Startups need the help of experienced leaders in business and finance because the risk of failure is real. In 2011, a Harvard Business School study shared that 30–40 percent of venture-backed startups with “high potential” ended up in liquidation.
Founders familiar with the equity funding process stand a much better chance of finding the right advisors. And your advisor will guide you through the equity fundraising process.
What is equity funding?
Equity funding sells a piece of the company (stock) in exchange for capital investment (money).
Startups might consider an alternative called venture debt. Usually, this option comes after a few completed rounds of equity funding. The order—using equity funding to leverage debt financing—makes sense because lenders often require collateral that most startups don’t have.
Equity investors want greater returns than interest payments on a principal loan. Angel investors and venture capital want a cut of the profits.
What types of funding are available to startups?
Your company needs cash to bring a product or service to market, cover daily operations, and expand into new markets, and your funding options are debt or equity.
Raising capital by debt requires collateral. For instance, venture debt lenders want interest payments of up to 20% of the principal loan. Default is a concern for both the lender and a startup founder.
The other side of the coin is equity funding which doesn’t require collateral or monthly interest payments. And a lot can change between your first $25,000 and a $3 million capital raise. There are risks associated with both options.
Here’s the thing, there is no substitute for experienced financial advice because every company is different.
Getting the gist of equity fundraising will help you come to an informed decision of whether you’re ready to pitch and if investors are the right thing for your company at this early stage.
Funding rounds and what they mean for your startup
Most likely, you’ve heard of funding rounds such as seed-stage and Series A, B, and C. However, the rounds don’t stop there; some companies go to an H round. Note, savvy investors may suspect there are issues with your company past a Series C or D.
What’s important to take away is that each round corresponds with your company’s evolution and attracts different kinds of equity investors.
In the earliest days of a startup, the founder invests in their idea with their own money. It’s a modest investment relative to a Series A round but meaningful financially and emotionally. Founders might take out a personal business loan or max a credit card to debt finance their startup. I call this the “Founding Round” of capital fundraising.
Another very common pre-seed capital option is approaching friends and family for $10,000., also known as friends and family funding. Hopefully, a Founders Round of capital will provide you with enough time to develop your business plan or prototype to take it to outside investors who want to stake your company.
Seed Stage Sets the Stage
At the Seed Stage, a startup is ready to test itself on the market but needs capital. Seed-stage investors are often high net worth individuals like a wealthy tech entrepreneur who can make an angel investment of $200,000 or more for equity in the business. These high network individuals are also known as Angel investors.
Often at this juncture, it may not be possible to compare and calculate the valuation of your company. In that case, angel investors may accept convertible or SAFE Notes, which is debt that converts to equity at a discounted rate (typically 20%) at the Series A round.
Angels are either high net worth individuals or groups of investors such as Band of Angels, Sand Hill Angels, or Columbia Business School’s Angel Network that look for early-stage companies with the potential to become profitable.
It has been known to happen that companies may raise enough capital in the Seed Stage to become profitable and don’t need a Series A round. Please note this is very rare.
Series A, B, C Rounds Summarized
The reality of fundraising is that not all companies will become successful. Some (i.e., a unicorn) are uniquely fortunate to go from Series A straight to $1 billion. According to Fundz, the average Series A raise was $15.6 million in 2020. This high level of funding indicates that there’s a lot of money out there for the right company. Also, companies aren’t tied to the IPO route to secure large sums of capital for growth phases.
Most startups need regular infusions of capital (rounds) to become profitable. And each round has a specific purpose in the lifecycle of a startup.
The equity fundraising process can move very quickly. Often, investors want founders to spend and to raise a new round of capital every 18 months.
Startups with customers and a business plan can attract greater investment from angels and venture capital groups. A typical Series A raise in Silicon Valley of $5 million enables a founder to focus on building that customer base.
Series B funding rounds are typically limited to institutional investors like Sequoia Capital and Greylock Partners, interested in startups poised for rapid growth. A company that is growing needs capital for capacity-building, marketing, and investing in technology.
I caution against applying general valuations from survey data to your startup fundraising. Remember that valuation should be linear between the Seed Stage and Series B. So, if in Series A your valuation was $8 million, it will be higher in Series B. The opposite is true in terms of investors. In the A round, investors will typically want a 30% stake, and in Series B, 20–25% equity is typical.
Series C is for startups that have a proven track record and need to double-down on growth. Your startup could have met its target KPIs in one market, and now it’s time to take on another, larger one. To maintain a competitive advantage, your company may need to merge with a competitor or acquire it. At this expansion stage, hedge funds, investment banks, and private equity come calling with significant sums to invest.
A few words about Bridge and Mezzanine Rounds
There are rounds between Series A, B, C. An existing investor may loan a company that has burned through their cash as a bridge to the next round of fundraising. A mezzanine round is the last infusion of cash before the IPO.
Some CEOs prefer to sell rather than go public. Some CEOs aren’t interested in dealing with the filings and stress from The Street.
Be aware that companies that advance beyond the C round could experience a “down round.” A company may have valued at $250 million in a Series C round, and that valuation falls to $100 million in a D round.
Can equity fundraising work for your startup?
Yes. Equity fundraising provides the much-needed capital scaling a business requires. Also, preparing for a pitch is an invaluable experience for most early-stage CEOs regardless of the outcome.
The basics of attracting investors are:
a great pitch deck that is vetted,
a pitch that is practiced and ready to go, and
a financial plan that shows you’ve thought through the business of it all, and your financial model has a 2–3-year trajectory.
Be prepared to meet the right funding opportunity.
Now that you’ve got the basics of equity fundraising, it’s an excellent time to find an advisor who can guide you as you prepare for your Series A round.
Our world-class CFO consulting team is passionate about helping clients reach their business goals. Get in touch with Rooled to find out how we can help your company grow.
About The Author
David P. Johnson
David P. Johnson is the Board Member/Advisor of Rooled. His entrepreneurial journey started as an accountant for two Big Four accounting firms. He switched to managing rock bands for ten years. Financial advising called him, and he built one of the first outsourced accounting and finance service firms in the country, tempCFO, which advised 4,000 companies over 15 years. After David sold tempCFO, he has been advising entrepreneurs and businesses. He recently joined Rooled as a Board Member. David is proud to work with the best-of-the-best in outsourced accounting, tax, and financial advisory that is the Rooled team. When he’s not advising founders and CEOs, David is skiing wherever there is fresh powder.
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