Raising capital is vital for most startups. In particular, companies who have strategically chosen to allocate their resources into growing and scaling their business as quickly as possible in order to capture sufficient market share will undoubtedly need periodic installments of cash to fund operations and growth.
When startups begin their capital-raising journeys, they must make a strategic decision as to what financing instruments to offer investors. This decision will be impacted by several factors, but this article will focus particularly on the typical stages of a startup and what financing instruments are best suited for that stage.
The Lifecycle of a Venture-Backed Startup
Although startups rarely demonstrate a linear path as they grow, startups typically follow a fairly well-defined road map that includes the following stages:
1. The Idea Phase: As the initial idea for the startup begins to take shape, founders will attempt to build on the idea by creating sketches, low-level prototypes, mockups, and wireframes. These visual representations of the founder’s idea will be used as a starting point for soliciting advice from advisers and potential customers.
2. The Proof of Concept: Next, founders typically need to test their product in the marketplace at a low cost. In order to do this, they will build a minimum viable product with the bare minimum functionality required to solicit meaningful feedback.
3. Build the Concept: If the minimum viable product is validated, the company is ready to take on some initial investors in order to hire the necessary experts and employees to build a more robust version of the company’s product. Once this is built, the product will be released to the broader marketplace.
4. Scale the Business: At this point, the company has created a version of its product that has the capability to scale. Its focus now shifts to capturing a large customer base and addressable market with its product. In order to get ahead of the competition, companies typically try to scale as rapidly as feasibly possible.
5. Mature and Seek an Exit: Finally, as the company becomes mature, the focus shifts from maximizing revenue to attaining profitability. Though profitability is not necessarily a requirement to obtain a successful exit, many companies position themselves to be profitable in order to make themselves more attractive to potential acquirers.
The initial round of financing for startups is referred to as a “seed” round. This round typically consists of three types of investors: (i) friends and family, (ii) angel investors, and (iii) super-angels.
Seed rounds tend to be fluid. That is, most startups close multiple seed rounds before they are even in a position to raise a Series A Round from investors. The early days of a startup are difficult to budget and forecast, necessitating small infusions of cash at unpredictable times.
Most startups will close seed rounds towards the end of the startup’s idea-phase. At the beginning of the idea-phase, founders are oftentimes working a full-time job and working on their new venture in their spare time (i.e., moonlighting). This means that the capital being infused into the venture at the beginning of the idea phase is coming from the founder’s own pockets (i.e., bootstrapping).
In a typical seed round, companies will raise anywhere between $25,000 up to $1 million (and sometimes upwards of $3 million). Given the relative low-capital amounts raised and the types of investors participating in seed rounds, the type of financing instrument granted in this capital-raising stage are convertible notes, simple agreements for future equity (SAFEs), or equity with basic terms in the form of convertible preferred stock or common stock.
Series A Financing
Once a startup has successfully navigated its idea-phase (lifecycle step #1 above) and has successfully tested a minimum viable product in the marketplace (lifecycle step #2 above), it is ready to position itself for growth in the building-phase of its lifecycle (lifescycle step #3 above).
At this juncture, it is often necessary for startups to raise another round of financing. This financing round is typically referred to as its Series A Round (although some startups prefer to use the terms Series A-1, or Series AA depending on the amount raised and how it wants investors to perceive the financing round).
In a Series A financing, startups will typically raise between $3 million and $5 million, and will almost exclusively issue convertible preferred stock as the financing instrument.
The investors who participate in Series A investment rounds are either high net worth super-angels or venture capital funds focusing on early-stage investing.
As discussed above, the terms of a seed round of financing are fairly standard. As a startup engages in its Series A Round, investors will require more sophisticated equity terms due in large part to the substantial sums of money involved. Below is a cursory overview of a few key terms startups need to be aware of as they are negotiating Series A term sheets.
- Liquidation Preference: The terms of Series A Preferred Stock instruments generally provide that, before any proceeds from a sale or liquidation of the company can be distributed to the holders of common stock, the holders of Series A stock (and holders of Series Seed stock, if the company issued preferred stock in its seed round) must first receive a liquidation preference equal to the original purchase price of their preferred shares (known as a 1x liquidation preference). If the proceeds from a liquidation or sale are great enough that the preferred stockholders would receive more than their liquidation preference by converting their preferred shares to common shares, they receive the greater amount.
- Conversion: Shares of Series A Preferred Stock are convertible into shares of common stock on a 1:1 basis (subject to adjustment in case of certain dilutive events) at the holder’s option at any time. In addition, the entire series of preferred stock automatically converts into common stock if a certain percentage (for example, a majority) of the holders agree to convert their preferred shares, or the company completes an IPO.
- Price-Based Anti-Dilution Protection: Most Series A investors negotiate to receive a downward adjustment to the purchase price of their shares if the company later issues common or preferred equity (or other securities convertible into equity) at a price below the Series A price (subject to exceptions for certain types of issuances). If a company does sell stock for less than the Series A price after the Series A round closes (known as a “down round”), the Series A conversion price adjusts to give the Series A investors more than one common share for each share of Series A preferred stock they hold, if and when the Series A stock converts to common. This is known as a conversion price adjustment, and since the preferred stock of startup companies generally votes on an as-converted to common stock basis, the conversion price adjustment increases the economic value and voting power of the preferred stock.
