Founding a startup is the new American Dream.
It’s not just a badge of pride for entrepreneurs. Startups have practically replaced the traditional small business with more than 77,000 new startups every quarter in the US.
As with all businesses, the funding of startups is an important and complex task. The startup culture, in particular, has developed its own nuanced funding patterns in the past couple of decades. It can be tricky to navigate if you’re not familiar with the lingo and the important players at each stage.
How does startup funding work?
The process of funding a startup can take several different paths. The path chosen largely depends on the following three criteria:
- The Founder – What skills does the founder possess? Are they a jack-of-all-trades or an expert in a narrow field? Do they have the mental and physical fortitude to carry the project to completion on their own?
- The Product or Service – What is the scope of the startup? Is it B2C, B2B, or B2G? Is there a need for extensive customer support? Is the project a one-and-done Software-as-a-Service (SaaS) or is it an ongoing, evolving product
- The Goal – Not everybody wants to start the next Facebook. Some people are totally content with building a product to success and then letting it run on autopilot. Is growth at all costs the goal? Is it to go public? Is it to be acquired by another company?
Before starting work on a startup, the founder should have already created a business plan (or business model) that addresses the above. With those criteria in mind, you can choose the appropriate method of startup funding.
Check out our roundup of the Startup Business Loans
Self-funded startups (Bootstrapping)
The “romantic” perception of startups – late nights coding, fueled by Red Bulls and pizza, persevering until the big payoff – generally describes the process of bootstrapping.
The core of bootstrapping is that it’s entirely self-funded. At no point does the startup accept any outside funding. Initial costs are covered by the founder and are hopefully recouped quickly with the release of a Minimum Viable Product (MVP), which is then fine-tuned to the final product.
Most businesses have the potential to be self-funded in this way, with the exception of ones that require very large upfront investments (such as manufacturing or medical companies). The founder chooses to trade time and effort, and a little money, for the power to maintain full control over the company. It’s a high-risk, high-reward scenario – the startup could fail and the founder would lose their investment of time and money.
Still, Bootstrapping remains a very attractive option for first-time (or very confident) entrepreneurs.
Pros of bootstrapping
- Maintain 100% equity
- No external pressure, deadlines, or benchmarks to meet
- Creative control
Cons of bootstrapping
- Limits the scope of startup
- Scale slowly
- Risk wasting personal time and money
Externally funded startups
When people envision the dynamic Silicon Valley startup scene, they see millions of dollars being thrown at anyone with grandiose dreams or even just a half-baked idea.
The reality of startup funding is a little more complicated than that, but millions of dollars are certainly being thrown around – billions, actually.
What’s the catch? Most of this money is only given to experienced entrepreneurs with a history of successful startups or other business. Alternately, a bootstrapped company that has validated its market, found a customer base and shown positive potential will also be considered for funding – whether that funding comes through the standard stages of startup funding (discussed below) or even through winning a startup pitch competition.
Many companies start off bootstrapped for financial reasons (or lack of demonstrable experience) but seek external funding as soon as possible. Others bootstrap with the intention of staying self-funded but come up against obstacles insurmountable without a significant cash injection.
Pros of external funding
- Much larger amounts of money for growth, scaling, diversifying
- Ability to bring on additional talent and experts
- Reduced personal risk
- Accompanied by mentors
Cons of external funding
- Lack of directional and creative control
- Significantly reduced equity and diluted shares
- Working against time
What are the different stages of startup funding?
If the startup is to be bootstrapped, that’s the beginning and the end of funding. They might seek personal loans or eventually go public with an IPO, but by then the company will be established and able to support itself on its own merit.
Startups that are utilizing external funding to accelerate their growth often follow a very standard trajectory. There are 5 stages set on a linear path, each stage providing greater quantities of money. Usually, the money at each stage is intended for a (somewhat broad) purpose.
However, not every startup (even the completely successful ones) will go through every stage. Depending on the scope of the startup, they might be satisfied with the money raised in Series A. There’s no need to continue through Series B or C, and they can go public at will.
Below we describe each of the stages of startup funding and the kind of funding the characterizes each stage.
Seed funding
Seed funding is a bit of a catch-all term for any sort of funding that happens before venture capitalists get involved. Some people split it into both Pre-Seed and Seed Funding. In this case, Pre-Seed would be money (and time) invested by the founder – it describes the bootstrapped beginnings of a startup.
Seed funding is from an external source, and almost always from individuals rather than companies. The goal of seed funding is to actually get the company off the ground and to find a market for the product or service. The money is usually spent on:
- Incorporating a business and acquiring relevant permits/licenses
- Hiring employees
- Purchasing the necessary equipment
- Product prototyping
- Market testing
What type of startup funding is used at the seed funding stage?
