Series or Rounds of Financing (Startups) - Explained
What are Financing Rounds or a Financing Series?
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Table of ContentsWhat is a Funding Round?What are the Rounds of Financing? What are the Characteristics of a Financing Round?Types of Funding RoundsPre-Seed Funding Seed funding or Angel round "A" round or Series A financing"B" round or Series B financing"C" round or Series C financingAdvantages of Round FinancingDrawbacks to Round FinancingOther Funding Rounds Academic Research on A Round Financing
What is a Funding Round?
Round financing, also funding round, series funding round, or venture round; is the attempts companies- mostly startups- make to grow their line of business by seeking outside or external investments in exchange for equity. The difficulty of obtaining funding from banks and other financial institution has resulted in equity financing to be more popular compared to debt financing. Jumpstart Our Business Startups Act commonly referred with the acronym JOBS Act reduced regulatory requirements for small businesses from some provisions of the U.S Securities law. The bill allowed startup companies to have a lesser strict set of disclosure for an initial public offering (IPO) and legitimatized soliciting of capital through crowdfunding over the internet. For many billion dollar startups, one thing stands out, is the many rounds of financing the companies had to go through to secure investments propelling them to their current staggering valuations.
What are the Rounds of Financing?
There are several stages or rounds that a company may require capital injection, with each funding round having a designated identity. Some of the financing rounds may include;
- Pre-Seed Funding.
- Seed funding or angel round.
- "A" round or Series A financing.
- "B" round or Series B financing.
- "C" round or Series C financing.
Each designated round provides venture capitalists and other institutional investors with information on risk level as well as growth, with each round having different company valuations. Notably, most investors, especially private equity investors, will typically prefer convertible preferred stock to common stock for the various rounds of financing for a startup. Well, the reason for an investor opting for convertible preferred stock is primary the special features that the security has that makes it a hybrid security, falling somewhere between debt and equity. Apart from claiming dividends, if the startup falters and liquidates a holder of a convertible preferred stock will be paid together with creditors prior to common shareholders. It is like hedging the risk of ones equity investment.
What are the Characteristics of a Financing Round?
Before delving further into how a financing round works, we can identify some of the key participants to the various rounds of financing and related interests at play; Firstly, there are the entrepreneurs hoping to secure investments for their business ideas. The primary interests being to get its operations up and running. Also, the entrepreneur seeks strategic investors who bring on board experience that can fast track the growth of the company to desired ranks relative to competition. Secondly, there are potential investors who not only believe in the spirit of entrepreneurship but are also willing to risk their funds by investing in startups. The investors also hopes that the company will succeed and gets a worthy return on investment in the long term that is commensurate with the investment made. Generally, the investor will take up part of the company ownership as compensation for investing and if the company grows and earns profits, the investor is compensated in the form of dividends. Thirdly, there are accountants lawyers, and valuers as well as business analyst having a role to play in funding transactions. Accountants will ensure the business health is ascertained as solvent by auditing the companys financial books. Valuers, on the other hand, will try to value the companys worth on various factors such as cash flow or capital among others. Whereas, lawyers will ensure every statutory requirement is complied with in the transaction. Business analyst will assist investors in doing a comprehensive due diligences and necessary background check that may take months. Additionally, they will evaluate the business plan, pitch deck and proposed business strategy and validate their credibility. This stage is what will inform the amount of funds that an investor is willing to put into a startup.
Types of Funding Rounds
To better understand how Round Financing works, we can discuss each designated round in details to unravel what each stage involves. Thanks to crowdfunding, any individual can invest alongside other established venture capitalist, private equity firms as well as angel investors in any round of financing a startup.
This is the idea stage with no working prototype but only a vision. The startup idea will be kick started with the founder(s) personal savings. It is the earliest financing round ,and as the idea crystalizes and there is a working prototype the entrepreneur or founding members will typically seek additional funding from family members and close associates. However, at this stage the funding may not be considered investments but rather a grant typically depending on the generosity of family members as well as friends. Nevertheless, some associates might contribute with intention of joining the entrepreneur as founders and assist in spearheading the startups vision. The funding will assist the entrepreneur(s) to register the startup and ensure other statutory requirements are complied with. Additionally, some of the funds may be used for further product development to ensure a viable product that can be commercialized. Also, the entrepreneur can decide to fully rely on his/her own money other than outside investments. Such an individual is said to be bootstrapping since there is a deliberate attempts to establish a company from personal finances or the operating revenues of the new company. Bootstrapping puts a lot of financial pressure as well as risks on the entrepreneur and a possibility of limited funds to propel company success at a reasonable rate.
