How does venture funding work?
An easy-to-read guide on everything you need to know about the different stages of raising venture capital funding for your start-up or small businessby Shane Donnelly
Often marred by marketing jargon, overly-technical terminology, and ever changing definitions, raising venture capital funding can seem an intimidating process for both fledgling and veteran entrepreneurs alike.
Despite its daunting nature, venture capital funding remains an increasingly popular and attractive option for businesses who have been refused finance from more traditional lenders – and for entrepreneurs looking to scale quickly with a firm eye on an eventual, lucrative exit.
So, what is venture capital funding? What’s the difference between the investment stages? And what does a venture capital firm offer besides investment?
Read on below to find out…
What is venture capital funding and how does it work?
A venture capital fund is an investment fund made up of contributions from wealthy individuals or companies, who give their money to a VC firm to mange their investment portfolio for them and to invest in high-risk start-ups in exchange for equity.
All investors are made aware of what funds or businesses their money is being invested into, as well as the potential risks and rewards of such investments.
Often when raising a fund, venture capital firms will target a certain amount or specific sector they’ll invest in.
Most start-ups who raise venture capital funding have been refused funding by traditional lenders, such as banks, because they’re deemed too risky a bet.
However, of those that don’t fail (of which there will be many), the likelihood is that they’ll experience long-term growth and provide a substantial return for investors.
While venture capital firms know that not all investments within a particular fund will pay off, it’s hoped that those that do prove a winner will be so successful that they’ll not only offset against any losses – but also far exceed them.
An important consideration for entrepreneurs, venture capital funding is absolutely no guarantee of success, and for many venture capital firms the process is akin to commercial fishing: if they cast a big enough net (invest in multiple businesses via a fund) they’ll be bound to catch something.
As part of the investment contract, many investors will also have additional requirements. For example they may want to sit on the board of directors or be involved in certain recruitment practices.
As you’ll read below, perhaps the biggest benefit of working with investors is that, due to their industry knowledge and experience, they’ll be able to offer your business a lot more than just cold hard cash.
The difference between investment stages
While 10 or 15 years ago venture capital funding was almost solely reserved for a select few start-ups with massive growth potential or a wealth of good connections, recent years has since a surge in finance available for businesses of all sizes and sectors.
Previously, you may have been tempted to bootstrap entirely, but the likelihood now is that you’ll need to rely on more than just family and friends for the capital necessary to launch and scale your start-up.
With a multitude of firms bagging funding nearly every day, compiled with the unstoppable rise of alternative forms of finance such as crowdfunding, its easy to get overwhelmed and confused by the different forms of venture funding currently available to businesses.
So, what do the different series of funding (pre-seed, seed, Series A, Series B, Series C etc.) mean?
Essentially, each letter corresponds with the development stage of the start-up that has received funding.
However, it’s worth remembering that as the number of start-ups accessing venture capital funding changes – so too does the definition of each round.
Mandeep Singh, co-founder of online marketplace Trouva, who recently raised $10m in a Series A funding round, explains the constantly changing definitions:
“There is no fixed rule and the definition has changed over time. Historically seed funding was to build a product, Series A was to identify product-market fit, Series B was to scale.
“However, with the rise of lean technology start-ups and more early stage funding, most start-ups now get angel funding to go and build their product and then raise one or more institutional seed rounds to find product-market fit.
“Series A are therefore these days often harder to achieve but larger than they used to be as they are the stage where you also scale the business.
“Series B onwards are also expansion rounds for things like international expansion, launching new products or simply scaling revenues.”
What is pre-seed funding and seed capital?
Helping to get your start-up off the ground, the pre-seed and seed funding stages serve a very similar purpose – and always take place when a start-up is very early in its journey, sometimes less than a year old.
Often helping to support the initial market research and R&D for a start-up, businesses who raise seed funding will often still be at a prototype stage – and may not have fully developed their idea or even know exactly who they want to sell to.
For many, the seed stage will be the first opportunity to employ staff outside of the original founding members too.
Angel investors and early-stage venture capital firms are the main backers at the pre-seed and seed funding stage – one that is both the most daunting for entrepreneurs and the riskiest for investors given the lack of track record of the start-up involved.
Normally, a seed funding round will contain less than 15 investors who’ll gain convertible notes, equity, or a preferred stock option in exchange for their backing.
As a general rule of thumb, most pre-seed rounds will normally describe a funding round of around $100,000-$250,000 with the relevant start-up having a pre-money valuation in the $1-$2m bracket – while seed funding will start to come in around the $1m – $2m mark (but will sometimes be more).
While a business may have certain aspects unfinished or be still in a development stage when looking to raise seed capital, they will need a minimal viable product to raise seed funding – but not pre-seed funding.
Either way, for entrepreneurs with eyes on an eventual lucrative exit or IPO success, pre-seed and seed funding rounds are considered stepping stones on this journey.
Advantages for start-ups in raising pre-seed and seed funding range from being given more time to fine-tune their business model, more time to find experienced business partners, increased capital for future rounds, and more flexibility to pivot if some drastic changes need to be made.
What is Series A funding?
While you can certainly raise seed funding on nothing more than potential alone, bagging some Series A funding is all about demonstrating that your start-up has a proven track record and the ability to scale quickly and provide a serious return for investors.
