It’s now increasingly common to see on the front page of the Australian Financial Review, “Company X closes $Y million in Series A, now valued $Z billion”. But if you don’t have experience with capital raising, you may not understand why companies raise money or how they do it. As an outsider, you may be wondering ‘what do these numbers mean?’, ‘why does a company raise funds?’ and ‘what is a series round?’. Below, this article unpacks commonly asked capital raising questions to help you understand the different capital raising stages.
Why Raise Funds?
A company turns to external funding when it looks to supercharge its growth. New startups often bootstrap (i.e. operate without external funding) as far as they can before they seek investors to help fund their venture. Startup founders should have evidence of growth and traction, or at least genuine interest in the market of the product or service before they reach out to investors.
If investors see potential in the company to produce a financial return, they will invest money into the startup in exchange for an equity ownership stake (e.g. a certain number of shares). As the company grows, their shares will increase in value. If the company successfully exits (i.e. gets acquired or is listed on a public stock exchange), investors will make a significant return. If the startup goes bust, they lose everything.
Startup founders will typically provide a valuation of the company before investors part with their money in each round. Investors then use the valuation to assess a number of factors about the company’s likelihood of success, including its track record to date (revenue, if any), the size of the market it operates in and the company’s profit margin.
Source: startupljackson.com
Why Not Bank Loans or Credit Cards?
Many banks do not issue loans to new businesses who do not hold many assets. A startup looking to borrow $50,000 to pay app developers will find it difficult to request a loan unless they put up their personal assets as guarantees (such as a car or home). If they successfully obtain a loan, they are obligated to repay the loan in a timely manner with interest.
Credit cards can provide a short-term source of finance for necessary purchases. A laptop or business flights can be put on a company credit card to separate funds from personal bank accounts. Atlassian, one of Australia’s most successful startups, began with $10,000 from their credit cards to fund the business. However, credit cards will not provide the funds required to hire staff, invest in production nor make significant capital purchases.
Raising capital from investors often brings other benefits aside from their financial investment.
Investors often have industry experience and can offer business advice, introduce you to their network, or refer you customers. Such benefits have a significant advantage over a debt financing option such as a bank loan or credit card.
However, debt financing should not be ruled out as an option to grow a startup, especially those with traction and can prove it to lending institutions. Startups can turn to convertible bonds or convertible notes to raise funds. Uber, the ride-hailing app company, has turned to debt financing on a number of occasions to supplement its equity rounds. Whether you turn to equity or debt financing will depend on your business’ growth journey.
How Do I Raise Funds for My Startup?
This is the million (or billion) dollar question. There is no one answer to raising funds for your startup – this will depend on your business, network and industry.
- If you work in a startup accelerator or incubator, speak to other startup founders and entrepreneurs to understand their capital raising journey.
- If you are new on the scene, attend startup funding events to understand the landscape and make connections with investors and their networks.
Aside from impressing investors with your pitch, they will also be looking at your team and experience in executing ideas. Investors receive countless requests for coffee meetings and opportunities to hear pitches – you should have solid evidence of traction or growth to prove why investors should invest in your startup as you’ll often only have one shot.
Remember, you don’t need to look for investors unless you really need funds to take your startup to the next level. Many new startup founders will turn to their family and friends for initial investment, as covered below.
Family and Friends Round
In the early days, asking family or friends for capital (through a family and friends round) can be the easiest and fastest way of raising funds. However, founders with no experience in capital raising can often fall into the trap of over-valuing the company and cause detrimental damage to future funding opportunities.
Raising a family and friends round with poorly planned execution can cause structural problems for future investors.
It is advisable to formalise the process (and thoroughly document it), speak to founders who have gone through a similar process, and be as transparent as possible to family and friends about the risks of their investment.
What is a Seed Round, Series A, Series B etc.?
A seed round is often the first funding round, and each subsequent round of funding has a letter attached to it, starting with A (that is, Series A). Angel investors and venture capitalists (VCs) often come in at this stage. To distinguish, Angel investors invest their own money while VCs manage an investment fund.
By understanding the differences between these funding rounds, it will be easier to analyse the newspaper headlines concerning startups and investment. Each round is a stepping stone to turn a company from an idea in a garage to a successful publicly listed company through an IPO (initial public offering).
The primary differences between each fundraising round (and Series) are the maturity level of the company, the level of risk for investors and the purpose of raising capital.
| Round | Who Invests? | Description of Round | Goals for Company |
|---|---|---|---|
| Seed | Angel investors, early-stage VCs | A seed round is often used to initially inject capital to cover expenses and get traction until a startup can start earning revenue. At this stage, the startup is likely to have validated its market and measured the value of its customers. Founders are selling their vision, a prototype and a good team. Seed rounds can vary between $100,000 to $2 million, but this amount differs widely on a case-by-case basis. |
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| Series A | Professional angel investors, venture funds or VC firms specialising in early-stage | The first round of shares offered to external investors during early-stage investment. Valuation is determined by a number of factors including proof of concept, team, market size and the company’s progress with its seed capital. At this stage, startups would have figured out its product and user base. |
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| Series B | Similar to Series A but also venture capitalists that focus on later-stage growth | The second stage is focused on continuing to scale the company. It is likely that a business model has been established and there is traction with customers. Valuation for a Series B round is determined by revenue generated, company’s assets (such as IP) and its performance in the industry. |
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| Series C, D, E and onwards | Private equity firms, VC funds, hedge funds, investment banks and secondary market groups | Subsequent venture rounds are used to scale the company, make acquisitions, maximise market share, grow internationally and prepare the company for an acquisition or public listing. Some companies raise significant capital to allow them to buy out other firms. |
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Key Takeaways
Series funding allows entrepreneurs to fulfil their dream of taking their company from the garage to an IPO. However, approaching investors and closing a round is never an easy task, especially if you have never raised from external investors or VC firms.
In fact, according to Fundable, only 0.05% of startups even become funded by VC firms in the first place.
If you are looking to raise multiple rounds of capital, remember that investors look for different things between each round due to the risk profile and maturity level of the company. Understanding the differences between each round will make it easier to target and communicate with the right investors. Questions? Get in touch with our startup lawyers on 1300 544 755.