Types of Funding and How They Help Businesses
All businesses need funding at one point or another, and startups even more. There are numerous types of funding available, but all depend on where your business is at the moment.
Funding or financing is the contribution or pooling of resources for financing a project or business, especially a startup. Some companies look for funding more than once, with each time called a round. In this article, we will look at the different types of business funding and how the rounds of funding work.
How Funding Works
In a business environment, there are various participants when it comes to funding. First off, there is the startup owner who is looking to raise funds for the business. As the business grows, it goes through funding rounds, which start with a seed round and progress to A, B, and C.
On the other hand, there are potential business investors. Investors want your business to succeed because they are avid supporters of entrepreneurship—and they also want to get a return on their investment. Almost all investment put into a business in any stage of development funding is done so that the investors hold part ownership of the startup.
What Is Seed Capital?
Seed capital is the initial startup funding that is used to finance a new business. The seed capital can be money from the startup owner’s assets or their friends and family. Around the world, thousands of startups depend on seed funding to finance their businesses.
To create a successful business venture, raising seed funding is the first and most significant step. Raising the seed funding helps startup founders chart a business plan, covering the operating expenses before the business starts turning profits.
1. Pre-Seed Funding
Pre-seed funding is the earliest funding for a new company. It happens so early in the funding process that it is rarely included in the funding rounds. This type of funding indicates that the startup founders are just beginning to get the company off the ground and are looking for funding sources.
To eliminate any interest on loans, they can use credit cards or their own money from savings to help them get their business idea up and running. The most common funders in the pre-seed stage are usually the startup founders.
2. FFF (Friends, Fools, and Family)
Startup founders can raise funding from their FFF tribe—friends, fools, and family. These are generally the earliest supporters of a startup. Depending on the company’s nature and the initial setup costs of the business development, this stage may move quickly or get stuck in one place for a long time. Choose who you engage with carefully. Ensure that your arrangement is a formal one with a contract signed by all parties. This prevents disputes from arising much later.
A business that is still in the validation stage can apply for grants. Selling your company’s equity stake is not required for a grant, and they vary depending on the country. Generally, a few types of grants help startups in their early days, but usually with restrictions and limitations regarding the number of years the company has been operating.
A grant is typically given for a particular stage of a project, where the startup should have at least raised the capital needed. If you need 100% funding and the grant is giving 50%, the other 50% should have been raised before the grant is awarded. If you are eligible for government grants, you may get help to subsidize your business activities or training costs.
4. Angel Investors
Angel investment comes from a person or people who have money for backing up startups. Angel investors are typically wealthy individuals who expect a return on investment at the end of the day because they have essentially bought some ownership or equity stake from your business by funding it.
If the angel investors make a wrong investment choice and sink their money into a business that goes bust, they are prepared to take a hit and experience loss. This makes angel investors safer than taking out a business loan. However, what a business owner needs to remember is that they are selling part of their company equity in exchange for funding. This sale means you may not necessarily have full control of your business, and you have to play the tune called by the piper, aka the investor.
In order to attract an angel investor, you have to have a business plan and a way forward. Angel investors can be family or friends, but they are not easy to get.
5. Venture Capital Funding
A VC, or venture capitalist, is a private investor who finances promising startups. Venture capitalists are usually members of large venture capital firms that have boards. These boards vote on the startups they want to back with funding.
If the venture capital firm selects a business, a venture capitalist will reach out to the company with their offer. In a conventional setting, venture capitalists purchase equity in a business, which means they expect returns when the company becomes a success—assuming it does. If the business fails, the VC counts its losses and moves on.
If your startup has passed the ideation stage and already has an MVP (Minimum Viable Product), you make a suitable candidate for a VC. Venture capitalists may be business people, but they certainly are not in business to take risks that have no promise of success. To become VC candidates, a startup needs to be on the threshold of bringing their product or service to the public but lack the finance muscle.
A startup can get a loan from investors, family, friends, or a short-term small business loan from a bank. A loan from a support organization or from investors does not need a personal guarantee. A bank loan, however, always requires collateral. For this reason, it's important to be cautious: if you put up your home as security and your startup fails, you will lose it. You should only take a loan with collateral after your business has reached the market/product fit stage and is looking to scale.
