Over the past few years, there is an increasing tendency to glorify bootstrapped startup models - a.k.a. companies that grow their business without any external funding. What most founders don’t know is that only a tiny percentage of early-stage companies are able to materialize their idea without first raising external capital.
In fact, most successful startups, even today, depend heavily on early-stage financing. By injecting capital into a company’s long term potential, investors receive a certain amount of equity from the company they choose to support.
This funding process occurs through several stages of venture capital funding, which we will discuss in this article. We will help you understand what each round is all about, the type of companies that are able to participate, and what sort of amounts you can expect to raise.
We will also briefly discuss additional stages (or methods) to raise funds for your company by delving into somewhat complex funding terms. Before we delve into the different stages, it’s important to first outline how the funding process is structured and how companies can qualify for them.
How Capital Funding Works
Each funding round consists of two (groups of) participants. These are:
- Startup founder(s), who are looking to raise funds for their company
- Investors, who support entrepreneurs and hope to earn a profit from their investments
The dynamics between the two parties explain why founders choose to offer equity (partial ownership of their company) in exchange for money - if the business grows, so will the value of the shares that investors own. This incentivizes the funding parties to not only offer financial assistance but to also remain actively involved with the company’s progress.
Before a startup is able to participate in a funding round, qualified analysts look into several different factors (management, track record, market size, industry risks, etc.) to determine its valuation.
- The valuation and growth stage of a startup determines the investment they need to receive and the percentage of equity that reflects its value.
- A company’s valuation also impacts the types of investors that choose to participate in the round.
Stages of venture capital funding
Now that you have a better understanding of the process, it’s time to look at all the different stages of venture capital funding.
The very first funding stage occurs very early in the process and is often not considered to be an official part of the funding process. Commonly referred to as a “pre-seed” round, this funding stage takes place during a company’s ideation stage; namely the time between turning an ambitious idea into a usable product.
The reason pre-seed funding is often not seen as a funding round is that, in most cases, capital comes from the founders themselves, as well as their family members and close friends. Due to this, there is usually no equity at stake, and the capital they manage to raise is tiny compared to the following rounds.
The second stage, known as seed funding, is (officially) the first and most important capital round that a startup engages in. For some startups, it is the only investment they will need, and they never proceed to additional funding rounds until their exit.
The name “seed” is not random either. In fact, it’s a great analogy to help you understand the importance of this stage. This initial financial boost is the “seed” which helps the business grow. By “watering” the seed through sufficient revenue, a great idea, and a dedicated team, the startup will eventually bloom into a “tree”.
Seed funding occurs at the ideation stage of a company when a concrete product is not yet developed. The finances are used for the early stages of the process, including market potential analysis and the development of an MVP product. It is at this point that startup founders need (and are able) to decide what their final product will look like and who their target audience is.
When it comes to the capital being raised at this stage, amounts can vary. This is because founders only seek the necessary resources to materialize their company’s vision. For some, this can be $15.000 while for others it can rank up to a million. Overall, it’s good to remember that most early-stage companies who engage in seed funding are valued between $3 million and $6 million.
Note: This round is also open to angel investors, who tend to prefer high-risk ventures with no track record. This happens through a dedicated “Angel round”, where startups allow individual investors to offer up to $100.000.
While a small number of venture capitalists may be willing to participate in the seed round, it is usually at this stage that startups begin to offer equity options.
Series A funding helps growth-stage companies (with an established community and a steady revenue flow) raise capital to improve their product and grow their user base. It is also a great opportunity for companies that wish to expand their product across different industries. At this stage, there is less risk for investors, and businesses are able to demonstrate how their efforts could lead to long-term profit.
During Series A funding rounds, it is common to see a small number of large venture capital firms taking the lead. When a startup partners up with a large-scale investor, it is typically easier to receive more offers from other VCs. Angel investors may still participate at this stage, but the amount of equity they receive (and the influence they have over the process) is much smaller than in the Seed round.
Generally, this funding round helps companies raise between $2-$15 million with the 2020 average estimated at $15.6 million. The number keeps growing on an annual basis since many early-stage tech startups receive very high valuations.
Series B Funding
Series B rounds are all about scalability. Companies that make it to this round are later in their development stage, looking for opportunities to expand their operations and market reach. At this point, they already have a large user base and data-backed growth potential (Series A).
The purpose of Series B funding is to help a business venture execute their scaling strategy. The funds are used to build a capable team and give them whatever they need to build a winning product. For that reason, apart from talent acquisition costs, startups will need to invest in marketing, sales, business development, and customer support. This is why Series B rounds help companies raise, on average, $33 million. Obviously, the valuation of a given company needs to reflect this amount. Typically, companies that make it to this round are valued between $30-$60 million.
When looking at the type of investors that participate in this round, the process is very similar to previous stages of venture capital funding (Series A). The round is led by a small pool of key players, followed by many smaller investors with relevant industry experience. The main difference in this round is that the participating venture capital firms are more experienced in later-stage funding.
Startups that manage to reach Series C funding are already established in their industry. Raising funds at this point helps them create new products or services, and scale their operations in international markets.
Scaling, at this stage, happens also through the acquisition of other businesses. For example, let’s assume that a Keto-friendly supplement brand has reached great success in the US and wishes to expand by entering the European market (based on market potential research).
