04/01/2018
How Funding Works
Investors aren’t just altruistic entrepreneurial-loving businesspeople. Although they may be genuinely interested in the business, as many angel investors are, they ask for a portion of the business in return for giving money.
Before each round, a valuation of the company pie is typically released. Valuations derive from considerations such as management, proven track record, market size, and risk. To grow the pie’s circumference, more than a few slices need to be given away. In fact, most of the slices will be auctioned off for funding. Many small business owners with a big idea would rather have a sliver of a massive pie than the entirety of a bite-sized treat.
Planting the Seed
You can think of seed capital like an analogy for planting a seed for a tree. This round nurtures the seed or the idea for the startup. The seed hopefully grows into a mature operating business, or “tree,” when enough revenue is generated with the help of perseverance and investors' wallets. The capital raised during the seed phase is roughly around $500,000 to $2 million but differs widely on a case by case basis.
Seed funding raises substantial funds to support the initial market research and development work for the company. This includes figuring out what the product will be and who the users or consumers will be. Additionally, the money will help employ a team to do this work. Before this stage, many entrepreneurs are working alone or with just a few business partners. With seed capital, the team will build and launch their product at a target audience.
The key players in this round are more of the risk-loving type. Usually, angel investors and early stage venture capital firms dabble in this less formal round of funding.
Optimize: Series A
After the business has shown some of a track record, Series A funding is useful in optimizing product and user base. Opportunities may be taken to scale the product across different markets. In this round, it’s important to have a plan for developing a business model that will generate long-term profit. Often times, seed startups have great ideas that generate a substantial amount of enthusiastic users, but the company doesn’t know how it will monetize the business. Typically, Series A rounds raise approximately $2 million to $15 million, but this number has increased on average due to high tech industry valuations, or "unicorns."
The investors involved in the Series A round come from more traditional venture capital firms. Well-known venture capital firms that participate in Series A funding include Sequoia, Benchmark, Greylock, Accel, and so on.
How exactly the process works differs slightly from seed capital rounds, since in a Series A round there can be more politics at play. A few firms lead the pack, and may strategically do so. Angel investors also invest but tend to have much less influence in this funding round.
B Is for Build
Series B rounds are all about taking businesses to the next level, past the development stage. Investors help startups get there by expanding market reach. There’s already a big pie that’s been cooking up in Seed and Series A rounds. In Series B, venture capitalists have more of a vision around what the pie will look like, and how big of a slice they hope to obtain.
Building a winning product and growing a team requires quality talent acquisition. Bulking up on business development, sales, advertising, tech, support, and other people, costs a firm a few pennies. Estimated capital raised hovers around $7 to $10 million.
Series B appears similar to Series A in terms of processes and key players. Series B is often led by many of the same characters as the earlier round, such as Sequoia Capital. The difference with Series B is the addition of a new wave of other venture capital firms that specialize in later stage investing.
Let’s Scale: Series C
In Series C rounds, investors inject capital into the meat of successful businesses, in an effort to receive more than double that amount back. For example, let’s say that our meatless meatball shop from Series B now has the potential to put all Burger Kings out of business. Series C is about perfecting, and of course, continuing to scale fast and wide. Companies raise single digit to hundreds of millions in this final round.
One possible way to scale a company could be to acquire another. Say our vegetarian startup has shown unprecedented success selling their specific type of meatless meatball in the United States. The business has reached targets coast to coast. Through confidence in market research and business planning, investors reasonably believe that the business would do well in Europe.
Perhaps our meatless meatball startup has a competitor who currently possesses a large share of the market. The competitor also has a competitive advantage that we could benefit from. The culture appears to fit well as investors and founders both believe the merger would be a synergistic partnership. In this case, Series C funding could be used to buy another company.
As the operation gets less risky, more investors come to play. In Series C, groups such as hedge funds, investment banks, private equity firms and big secondary market groups accompany the before-mentioned investors.
The Bottom Line
Understanding the distinction between these rounds of raising capital will help you decipher startup news and evaluate entrepreneurial prospects. The rounds of funding work in essentially the same basic manner; investors offer cash in return for an equity stake in the business. Between the rounds, investors make slightly different demands on the startup. Company profiles differ with each case study but generally possess different risk profiles and maturity levels at each funding stage. Nevertheless, Seed, Series A, B, and C investors all nurture ideas to come to fruition. Series funding enables investors to support entrepreneurs with the proper funds to carry out their dreams, perhaps cashing out together down the line in an IPO.