- Protective Provisions: Since Series A investors are almost always minority shareholders who also lack control of the company’s board of directors, they usually receive negative control rights over certain actions. These provisions typically require that the delineated actions must receive approval from holders of a majority of the Series A shares before proceeding. These veto rights generally cover critical company actions that impact the economics of the Series A shares, such as (i) taking actions that adversely affect the rights, preferences, or privileges of the Series A Preferred Stock, (ii) amending the company’s organizational documents (namely the certificate of incorporation and bylaws), (iii) issuing senior or pari passu securities, (iv) declaring or paying dividends, (v) redeeming or repurchasing the company’s outstanding stock, or (vi) increasing or decreasing the size of the company’s board of directors.
- Board Matters: The lead Series A investor is typically entitled to one seat on the company’s board of directors (the Series A director). This leaves control of the board to the company’s founders but allows the Series A director to be involved in all important decisions. Since the Series A director does not control the board, Series A investors will sometimes require that certain important operational matters be approved by a majority of the board including the Series A director. When the Series A investors do not have a representative on the board, they are usually allowed a non-voting board observer.
- Financial Information and Inspection Rights: Larger Series A investors are usually contractually entitled to receive certain financial information, including annual, quarterly, and sometimes monthly financial statements, as well as annual operating budgets and financial forecasts. They are also given rights to inspect the company’s books and facilities.
- Rights of First Offer: Larger Series A investors typically receive a right of first offer (also known as a preemptive right, pro rata right, or ROFO) to purchase new securities offered by the company, allowing these investors to maintain their proportional ownership of the company.
- Rights of First Refusal: Series A investors generally have the right to purchase the shares of larger common stockholders (such as the founders) when those stockholders seek to sell shares to a third party.
- Co-Sale Rights: If the company and Series A holders do not exercise their rights of first refusal to purchase all of the shares on offer in a proposed transfer, the Series A holders then have the right to sell some of their preferred shares proportionally alongside the selling common stockholder on the same terms the common holder receives (also known as tagging along).
- Drag-Along Rights: Series A financing documents often include a drag-along provision by which smaller stockholders of the company can be compelled to agree to a sale of their shares if the majority of the common stockholders (usually the founders) and a majority-in-interest of the Series A investors are in favor of the sale. This prevents smaller investors from exercising appraisal rights or otherwise preventing or delaying a sale of the company.
The rights granted in a Series A financing are typically set forth in five standard transaction documents and several shorter ancillary documents. The five standard transaction documents include a Stock Purchase Agreement, Restated Certificate of Incorporation, Investor’s Rights Agreement, Right of First Refusal and Co-Sale Agreement, and Voting Agreement.
Series B/C/D Financing and Beyond
Once a startup has successfully validated its minimum viable product through its build-phase and the marketplace responds favorably, the company is positioned to scale its product (step #4 above). In order to accomplish this, the company will need to continue to raise increasingly large sums of capital.
The investment round immediately following a company’s Series A round will be known as a Series B round, and then all subsequent rounds will be named in alphabetic order.
In these subsequent financing rounds, startups will raise anywhere from $5 million to $10 million in a Series B round to as much as $100 million in a Series E round. The amount typical in each round varies by industry and market cycle, but these are rough estimates.
At this stage of financing, the primary investors tend to be venture capital funds, growth private equity funds, and occasionally mutual funds and hedge funds in the later-stages. As with Series A rounds, convertible preferred stock is generally the financing instrument of choice among investors. The terms of later-stage preferred stock will be layered on top of the existing Series A documents simply be amending and restating these documents.
Later stage financing rounds are concerned with many of the same issues as a Series A round, including the following:
• Whose approval is required for the company to take certain actions.
• Who will serve on the board of directors.
• Which actions will require stockholder approval.
• How much coverage and disclosure the company’s representations and warranties should require.
• Whether founders and early employees should have an opportunity to sell a portion of their holdings.
When companies need additional capital in between traditional financing rounds, they will oftentimes turn to intermediate bridge financing in the form of convertible notes to help float the company until an official round can be achieved.
Bridge notes are functionally the same as convertible notes used in a seed round, but the economic terms typically differ considerably due to the later-stage financing inherent in these notes.
Bridge financing most often occur in the following situations: (i) when the company is distressed and close to running out of capital, and (ii) when the company is performing well but could achieve a higher valuation from outside investors with a small infusion of capital from investors. There are two basic scenarios in which a later-stage company will need to use convertible notes:
Early-state startups typically do not seek out commercial bank loans unless the founders are willing to give personal guarantees and they have personal assets in which to pledge as collateral. However, once a startup obtains venture-backed financing from investors, there are certain banks who are willing to provide commercial loans.
From a lender’s perspective, offering commercial loans to startups is risky business. As such, startups receiving venture debt will oftentimes be required to provide equity warrants to the lender based on a certain percentage of the principal balance of the loan. This allows banks to cash-in on the homerun deals in order to compensate for the deals which fail.
As you can see, a startup’s lifecycle will often dictate the type of venture financing available to the company. If your company is interested in discussing how you can leverage yourself today in order to position your company to be an attractive candidate for venture financing, feel free to reach out to me, and we can talk through your company’s options.