- Self-funding — Even if the goal isn’t to bootstrap, the reality is that any founder is going to put a lot of sweat, blood, tears, and money into a startup. Remember that cold, hard cash isn’t the only form of investment. Time is a significant investment (especially in terms of opportunity cost).
- Friends and family — Many founders receive financial support from close friends or relatives. There’s a huge amount of risk inherent in founding a startup, after all, and they are likely to have more faith in you more than an investment banker would. Oftentimes the amount of money invested is relatively small, between $1000 – $15000. People with larger networks can amass more, but that’s not the goal. This money is meant to sustain a company until it can reach sustainability (or enough success for Series A funding).
- Angel investing — Somewhat overlaps with Friend and Family investing, as it’s not unusual for an angel to come from that group. The difference is that the angel is usually a wealthy investor who contributes significantly more. Additionally, unlike traditional investors, an angel investor is usually investing in the entrepreneur rather than the business. That means the terms will be much more favorable for the founder and such a partnership often comes with extra benefits like mentorship.
- Example Angel investors
- Friends, family, mentors, local investors
- Angel List
- Example Angel investors
- Crowdfunding — A relatively recent phenomenon, but crowdfunding is a popular option for startups that are product-based. If the product has mass appeal, and a startup has an excellent marketer, it’s possible to raise several millions of dollars. The benefits to crowdfunding are twofold: the startup doesn’t have to sacrifice equity to investors, it merely has to fulfill backing promises to the funders. Furthermore, it simultaneously validates market demand and creates a pool of customers to draw from for future products.
- Example crowdfunding platforms
Series A funding
Once a startup has proven its worth by surviving the gauntlet of “Death Valley” (a term that describes the phases of founding and the Seed Stage, where most startups fail), it may attract the attention of big fish.
A startup doesn’t need to be profitable to receive Series A funding – on the contrary, many aren’t. Startups at this stage have already acquired users, customers, distribution channels, or demonstrable positive growth.
Money in Series A is usually used for the following:
- Improve processes and workflows
- Offset negative cash flow
- Convert to profitability model
What type of startup funding is used at the Series A stage?
- Venture capitalists — At Series A, these usually take the form of venture capitalist firms. These professional investors rarely care about the soul of a startup – your company is just a number on a spreadsheet. Expect large sums of money with plenty of strings attached. Oftentimes, the strings will turn out to be equity – it’s not uncommon for founders to own less than 30% of their startup by the end of Series A funding. Still, a small slice of a huge pie can be more pie than a whole, bite-sized pie.
- Example venture capitalist firms
- Accelerators — Although there is usually money involved, the value of accelerators isn’t measured in USD. Accelerators provide a number of services to the startups they accept, and in many cases, there are local options as well (including this women-led small business accelerator in Ohio). First and foremost is a mentorship program that takes place over a few months. The startup will retain the guidance of a mentor after the intensive program as well. Furthermore, most accelerators provide office space and networking opportunities.
- Example accelerators
- Equity crowdfunding — Very similar to regular crowdfunding, with the obvious difference that each backer is receiving equity in return for their investment. Equity crowdfunding is relatively new but rapidly becoming more popular. The truth is that even a startup that was successful in the seed funding stage may not attract Series A funding. Crowdfunding equity allows smaller commitments from many investors, which is generally an easier sell.
Series B funding
The Series B stage is characterized by building out new services, products, or markets. Startups that qualify are already successful businesses in their own right (though not necessarily profitable).
In addition to increasing the scope of the startup, Series B funding is used for scaling – but usually in terms of internal growth, rather than simply acquiring more users or customers.
Of course, that doesn’t mean Series B money won’t be used for advertisements. Rather, investors agree that the startup in question has already proved itself sustainable, has responsibly used previous investments, and still has even bigger potential. At Series B it’s all about pushing that last bit of growth and development out of a company.
Money in Series B is used for the following:
- Develop ancillary products and services
- Acquire top talent to spearhead new initiatives
- Perfect business model and operations
What type of startup funding is used at the Series B stage?
- Late stage venture capitalists – Once a startup gets to Series B, it can be valued around $50 million. Funding significant amounts either comes from specialized late-stage investing VC firms or from individual venture capitalists with extremely high net worth.
- Example late stage venture capitalist firms
- Anchor investor – One difference is that Series B funding is typically difficult to secure. It often happens that a startup will manage to attract a single anchor investor, often one of those individuals VCs, who paves the way for other investors by lending the startup their support and confidence.
- Example anchor investors
- High net-worth venture capitalist individuals
- Any of the previous VC firms
- Example anchor investors
Series C funding
Startups that make it to the Series C Stage are robust, growing companies. At this point, they are almost always profitable and self-sufficient.
Investors may choose to invest money because of that fact. Many Series C startups are practically money-printing machines. It’s a safe bet that, given their history of success with previous funding stages, the startup will be similarly responsible with additional funding.
