When one thinks of American business, large multinational corporations come to mind.
Contrary to popular belief, however, the majority of businesses in the United States are startups. Popularized by stories such as Facebook, Uber and Netflix—professionals are moving in droves to places like Silicon Valley and Austin to join or start the next big thing. As a professional looking to succeed in the startup space, one area that is often overlooked is funding. Startup funding is almost as important as the seed idea itself. A strong understanding of this space will allow you to overcome many of the early speed bumps you will invariably face and maybe even find a strong business partner for years to come.
At the most basic level, startups follow a general growth cycle from seed stage to early stage, then late stage and finally an exit event. The seed stage is the first stage of a startup. There are no revenue-generating activities at this point and this stage is often referred to as the “valley of death.” An entrepreneur in this stage of financing generally receives funding from two sources: FFF or Angel investors. FFF consists of family, friends and fools, and is often the easiest group from whom to raise capital. Angel investors are extremely wealthy individuals or a group of individuals (angels) that invest their own capital in companies in return of equity ownership or convertible debt (debt that can be converted into equity). Angel investors take significant risks with their capital—with later rounds of financing, their equity ownership is often diluted. Angels invest their capital at the stage where the risk of startup failure is the highest. As such, angels require significant return on their investment—often 20-30 times over a five to seven year period. The majority of angel investment activity occurs in Silicon Valley, the #1 location for hopeful entrepreneurs.
The next stage of startups is early stage startups. In this stage, startups have typically gone through a seed round (internal funds) and an angel round of financing. Early stage companies typically have one or two rounds of funding from venture capital or private equity firms called Series A and/or Series B. Firms that participate in Series A have the first chance at investing in an opportunity and generally receive proceeds in the form of convertible debt or preferred stock. Convertible debt is useful because in the event of failure, debt owners are repaid before equity owners. In the event of success, convertible debt owners can convert their ownership into equity. Preferred stock is better than common stock because it is impervious to dilution (from subsequent rounds of financing) and any unpaid dividends must first be paid to preferred shareholders before common shareholders. Series A funding is also the first time that the company is given a valuation, determined by the Series A amount divided by the equity ownership percentage. Buying into the startup in subsequent rounds will be more expensive than Series A and will continually adjust the startup’s valuation. Early stage startups generally have been in business less than three years, have started to generate revenue but are not yet making a profit. These first rounds are to help expand operations, generate sales, build a management team and propel these companies to the next level.
Startups are generally designated as late stage companies in the third round of financing—Series C and beyond. These companies have been in business for more than three years, have experienced significant revenue growth but may or may not be creating profit.
While earlier round financing is designed to develop operations and spur growth, financing in this later stage are more strategic. They are used for specific expansion projects, targeted marketing efforts or product improvement. There are also Mezzanine/Bridge loans. Bridge loans can be raised between any significant venture round and are designed to provide companies with interim financing between the more traditional venture rounds.
These loans are short-term (less than one year), high-interest loans usually “bridged” (backed) by some collateral, either real estate or other inventory. Mezzanine funds are used when the company is gearing towards an initial public offering (IPO).
With the success of numerous startups in the last 20 years, it is an incredibly popular field. Whereas in the past, the most popular field was finance, young and experienced professionals are now moving towards entrepreneurship. Y Combinator is the world’s most famous early-stage incubator/accelerator. For many years, Y Combinator provided startup guidance, connections and seed capital in return for about 6% equity. In 2014, it changed its terms to $120,000 seed investment for 7% equity ownership. The combinator has an application process by which anyone can apply to be a Y Combinator member company.
Notable graduates of the Y Combinator program include AirBnb, DropBox, and Reddit. It is just one of many incubators out there, a testament to how popular and successful startups are. With individuals’ access to information, funding and business connections, startups have essentially democratized business success. With the amount of support and interest that is in place for entrepreneurship today, anyone with a good idea should pursue it.
This article is the opinion of the author and is not shared by India Currents or any of its staff. All investors should conduct their independent analysis before taking any actions and should not make any decisions on the information provided in this article alone.
Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and works in the tech industry as a financial analyst. If you have feedback or have a topic you would like addressed please contact Rahul at [email protected]