Perspectives on different types of financing
Early in the life of a company, the idea of a financing arises. While many companies are bootstrapped and rely on sales to fund the business, a wide variety of companies choose to raise a financing, or a series of financings, to help build a product, enter a market, or scale the company.
These financings can take many forms. In 2010, when my partner Jason Mendelson and I wrote the first edition of our book, Venture Deals: Be Smarter Than Your Lawyer and VC (Wiley), the terms and approaches to venture capital financings were a mystery to many entrepreneurs. Since then, there has been an explosion of startups around the world where financings of early stage, private companies have become pervasive.
In this section, I’ll talk about a variety of different financings along with common terminology used by the various players. I’ll lead you through the different stages of financings, discuss several types of venture capital funds, describe how syndicates work, and then finish with a brief discussion of equity and product crowdfunding.
Friends and family
The first financing a company often does is called a friends and family round, where the investors are either friends or family of the founders. For some, this gets called the 3F round, or friends, family, and fools, as a common joke is that only a fool would invest so early in the life of a company.
While this is a very risky round to invest in, when companies are successful, these three F’s can receive enormous financial rewards. These early rounds are typically small, often less than $250,000 in total. If the founders are unsophisticated, the documentation for these rounds is often sloppy and informal, which can come back to haunt either the investors or the founders.
You should treat a friends and family round with the same level of seriousness as any other financing, even though the money may be coming from your mother. Realize that these friends and family are betting on you and, by structuring the round as a formal financing, you are setting the right tone and expectations for all investors from the beginning.
The next investor type that a founder typically encounters is an angel investor. These angels are often a key source of early-stage investment and are very active in pre-seed and seed stage financings. Angels can be professional investors or successful entrepreneurs and often invest alongside friends and family members.
While angel investors are usually high net-worth individuals, with the passage of the JOBS Act in 2012 they no longer have to be. However, the rules around these financings, especially if done with nonaccredited investors, can be complex, so make sure you have advice from a good corporate lawyer who knows how to do these types of investments.
Some angel investors, known as super angels, make many small investments. Super angels are often experienced entrepreneurs who have had multiple exits and have decided to invest their own money in new startups. These super angels are often well known throughout startup communities and can be a huge help to the founders of early-stage companies.
Angel investors are called angels specifically because they are expected to help the companies, both with capital and advice.
Some angels end up forgetting their role and become devils. Reputation matters, and as an entrepreneur make sure you do your diligence on any potential angels to make sure their goals and values are aligned with you.
Many angels invest together and some end up forming angel groups. The level of formality varies widely from dinner groups of angels that meet with entrepreneurs but make their own individual investment decisions, to formalized funds that look like small venture capital firms.
Once you’ve raised an angel round, your next round will often be done with a venture capital (VC) firm. In some cases, the angels and VCs will invest side by side, just like angels do with friends and family. It’s important to realize that while there are distinctions, there are no rigid boundaries.
Firms used to define themselves by the stage of financing they invested in. You’d hear about seed-stage firms that invested very early. Or series A firms that invested once a company had a product in the market. Or series B/C firms that were mid-stage investors. Then, firms wanted to be positioned earlier in the financing timeline, so the idea of pre-seed firms appeared. In some cases, firms want to position the investment as early, even though there have been several rounds, so you’ll end up with series A-1 rounds following a series A round.
There is no magic to or legal definition in naming rounds. The key is that there is a way to discuss how early or late stage a company is when determining which VC might be right for you.
Generally, pre-seed, seed, and series A are early- stage companies, series B and C are mid-stage companies, and series D or later is a late-stage company.
Types of venture capital funds
The smallest type of VC firm is often referred to as a micro VC fund. These are firms with one general partner who often started out as angel investor and created a VC fund after having some successful angel investments. While the size of a micro VC fund will vary, most are from $2 million to $15 million. Micro VCs invest almost exclusively at the seed and early stages.
Seed-stage funds are the next step up and can scale up to $100 million per fund. They are often the first institutional money into a company but rarely invest in later rounds past a series A. Seed- stage funds often provide your first noncompany board member.
