Raising Startup Capital for Technology Companies
All memorandums are for informational purposes only and do not constitute legal advice. Additionally, the memorandum does not create or intend to create a solicitor-client relationship between the reader and the initio Technology and Innovation Law Clinic
Raising Startup Capital for Technology Companies
What is startup capital?
Startup capital, also known as seed capital, is money that businesses formally raise to finance their activities. This money is raised through investments into the company by individual investors, institutional investors, banks, or other entities. Startup capital can be used for anything related to the company and its growth.
Founders and entrepreneurs do not generally seek formal financing from external investors until after they have exhausted other means of funding. This includes ‘bootstrapping’ (using your own money), asking friends and family, and accessing public grant programs.
What are startup funding rounds and how do they work?
There are different series, or rounds, in which startup capital is raised from investors. As a company continues to grow and use funds raised through a funding round, they may find the need to raise more startup capital in a subsequent round. This is often the case: few technology companies have been known to gear up expansion and spending based solely on their revenues alone; they often need help from outside investors.
There are generally the same steps involved for each funding round, though these can differ depending on a company’s given circumstances. They are:
Gathering information and data
Researching potential investors, angels, and VCs
Drafting a pitch and pitch deck
Making your pitch to potential investors
Getting to know your potential investors
Considering the terms of the funding round and offers
Going through due diligence
Receiving the investment amounts and closing the round
Investors are looking to get something back for their investment over the medium- to long-term, and they therefore seek ownership, or equity, in the company in return for their investment. To determine how much an investor will invest to receive a given percentage of ownership of the business, they will undertake a valuation of the business to determine how much it is worth. For example, Jeff wants to invest in GrowthInc. Before he determines how much to invest, he calculates the business's valuation at $1 million, based on things such as past sales, market factors, management, and assets, among others. Jeff decides he wants to invest $100,000, to which GrowthInc agrees. In return for his investment of $100,000, Jeff receives shares (or equity) equalling 10% of the company ($1 million divided by $100,000). This is a simplified example and there are often many other factors that factor into these amounts.
What are the different types of funding rounds?
There are different types of funding rounds. These will be discussed in turn.
Seed Round
The first funding round is usually an initial pre-seed and/or seed round. A seed round is a series of investments where investors (usually 15 or less) provide the company with anywhere between $10,000 and $2 million for early product development and research. Seed rounds usually finance things such as core team hiring, product validation, and market research. In rare instances where companies need large sums of money, they sometimes skip formal seed rounds and go straight to a Series A.
In return for their investment, investors are usually provided with convertible notes, equity, or stock options. Investors in seed rounds often include angels and VCs. Some major investors may request board seats in return for their investment, while some companies may offer board seats to angels or VCs who can provide technical or strategic know-how to the company.
Series A
After a company has proven their business model and built up a business foundation, a company may pursue Series A funding. Funds raised from a Series A assist in scaling the company and pursuing rapid growth, providing funding between $1.5 and $15 million.
In exchange for their investment, investors continue to receive convertible notes, equity, or stock options. Major investors will likely request a board seat. While angels still invest in Series A rounds, VCs tend to have more clout and influence. One or two VCs will usually “lead” the Series A, acting as an anchor to solicit more investors and investments.
Fewer than half of all companies who go through a seed round go on to raise a Series A.
Series B
The goal of Series B funding is to propel a business past the development stage, providing funding for hiring, business development, technology, sales, and advertising. Series B rounds are similar to Series As in that their structure and types of investors are the same but differ in the sense that most investors will be specialists in later- or mid-stage funding. Angels, however, do not usually invest past the Series A.
Series C
Few companies make it to a Series C. At this point, companies are already successful and are now looking for funding to expand beyond their original products or markets, or they look for acquisitions of other companies. Series C rounds will see more sophisticated, institutional, and international investors come on board, and total funding amounts can surpass $100 million.
Some companies may also pursue Series D and E rounds, though these are rare. After all funding rounds, exceptionally successful companies may pursue an initial public offering (IPO), where they become publicly traded on a stock exchange.
What is/are…?
Angels: short for angel investors, are private investors who invest in small early-stage companies. While family and friends can be considered angels, “angel” most commonly refers to high-net-worth individuals who invest in early-stage companies as professional investors. Professional angels often help companies by providing advice and expertise in a given subject area.
Bootstrapping: a term used to refer to using one’s own savings, equipment, home office space, and money to finance their company.
Convertible notes: a type of share issued to investors in return for providing their investment in a company. In exchange for the investment, the investor receives a right to stock at a later time where it may be worth more. Convertible notes are unique in that they are a form of debt or an IOU, with the investor essentially loaning money to the company and where the company repays that debt at a later point in the form of shares or equity.
Crowdfunding: a fund-raising method that entails raising small amounts of money from many individual investors, usually through the internet. For example. GoFundMe is a website that allows individuals to provide amounts as low as $5 to companies seeking capital to expand and grow.
Equity: or shareholders' equity, is the value of shares that an investor or shareholder holds in a company. Equity can also be considered a form of ownership in the company. “Stock” also refers to equity, and vice versa. For example, if Jeff holds 100 shares worth $10 each in BigCorp., he holds $1000 worth of equity.
Pitch: a presentation of your business, company, or idea that you give to investors to entice them to invest in your company. A pitch deck is the slideshow that you present as part of your pitch.
Private equity: a type of investment that is composed of the pooling of funds of multiple individual investors. For example, FundX Inc. is a private equity firm, which manages $100 million that it received from 1000 separate investors. FundX invests that $100 million to provide investment returns to its 1000 investors, including investing in startups and other companies.
Stock options: a financial instrument that entitles the holder to convert the number of options they hold to the same number of stock. Option holders can only convert their options to shares at a pre-agreed price for the shares, known as the strike price. For example, Jeff invests $10,000 in Little Inc. in return for 1000 options exercisable at a strike price of $15. At the time, the valuation of the company only values a share at $7.50. When Little Inc. share prices hit $15, Jeff exercises his options and converts them to 100 shares, worth a total of $15,000.
Venture capital (or VC for short): a form of financing that investors provide to startups and emerging companies. VC funding is given with an eye to long-term growth and earning potential. Venture capital is a form of private equity, and venture capital investors are referred to as venture capitalists or VCs. VCs are often institutional investors or large investment firms, though individual investors are also considered VCs.
Sources
Included in Downloadable Copy