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What are the stages and series of funding?

In our previous article, we talked about what investors do in order 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 get a better understanding of what each one entails.

Pre-Seed Funding

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 depending on 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 on the business model, under the guidance of our technical and business mentors.

Seed Funding

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, in order to grow the value of the company 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 let’s say the US nowadays, it should be valued anywhere between $2 million to $6 million. The startup needs to show “traction”: one or more pilot projects already implemented, or 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. In fact, 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 important aspect for entrepreneurs to grasp is the fact 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 time of 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 individual 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 capable of generating 10x returns. That is why joining a good accelerator program is important.

Series A Funding

In this round, the accent is placed on further developing our business model. The previous seed funding stage amplified the initial traction. We know more about our customers’ needs, about what it takes to service them well, and about how our technical solution should be developed, to further grow our business. However, this is all knowledge. 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 will 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 which cannot attract the next round. It even paints a more gruesome picture: 67% percent of the companies which attract seed funding either die or turn into regular companies, as in 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 the 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. 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 important 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 business 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 after Series A, there might be other rounds of financing. The purpose of subsequent rounds is to build the business until the IPO happens. Any further round past B would only happen 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 to angel investors and VCs. We begin envisioning how to create 10x returns for our early investors, which entices us to start thinking big and changes our worldview forever.

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