Loans from banks may include SBA (Small Business Administration) loans. These types of loans have lower interest rates than other loans without an SBA guarantee. This guarantee does not imply that you are free from repayment obligations if your business does not take off. The best thing about SBA loans is that you have the advantage of being approved for loans you would not have been approved of in other circumstances.
7. Mezzanine Financing
Mezzanine financing is a type of funding that uses debt and equity. This form of funding is called a mezzanine because only middle-sized companies are interested in this funding form. The lender gives a loan, and the borrower is given a repayment schedule on terms they negotiate on.
In this form of financing, the lender can set terms for the borrower, such as financial performance, before they fund the business. Some of these terms include an adequate operating cash flow or the company’s ability to pay their current debts—or an excellent shareholder equity ratio, which means there is shareholder value after the company pays off debts.
One advantage for borrowers in mezzanine funding is that the funding can go over and above what a conventional lender can grant. Mezzanine debts offer a low debt-to-equity ratio for the borrowers, which is suitable for drawing in investors, as this is a good indication of low risk.
Royalty financing is based on revenue and is an equity investment in the future sales of a product. Royalty financing is different from angel funding and venture capitalists in that the business needs to be making sales prior to receiving the funding.
An investor will demand payments immediately as per the agreements. Royalty funders give cash up front for any business expenses, and in return, get a slice of the revenue from product sales.
Crowdfunding is a form of funding where a startup is financed by numerous individuals who sponsor the business with a small amount of money. This method can enable a company to raise a lot of capital and is similar to fundraising. The most well-known crowdfunding platforms are Indiegogo and Kickstarter.
The most popular crowdfunding forms are based on free-of-charge financing, a preorder for you to develop your product in practice, or a situation where the investors get a stake in the business equity for a small amount. On the crowdfunding platform, you create a campaign that features your business, then set a target goal to meet. The public gets incentives like company shares or gifts in exchange for a small amount of money.
Building your business via cash flow is known as a bootstrap. This is where you sell a service or product with minimal capital and grow the company from the income made from selling the service or product. This bootstrapping model works well with businesses that are into creating software or other tools. Any product that needs heavy infrastructural investment often needs outside funding. In the early stages of a startup, it barely has any cash flow, so any business geared for high growth can rarely be funded by bootstrapping.
10. Incubators and Accelerators
Business incubators can invest some money toward a company’s operation, and in return, they get 5 to 10% stock equity. This incubation period can last anywhere from several months to one year. Other startups, known as the incubator mentors, help get the startup in shape for the next funding round in this period.
Accelerators are programs that offer startups an investment in their business, and in return, they get equity in the startup. The startup owners get office space, access to networks, and mentorship, enabling them to grow their business.
Seed Round Funding
Startups go through numerous financing rounds before they can begin earning ample money to run their operations and run independently. The seed-stage funding comes after the pre-seed financing but is regarded by most as the first stage.
In this stage, funds are raised to build up the business and cover some early expenses like market research and product development. The seed money often comes from third-party investors like family, friends, or other investors like individual angel investors, incubators, or seed-funding companies.
Numerous venture capital companies provide startup owners with capital for funding their business idea. In return, the investors get partial ownership of the startup. When the business takes off and is profitable, the investors can get their ROI by selling the company shares for a profit.
Early Stage and Seed Funding
In the early stage and seed funding, the concentrations gravitate more toward VCs because they invest more at this stage. Selecting early-stage and seed funding takes many investment strategy approaches and works with the startup founders.
The fund life cycle is the same for various types of funding. Venture capital funds have a general life span of ten years. Of these ten years, four to five years are set aside to make investments in companies. The rest of the five or six years are for collaborating with the existing companies; then comes the exit.
Seed funding can be anywhere in the range of several thousands to millions of dollars. At this stage, the investor invests mostly in the product concept, the team, and their business potential. A smart entrepreneur who has a great team's backing and a revolutionary idea can get considerable seed funding, even before the business potential or the concept is verified on the market.
What Are Funding Rounds?
