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Equity Financing Stages for Startups
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It is rarely possible for startups to raise sufficient capital to kick-start their operations, launch products and break even. Although a ‘one-time investment’ strategy is theoretically possible, it is hard to cite examples of any successful startup that has gone this route. Moreover, most angel investors and venture capitalists prefer to fund startups in steps. This practice helps investors assess the value of the company and minimize the startup risk. Therefore, entrepreneurs should articulate their investment requirements, while keeping in mind how investors like to fund startups.

Venture capitalists and angel investors categorize startups into stages based on a number of startup parameters including who makes up the management team, the value proposition, the risk, customers’ profiles and engagement, revenue, etc. and provide equity finance accordingly. Most startups are categorized into the following stages:

  • Early Stage
    • Seed round
    • First round
  • Expansion Stage
    • Second round
    • Third round
    • Bridge loan
  • Liquidation Stage
    • Merger & Acquisition round
    • Initial Public Offering (IPO)
    • Leveraged buyouts

Early Stage

Early stage refers to the initial days of a startup. The company starts off with a business idea, experiments with, and articulates its economic viability. The company establishes its proof-of-concept by demonstrating the technology and getting potential customers on board. This can be done in several ways. If the business idea is product based, the company would demonstrate a prototype of the technology to real world customers and get them on board. If the business idea is web based, the company would set up a website, track the internet traffic and get user feedback. In either case, the company is testing the market and establishing the viability of the business idea.

This phase is very important for a startup. It is crucial for a company to prove its concept and establish its business case. Some companies can get through this phase without the need for investment. However, other companies need investment to complete this phase. For example, an online company hardly needs an investment to prove the concept. However, a pharmaceutical company would need investment. Companies that need investment to establish their proof require seed investment or seed round investment. This round has the highest risk in terms of Return of Investment (ROI). Most investors shy away from investing in this round and would like to see the company pass this stage without the need for investment.

Once the company establishes its proof of concept, it prepares a roster of potential customers who are willing to positively talk to venture capitalists. The individual customers should be ready to say, “Hey VC, if you fund this company and help it launch a product, we will engage with the company and take the relationship to the next stage. The technology interests us because.. ” A customer reaction like this is the Holy Grail for an early stage company seeking venture capital.

Companies that have passed the proof of concept stage, have an established team and a list of potential customer references need money to start their operations and launch a product. Such companies need their first round investment. First round investments are comparatively less risky than seed round investments.

Early stage investment is the most risky stage compared to all other financing stages. The majority of startups fail in this stage. The key to surviving this stage is the ability to bootstrap the operation. (Refer to the “Go-To-Market Strategy” article on our website for some strategies.)

Expansion Stage

After the first round of investment, most companies launch their products or services and get a few paying customers. However, these companies need further investment to expand their product line, operations and marketing efforts. This phase is called the expansion stage because during this stage most companies have to expand their operations and invest in expensive marketing efforts.

Second round investment is meant for companies that have a production-quality product along with a few paying customers. However, they need more money to improve their products and attract more customers. It is very important for companies to get positive paying customer references at this stage. The customers who are using the products should be able to say, “Yes, I have been using the alpha version, but I need more features. I am more than willing to pay $x for further capabilities.” Apart from this, the company should also have more business opportunities on the horizon.

After the second round investments, companies can launch any number of expansion stage rounds. Note that the company has to dilute its equity for every expansion round. Given this situation, it is better that companies attain break-even at the earliest. The sooner companies break even, the better it is for all the investors so that they can take their money out.

At times, companies that are in their expansion stages can opt for bridge-financing instead of equity-financing. Bridge-financing refers to short-term interest only financing. Companies typically need this for restructuring boards, especially if certain early investors want to reduce or liquidate their positions, or when the former management’s stockholdings change and management is buying out former positions to relieve a potential oversupply of stock before becoming public.

Liquidation stage

Companies need money to liquidate their stock so that some investors can cash in their stocks. Companies liquidate stock either through going public, Merger & Acquisition route or through a leveraged buyout. Most of the investment money is required to engage investment bankers and other legal services for the transactions. Leveraged buyouts enable an operating management group to acquire parts of the business (which may be at any stage of development) from either a private or public company. The acquisition may be through the purchase of select assets or stock.

Most companies fail during the first funding stage. Entrepreneurs should really analyze their business case and try to minimize their risk before investors come in. As companies progress from the seed round to the expansion stage, the risk decreases and raising money becomes easier.

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