Course overview
Financing
Different types of funding

II.Different types of funding

Pre-seed funding

When you are exploring your concept and validating your idea, you are in the pre-seed phase in terms of funding. The sources you might consider at this point are FFF (friends, fools and family), grants, loans, crowdfunding, bootstrapping, angel investors and some early stage VCs:

1) Friends, fools and family

These people are the first source of financing for many people. FFF means people who are either close to you – or believe in your idea so much that they are ready to risk their own money on your dream. What you should consider here is whether you want to mix your personal relationships with business. These people might be the easiest source of financing at first, but the situation may become unpleasant in the future. After all – when you are attempting to build a high growth company, a very likely scenario is that you might fail. Do you want to end up losing your friend’s money?

2) Grants

Startups still exploring their concept and validating their idea can often be applicable for grants. A grant is money that does not require the transfer of shares. While the type of grants available vary by country, typically there are a few different types of grants to help with startups in the early days (usually with some restrictions on how many years the company has been up and running). Typically, grants are awarded for a specific part of a project and the company must already have raised some capital. For example, if the cost of building a prototype will cost €100,000, 70% of the subsidy can come from a grant, and €30,000 must already be in your account.

3) Loans

A loan can be obtained from an investor, FFF, or a bank. Loans from investors and support organizations generally do not require a personal guarantee. In practice, a bank loan always requires some form of security. In general, you should be extremely careful before securing a loan for your business or putting up your home as collateral – these decisions can cause a lot of grief if the company eventually goes bust. Loans with any type of collaterals or personal guarantees should generally not be taken before a company has reached product/market-fit and is ready to scale.

A convertible loan is a kind of investment where an investor can finance a company in a situation where the valuation of the company is still difficult to determine or if the company needs cash between investment rounds. In this case, the form of financing is basically an unsecured loan, the terms of which include (in addition to the normal interest rate and other terms of the loan) a variety of preferential rights that an investor may wish to purchase with the invested capital in the next round. In practice, this often means that the capital invested in a convertible bond will have the opportunity to buy shares at a slightly lower price than the round valuation itself. Some angel investors and early stage VCs really like using convertible notes, others will not even consider using them.

4) Crowdfunding

Crowdfunding is a form of financing where a startup is funded by a large number of individual people who finance the company with a small amount of money. While a single investment may range from a few dozen to a few hundred euros, if the firm grows into a phenomenon, huge amounts of funding can be raised this way. The best-known crowdfunding platforms are Kickstarter and Indiegogo. The most common forms of crowdfunding are based on either free-of-charge financing, which is a pre-order for a product to be developed in practice, or crowdfunding where individual investors get a small stake in a company for a small amount of money. The most successful international crowdfunding campaigns have raised tens of millions of dollars.

5) Bootstrapping

Building a business mainly through cash flow is called bootstrapping. This is when a startup aims to sell a product or service with minimal capital and only grow the business with the income they get from selling their product and service. This model generally only works with companies who are creating pioneering software or other cost-efficient tools. Products requiring heavy investments in infrastructure almost always need outside capital. Startups rarely generate cash flow in their early stages, so it’s quite rare for a startup aiming for high growth to be bootstrapped.

6) Business angels

These are often wealthy individuals who want to invest their time and money into very early companies. Business angels often invest less capital in fewer startups than venture capital funds. As angel investors are individuals, their practices vary a lot and so does their investment approach. If you are considering angel funding, you should get to know the person and their way of working.

7) Venture capital

Many venture capital funds investing in the early stages (usually from seed until A-rounds) are more than happy to jump in even earlier than usual if they see an idea with extreme potential and an extraordinary team. There are some funds that focus explicitly on the very early stages of a company and might even invest in just the team. There are also some funds whose strategy is to put the team together, incubate them and invest a small amount of capital in order to get them going.

When you are considering different options for financing, it’s good to keep in mind that the best early stage VCs often have a lot of expertise in their team and have most likely seen many companies go through the same struggles you are having. When selecting which VC you would like to work with, do your own due diligence on the VC firm as well to ensure good working relations and that they have the capabilities and expertise you need for your growth.

8) Business incubators

Business incubators sometimes invest a small amount of money (a few tens of thousands of euros) in the operation of a company in exchange for 5-10% of the stock. The incubation period lasts from a few months to a year. During this time, other incubator startups, the incubator's mentors and other mentors are trying to get the startup into good shape for the next round of funding.

How much equity will you need to give away?

Depending on the source of financing, the amount of equity you need to give away can vary from 0% to around 20%. Loans and grants don’t take equity (meaning they are non-dilutive) but angel investors and venture capital investors require equity in return for their capital. To give you some idea, the amount that an equity investor (angel or VC) invests can vary from ten thousand euros up to a million euros, but there’s a lot of variation. Usually angel investors are on the lower end of that scale and VCs on the higher end.

Seed funding and early-stage funding

In general, the most typical financial instrument for a startup is an investment. In the seed and early stage funding, the focus shifts more towards VCs as there are a lot more of them investing in this stage and ticket size (“ticket size” is the amount of money a single VC invests, while “round size” is the amount invested into the company at a single time). This is the time when you are building your product and working with your go-to-market strategies.