As mentioned earlier, a company may need more than one round of funding. For some businesses, a seed funding round is enough if the founders feel that they do not need more funding to get off the ground properly. Some of the necessary rounds for a startup are as follows.
a) Series A
Once a venture has established a customer base, has consistent income generation, or demonstrates other KPIs (key performance indicators), it may choose to carry out Series A funding. This type of financing improves its customer base and scales its product in various markets.
Most times, a seed startup may have a groundbreaking idea that can generate a lot of income. It gains many users, but unfortunately, the company has no way to monetize its business. Series A funding rounds generate at least $2 to $15 million, with this figure rising in recent times due to industry valuation. As of 2020, the average funding of Series A was $15.6 million.
Investors in Series A are not scouting for great ideas only. Still, they look at companies with unique ideas and a superb and robust strategy for turning their idea into a money-minting business. Most firms in the Series A funding rounds have been valued at approximately $23 million! The investors in this round come from more conventional venture capital firms.
In this stage, most investors take a different process, and it is the norm for a select few venture capital firms to take the lead. One investor may be the anchor funder, and the company attracts more investors. Angel investors might come on board at this stage. The angel investor influence is diminished in this funding round, unlike in the seed funding stage.
More and more companies are using equity crowdfunding as part of the Series A round. This is because most companies, even having generated seed funding successfully, may fail to capture investors' interest in the Series A funding. Less than half of the seed-funded companies progress to Series A funding.
b) Series B
Series B rounds are about progressing the business beyond the development stage, and investors assist startups by expanding market research. A company that has passed through seed funding and Series A has developed a significant customer base and has proven that they are ready to take off to the next level of success. Series B funding is for growing the business to meet these high levels of demand.
Building an exceptional product and growing a team demands the acquisition of excellent talent. This stage requires more business development, advertising, marketing, and tech, which all cost a lot. The approximate average capital a Series B round raises is $33 million. Any company doing Series B funding is already well-established, with an equally good valuation.
Series B is almost the same as Series A funding in its process and the top players. Series B is usually carried out by the same people from Series A, including the leading investor who attracts other investors. The difference here is the addition of other venture capitalists that are specialists in later-stage investments.
c) Series C
Any business that makes it to the Series C stage is already doing very well. These businesses look for extra funding to expand into new territories, build new products, or acquire other companies. In this funding, the investors pour money into an already flourishing business with the expectation of getting their investment back twofold. Series C focuses on scaling the business and growing it fast, yet successfully.
One way to scale a business is through the acquisition of another company. For instance, a company believes it can do well in a different market. The investors think a merger with a company in that market is necessary for conquering the new market. A Series C funding in this scenario can be used to acquire that company.
As the stakes get higher, more investors come in. In Series C, private equity companies, investment banks, hedge funds, or large market groups get into the funding. This is because the company has already proven its success and worth. The investors are sure of getting their investment back with profit and securing their positions as leaders in the business world.
Usually, a company will exit all external equity funding at this stage. However, some businesses might take it a notch higher and go to Series D and E funding. Series C funding companies have already established steady revenue streams and robust client bases, and their valuations are not based on hypothesis but hard data. The companies that continue with funding after Series C are usually seeking to get that push before they launch an IPO (initial public offering) or because they have not reached their target goals with the Series C funding.
Mergers and Acquisitions
When you are growing your business, make sure your relationships with competition and other players stay intact. This ensures that when it comes to selling the company, the potential buyers know who you are, making the process more seamless. For most businesses, their exit is usually M&A (merger and acquisition), which means the firms merge with another business or are acquired by a much bigger company.
IPO or initial public offering is a well-known, though non-standard exit for a company. The IPO means the company’s stock is listed for public trading. Some of the most notable startup companies that recently did their IPOs include Lyft and Dropbox.
These rounds of raising capital may be confusing to the new startup owner. You must understand them before you get into a form of funding that may work against you, especially taking loans with collateral.
The best way of raising money would be to not make too many demands on the business. No investor wants to lose money or go into a failing business. They all expect to get a return on investment as fast as possible, double it, or even triple it if possible.
Each round has different demands for funding, and each case has its risks that depend on various factors. Seed investors and Series A to C greatly help business owners nurture their businesses into successful entities.
Before you proceed with funding, due diligence is crucial. Study the pros and cons of each funding method and make an informed decision.