In our previous article, we talked about what investors do to minimize the chances of an unsuccessful venture. In today’s piece, we’ll be looking to go further in-depth on the more technical side of things, analyzing each phase of the funding process to better understand what each one entails.
Pre-Seed Funding, also known as Bootstrapping, is the earliest stage of funding and represents the very beginning of the operational processes in a startup. Usually, the investors are the founders themselves, their families, friends, or close supporters.
Depending on where the founders are located and their need to hire additional help, the amount of bootstrap money would vary. A back-of-the-envelope calculation would be the money needed for the team to pay their bills while eating cheap food for as long as it takes until you create a product that a client would pay for. Sometimes this is called “noodle money”, as an allusion to the entrepreneurs surviving on noodle cups while preparing for the stage where they meet their first investors.
During this time, we would work on both the technical side of the solution and the business model under the guidance of our technical & business mentors.
The name says a lot about what happens in this stage: this is when the “seed” is planted, after which the founders might expect to see the first results. It is when more sophisticated market research and further product development are done to grow the company’s value and attract even more funding.
There are many potential investors in this stage, but the most common ones are the so-called “angel investors”. For a startup to attract angel investors in the US nowadays, for example, it should be valued anywhere between $2 million to $6 million. The startup needs to show “traction”: one or more pilot projects already implemented, lots of adopters, or a high rate of growth month-to-month or year-to-year, etc.
The term “angel investor” is a bit misleading, for it suggests such investments are charitable acts. The actual origin of the term relates to such investments being miraculous, as it would be for an angel to show up in real life.
The critical aspect for entrepreneurs to grasp is that angel investors would only commit money if they were shown a credible plan about how such money could increase the value of the company 10x by the time the exit happens.
What does the exit mean?
All investors make their money when a startup is either purchased by another company or at the IPO (Initial Public Offering) when the startup becomes listed on the stock exchange. Since angel investors are the first to invest, they have the longest time to wait and face the highest risks.
Seed money offered by each angel investor can be between tens of thousands and several hundreds of thousands of dollars. However, a project will only get such money if it showcases a business that generates 10x returns. That is why joining a good accelerator program is essential.
Series A Funding
In this round, the emphasis is placed on further developing our business model. The previous seed funding stage amplified the initial traction. We know more about our customers’ needs, what it takes to service them well, and how our technical solution should be developed to further grow our business. However, this is all knowledge and theory. We need something more palpable, which is why a new series of funding becomes necessary.
Series A rounds are expected to raise from $10 million to $30 million and are usually led by venture capital funds (VCs). A 2018 CB Insights report discovered that only 48% of seed-funded startups tend to make it to the next round.
Remember our earlier discussion about angel investors’ motivations? This particular report shows that more than half of their investments are spent on companies that cannot attract the next round. It even paints a more gruesome picture: 67% percent of the companies that attract seed funding either die or turn into regular companies, as they never truly take off.
Why turning into a regular company is gruesome for early investors?
Angel investors and VCs take huge risks when funding startups. The average dividend yield between 2008 and 2018 for US companies was 2%. Angels have a whole portfolio of investments, the majority of which will never be profitable. That dividend yield would require them to be right more than 98% of the time just to recover their losses.
This is why they need an IPO as an exit – IPOs are the only ones that sometimes bring them the 10x returns they want, and dividends cannot. A TechCrunch piece of research found out the actual return for angels in the US, and the UK is around 2.5x on average. This is why they must aim for 10x when looking at promising startups.
The same reasoning applies to the Series A VCs. The vital lesson for us, as startup founders, is if we want angels and VCs to invest, we should look to focus on creating a business that gives investors that type of return, the 10x kind. If our company only brings regular rates of return to early investors, as dividends do, then we should finance it through other means.
Series B and beyond
If we have understood that an IPO is what any early investors want from a startup, it is also easy to understand why there might be other rounds of financing after Series A. The purpose of subsequent rounds is to build the business until the IPO happens. Any further round past B would only occur depending on how convincing the possibility of the IPO is.
This is why it is great fun to run a startup. We get into something that will grow huge and can potentially offer us an experience like none other. We learn and expand our horizons beyond just our technical creativity. We learn to connect to our customers and angel investors & VCs. We begin envisioning how to create 10x returns for our early investors, which entices us to start thinking big, changing our worldview forever.