Seed funding or Angel round
A seed capital is the first capital outside capital injection into the business. This is the official first round of equity investing. It is common for angel investors who have an appetite for risk to provide modest sums typically close to a million dollars at this stage. Seed funding is a crucial stage that kick starts the process converting a prototype into an actual concept capable of generating revenues for the startup. Why seed? Well, one can think of the "seed" funding as part of an analogy for planting a tree. The seed is the product that is being funded by the angel investor and the soil is the market. If the soil (market) has sufficient nutrients (enough seed funding and a successful business strategy) the seed (product) will grow into a tree (Successful brand). Seed funding is usually provided by high net worth and affluent individuals called angel investors; probably retired executives or entrepreneurs. The term Angel investor was coined from the Broadway theaters, when wealthy individuals donated funds back then to aid in theatrical productions. Essentially, these individuals have the finances and desire to provide market insights as well as a successful business strategy for the startups to succeed. There are many reasons or motivation that angel investors take the risk to invest in startups, some of the possible reasons may be;
- They have been successful as entrepreneurs and want to give back by supporting upcoming entrepreneurs since they can relate with the experience.
- They are passionate about entrepreneurship and assist startups for intellectual satisfaction.
- They are either part of a crowd of smart entrepreneurs or business executive who are encouraged to invest in the next generation of entrepreneurs changing the world.
- They want to stay updated with the latest development in the entrepreneurial ecosystem as well as to make money.
"A" round or Series A financing
At this stage, there is a proof of concept demonstrating that the business idea concept is viable has generated revenues as well as profits. This is the second round of equity financing. However, it is the first major round of business financing by private equity firms or venture capitalist firms. The first equity investment was by an angel investor. The valuation prior to investment is based on progress made with seed capital, quality of executive team, market share and risks involved. With A round financing, the company is typically looking to expand operations or production due to increased demand. The funding from a private equity firm or venture capitalist firm may easily exceed one million dollars. Securing finance at this stage is an early sign of confidence that the business is headed in the right direction and the business concept is worth pursuing. However, with great investments comes a great demand. The company will be required to relinquish more shares to the investors. The level of accountability is elevated with set milestone by the latest investors expected to be achieved. More talent may be brought on board by the investor to protect their interest and to stimulate further growth at an accelerated level. Also, at this stage, angel investors may invest but will have less of an influence compared to the seed funding stage. Notably, less than fifty percent of startups can raise funds as part of a Series A funding round through private equity firms or venture capitalist firms as they tend to fail to appeal to investors. Consequently, it is increasingly common for companies to use equity crowdfunding websites such as Kickstarter, Indiegogo, GoFundMe, 40Billion, and many others in order to raise additional funds.
"B" round or Series B financing
At this stage, the business is considered to be past the startup or development stage and additional funding is purposely to take the business to the next level. Companies that have gone through seed and Series A funding rounds have already typically achieved a substantial market share and have achieved milestones set by investors and are ready for succession a larger level. Here the B series is for build, it involves seeking capital in order to build a strong marketing approach, attract additional quality talent, create a good customer support and acquire the latest technology. The company at this stage is also highly valued and may attract investment of up to ten million dollars and upwards. The goal of financing here is to break even in the market but to also have the net profit with the advantage of low risk. The valuation prior to investment is based on companys performance relative to competition and the overall industry, revenue forecast as well as assets owned by the company. Series B funding is the second round of equity financing and can either be from private equity investors, venture capitalists, crowd funded or credit investment.
"C" round or Series C financing
At this stage, the company is much successful and has demonstrated shrewd business acumen when it comes to selling its products in a certain geographical market. Companies that have reached this funding stage typically have established a strong customer base, revenue streams, and proven steady growth. Business research as well as well curated business plans give the existing investors confidence that the business should exploit new market, develop new products or even to acquire other companies to gain competitive advantage. To achieve the set objective to business needs another third round of equity finance; Series C funding. At this stage the company valuation is based on data and not prospect and may attract funding of upward of a hundred million dollars. The huge funding is because the company has already proven itself to have a successful business model. Additionally, the playing field is less risky and more investors including as hedge funds, investment banks, private equity firms and big secondary market groups come to play. Generally, a company will end their appetite for external equity funding with Series C rounds but still continue to develop on a global scale. Alternatively, many of these companies may utilize Series C funding to help boost their valuation in anticipation of an initial public offering (IPO).In addition, this stage may be an exit strategy for any investors wishing to cash out their investment.