If the European market already has a well-established ketogenic brand that captures a large part of the supplement industry, it might be a great opportunity to buy the company and develop a collaborative partnership. In this instance, capital raised through Series C funding would be used to acquire the European competitor.
In this stage, investment risk is lower, but so are the potential returns. Due to this, more external parties enter the investment management process. At this stage, apart from venture capitalists, we see hedge funds, private equity firms, as well as investment banks, all trying to get a share of the company’s equity.
Many startups choose to host a Series C funding round to increase their valuation before an Initial Public Offering (IPO). At this stage, a company’s average valuation is in the range of $110-$120 million, with some ranking much higher. The valuation process is now based on concrete, data-backed evidence and does no longer constitute a “bet” on the potential of future success.
In most cases, a company will conclude its external funding at this stage. In some cases, however, companies may choose to host subsequent stages of venture capital funding (Series D, Series E, etc.). This happens mainly for two reasons:
- The startup wants to further increase its valuation prior to an IPO
- The goals set during the Series C funding round have not been reached yet
Overall, however, the final funding round should provide sufficient capital to expand in the global market.
Other methods and stages of investing
Apart from the 5 stages of investing shared above, there are more methods that help startups raise funds. In short, here are some of the terms you should familiarize yourself with:
- Equity crowdfunding - Raising funds from many individual participants. Typically occurs on equity crowdfunding platforms like CircleUp or AngelList.
- Product crowdfunding - Raising funds through pre-selling a product that is still in development. Typically occurs on funding platforms like Kickstarter or Indiegogo.
- Private equity - Late-stage round led by a PE firm or hedge fund. It is considered to be a “safer investment due to the company’s size and proven track record.
- Convertible Note - An intermediate round to assist companies until their next funding stage. These notes convert upon the following round offering a discount entry to the investor.
- Debt financing - The process of borrowing money from an investor and repaying it at a later point in time with interest.
- Grant - Non-equity capital offers from individual investors, companies, or government agencies. Often seen in hackathons or pitching contests.
- Corporate round - A funding round led by a company instead of venture capital firms. In other words, one company finances another company. Typically occurs when companies form partnerships or partial acquisitions.
- Post-IPO equity - A funding round that occurs after a company goes public (IPO).
- Non-equity assistance - Free office space, networking opportunities, or mentorship without the need to give up equity. Certain incubators and accelerators offer this type of assistance, though mostly for ideation-stage startups. It is considered to be one of the later steps of the investment process when launching a bootstrapped startup.
If you made it this far, you should now be able to understand the distinction between the different stages of venture capital funding. Overall, each of the stages we discussed work in the same basic manner; VCs offer a certain amount of money in return for partial ownership in the company they invest in. Each subsequent round of funding has higher financial demands that grow parallel with a company’s ability to dominate within its industry (higher funding = increased maturity and less risk).
That being said, the process and methods of venture capital financing do not only aim to a high ROI but also to help entrepreneurs innovate with additional guidance and support from industry leaders. It is only through this combination that companies are able to grow and thrive in the long run.
Frequently asked questions
Now that you are familiar with all the funding stages a company has to go through, let’s dive into some common Q&As that might offer some additional value.
How can I maximize my odds of success during a venture capital funding process?
A common misconception surrounding the different stages of venture capital financing is that money only flows to smart people with great ideas. The truth is somewhat different. Venture capitalists tend to invest primarily in growing industries. There are several examples of this. In 1980, nearly 20% of all venture capital was allocated to project in the energy industry. Today, we see a larger allocation of fintech and blockchain tech projects.
All this indicates the importance of timing. To maximize your odds of success, you need to ensure that your product is solving a pressing problem in a growing industry. If not, there is not much of an upside for VCs, no matter which venture capital stage you are in.
What are the 5 stages of venture capital financing?
The official stages of funding are divided as follows:
- Pre-seed phase - 1st stage of funding
- Seed phase - 2nd stage of funding
- Series A phase - 3rd stage of funding
- Series B phase - 4th stage of funding
- Series C phase - 5th stage of funding
What business equity % is at stake during each of the venture capital funding stages?
The equity percentage handed over during any of the business funding stages varies on both the business and investors. The following amounts indicate the ranges you should be looking at. Note that earlier stages will consist of a lower financial amount, usually at a higher than average equity. This is due to the risk that investors will need to take when making their decision to invest in your company.
- Pre-seed - Usually no equity as the funds come from family and friends.
- Seed - 10% - 20%, sometimes 25%
- Series A - 15% - 35%, average 25%
- Series B - 10% - 20%, average 15%
- Series C - 10% - 20%, average 15%
Is it possible to skip any of the funding stages for startups?
When it comes to early-stage companies, skipping venture capital stages happens very rarely. The reason for all the different stages of funding is to minimize risk for all parties involved while setting milestones along the way. Companies aim to raise as little money as possible to avoid dilution, but enough for them to grow their business and achieve their long-term goals.
In most cases, companies that skip funding rounds (venture capital stages) have either (a) bootstrapped their way out of the seed round, or (b) achieved most of their targets with seed money to be able to skip series A. The first one happens quite often; the second one is the goal of every startup founder.