What are the financial stages of a startup?

Stage 1: The entrepreneur puts in their own money as first cash in the business

Investors no longer fund ideas. In an era of increasing technology and decreasing costs, the expectation is that the entrepreneur will be bringing an operating company with at least some traction.

Stage 2: The first outside capital is often raised by friends and family

Although this stage is not required, most startups do raise money from friends and family in the form of equity or loans, to help get the company to a stage at which it is legitimately investable by third parties. The amount raised here can vary significantly based on family resources, but we typically see investments at this stage of $25,000 to $150,000. Well-heeled entrepreneurs often start off with $1 million or more.

Stage 3: The entrepreneur begins fund raising

In the same way that an angel, is looking under every rock for a great entrepreneur, so is the founder of a startup looking in every nook and cranny for a great investor. The entrepreneur, if he is smart, will start by letting everyone know that he has a great startup looking for early investors. So keep your eyes and ears open for leads to interesting investment opportunities, even from the most unexpected sources.
At the same time, the entrepreneur must research which specific investors would be productive to approach. Some angels only invest in their home city, others only invest $5,000 at a time, others only invest in biotech opportunities. Blindly sending a business plan or PowerPoint deck to every angel and VC in the world will have zero effect, and simply clogs the system “while annoying everyone — the smart entrepreneur knows this and behaves accordingly.”

Stage 4: The entrepreneur should consider applying to one of the new breed of accelerators.

Accelerators typically provide several months of intensive mentoring — together with small but meaningful stipends for company founders — at the end of which they host a Demo Day to introduce their graduating companies to a number of local angel investors. While Y Combinator (based in Silicon Valley) and TechStars (with several locations and affiliates around the world) are two of the best known, there are dozens of others: local, national, and international, many specializing in specific areas (including fashion, food, finance, gaming, and more).
Accelerators are an interesting sidestep when it comes to the usual trajectory of fundraising, valuations, and amounts raised. Rather than negotiate with each company and set valuations based on the company’s traction to date, accelerators tend to be extremely selective in the participants they accept into their programs, and thus come from a position of strength. While there is some variation, most accelerators provide investments of $25,000 to $50,000 to cover the team’s expenses during the three months of the program in exchange for 5 to 6 percent of the company’s equity (which works out to roughly a $500K valuation: low for a typical high-growth startup, but made up for — at least in theory — by the mentoring, contacts, and support from the accelerator).

Stage 5: Enter the angels, either independentally or in groups

As a very rough range, from $150,000 to $1.5 million in invested capital, the entrepreneur enters angel territory, either by lucking into one rich and generous angel, or (more likely) by pulling together either a group of individuals (at $10,000 to $100,000 each), or one or more organized angel groups, or one or more micro-VCs (colloquially known as “super angels”). Depending on the circumstances, these more-or-less professional, arms-length investors will fund their money either in the form of a convertible note (with a cap on valuation), or in a Series Seed or Series A convertible preferred stock round, using similar documentation to that used by venture capitalists.

During this period and each of the subsequent fundraising episodes in a company’s life, the most important goal for the entrepreneur is to identify a lead investor or champion. For many reasons — most notably limited experience/skill in the case of a novice angel, and limited bandwidth/capital in the case of an experienced angel — this is often a challenge. The deal lead will be critical in rounding up other investors, drafting a term sheet, and getting the deal done. He or she will be the entrepreneur’s primary champion and often mentor. The lead investor can vouch for the entrepreneur other investors in their circle or who follow them on online.

Stage 6: Venture capital and series A crunch

After angels have been tapped for whatever funds they can supply (generally no more than $1 to $2 million), the company has to deliver on its rosy projections. Just as the majority of companies that raise money from friends and family never make it to the angel stage, the vast majority of companies — 90 to 95 percent or more — that are funded by angels never see venture financing. It is this tough winnowing process that periodically has entrepreneurs bemoaning the apparent crunch in funding once they begin to need large amounts of cash.
For the successful/lucky ones that do make it, they will raise amounts from roughly $1.5 million (perhaps from one or two seed-stage funds joining together) up to $5 million to $10 million (likely from one or two traditional venture funds). In either case, these professional investors will almost certainly be investing in the form of convertible preferred stock using something like the National Venture Capital Association’s Model Series A documents. They will likely make their first investment about half of what they’re prepared to put in, with the rest coming in one or more follow-on rounds if the entrepreneur successfully executes the business plan.

Stage 7: Growth capital and letters beyond B

Finally, north of $10 million to $20 million in total capital raised, the entrepreneur will be getting money from a later-stage VC growth fund, whose paperwork will be similar to the earlier venture capitalists. They will put in much larger amounts of cash in successive rounds of convertible preferred stock investments (known as Series B, Series C, Series D, and so on) but the business valuation will be much higher, so they may end up with a smaller stake than the earlier investors (who likely would have continued to invest in each round in order to maintain their percentage ownership).

Stage 8: The public or private exit

Once the later stage funds have provided the company with the cash it needs to generate value, the focus shifts to the long-term future of the venture, and, more important, how to provide liquidity for the company’s founders and investors. The choices here are typically an acquisition by a larger company, or entering the public markets through an initial public offering (IPO). The former path is much more common than the latter, but in both cases the company’s investors are able to see the fruits of their prescience and bold actions. While the bulk of acquisitions happen in the $30 million to $50 million range after a Series A or Series B round, if the original investments were priced correctly, those exits can often return 10 to 20 times to the company’s early investors. And, in the unlikely case of an IPO (which would typically happen only after several later stage investment rounds), the returns can be 100x or more.

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Ravi Kumar.

Ravi Kumar.

Building nextgen real estate platform at PriceHubble & podcaster at productlessons.com. I blog about products, business around products, and growth strategies.