Advantages of Round Financing
- Apart from financial resources, venture capitalist for instance provides guidance and consultation to startups. Such knowledge resource ensures better decision making in key management.
- A startup benefits from lawyers as well as accountants retained by the investors who will provide active support to the startup to ensure faster growth success.
- Venture capitalist as well as private equity firms usually has a web of well-established network that the startup can tap into to propel the business.
- Round financing are equity financing models and there is no burden of collateral or the need to make debt payment every month in contrast to debt financing.
- Ability to attract more funding depending on the business prospects compared to debt financing which depends on the value of the contingency for the loan.
Drawbacks to Round Financing
- Loss of company control since every investment require and equity exchange and therefore decision making requires a vote.
- Share the profit accruing from a successful implementation of ones idea with other investors in form of dividends.
- Getting a suitable investor and the paperwork take up a lot of time sometimes running into months which may delay anticipated activities from proceeding.
- Not suitable to family owned businesses that have no intention of giving up equity with intention of obtaining additional capital.
- Potential for conflict when shareholders have different vision and prospects for the company. For instance, Apple Inc.s board at one time fired its founder Steve Job due to difference in opinion.
Other Funding Rounds
A startup generally goes through four phases of investment: Seed capital (Angel investment), venture capital (Series A, B and C) mezzanine funding, and an initial public offering. When the company is well established and has closed external equity funding then mezzanine funding, and an initial public offering are on the menu;
- Mezzanine funding This is when a company secure debt financing from financial institutions which has an option of being converted into shares in case the company defaults in repayment. At this stage the company is well establish and can secure funding based on cash flow as well as against some of its assets as collateral.
- Initial public offering (IPO) This is the stage that the companies goes public either as a requirement by the SEC having met set threshold. The company will typically get funds from the public in exchange for shares.
Academic Research on A Round Financing
- Venture capital financing and the growth of startup firms, Davila, A., Foster, G., & Gupta, M. (2003). Journal of business venturing, 18(6), 689-708.
- Who bankrolls high-tech entrepreneurs?, Freear, J., & Wetzel Jr, W. E. (1990). Who bankrolls high-tech entrepreneurs?. Journal of Business Venturing, 5(2), 77-89.
- Specialization versus diversification as a venture capital investment strategy, Norton, E., & Tenenbaum, B. H. (1993). Journal of Business Venturing, 8(5), 431-442.
- Patents as signals for startup financing, Conti, A., Thursby, J., & Thursby, M. (2013). Patents as signals for startup financing. The Journal of Industrial Economics, 61(3), 592-622.
- How well do venture capital databases reflect actual investments?, Kaplan, S. N., Strmberg, P., & Sensoy, B. A. (2002).
- Optimal investment, monitoring, and the staging of venture capital, Gompers, P. A. (1995). The journal of finance, 50(5), 1461-1489. Staged financing: an agency perspective, Neher, D. V. (1999). The Review of Economic Studies, 66(2), 255-274.
- How does venture capital financing improve efficiency in private firms? A look beneath the surface, Chemmanur, T. J., Krishnan, K., & Nandy, D. K. (2011).
- Does angel participation matter? An analysis of early venture financing, Goldfarb, B., Hoberg, G., Kirsch, D., & Triantis, A. (2009).
- Determinants of venture capital performance: Europe and the United States, Hege, U., Palomino, F., & Schwienbacher, A. (2003). (p. 4). working paper, HEC School of Management.
- The effect of venture capital financing on the sensitivity to cash flow of firm's investments, Bertoni, F., Colombo, M. G., & Croce, A. (2010). European Financial Management, 16(4), 528-551.
- New venture teams' assessment of learning assistance from venture capital firms, Barney, J. B., Busenitz, L. W., Fiet, J. O., & Moesel, D. D. (1996). Journal of Business Venturing, 11(4), 257-272.