So, Series C is all about scaling to exploit every nook and cranny of the market, squeezing every drop of efficiency out of advertising, and optimizing production and distribution. Many startups use Series C funding to acquire other companies for a greater share of the market, or to expand overseas to new markets.
The vast majority of Startups don’t ever make it to Series C, and only a fraction of the ones that do make it go beyond this stage. It’s possible for funding to continue to D or E stages, but very rare.
Money in Series C is used for:
- Scaling to fill existing markets
- Acquiring similar companies
- Expanding operations abroad
What type of startup funding is used at the Series C stage?
- Hedge funds – Hedge funds are a private investment vehicle that generally focuses on a narrow range of investments, injecting huge amounts of cash, and hoping for a relatively short (2-3 years) return on investment. Startups in Series C provide a perfect match – they require tens of millions, if not hundreds, for a significant investment. They are reliably growing, however, and will almost certainly do an IPO within a few years.
- Examples of hedge funds
- Investment banks – They get in at this stage for two reasons. The first is that investment in a Series C company is a very low risk. The second is that investment banks are the most common route to an IPO. By getting in with a startup a little early, not to mention owning a portion of the company, they position themselves to broker the IPO later.
- Examples of investment banks
IPO
An IPO, or Initial Public Offering, is the end goal for many startups. Being a publicly traded company is the mark of a successful transition from a startup to an established company.
Truthfully, however, an IPO is yet another round of funding. It’s simply allowing the public to invest in a company, rather than restricting it to accredited investors. Money raised from an IPO will be used to finalize any major changes to the business model that still haven’t happened.
And, for some founders and investors, the IPO is the cue for an exit. Serial entrepreneurs (and investors) enjoy the thrill of the chase, so to speak, rather than the day to day running of a company. They will use this opportunity to exit the company… which occasionally leads to dramatic shifts or even failure.
What type of startup funding is used during an IPO?
- Investment banks – While the IPO itself is the actual fundraising, an investment bank (or underwriting firm) will handle the process. It’s a lengthy legal process involving lawyers, certified public accountants, and Securities and Exchange Commission (SEC) experts. The investment bank will usually front the necessary money and take a cut of dividends from the IPO, as well as a flat service fee.
Useful startup funding resources
- Crunchbase — At its core, a data aggregation site about startups. In practice, it’s an invaluable directory of all the stats related to every important startup. There you can find information about trends, investments, and news about the startup world to inform your own decisions.
- Gust — A funding platform that connects founders, investors, and accelerators. It’s particularly useful to someone eager to dive into the startup scene because it’s geared towards new and first-time founders. They take care of most of the paperwork and other tedium so that founders can focus on what’s important – the startup.
- Startup Stash — A directory of various tools and resources that help founders to build startups. You can browse by categories to discover all of your options for vital startup needs: mailing list management programs, referral software, email and landing page templates, and more. It’s particularly useful for finding free alternatives to tools that are pricey (such as keyword research or SEO tools).
- GAN (Global Accelerator Network) — A network of accelerators, partners, and investors that span the globe. The mission is to help facilitate startups in every country so that entrepreneurs don’t have to leave home to go to a country with a more robust startup scene. The program includes grants, mentorship, and consulting from experienced entrepreneurs.
- Clarity — A website that allows experienced professionals and experts in any field – especially finance and business – offer their expertise over the phone for a short period. There is a nominal charge for the consultation, but founders will find the bite-sized sessions particularly useful. Instead of bringing on a consultant, you can have your questions answered in 5 or 10 minutes.
- Startup Grind — Possibly the largest community of startup founders, it’s a world-spanning organization that hosts a multitude of panels, conferences, and meetups every year. The organization has roots in connecting entrepreneurs to potential funders by the tried-and-true method of networking events.
- Celery — For product-focused startups, is a superb tool for raising funds. In essence, it’s a crowdfunding pre-order platform. It’s particularly useful because it’s totally free until you actually charge customers for the orders – which gives plenty of time to get production up and running. It’s an excellent stop-gap measure before investing in a whole website and payment infrastructure.
- Your First Investor — As the name implies, Your First Investor helps founders move from the idea stage to seed funding by setting them up with a (usually) local investor. Not just individuals either, they partner with investment companies and accelerators around the world. The best part? There’s no equity transfer.
- Republic — An equity crowdfunding platform for both investors and founders. The onboarding process is very streamlined and quite simple (even more so for investors). It’s unique in that it utilizes some loopholes to allow pretty much anyone to invest instead of just “accredited investors”, so startups have a greater pool to draw from.
- Kiva — A totally novel idea, is an investment-charity platform. Investors loan money to individuals and their companies, often in underserved parts of the world like developing countries. Those founders use the funds to kickstart their business, then repay the loan (with no interest). Kiva itself is funded with donations, so 100% of proceeds go to the recipients.
