You see it on TechCrunch all the time: company X raised $X million at $X valuation. But if you don’t work in venture capital or finance, you might not know what all this means.
So, we’ll break it down for you.
Why are startups getting the money?
Investors are giving the startup money in exchange for an ownership stake. They are hoping that the share price will go up as the startup grows into a larger company.
Do they have to pay it back?
No. If the startup goes bust, the investors lose out. But if the company gets acquired or goes public, they could potentially make a lot of money.
Why not just take a loan?
It can be hard for a young business to get a bank loan. And while loans don’t dilute company ownership, they do need to be paid back eventually with added interest. Yet startups often do take loans in addition to funding rounds, from places like Silicon Valley Bank or Square 1 Bank. Sometimes the banks take a small equity stake, too.
What is the valuation and how do they figure it out?
The valuation is how much the company is worth. Determining this can get complicated, especially for early stage startups. Many startups raise funding when they are pre-revenue, so it’s really just a bet on how big the company could be someday. They take into account the estimated market size for the product or service. Later on, revenue, growth trajectory, and the likelihood of a successful outcome (IPO, acquisition) are all measured.
Do you want the highest valuation possible?
Not necessarily. Raising the valuation raises the stakes. If the startup raises money at a $500 million valuation and it sells for $200 million, that means that the investors who bought at the higher valuation lost money on the deal. It also can be bad news for employees with equity compensation if they joined the startup when it had a higher valuation.
What do funding rounds mean for employees?
Startups often lure employees with significant equity compensation packages. If the company gets acquired or goes public someday, these shares can be worth a lot of money. But the upside potential is greatest when an employee joins a startup in the early days. Valuations (generally) go up over time and the value of the equity compensation grows with it. This is often paper money until a liquidity event like an IPO or acquisition, but many startups permit their employees to sell their shares through a secondary offering. These shares are usually sold based on the latest valuation. However, if the startup goes bust, they don’t end up making money from the shares.
What is seed vs. Series A etc?
These designations relate to the stage of investment. Seed means that it’s the startup’s first funding round and each subsequent round has a letter attached, starting with “A.” Many investors specialize in different stages, often labeling themselves “seed-stage funds” or “late-stage funds.”
What’s the difference between an angel investor and a venture capitalist?
Angels invest their own personal money and VCs manage a fund. The “LPs” who invest in the fund can be financial institutions, high-net worth individuals, pension funds, university funds, or a variety of other sources. Many venture firms have a ten-year life cycle to their fund and are expected to provide returns at the end of this period. These are earned through “exits” like IPOs and M&A. The VC firm also keeps a portion of the returns. It is expected that most startups will fail, but that the best ones will provide enough returns to cover all the losses and then some.
What do startups do with the money?
The money is used to accelerate growth. It is often used to hire new employees, sales & marketing efforts and any sort of production costs. It largely relates to the nature of their business.
How often should a startup raise money?
This varies, but many startups raise funding every 1-2 years. It all depends on how much money is in the bank, how much more is needed and how much investors want to invest in you. Many startups choose to raise funds well before they need the money, in case they run into problems later on.
How do you get investors?
Of course you should have a solid business proposal, but there’s no question that connections are important. The inboxes of top investors get flooded with pitches and the best way to stand out is by coming with a reference. Many investors will tell you that their decision to invest is “all about the people.” They recognize that startups often face unforeseeable obstacles and have to change course, so they want to invest in someone they can trust to get the job done, regardless of what happens. So network. Go to industry events, form relationships and ask to be introduced. While many of the best investors focus on Silicon Valley, tech communities have been springing up throughout the United States.
How should you pick investors?
After a business gains traction, the most in-demand startups have their pick of the litter when it comes to choosing VCs. The reputation of the venture firms is often taken into consideration. Having a credible investor like Sequoia attached to a startup can assist with credibility, which can be helpful in forming business partnerships and hiring new employees. Many investors wind up taking board seats, so for these roles it can be helpful to find someone with industry experience or an expertise in scaling startups. Investors can help with problem-solving and can also make introductions. Sometimes celebrities get access because they can help with publicity.
So you’ve raised millions. Does that mean you’re going to succeed?
Sadly, probably not. While some startups make billions of dollars, the majority of them fail. Smart hard-working people with great ideas often run into challenges. It can be difficult to keep up with the pace of innovation, especially if a giant tech company decides to enter your field. But if you have a brilliant idea, don’t be discouraged. Just know that you’re taking a gamble.
Featured Image: Bryce Durbin/TechCrunch