Unless you’re lucky enough to have started a business that’s generating cash like an engine, you’ll likely need to look for external finance at some point. Even the most successful Silicon Valley cash cows, Google, Facebook and Amazon among them, all received funding from business angels and institutions on their way to initial public offering (IPO).
For example, let’s say you want to expand your market, develop a new product or acquire another business. You’ll need capital to hire new talent, do market research or make your purchase. And each time that happens, you’ll go to the market to raise funding, known as a ‘funding round’. The aim of each funding round is for founders to trade equity in their business for cash they can use to scale and grow.
If you’re considering a funding round, you’ll be faced with jargon relating to the type of funding you require. Seed, Series A, and IPO all mean different things and – although in some cases the difference between them are overlapping – you’ll need to understand the basic principles that underpin them.
What are the different stages of start-up funding?
While not all start-ups need to resort to pre-seed funding, business owners sometimes go this route to develop a protoype or an idea. If you’ve got a solid plan about how to go to market, you may attract investors to back you. The objective? To use the funding to develop your concept into a minimum viable product or MVP.
The usual goal of pre-seed funding is to fund initial expenses to create your MVP such as incorporating your business, researching the market, developing the concept, travel, meetings and perhaps a few discretionary purchases along the way.
If you’re successful at this early stage, then you’ll proceed to further funding rounds, starting with seed funding.
At this point in your business life, you’ll probably have little more to show investors than a business plan and pitch deck, combined with data on the potential market. Funds raised are relatively small.
Typical participants in pre-seed funding rounds are angel investors, start-up accelerators, crowdfunders and specialist pre-seed venture capital firms, together with founders, friends and family (otherwise known as bootstrap finance).
If you’ve made it through the pre-seed funding stage (or skipped it altogether), the next ‘proper’ funding round is known as ‘seed’. At this point, your product has gained sufficient traction to gain interest from more mainstream investors.
Seed funding is widely considered the first round of ‘real’ investment. As the name suggests, it generally happens when companies are very small and require money to move into an initial phase of fast growth.
Companies going after seed funding will have laid down the foundations of their business (team, product, operations), but are yet to make a sale.
At this stage, you should have a proof of concept and a MVP, a launch team incorporating the founders and any key employees, and a marketing strategy to achieve the growth the funding will help you achieve.
Seed funding is used to help expand your idea, increase your company’s value, and prepare the business for future funding rounds. As with pre-seed, funds may be used for working capital or recruitment. Typical investment routes are crowdfunding, VC funding, incubators or accelerators, angel investors and funding from large institutions that specialise in growing new businesses.
Seed funding usually ranges from £10,000 to £1 million. In the UK, popular angel groups include private investor clubs like Angels’ Den, fintech businesses connecting investors to scale-up companies like Envestors and tech mentorship organisations, including Nova.
If you’re planning on the crowdfunding route, you may get a good deal, but creating the marketing content (videos, images, descriptions, updates, and inducements) can take time and effort.
It pays to shop around for investors, as the perceived value of your business will vary from person to person, as will the experience and expertise of the investor. Your business is a high-risk prospect, so expect to relinquish a sizeable chunk of equity – anything from 10-50% is normal, but it’s important to retain as much as possible, especially if you are planning future funding rounds which will dilute your shareholding further.
For more information see: FAQ: Seed funding.
Series A to C funding
After pre-seed and seed funding come the alphabet rounds: A, B, C and so on. These represent successive rounds of funding that are stepping stones to scale your business. As you’d expect, a Series C round is usually a more valuable investment in bigger businesses than Series A.
Theoretically, there is no limit to the number of these rounds a business can apply for, but at some point – perhaps from D onwards – investors might become sceptical as to whether the business will ever be able to stand on its own two feet without outside funding.
One thing these funding rounds have in common is the profile of participating investors: generally larger institutions involved in VC, banking and private equity. As the amounts grow, the capacity for private individuals to get involved ebbs away.
With the introduction of professional investors comes a more structured approach. Institutions employ teams of analysts who will compare your business to industry key performance indicators (KPIs), profit margins, customer base, market penetration, risk factors and so on.
They want an advanced level of insight backed up by proof. Most will conduct some level of due diligence, a process that involves accessing company records and other data to better understand the opportunity on offer as well as any potential banana skins.
While there is no hard and fast distinction between series A and B, or B and C, the following provides the basic premise of each stage:
Series A funding
Series A funding refers to investment in a start-up following pre-seed and seed. If the preceding stages have been successful, you’ll have demonstrated the potential to generate predictable revenue and good market penetration.
Series A funds are usually invested in streamlining your business operations and processes, expanding your sales team and making strategic hires who will focus on business growth.
Due diligence during the series A funding stage will be more intense and will last longer, so be prepared to communicate with potential investors well ahead of the round, so they’ve got a good idea of your business fundamentals before negotiation.
