niche role in a marketplace.
This hypothetical business has potential, but you realize quickly that this business is not going to bootstrap itself. There is no way that your current funds will be enough to get your business off the ground.
Trying to fund your early stage business through personal funds, or working on it as a side-hustle, can be a recipe for disaster. Companies typically need time before they obtain reliable customer bases, which makes it extremely difficult to finance a startup through early-stage revenue.
If you plan on keeping your day job while you work on your company in your free time, beware that there are others out there who may beat you to market if they have a similar idea and more time to work on their company.
The fact of the matter is that if you want to start a business, you will most likely need to obtain external capital. The purpose of this blog is to explain the basics of the first two rounds of startup funding and how it can help your startup.
Initial expenses for businesses can be quite costly. It depends on the nature of the business, but it is safe to say the list of possible costs for a nascent business can seem endless. For example, funds are necessary to hire staff, lease or buy expensive equipment, or put a deposit down on renting space in a building.
Without external funding, your business will likely fail. Why plan on bootstrapping your way through this period when you can get help?
Seed Funding, sometimes referred to as Seed Capital or Seed Investment, is the first round of funding a company goes through. The purpose of this round of funding is to make the company look attractive enough to investors to secure more funding in the future.
Seed Funding can come from a variety of different places:
1. Angel investors look for new companies to invest in.
- Angel investors are accredited investors with high net worth, respectively, that diversify their portfolios by investing in startups
2. Friends and family may agree to loan you money.
3. Money from your personal account can be used to get your business going.
4. In recent years, crowdfunding on websites like Kickstarter have become popular ways to raise seed capital.
5. Accelerators and Incubators are alternative options that have become popular in the past few years.
- An accelerator program is a fixed-term program designed to help select ventures grow through their nascent stages, ending with an event where the ventures showcase their business to investors. The role of an accelerator is to help startups design products or services, identify target markets, and obtain capital.
- An incubator is a company that helps startups for undetermined periods of time, providing space to work and capital to use.
These potential sources of capital are not in the business of handouts.
Accelerators and Incubators may require equity from a company in exchange for their services.
Angel investors expect equity from a company in return for their contributions of early stage capital. Investing in a startup that has yet to prove itself is risky. Generally, angels accept more risk than venture capitalists, many of whom desire a proven product/service with a reliable customer base and revenue stream.
One important trait that separates angel investors from VC’s is that they tend to value intangibles more than any other type of investor. The product/service idea and the management team matter a great deal to angel investors since most startups lack a proven track record of success.
Angels often like to be involved with the founders of the company on a personal level, often giving advice and expertise along the way. It is important to understand that they will want their voices heard and acted on if they invest in your company, especially if they own significant equity.
Friends and family are loaning—not gifting—money most of the time; they will expect to be paid back.
Participants of a crowdfunding session expect a product or a service that they can later use, and your reputation can be jeopardized if you cannot deliver what they want. Recently, equity crowdfunding has become en vogue, and your company might need to give away securities in exchange for capital.
You likely noticed that a company raising Seed Capital is going to give away equity between 10-25%. Occasionally, investors will ask for preferred stock with anti-dilution provisions because of the inherent risks of investing in an early-stage startup.
Paul Graham, a Silicon Valley entrepreneur and venture capitalist, advises startups to have a plan when it comes to giving up equity:
“If you can manage to give up as little as 10% of your company in your seed round, that is wonderful, but most rounds will require up to 20% dilution and you should try to avoid more than 25%. In any event, the amount you are asking for must be tied to a believable plan. That plan will buy you the credibility necessary to persuade investors that their money will have a chance to grow.”
The amount of equity a company at this stage gives out is at the discretion of the company leaders, but rest assured that some portion of equity will be requested by investors.
Once a company acquires Seed Capital, they can use it for a variety of purposes:
- Developing the product / service
- Creating a prototype for the product
- Paying salaries and living expenses of employees
- Market research
- Research and development
- Hiring additional employees
- Purchasing necessary assets to grow operations
- Paying back small loans
The valuation of a company that completes a round of Seed Funding is roughly $500,000-$3,000,000. The average amount raised is difficult to gauge because of the variation in fundraising, industries, and other disparate factors, so valuation is more useful in identifying businesses in this stage.
In an ideal world, every startup uses initial Seed Funding to get their business going and never needs to raise another dollar. However, many startups inevitably need another influx of capital to grow and expand, which means they must undergo further rounds of funding.
When a business reaches this stage, it tends to be far more fleshed out than it was when it was while raising seed capital with a much higher valuation.
The venture will have reached company-specific revenue goals. It will probably have a reliable consumer-base, evident, perhaps, in the form of users of an app, or of a certain number of widgets sold. In any case, the infrastructure of a successful business will be established, albeit at a small scale.
Investors are looking for signs of that infrastructure. They will evaluate a selected business to determine if it is a potentially lucrative investment. Every investor looks at and values different aspects in a given company, but there is a general criteria which must be met to determine if they will invest.
- Is the company satisfying a market need? Investors will try to understand the consumer base of the business, and if the product/service is solving a noticeable tension or pain point for customers.
- Is the company aware of its market? A business seeking this funding will need to be cognizant of its competition, its ideal customer, and its addressable market. Furthermore, the business should have an exit strategy in mind.
- Bright, hard-working founders. A business can only reach its potential with the correct people behind it. Can you present in a professional manner? Do you work hard? Is your network strong? Ultimately, are you the right person to trust with capital in order to bring this idea to market?
Series A Funding can raise capital between $2-15 million dollars, which is a noticeable increase from the $500,000-$2,000,000 range typical of seed funding.
What Series A allows a company to do is grow. Some tangible examples of this growth are:
- Hiring talented, productive team members
- Launching a marketing campaign to attract new consumers
- Working on the continued development of the successful product/service offered by the business
- Research and development into new products or business models
Investors in companies at the Series A stage are primarily Venture Capitalists and Angel Investors. The influence of Angel Investors at this stage is reduced drastically from Seed Funding.
Some of the top Venture Capital Firms are:
- Accel Partners
- Andreessen Horowitz
- First Round Capital
- Kleiner Perkins Caufield & Byers
- New Enterprise Associates
- Sequoia Capital
- Union Square Ventures
After receiving Series A Funding, companies can use their newfound capital to shift their business into high-gear. However, many companies may need additional funding. Read more about how businesses use Series B and C funding by clicking here.