How Startup Funding Works

Founders frequently need more money than they can afford to provide. For a software startup, for launching new products, or for expanding to new markets, funding is the fuel that transforms ideas into businesses. As an entrepreneur in the startup ecosystem, understanding how startup funding works is a must, whether you are raising money for your business through VC/Angel investments or coming from the perspective of an investor.

Startup funding is the process of raising funds to grow a company. Generally, investors get equity (which means you are interested in the business) for money. The process of capital funding often follows a number of stages that are each aimed at supporting particular periods in the development of the business.

Understanding Startup Funding

Startup funding is the capital that entrepreneurs raise to build and grow their companies. Founders spent these funds on product development, hiring employees, marketing, and research.

Traditional businesses rely on banks for funding, while startups seek individuals and firms willing to take risks in exchange for higher rewards.

For the most part, startups are not profitable in their early years. Investors invest because they think that the company could scale with significant revenue and/or profit as a public company or an acquisition target.

The Startup Funding Lifecycle

As startups grow, they typically go through multiple rounds of funding. Different stages often have different investors and amounts raised.

Bootstrapping

The oldest form of startup funding. At this point, founders are financing operations with their own resources, income or profits raised from the business. Entrepreneurs who bootstrap their business retain 100 percent ownership and control of their company. This is how many successful companies started, as it puts pressure on the founders to operate efficiently and test if their business model works before going out for outside funding. That said, bootstrapping can stunt growth if really only founders with substantial savings are working in your favor.

Friends and Family Round

Once personal savings are depleted, friends and family are the next step for many business owners. Early-stage investors typically do not perform financial modeling and are likely to invest based on their personal conviction and trust in the founder.

Amounts funded in this round are usually between hundreds to thousands of dollars. Raising money from family and friends can be a great source, but founders still need to dot their i’s and cross their t’s on other agreements because that could lead to future misunderstandings.

Seed Funding

Seed funding is typically the first stage of required investment in a startup. This funding allows companies to develop products, validate the market, and gain early customers. Startups typically enter this stage with an idea, a prototype, or an early product, but little in terms of revenue at this point.

Common seed investors include:

• Angel investors
• Seed-stage venture capital firms
• Startup accelerators
• Incubators
• Crowdfunding platforms

Seed rounds in general are anywhere from $100,000 to a few million dollars based on market conditions, industry, and the potential for your startup.

Angel Investors

Many, including Peter Thiel, become angel investors in startup ecosystems. Angel investors are high-net-worth individuals who use their own money to invest in early-stage startups. In addition to capital, they usually offer mentorship, domain knowledge and access to important business networks.

Angel investors typically inject cash in the seed stage, at a time when risk is still very high. Due to the statistic that many startups end up failing, angels tend to construct a diversified portfolio of investments. Angel investors generally receive equity ownership for their investment.

Startup Accelerators and Incubators

Accelerators and incubators provide seed-stage startups with funding, mentorship, education, and networking opportunities. There have been lots of successful companies that have come out because of programs like you get to go through Y Combinator and Techstars.

Accelerators generally provide limited cash in exchange for equity and fast-track the mentorship process over a few months or more. Startups typically pitch to investors on a demo day at the program’s conclusion. Incubators, on the other hand, typically have a longer-term focus with respect to supportive business development.

Series A Funding

Series A — At this point, all startups showing product-market fit and starting to grow consistently can seek their first round of institutional funding, a Series A. Product-market fit is when the need for your product grows more rapidly to meet its demand by potential customers, such that they are eager to purchase your goods.

Series A funding usually assists startups to:

• Expand teams
• Improve products
• Increase marketing efforts
• Scale operations
• Enter new markets

Typically, investments at this stage are from $2 million up to $15 million or more. Venture capital firms are the main investors in Series A rounds.