Here are the principal characteristics of Series A funding:
- Your business will have developed a base of customers and be able to demonstrate increasing reach – almost always revenue too
- You have a business model/plan for long-term growth and profitability
- You’ll expect to raise anything from £1 million to £30 million depending on the need and the market potential
- Investors are looking beyond ideas and assessing performance
- You may attract money from more than one venture capital firm, individual and banking partner
- Companies may use crowdfunding platforms and business angels as part of the funding round
- Venture capital companies operating in the UK at the Series A level include: Fuel Ventures, Accel, Index Ventures and Albion Capital
At series A stage, it’s highly likely that you’ll be offering shares rather than convertible notes or SAFEs. Expect to negotiate a term sheet that will set the stage for the formal legal agreements, and that will contain the basic premises around your investors’ expected return and level of control over the business by having a veto or control over decision-making.
In addition, your company will have to be valued so that shares can be priced. You’ll need to factor in any shares issued in connection with employee incentive schemes.
Series B funding
While series B may look like series A funding, the fundamentals are different, not least the amounts raised:
- Companies looking for Series B funding are established and focused on market growth as well as geographical expansion
- Businesses will be investing in infrastructure and personnel to meet demand for a product or service
- Funds may be spent on marketing, business development capacity and bigger premises costs, for example
- Series B are a step up in value from Series A, with most companies hoping to raise between £20 million and £50 million
- As in the case of Series A, funding rounds will often be led by an ‘anchor investor’ who attracts other entities to join the round
- Expect to deal with later-stage growth investors, including private equity firms and bigger institutions such as Long Ridge Equity Partners, Deutsche Bank, and Eurazeo Growth
- Even at this level, many companies choose to go the crowdfunding route if their funding target is at the smaller end of the scale. In September 2020 fintech company Chip raised £10.7 million Series B funding on Crowdcub
Series C funding
- Businesses entering a Series C funding round will have a strong track record of growth
- They have probably established a national base and expanded into new territories
- Often the funding will be required to launch a new product or service or change direction to take advantage of an emerging trend or opportunity
- It might also be needed to acquire a rival business
- Because Series C companies are larger and more established, their risk profile is lower and they will attract large banking, hedge fund and private equity institutions
- These include retail banks like Lloyds, Barclays and HSBC as well as Evolution Equity, Novo Holdings and FTV Capital.
- Some companies go on to raise Series D funding and beyond, but a more popular way to attract investors at this stage is to list your business on the stock market with an IPO
An initial public offering, or IPO, is when a company debuts on a stock market, allowing investors from all over the world to buy shares. These can be private individuals, banks or institutions like pension funds, insurance companies and even large corporate businesses that have developed their own investment arm.
Companies that list on the stock market are typically large and complex, although there are markets for smaller businesses – such as the Alternative Investment Market (AIM) – that want the benefits of an IPO before they reach full scale.
The influx of cash that comes with an IPO can go towards growth, acquisition or simply paying off debt. Once they have floated, companies can offer their shares as an incentive to attract senior recruits or as a part-payment method for companies they want to buy.
Investors buy shares at IPO in the hope that their value will increase quickly and some of their money will go towards the salaries of the top team.
There are downsides to an IPO, however. It’s an arduous process involving due diligence and compliance measures that inevitably distract the top team from core business needs. In addition, the business will have to accept new board members who can dismiss directors they believe are not serving shareholders’ interests.
There are ongoing compliance measures and legal responsibilities which listed firms must follow. Directors can face criminal investigations if they fail to do so. In fact, the operational requirements of the business change dramatically once it is listed and some founders regret their decision to go public.
For teams who still want to press on with an IPO, there are a few steps to take care of before you float:
Broker and corporate finance team
You’ll need a banking advisor to sell your shares to other investors and financial institutions. They charge a percentage of the IPO’s value as a fee.
Your corporate solicitor will need to help you with the due diligence process and file the necessary papers. The process is necessary to prevent fraud and to protect money invested by individuals against exaggerated claims by the business intending to IPO.
Pricing your shares is an essential step in the listing process. If the valuation of your business is inflated, your IPO will fall flat due to a lack of demand, but price too low and you’ll miss out on a valuable influx of cash, which will instead slip into the pockets of IPO investors.
Businesses undertake a ‘roadshow’ circuit of potential investors to promote the event. The plan is to drum up enthusiasm for your stock and ensure a busy first day on the market.
Once a business floats, people can start trading its shares. This is a nail-biting period for everyone concerned because no one is completely sure what will happen to the share price on day one. In 2019, Saudi state oil company Aramco’s share price lifted 10% on its first day; but the year before, music platform Spotify lost 10.2% during the same timeframe.
Whatever stage you’re at in terms of funding rounds and your business’ growth, our team of solicitors specialise in supporting start-ups and scale-ups in all aspects of their legal requirements, from writing investment agreements to advice on stakeholder split, to intellectual property rights, commercial contracts, employment law and beyond.