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Equity Financing Stages for Startups

It is rarely possible for startups to raise sufficient capital to kick-start their
operations, launch products and break even. Although a ‘one-time investment’ strategy
is theoretically possible, it is hard to cite examples of any successful startup
that has gone this route. Moreover, most angel investors and venture capitalists
prefer to fund startups in steps. This practice helps investors assess the value
of the company and minimize the startup risk. Therefore, entrepreneurs should articulate
their investment requirements, while keeping in mind how investors like to fund
startups.

Venture capitalists and angel investors categorize startups into stages based on
a number of startup parameters including who makes up the management team, the value
proposition, the risk, customers’ profiles and engagement, revenue, etc. and provide
equity finance accordingly. Most startups are categorized into the following stages:

Early Stage

Early stage refers to the initial days of a startup. The company starts off with
a business idea, experiments with, and articulates its economic viability. The company
establishes its proof-of-concept by demonstrating the technology and getting potential
customers on board. This can be done in several ways. If the business idea is product
based, the company would demonstrate a prototype of the technology to real world
customers and get them on board. If the business idea is web based, the company
would set up a website, track the internet traffic and get user feedback. In either
case, the company is testing the market and establishing the viability of the business idea

This phase is very important for a startup. It is crucial for a company to prove
its concept and establish its business case. Some companies can get through this
phase without the need for investment. However, other companies need investment
to complete this phase. For example, an online company hardly needs an investment
to prove the concept. However, a pharmaceutical company would need investment. Companies
that need investment to establish their proof require seed investment or seed round
investment. This round has the highest risk in terms of Return of Investment (ROI).
Most investors shy away from investing in this round and would like to see the company
pass this stage without the need for investment.

Once the company establishes its proof of concept, it prepares a roster of potential
customers who are willing to positively talk to venture capitalists. The individual
customers should be ready to say, “Hey VC, if you fund this company and help it launch
a product, we will engage with the company and take the relationship to the next
stage. The technology interests us because..
” A customer reaction like
this is the Holy Grail for an early stage company seeking venture capital.

Companies that have passed the proof of concept stage, have an established team
and a list of potential customer references need money to start their operations
and launch a product. Such companies need their first round investment. First round
investments are comparatively less risky than seed round investments.

Early stage investment is the most risky stage compared to all other financing stages.
The majority of startups fail in this stage. The key to surviving this stage is
the ability to bootstrap the operation. (Refer to the “Go-To-Market Strategy” article
on our website for some strategies.)

Expansion Stage

After the first round of investment, most companies launch their products or services
and get a few paying customers. However, these companies need further investment
to expand their product line, operations and marketing efforts. This phase is called
the expansion stage because during this stage most companies have to expand their
operations and invest in expensive marketing efforts.

Second round investment is meant for companies that have a production-quality product
along with a few paying customers. However, they need more money to improve their
products and attract more customers. It is very important for companies to get positive
paying customer references at this stage. The customers who are using the products
should be able to say, “Yes, I have been using the alpha version, but I need more
features. I am more than willing to pay $x for further capabilities.
” Apart
from this, the company should also have more business opportunities on the horizon.

After the second round investments, companies can launch any number of expansion
stage rounds. Note that the company has to dilute its equity for every expansion
round. Given this situation, it is better that companies attain break-even at the
earliest. The sooner companies break even, the better it is for all the investors
so that they can take their money out.

At times, companies that are in their expansion stages can opt for bridge-financing
instead of equity-financing. Bridge-financing refers to short-term interest only
financing. Companies typically need this for restructuring boards, especially if
certain early investors want to reduce or liquidate their positions, or when the
former management’s stockholdings change and management is buying out former positions
to relieve a potential oversupply of stock before becoming public.

Liquidation stage

Companies need money to liquidate their stock so that some investors can cash in
their stocks. Companies liquidate stock either through going public, Merger & Acquisition
route or through a leveraged buyout. Most of the investment money is required to
engage investment bankers and other legal services for the transactions. Leveraged
buyouts enable an operating management group to acquire parts of the business (which
may be at any stage of development) from either a private or public company. The
acquisition may be through the purchase of select assets or stock.

Most companies fail during the first funding stage. Entrepreneurs should really
analyze their business case and try to minimize their risk before investors come
in. As companies progress from the seed round to the expansion stage, the risk decreases
and raising money becomes easier.

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