Imagine a startup raising capital as a spacecraft, blasted into space by rockets. As each booster rocket ignites and burns out, it falls off in stages. Startups raise capital in a similar fashion, and your “booster rockets” are as follows:
- Friends and family round;
- Professional seed round;
- Series A round; and
- Series B+.
Below, we provide a brief overview of startup funding rounds, how they work and what the relevant stakeholders are looking to achieve.
Friends and Family Round
If you’re a first-time startup founder, it can be difficult to raise your first round from professional investors, and so many will turn to their friends and family. Typically, your friends and family will not fully understand what sort of deal to expect when investing in a startup. After all, it’s probably the first time they’ve invested in the venture capital asset class. We often see this first round completed as an equity round (i.e. the investors are issued with stock in the company). However, it’s becoming increasingly common for founders to structure friends and family rounds as a convertible note. Ensure that you speak with a startup lawyer to help you craft a fair deal and to seek advice on the market standard.
Professional Seed Round
If your startup gains traction, usually your next pitstop when raising capital is a professional seed round. Over the last couple of years, angel investing has become increasingly popular, and there are now multiple angel groups in each of Australia’s major cities, such as Sydney Angels and Melbourne Angels. You can either source an Angel round through your contacts or apply to one of the Angel groups mentioned above. The startup then submits an application, provides an investment deck (i.e. a basic information memorandum) and the Angel group then invites interesting startups to pitch at a formal meeting.
If one or more professional angel investors want to invest in your startup, you will likely raise through either an equity round or a convertible note. Professional investors in Australia are price sensitive so prepare to negotiate!
If you raise through an equity round, you will need to negotiate a pre-money valuation of your company. If you raise through a convertible note, you’ll negotiate a discount rate and potentially a valuation cap. To better understand the ins and outs of convertible notes, you can read more in our article.
If your startup does well and wisely uses the cash raised in your seed round, a Series A round may make sense. In Australia, a venture capital (VC) fund typically leads a Series A round. A VC fund’s goal is to invest in high growth startups that are going to increase dramatically in value over the fund’s lifetime (generally 5 – 7 years).
Your startup may not be the right sort of investment for a VC fund, and that’s no bad thing. If you are the type of startup VCs are looking to invest in, and you agree to a deal, it’s likely that the fund investing will want your startup to issue preference shares.
Preference shares often have different voting rights to ordinary shares, and they will also generally have a liquidation preference attached to them. This means if the startup sells for less than the valuation at which the venture capital fund invested, the VC fund will have the first right to be repaid the amount that it invested from the proceeds of the sale. Although this is standard practice, it’s important that you work with an experienced startup lawyer to ensure your interests are protected.
Beyond the Series A round your trajectory really depends on how your startup is growing and where it’s headed. Some startups will be successful and never raise another round while others will raise multiple rounds at higher and higher valuations. At the end of the day, what matters most is whether your business continues to grow, and eventually becomes profitable. Raising money is not an end in itself!
Some Quick Tips and Things to Look Out For
It’s impossible to list everything you should keep an eye out for when raising capital, however, here are a few to keep front of mind:
- Are you complying with ASIC regulations on capital raising? You can’t just raise capital from anyone. There are significant restrictions on what type of investor is eligible. Check out this article for more information on capital raising regulations.
- Is the round structure best suited to your startup? For instance, a convertible note only makes sense if you’re planning on raising additional capital in the future. Think it through before committing.
- What Warranties are you providing to investors? Make sure a startup lawyer checks these over.
- Have you sorted out all your documents? You’ll need to incorporate your company early on, and then ensure all your shareholders enter into a shareholders agreement. You’ll also need to make sure all of your company secretarial documentation is taken care of. These are the sorts of things investors will look at before investing.
It’s vital to reiterate that raising capital isn’t going to be for every startup. If you’re unsure or have any questions about capital raising, ask us on 1300 544 755.