Finding your way through a forest of startup financing options can seem daunting. However, understanding your options is crucial when building the foundations of your company. Each source of capital has a specific set of obligations that founders should explore before raising capital. The more guidance you have, the more likely that your funding round will be successful. Different sources of capital are better suited to different company stages, industries, and deal dynamics.
Many traditional financing sources such as bank loans may not be generally available to startups, so you may need to look for more appropriate sources of early-stage investment funds. There are several places that a startup can find cash to fuel its growth.
Bootstrapping is the process of funding a startup primarily from revenue or the entrepreneurs’ personal finances. Bootstrapping can make sense for lower-growth businesses, or those that have strong unit economics and minimal operational overhead. For many startups, however, bootstrapping can be result in slower operational growth, and without additional capital to invest in growth and marketing, can result in falling behind by better-funded competitors.
Friends and Family
Some startups can get running with small contributions from friends and family. Mixing personal relationship can be either a boon or a strain depending on the dynamics of the relationship. Startups should accept capital from potential early investors based on whether or not they would be good investors first, and as friends or family second.
Accelerators and Incubators
Organizations that provide investment and/or other services such as office space, mentoring or training programs are referred to as accelerators or incubators. Some startup accelerators provide early-stage investments in return for equity or convertible notes in a company. For some startups these programs can be a valuable source of advice, networking, and profile raising.
Angels often invest alongside other angels in an angel group. This has historically been one of the most important source of startup funding. Angel investors frequently come from strong industry backgrounds (and are often former entrepreneurs themselves) and can add significant value through mentoring and business introductions.
Venture capital firms invest funds on behalf of underlying investors such as endowment funds, family offices, and large institutions. Venture Capital firms may have particular mandates regarding the stage and type of investments that they can make. It is important for companies to do research before approaching potential venture capital investors to ensure a good fit.
The emerging industry of equity crowdfunding allows entrepreneurs to combine multiple sources of capital into a single investment round. Equity crowdfunding rounds can include investments from customers and friends, alongside investments from angel and venture capital investors. Equity crowdfunding suits companies that want to build a community around their business and can benefit from having a broad base of investors who are willing to contribute resources, introductions, and connections.
As your startup grows, there will be different types of investors that will invest in different stages of the company. The common funding stages include:
- Series A
- Series B
- Growth Capital
Each stage of startup financing involves different types of investors, deal structures, and pricing dynamics.
Debt financing and loans are not usually available to early-stage companies. But if available, they can provide a predictable cost of capital. However, the repayment terms and security required can make normal business loans an unsuitable source of capital for a startup that has minimal assets and low or lumpy revenue.
Equity is the most common source of investment into an early-stage company and involves the issuance of shares in the business to the investors. The return on investment for these investors comes through the increase in the value of the shares and the eventual sale of those shares to a third party.
Convertible notes are a form of debt investment that may convert into equity at a later date. These can provide a streamlined form of investment for early-stage companies.
Warrants are a type of stock option that provides for the issue of new shares to the investor by the company at a future date or when certain conditions are met.
Employees at a startup are often compensated in part with shares in the company. It is common to structure this type of compensation as stock options. The conditions on these options may include personal, team, and/or company performance.
The term sheet is a non-binding summary of the main terms that will form the basis for the investment in the company. The key terms contained in the term sheet usually relate to the economics of the transaction and control of the company.
The valuation for a startup investment round can be determined in many ways. The most fundamental method of determining a valuation is to determine how much cash is needed by the company at this stage and how much equity can be ceded by the existing owners at this stage in its growth. The total company valuation used to price an investment round provides a convenient shorthand to summarize the key deal terms of price-per-share and number of shares on offer.
Size of the Round
The burn rate of a company is the rate at which the company’s expenses exceed revenue. The burn rate is usually expressed as a dollar amount per month. One way to determine the amount of capital that your startup should raise in an investment round is by calculating how much cash you will need to operate until you are ready to raise your next round of capital. Your runway is the amount of cash available to fund operational expenses and can be expressed as the number of months that it will take to use up the cash based on your current burn rate.
How much equity you can give to investors in this round can be determined by assessing the number of rounds of capital that you may need to raise in the future and the amount of dilution this will cause for the founders and early investors
Your investment agreement may grant certain investors the right to receive information, financial statements, and/or business updates. Some agreements may also grant the investor the right to visit your offices and meet with key personnel.
Different classes of shares may have different voting rights in different situations. The important voting rights include the right to vote on changes to a corporation’s certificate, appointing directors, issuing new shares, raising debt, paying dividends or selling the company.
There are several different types of anti-dilution provisions. Ratchet rights convert preferred stock into common stock at a price or quantity that may prevent or reduce the effects of dilution. A full ratchet converts the preferred shares into common stock at the most favorable valuation. Weighted average ratchet rights calculate the price for conversion using a weighted average of the amount raised previously and the amount raised in subsequent rounds, taking into account both the number of shares for each round and the price per share for each round.
Pay-to-play provisions may balance the anti-dilution provisions by requiring investors to participate in future rounds to maintain some of the anti-dilution provisions.
Pro-rata rights allow investors the right to purchase shares in future rounds, up to the amount required to maintain the shareholder’s percentage ownership.
Entrepreneurs should always be planning ahead and fundraising when they don’t need to, as opposed to running into the situation where you may run out of runway, which can cause you to lose leverage when setting investment terms. Startups should time their capital raising based on both their capital needs and the timing for business and growth milestones. Launching new product versions, winning new customers and receiving positive press can all be helpful in providing buzz and attention that can help in conversations with potential investors.
Startups are most successful in raising capital online when they have proven that there is a market demand for the product that they have created. When there is proven demand for a product, the company can be said to have achieved Product/Market Fit. This traction helps validate the demand for the product and the willingness of the target customer to pay for the product.
Time Between Rounds
The size of your round can influence how long it takes to raise the round and how long the company can operate until the next round of investment. Companies can raise rounds of various sizes online depending on the amount of traction that they have achieved and the investor demand they are able to generate.
When communicating with investors, you should make sure that potential investors know what they’re getting into. The aim of the early-stage capital raising process is to find a partner so honesty and full-disclosure are the best foundations for an investment relationship.
As well as the softer qualification and relationship elements, you should also be aware of any legal requirements that may restrict who can invest in your startup. You should review the requirements for accredited investors, verification and the different legal rules for different types of investors.
What Investors Look For
Every investor is unique, but the factors that they use to assess potential investments are consistent enough that you should plan on addressing all the common investor criteria before you begin raising capital online. Early stage investors typically look for a combination of traction, team, market size, technology and customer demand. You can learn more about what investors look for in a startup in our guide for investors on How To Assess A Startup Investment.
This post was written by seedinvestedu on April 7, 2016
Sources of Startup Finance