When considering whether to raise Series A for your start-up, it can be helpful to consider whether you have a market-proven product that will allow you to easily multiply your revenue within 18 months – because that’s what investors are looking for.
Though unusual, some start-ups will skip seed funding and go straight to a Series A raise. This will normally come about because a venture capital firm will approach the start-up first.
However, in such an instance, the entrepreneur will be asked to give away quite a large chunk of equity – often bigger than 20%.
Rather than taking a punt on a novice, investors will also be more likely to back a business at the Series A stage, that hasn’t raised seed funding, if the entrepreneur in question has already had a successful large exit with a previous start-up – or significant experience and connections within their industry.
Generally, Series A funding rounds will range between $2m to $15m – though may be substantially higher than this if the business is considered to have ‘unicorn potential’ (a unicorn is a start-up that is valued at over $1bn).
Unlike seed funding rounds, investors at the Series A stage will come from more traditional venture capital firms – with angel investors having less influence. Typically, a few of the bigger firms will lead the investment, often strategically so.
During the Series A stage, a start-up’s valuation will be calculated by its proof of concept, progress made with initial seed capital, quality of executive team, market size and the risk involved.
Advantages for start-ups raising Series A include the ability to scale faster with a larger financial reserve – as well as increased recognition within their industry.
What is Series B funding?
After proving it has a perfect product-market fit and a scalable marketing blueprint, Series B is all about building – and in this round, start-ups should be well clear of the development stage and looking to expand their market reach.
Businesses looking to raise Series B capital will already have fully launched their product/service and will now be targeting a market share in their chosen sectors and looking to compete against larger, more established competitors.
While the chances are that a business raising Series B will already have a significant turnover, it’s at this point that it should start to also turn a profit.
Series B rounds can range anywhere between $7m and $20m – and will appear quite similar to Series A in terms of the process and what investors will be involved.
However, some venture capital firms that specialise in later stage investing may be present in a Series B funding round.
Sometimes considered the hardest round to raise, while Series B start-ups are considered less-risky than those at seed or Series A stage, any tendency by investors to suspend disbelief and back a business on potential is completely gone.
If seed is raised on vision, and Series A on hope – then Series B is raised on pure facts and figures.
A time of slow growth for the start-ups involved (Series C is where scale-ups start to grow really fast), Series B isn’t the most popular stage for investors either, as most would rather invest cheaper at Series A or with less risk at Series C.
Businesses who successfully raise Series B funding will normally invest in business development, sales, advertising and tech – as well as beginning to eye-up possible international expansion.
During the Series B stage, a start-up’s valuation will be calculated by, its performance in comparison to that of its sector, revenue forecasts and its assets such as intellectual property.
What is Series C funding?
Start-ups who are at the Series C stage of funding have all but proven to venture capital firms that they’ll be a long-term success – with original backer’s shares now having increased considerably in value.
As a result, Series C raises are considered a very safe bet, from an investor’s point of view.
Businesses at the Series C stage will look for an even greater market share and to develop even more products and services and may also start preparing for a potential acquisition – both of itself by a larger corporate – or to buy a smaller competitor.
The final stage for many start-ups before they seek an Initial Public Offer (IPO), valuation of a business at Series C is done on the basis of hard data – with this round more an exit strategy for the venture capital firm.
Groups such as hedge funds, investment banks, private equity firms and big secondary market groups will all also begin to invest at this stage where companies can raise anything from single digit sums to hundreds of millions.
What is the role of a venture capitalist?
With the unstoppable rise of the ‘armchair investor’, even someone with the most ill-informed views of what constitutes a sensible investment can now back start-ups to their heart’s content.
Indeed, via alternative forms of raising finance such as crowdfunding, businesses can nowadays rise millions of pounds worth of investment – without giving away an inch of precious equity.
So why do businesses decide to part with larger chunks of equity and go down the venture funding route?
The reason for this often lies in the role of the venture capitalist – and what they can offer your business besides the initial injection of cash.
What services can a venture capital firm offer besides investment?
- Support services: Increasing in popularity in recent years,many of the larger venture capital firms will have their own in-house marketing, legal, tech and recruitment teams that will offer their services to start-ups and smaller businesses that receive investment.
- Strategic introductions: Often experienced entrepreneurs themselves, investors or partners in venture capital funds should have a wealth of contacts that your business should be able to tap into. Streamlined and direct, these introductions will be highly specific, strategic and targeted. Said introductions could include potential partnerships with larger corporates, new investors or clients, or even potential hires.
- Experience in efficiency: A seasoned investor and businessperson can streamline communication channels and ensure boardroom meetings are suitably productive. Helping to formulate strategy and direction, an investor can ensure your business is prioritising properly – from the top down.
- Wider market knowledge: While you’ll no doubt have spent the majority of your time concentrating solely on your own business, venture capitalists have been scanning various horizons. As a result, an engaged investor can give much needed insight into international markets, potential new clients and even exit opportunities.
- Best practice: Investors can add significant value by helping instill good governance in areas such as financial controls and reporting, business ethics, and contractual issues and procedures.
A top tip to consider when sizing up potential investors,ask yourself whether you’d want them on your board without their cash. If the answer is ‘no’ you should probably go no further, if it is ‘yes’ you are likely to make a better decision.