Early-stage funds are in the $100 million to $300 million size and invest in seed stage and series A companies but occasionally lead a series B round. These firms also often continue to invest later in the life of a company.
Midstage funds are those that invest in series B and later rounds. The funds are often called growth investors, because they invest in companies that are succeeding but need capital to grow to the next level. These funds tend to be much larger, usually ranging from $200 million to $1 billion in size.
Late-stage funds enter the picture when the company is now a significant stand-alone business, doing its last financing before a prospective initial public offering (IPO). While late-stage funds can be VCs, some other financial investors, such as hedge funds, crossover investors that invest primarily in the public markets, funds associated with large banks, and sovereign wealth funds also show up in this category.
Firms do not tightly adhere to only one of these definitions. Some firms with billion-dollar funds have early-stage programs that invest in young companies. Others have multiple funds that invest in different stages of a company. Firms can have dedicated programs or partners per stage while others invest along the company life cycle with no special delineations. Ultimately, make sure that you are targeting the types of firms that invest in your stage of company.
While some VCs invest alone, many invest with other VCs. A collection of investors is called a syndicate. Syndicates can also include any investor, whether a VC, angel, super angel, strategic investor, corporation, law firm, or anyone else that ends up participating in a financing.
Most syndicates have a lead investor. Usually, but not always, this is one of the VC investors. Two VCs will often co-lead a syndicate, and occasionally you’ll see three co-leads. Having a lead investor makes it easier for entrepreneurs to focus their energy around the negotiation by negotiating with the lead, rather than each investor. Even though the lead investor may manage the other investors through the process, it’s still your responsibility as the entrepreneur to communicate with everyone and drive the financing process.
Equity crowdfunding is a new approach that appeared in 2012 around the creation of the JOBS Act (the Jumpstart Our Business Startups Act). AngelList popularized this approach, although there are now a number of companies providing crowdfunding platforms.
In an equity crowdfunding, the funding platform, such as AngelList, is an intermediary between the company and investors. The platforms allow companies to advertise their funding or use the power of a social network to attract other investors. In some cases, such as AngelList Syndicates, individual investors can aggregate other investors to participate in their syndicate, acting like a small version of a venture capital fund.
While crowdfunding has expanded to cover several situations, there are tight legal definitions surrounding each approach. As a result, some of the aspects of fundraising on platforms like AngelList are referred to as crowdfunding but are really not anything new, other than the use of an online platform to connect companies with potential investors.
In the United States, if you are selling a security, you need to register the security with the Securities and Exchange Commission (SEC) based on rules negotiated more than 80 years ago as part of the Securities Act of 1933.
Fortunately, there are a number of exemptions that allow you to avoid an SEC registration.
In general, unless you are taking a company public via initial public offering (IPO), you won’t have to worry about registering your offering with the SEC. However, there are important guidelines that you must follow in order to rely on an exemption. The two most important are the concept of an accredited investor and the process of general solicitation.
Another type of crowdfunding, popularized by Kickstarter and Indiegogo, is product crowdfunding. This approach is often used for physical products. In the product crowdfunding scenario, a company puts its product idea up on Kickstarter with content showing what the product will do and a series of rewards for backers. In most cases, the product is at an early design stage and months to years away from shipping. The rewards vary by dollar amount and often include things that, while linked to the product, are tangential to the product, such as T-shirts, sponsorship, or events to celebrate the launch of the product.
Many campaigns have a 30-day funding target that, if not achieved, results in the campaign failing. In this case, the funding doesn’t occur and the backers keep their money. But, if the campaign gets funded, it acts as a giant pre-order campaign and validation for the product. In this case, the company has raised nondilutive financing similar to bootstrapping a company by selling products to customers.
The real downside of product crowdfunding is when a campaign is successful but the company doesn’t finish building the product.
While some companies can raise equity to finish and ship the product, others simply shut down and fail to fulfill the preorders. In this situation, the backers are out their money, in the same way investors lose their money in a failed company.
Brad Feld, Managing Director, Foundry Group