Startup funding 101

If you plan to raise capital, there are some basics you should know. First, there’s a fairly standard set of stages startups and investors follow.

Startup round.

Most entrepreneurs begin with money of their own, and money from friends and family. At this stage, people tend to invest because they know / trust / love you, so they are not going to be as tough on your business plan as others. They will also be “patient capital” – they’ll be happy to make a profit on their investment, but they probably won’t be too upset if it takes longer than you expect. These rounds are typically less than $100,000 in total. Be sure not to take money from anyone who can’t afford to lose what they put in, and always make it clear that many things can go wrong, and that they could lose their money. This startup capital is typically used to the company prepared to launch its business by designing a product, creating samples or prototypes, and/or conducting market research. Some companies can get all the way to profitability using startup capital. Others must move on to the next stage.

Seed round.

Many companies seek outside capital in order to build a sustainable business. This stage is typically called a “seed stage”, and most entrepreneurs get seed stage capital from angel investors. An angel investor is an individual who invests their own money on an amateur basis – as opposed to a venture capital firm that invests the money in a fund, on a professional basis. Each year, angels invest about $26 Billion in more 57,000 companies – over 10x more companies than venture capital firms back each year. Some angels invest alone, and others invest through groups. Their levels of sophistication can vary widely; those in groups tend to be the most savvy, which makes them tougher to persuade, but also more valuable. Most angel rounds are below $1MM. The proceeds from these investments can be used for many different purposes. In many cases, angel rounds are designed to get a company to the point where it has a product or service up and running, and enough paying customers to prove that their concept works (aka “proof of concept”).

Series A round.

Companies that need significant amounts of capital often seek funding from Venture Capital firms. VC’s are tough nuts for the average entrepreneur to crack.  First, you’ve got to have the right background. Yes, VC’s sometimes invest in unknown, first time entrepreneurs, but there’s usually a back-story. More often, they invest in teams led by seasoned entrepreneurs with track records of success. Next, you’ve got to have the right idea. VC’s take a portfolio approach to investing. Let’s say a VC invests in 10 startups. Most of them will fail, or experience mediocre performance, in which case they’ll get merged or shut down. Maybe 1 in 10 of the companies will really succeed. For that reason, each of the 10 companies must have the potential to be a home run – to sell at a $100MM valuation or more, or make the equivalent from an IPO (remember those?). Oh, and it’s got to happen in 3 to 5 years. If your team or your idea doesn’t fit the bill, raising VC money will be painful or impossible.

Also, each venture capital firm has a specific focus. They invest in companies in specific industries and locations, and focus on certain stages of development – usually post-revenue. Plus, VCs tend to make larger investments than angels – typically more than $2MM, though there are some exceptions.


One Response to Startup funding 101

  1. globr says:

    Thanks for sharing. Now with open source the initial fund is lower, some invest hire developers, pay servers for less than 20k$. Think of Digg. Others have already reached profitability.

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