A friend of mine recently asked me about the different stages of startup financing — so I figured I’d write it down for you too!
There are certainly other sources of startup capital besides the ones listed below, but these five are the top ones; and they’re typically used roughly in the order I list them.
This is typically the very first investment of money used to for market research and developing product.
It can come from the founder’s personal savings (e.g. from a severance package from the founder’s prior job) or from acquaintances (aka a “Friends & Family” or “F&F” Round).
Seed capital can be received as a loan on in exchange for common stock.
Note: Credit cards/American Express are also used as a startup fund option around this time.
Since seed capital is sometimes limited, it is often necessary for an entrepreneur to tap into wealthy individuals outside their friends & family — this is often called an “Angel” investor.
You can receive money from an angel investor as a loan that is convertible to preferred stock (often it converts to the Series A round of stock below).
Friends & Family investors sometimes participate in this “Angel Round” of financing.
Venture capital (VC) funding is typically used by companies that are already distributing/selling their product or service, even though they may not be profitable yet.
If the company is not profitable, the venture capital financing is often used to offset the negative cash flow.
There can be multiple rounds of VC funding and each is typically given a letter of the alphabet (A followed by B followed by C, etc.)
The different VC rounds reflect different valuations (e.g. if the company is prospering, the Series B round will value company stock higher than Series A, and then Series C will have a higher stock price than Series B).
If a company is not prospering, it can still get subsequent Series-rounds of financing, but the valuation will be lower than the previous series: this is known as a “down round.”
These rounds may also include “strategic investors:” investors who participate in the round and also offer value such as marketing or technology assistance.
In the Series A, B, C, etc. rounds of financing, money is typically received in exchange for preferred stock (as opposed to the common stock that insiders/seed capital sources (and perhaps even angel investors) receive).
If you want to learn some tips on VC funding, check out my How To Raise Money From A VC: Insider Tips article.
Note: A line of credit from a bank is another startup fund option around this time as well.
At this point, companies may be eyeing the following types of opportunities that require additional funds:
To do so, they can tap into mezzanine financing or “bridge” financing.
Mezzanine financing is often used 6 to 12 months before an IPO and then the IPO’s proceeds are used by the company to pay back the mezannine financing investor.
Finally, companies can raise money through selling stock to the public in what’s called an Initial Public Offering…or IPO.
The IPO’s opening stock price is typically set with the help of investment bankers who commit to selling X number of the company’s shares at Y price, raising money for the company.
Once the stock is out, it is traded through a stock exchange (like NASDAQ or American Stock Exchange).
Companies can offer more of their stock through additional offerings.
If you’re raising money for your business from friends and family or angel investors, I recommend you consider using a convertible note or bridge loan to do it because it is typically cheaper and quicker than raising a “priced” round (in which you sell stock at a certain price).
Here are the main things you need to know about bridge loans/convertible notes:
Q: What is a bridge loan (or convertible note)?
A bridge loan/convertible note is simply interim financing until the next round of financing can be obtained. The word “convertible” is often used since the bridge loan will “convert” into equity at your next round of financing.
Q: Why use a bridge loan/convertible note versus selling stock?
Q: During which stage of financing is a bridge loan/convertible note most useful?
I find them most useful during the initial seed financing rounds of fundraising such as taking on a small amount of money ($500,000 or less) from private angel investors or friends and family (as opposed to venture capital firms).
Q: How long should a bridge loan be for? (what should the length of the term be?)
It will typically be one year or less (it should be timed such that the maturity date of the bridge loan is due roughly around the time that another financing (or liquidity) event occurs for the company.
Q: What should the interest rate for a bridge loan be?
A: The interest rates for convertible bridge notes vary but tend to be around five percent greater than the Federal Reserve rate (one point of reference: California laws dictate that there should be a cap of 10% on the bridge note interest rate).
Q: What happens if you reach the maturity date of a convertible promissory note and there hasn’t been another round of financing or liquidity event (and your company doesn’t have the money to pay back the loan)?
In this event, you can:
1) Ask the investor to extend the maturity date
2) Convert the loan into stock based on a price you pre-determined or a price you determine at the maturity date.
Q: What is a conversion discount (or warrants) for a bridge loan?
A “conversion discount”(or warrants) is a future discount that you provide to your investor (the person giving you the bridge loan) in the event that you do raise another round of money or have a liquidity event.
The conversion discount generally ranges between 20% and 40%.
So, for example, let’s say you get your bridge loan and offer a 30% conversion discount and then later you raise a Series A round of venture capital at $1 per share. Your bridge loan investor would then receive one share of stock for each $.70 that he loaned you.
Q: Do you have an example of a convertible note/bridge financing term sheet?
Here’s one: Convertible Loan Term Sheet
Q: Are there any drawbacks to taking a bridge loan?
If you take a bridge loan and can’t pay it back at maturity then an investor can technically use that as an “event of default” which could lead to bankruptcy — the way around that is to accept the bridge loan from someone close to you who you trust to see you through such a scenario.
Additionally, to protect yourself, you can try to get language into the bridge loan which converts the loan into something else (no matter what).
If you want to read more about bridge loans/convertible notes (which are also called “convertible promissory notes”), a great resource can be found at Convertible Notes by Yokum Taku, an attorney at Wilson Sonsini Goodrich Rosati (WSGR) in California, USA.
I have worked with the WSGR law firm on one of my startups and highly recommend their services. In fact, one of their attorneys was so good, I eventually hired him as our general counsel!