Venture Capital Firms

World-famous Venture Capital firms, like Sequoia Capital, Andreessen Horowitz, or Accel. Venture capital firms raise money from institutional investors, pension funds, rich individuals and corporate investors. They then put this capital into hopeful startups.

Many portfolio companies can go bust, which is why VC firms need to find companies that can achieve much higher returns. Venture investment often includes a comprehensive due diligence process, significant negotiation, and complex legal documentation.

Series B, C, and Later Funding Rounds

As startups grow up, they might proceed to raise more funding rounds.

Series B

Series B Funding: Series B funding is used to expand your business and scale operations to reach new markets. Businesses at this stage typically have validated business models and existing clientele.

Series C

Series Cs are typically for funding market expansion into new geographies, acquisitions, and product development.

Later Rounds

This particularly applies to larger startups, which may raise Series D,E, and additional rounds before being forced to IPO or sellout. Amounts for late-stage funding can be in hundreds of millions and sometimes billions.

How Startup Valuation Works

Valuation is the amount the startup is valued at. Say a startup has a $10M valuation and the founders raise $2M from investors. Investors will likely receive around 20%, depending on the valuation structure.

Valuations are based on several factors, including:

• Revenue growth
• Market opportunity
• Team experience
• Customer traction
• Competitive advantages
• Industry trends
• Technology differentiation

Early-stage valuations are based less on the company’s current performance than its future potential.

Equity and Ownership Dilution

In short, when startups raise money, founders generally give investors equity in return for the capital. Because new shares are issued, each funding round generally dilutes existing shareholders. If an existing company is 100% owned by its founders, and they sell off a non-controlling interest of 20% to investors, then the ownership of the founders proportionately declines. Standard Dilution: A normal incident in the startup journey. On the flip side, solitaire founders emerge as successful because with non-­equity money, recognised external development always increases the equity value of a future market.

Alternative Funding Options

Not every startup goes with venture capital funding.

Alternative funding methods include:

Crowdfunding

Platforms such as Kickstarter and Indiegogo enable entrepreneurs to receive funding directly from consumers and supporters.

Revenue-Based Financing

Investors give up capital in return for revenue percentages instead of equity stakes.

Bank Loans

Especially for established cash flow-positive businesses, some of these startups are eligible for traditional business loans.

Government Grants

Grants and support programs for innovative startups, mainly focused on technology, healthcare or clean energy, are offered by many governments.

Corporate Venture Capital

Most big companies also strategically invest in startups that work within their sphere.

Startup Exit Strategies

As a last resort, returns on investments are always expected from investors. There are usually exit events through which these returns take place.

Common exit strategies include:

Acquisition

The startup is acquired by a larger company, often with high returns to founders and investors.

Initial Public Offering (IPO)

When a company goes public, it makes its shares available for trading on a stock exchange and gives investors the opportunity to sell their shares. Some examples are Facebook’s IPO and Airbnb’s IPO.

Secondary Sales

Investors who are current shareholders sell their private stocks before a public issue or acquisition.

Risks of Startup Funding

While our startup market is full of possibilities, it’s only natural that people want to take their own risks. By reducing capital among founders, capital raising increases equity requirements and gives a bigger demand for rapid business outcomes. Strategic decisions and governance can be influenced by investors.

Due to the fact that a great many startups fail, investing in startups is still very dangerous for investors. They need to return enough on the wins to cover losses from the losers. Founders and investors should take care to analyze the terms of funding, the expectations and future developments before any contractual agreement.

Final Thoughts

Funding is essential for startups in order to turn those great ideas into successful businesses. Each stage of fundraising supports different levels of company growth, from bootstrapping whilst you are getting started and raising seed funding to venture capital and even public offerings.

Learning the ropes of startup funding helps you, as an entrepreneur, integrate taking money and making investments into your decision-making when it comes to raising capital, while teaching investors how to better assess opportunities. Funding is one of the hardest things for any startup to figure out, but if the right capital comes in at the right time, it can make a big difference on speed to market.