Funding is core for business and it is a known fact. Money is the factor that makes things to happen. In the previous article we discussed about the various sources of funding. It has to be understood, that a business does not stick to one single sources of funding throughout or go with one-time investment. Also, the fundraising is an ongoing process and it goes through various stages. Angel and venture capitalists prefer to fund the company in stages rather than investing the whole amount at the same time. Startups, depending on the stages of development, have different requirements of funding. Having a clearer picture of the stages of funding will help the founders and other top executives to understand the company needs and the source of investment the company demands for its needs. Though the differentiation between the stages are slightly arbitrary, they serve as an outline how the company’s needs and fund sources evolve. There are parameters to classify the stages which includes management team, the value proposition, the risk, customers’ profiles and engagement, revenue, etc. Generally, there are three stages of fundraising that a startup goes through to reach the point of sustainability in business. They are:
1. Early Stage:
Early stage refers to the initial or the beginning days of the startup. That is the stage when the founder kickstarts with the business idea, tries out its economic viability. The company establishes its evidence or strong proof with its technology, business model and get on board the working team and the customers. Pulling in customer can be through showing them the prototype or via the company’s website with its internet traffic and their feedback. In this stage the company gets to test the market and experiment with its business idea. The funding is through two ways in this stage. They are seed round and first round.
– Seed Capital:
Seed capital is the very first investment for the company used for the market research and the developing the business product further. This first injection of the capital into the company is usually through the founders, via direct investment or through sweat equity or both. The founders sought after friends and family, that is, the first circle to get the fund needed. After from the first circle, there are some government program also that could help the company in the stage of research and development of new products and services. This seed capital is used to cover initial operating expenses until the company can stand on its own and generate revenue and to attract the attention of other investors. It has to be noted that this round has the highest risk in terms of Return of Investment (ROI).
– First Round of Funding:
First round of funding or Series A funding refers to the class of preferred stock sold to its investors in exchange of the investment. It is generally the first set of stock before the common stock and the common stock options opened to the founders, employees, friends, family and angel investors after successfully completion of the proof of concept stage. This capital is generally used to figure out or increase the user base, move to new market, improve the business model from the working perspective. The risk involved in this stage is comparatively lesser when compared with the seed round investments.
Sourcing fund for the early stage of the startup is the most difficult and risky in comparison with other financing stages. Also, this is the stage where most of the startups fail. To survive and complete the stage, the management team and the company should have the potential to bootstrap the operation.
2. Expansion Stage:
From the early stage, the company move to expansion stage when the companies’ products are open to the market and the companies have some paying customers. In this stage, the company may or may not be profitable but is sure on the course of sustainable profitability. If the company is profitable, the company profits are re-invested into the business for its growth and betterment. The investors in this stage include capitalists, banks and other commercial lenders, strategic partners and the public markets through a public offering of shares. The expansion stage includes three types of funding – second round, third round and bridge loan.
– Second Round:
Growth is often exponential by this stage. Second round investment is usually for the companies that deals with production-quality products along with a few paying customers. This stage is after the first-stage financing and provides funding for the expanding the business that is producing, selling and shipping products and has growing user base and stock level. The startup at this stage should be capable of generating good amount of revenue if not able to make profits. Also, the company valuation ould be higher, which means the Series B investor would invest more in the company than the Series A investor.
– Third Round:
After successful second round investments, companies can go on with any number of expansion stage rounds. The third round is generally called as mezzanine financing phase. This stage of funding is done for the company which has increasing sales volume and is profitable. The fund received in this phase of funding is normally used for expansion, marketing or to improve the existing product. Venture capitalist funding happens during this stage. The core of this stage is that the external funding is invested in exchange for some form of equity interest, which is often preferred stock or convertible debt instruments.
– Bridge Financing:
Under this stage, the companies working on to expand choose bridge-financing rather than equity financing. It is generally a loan of short-term interest only financing to fill the time gap when an expenditure is made and the returns are generated. For instance, government grants are mostly in the form of bridge loan as the grant will not pay directly for the asses purchase but will pay/ reimburse the company after the purchase is made. This time gap between the expense to buy equipment and the reimbursement by the gap bridged with these bridge loans. Apart from the government grants, commercial banks are also provide bridge loans.
3. Liquidation stage:
Liquidation stage is where the companies in-need of money liquidate their stock to make some instant cash for the investors. It can be on a long-term too. Liquidation preferences would be negotiated and decided among the investors. At exit and after secured debt, trade creditors and other company obligations are paid, the liquidation preference decided and concludes the distribution between the preferred shareholders and the common shareholders. Non-participating simple preference, multiple preference, high multiple preferences are some of the liquidation preferences. This liquidation process is generally through going public, Merger & Acquisition or via leveraged buyout.
-Startup going Public or IPO:
Going public means the situation when a private company’s initial public offering (IPO), becomes a publicly traded and owned entity. Startups generally make use of this to expand their business further horizontally and vertically. Venture capitalists may use IPOs as a way to get out their investment in a company. Going public strengthens capital base, makes acquisitions simpler, diversified ownership and increases prestige. However, it puts pressure on short-term growth, increases cost, imposes more restrictions on management and on trading, forces disclosure to the public and the gives way to founders losing the decision-making control on the company. Also, IPO can have a lot of negative implications on time, resources, customers and employees and core business value.
– Merger & Acquisitions:
Mergers and acquisitions strategies can be used as both as exit strategy or also as a means to expand and expand the company. In recent days, it has become a popular means for many companies to address the increasing pace and the level of competition the companies face. Acquisitions give larger startups quicker access to technology, market, customers and acts as a quicker exit strategy. However, not all companies reap the same benefits through acquisition. This is mostly because of the poor integration of the acquired assets into the acquiring company. Integration can damage the acquisition and merger to a greater extent.
– Leveraged Buyouts:
A leveraged buyouts (LBO) is termed when private investors acquire a company with limited equity but large amount of debts. It makes use of the a loan to buy a controlling interest in a company from its stockholders. It is an aggressive business practice where the investors or a larger corporations utilizes borrowed funds or debt to finance its acquisition. The assets and the properties of the acquiring company and acquired company works as a collateral security in this form of deal. Most of the times, a leveraged buyout does not involve much committed capital. This form of business deal is called as ‘hostile takeover.’ However, the takeover need not be hostile in all the situations. It is also called as highly leveraged transaction and bootstrap transaction. It has to be noted that the risk involved in this type of buyouts are large. Investors hesitate to invest in the companies that have more debts on the whole. The initial investment required to ‘buy in’ to buyout is often large. It requires a lot of experience and careful analysis to decide whether a company is suitable for buyouts.
On the whole, funding a company or selecting the right investors of the startup is no easy deal. The founders or the CEOs should analyze the business case and work to reduce the risk before the investors enter. They should be able to assess the stage in which the company is to take the right financial decisions. As the company moves from the seed round to the expansion stage, the risk decrease considerably and raising funds get easier.