What is a funding round?
A funding round occurs when a startup seeks to raise capital from either new or existing investors; it concludes when said transaction is complete. Typically funding rounds grow in terms of both size and scope as the startup scales its operations and boosts its valuation. However, sometimes a new funding round may be lower than a previous round, when this happens it's referred to as a down round.
Startups attempt to raise enough capital in each round to fuel their growth objectives and fund their operating expenses until their next raise. Typically, each round will extend a startup’s runway by nine to twelve months, but this is highly dependent on the amount received and its burn rate.
How does a funding round work?
Funding rounds vary by stage, but typically involve some form of financial analysis, followed by due diligence, and negotiation. As startups mature, the level of complexity involved in each subsequent round increases, but so does their leverage. For example, in early rounds, startups may agree to a lower valuation, pro-rata rights, anti-dilution protection, and liquidation preferences because they do not have much traction. In later rounds, they may only agree to term sheets with a much higher valuation and few contractual provisions.
How to determine how much funding to raise?
The amount of funding a startup needs to raise is highly dependent on several factors including the stage of the company, the competitive landscape, the macroeconomic environment, the size of the market, and much more.
Generally speaking, the funding needs of a startup increase as they scale operations. To determine how much funding you’ll need, forecast future expenses based on your revenue and growth targets. Pro tip: consider adding a buffer of 15-20% to your projected capital needs.
How are ‘valuation’ and ‘funding rounds’ related?
When raising a new round of equity financing, one of the most important aspects to consider is valuation. The term ‘valuation’, describes the specific dollar amount that the company is valued at, at the time of the transaction. There are two types of valuation: pre-money and post-money.
Pre-money valuation is the value of a company before an investment, whereas post-money valuation refers to the value of a company after investment. In an equity raise, startups and investors agree on a valuation, which outlines the specific exchange of capital for equity, and the contractual provisions, or terms, of the agreement.
What are the various types of funding rounds?
There are three main types of funding rounds, which are further broken down into sub-types which include: equity, debt, and alternative financing.
Equity: Equity financing occurs when a company raises capital by selling an ownership stake in the company to investors. This is the most common type of funding round, as it allows startups to raise large sums of money without incurring debt. Subtypes of equity financing include:
- Pre-Seed: The earliest type of funding round, in which a company raises money from friends, family, and other personal connections. The average pre-seed round size is $50,000.
- Seed: The next chronologic funding round is the seed, in which a company raises money from typically either ‘angels’, ‘angel syndicates’, or ‘angel groups’. The average seed round size is $1 million.
- Series A: The Series A is typically the first round where a company has generated revenue and seeks to raise a fair amount of capital from institutional investors, otherwise known as venture capitalists. The average Series A round size is $3 million.
- Series B-C: The startup continues scaling operations, demonstrates initial product-market fit, and begins to understand its cost-per-acquisition and lifetime-value. The average Series B round size is $10 million, while the average Series C round size is $20 million.
- Series D-F: Very few companies raise Series D, E, or F funding. These are typically the last capital injections from private markets into a startup. The average Series D round size is $50 million, while the average Series E and F round sizes are $100 million.
- IPO: An IPO occurs when the company sells its shares to the public for the first time. The average IPO size is $250 million.
Debt: Debt financing occurs when a company raises money by borrowing money from lenders. This type of financing is typically reserved for companies that either: generate revenue, have collateral, or have recently raised a round of equity capital. Subtypes of debt financing include:
- Venture Debt: Venture debt is a type of debt financing that is typically leveraged in conjunction with equity raises. The average venture debt sizing is $5 million.
- Loans: Startups typically don’t qualify for hard-money loans unless they have collateral to secure the financing. The average loan size is $1 million.
Alternative: Alternative financing includes any type of financing that does not fall into the equity or debt categories. Sub-types of alternative financing include:
- Crowdfunding: Crowdfunding refers to the process of raising money from a large number of individuals who are not accredited investors, typically through an online platform. The average capital received from a crowdfunding campaign is $5,000.
- Receivables Factoring: Receivables factoring is a type of financing that allows startups to sell their invoices to an investor in exchange for capital. The average capital received from receivables factoring deal size is $50,000.
- Receivables Financing: Receivables financing is a type of financing that allows startups to receive capital by pledging their receivables as collateral. Unlike receivables factoring though, in receivables financing, the startup does not sell individual invoices to an investor, so the average size is much higher at $1M.
What are the various types of funding sources?
There are five main types of funding sources:
- Friends and Family: The first group of people that startups typically turn to for funding are ‘friends and family’. This funding typically comes in the form of a personal loan.
- Angel Investors: Angel investors are typically wealthy individuals that invest their own money in startups, but do not invest full-time, like venture capitalists.
- Venture Capital: Venture capitalists are professional investment firms that typically invest other people’s money in startups.
- Incubator: An incubator is an organization that helps startups grow their businesses. Incubators typically provide office space and resources to startups in exchange for equity.
- Traditional Banks: Traditional banks are another source of funding for startups. Startups typically take out loans from traditional banks to finance their operations.
- Fintech Providers: These providers leverage credit facilities from other financial institutions or their equity dollars, to provide capital to startups through receivables factoring or receivables financing.
What do startups use the funding for?
Startups typically use the capital injection from a new round of funding to scale their businesses. This typically includes hiring new employees, developing new products, and investing in marketing and sales, but it can also include acquiring a competitive business, launching in a new market, or pivoting their business model.
Why do investors provide capital to startups?
Investors provide capital to startups because they believe that the startup will be successful and generate a return on their investment. Investors are constantly on the lookout for new and innovative startups that have the potential to grow into large businesses, which in turn generate large returns.
What are the common mistakes to avoid when raising capital?
Some common mistakes that startups make when raising capital include:
- Choosing the wrong type of capital: Think of the various forms of capital as tools in your metaphoric “tool belt”, you want to select the right type of capital based on your needs. For example, if you don’t generate revenue, debt probably wouldn’t be the best fit because you have to make payments immediately.
- Prioritizing valuation at all costs: While valuation is certainly important, it shouldn’t be the only thing you prioritize when evaluating term sheets. Consider evaluating the contractual provisions as well, as they can have a drastic impact on your operations.
- Raising too much, too fast: Rather than raising as much money as you can, consider raising only what you need based on your forecasts plus a 15-20% buffer. Raising too much money too quickly can create a downward spiral very quickly. In some cases, the rapid influx of capital results in premature hires, product line expansion, market expansion, and more. This results in exponential burn growth and minimal revenue growth, as the reps need time to ramp and engineering needs time to build.