The selection of seed and early-stage funds have a lot of different approaches in terms of investment strategies and ways of working with founders. The one thing that is usually the same is the fund lifecycle. Venture capital funds generally have a lifetime of 10 years, of which four to five years are for making the initial investments in companies and the rest working with existing ones and finally exiting. The ticket sizes have a lot more variation than in the earlier stages as do the valuations. Sizes and allocation strategies may vary. Fund sizes can range from tens of millions up to hundreds of millions of euros. Allocation strategies may have some guidelines on how many cases need to be from a certain stage or ticket size and how much money can be invested as initial investment and how much as a follow-on.

The investment strategies also vary, which is a good thing for a founder to figure out, Some VC’s are very active investors who want board seats and observer seats and spend a lot of time with the founders they work with. Others prefer to take a back seat and only join during investment rounds with someone else already on board leading the round. Funds might also have some focus areas in terms of geography or industry or they might be completely industry agnostic. Others utilize their limited partner (LP) network and for some it’s just a source of their capital. It’s a good idea to do your homework on the VC before even contacting them to make sure you understand what they’re looking for and why you’d be a good fit to work with them.

Seed funding can range from hundreds of thousands to over ten million euros. At this point, the investor invests primarily in the team, product concept and business potential. Therefore, a sufficiently charismatic entrepreneur, backed by a team of superstars and a groundbreaking business idea, can mobilize very significant seed funding before any concept or business potential is verified on the market.

Series A/B

Series A or B rounds mean you are typically raising money for growth and expansion. This means you have a product with proven potential and a market that is ready to expand. These are the stages when numbers start to play a bigger role in the evaluation of the companies done by potential investors.

You always need to talk to as many funds as possible. When selecting potential partners, try to look for the funds that have expertise in your area or are located in the target markets that you would like to expand to next.

Corporate venture capital (CVC) often becomes a viable option at this point. Some CVCs invest even earlier or might work with startups as partners, but most CVCs work in this stage. CVCs often have a strategy that is closely related to their core business and the development of it, so they can have very specific scopes on what they want to do. If a CVC investor is what you’re looking for, it’s typically a good idea to also include a generalist VC in the mix to balance the strategic needs of CVCs.

Series C and beyond, M&A, and IPO

When your company is mature, you can still continue looking for venture capital funding, turn towards private equity investors, corporate buyers or even consider doing an initial public offering (IPO).

1) Series C

Series C and beyond is a completely different ball game from the previous rounds. Where seed funding can be obtained with a good team and product concept, raising funding during later stages is mainly about math. Of course, selling skills will help here too, but in the end, funds that invest in growth will only move if the earnings logic and scaling are clear. The purpose of each round at this point is to exponentially increase a company's turnover or user base.

Since each round also eats away the stakes of the old owners, it’s not worthwhile to increase the rounds of growth indefinitely. However, there are startups that are already in the E or F round. In that case the startup either hasn’t figured out a proper business model or exit strategy or they have a strategic reason not to go public.

2) Merger and acquisition

The best companies are always bought, not sold. When growing your company, you should keep relations with your competitors and strategic players in your field. This way, if the time comes to sell the company, potential buyers already know you which makes the process much faster and easier. For many companies, their exit is M&A, meaning they want to merge with another company or be acquired by a bigger player.

3) Initial public offering

The most well-known (but not the most common) exit is through an IPO, which means listing the company’s stock to be publicly traded. Well-known tech startups who have recently done their IPO include companies like Dropbox and Lyft.

Why VCs invest in scalable companies

Every VC you’ll ever talk to will ask you about scaling. How big is your total addressable market? How are you going to acquire your customers? Will you be able to grow in revenue without increasing your overheads?

While being bombarded with business buzzwords by an inquisitive VC, it’s easy for a founder to get frustrated, especially if they are already running a company with proven user traction, steady linear growth or even a profitable business. What else could an investor possibly want in addition to a proven business model and customer traction?

In order to explain why venture capital investors say no to companies with an already proven track record, you need to understand how the venture capital business model works and how it impacts a VC’s decision-making.

A venture capital fund is one asset class among many asset classes for the fund’s investors (so-called limited partners, or LPs in short). As with any investment, it comes with a certain expectation of return matching the risk reward profile. The limited partners – institutional investors, high net worth individuals and family offices – consider investing in a venture fund risky in comparison to other potential asset classes, such as stock market or real estate. Therefore, the potential upside needs to be significant in order to justify the risk.

VCs invest across a set period, let’s say eight years. Only after four to five years will the fund begin to see the first returns as the first companies they invested in are liquidated. In comparison to other assets classes, such as the stock market or real estate, VC investments are extremely nonliquid – a normal investor can sell their stocks or property at any time, but once capital is invested in a startup or growth company, the investors are not paid any dividends until the time of an IPO, trade sale or buyout. As an asset class, venture capital is also significantly riskier – according to statistics from early stage venture funds between 2004 and 2013, 65% of an average VC funds’ portfolio companies are no longer operational by the end of the fund lifecycle. These special characteristics make the return expectation for a VC fund significantly higher than for other alternative and more traditional asset classes.

VCs invest across a set investment period and begin to generate returns usually a few years after the first investment has been made.

Let’s take a €100 million fund as an example, and let’s assume the fund targets to invest in a total of 30 companies during the ten-year fund lifecycle with an average stake of 15% in each company with an average valuation of €20 million. At the time of liquidation, the stake has diluted to 10%. Let’s also assume that the fund only makes Series A investments, and that the invested capital is evenly distributed across the 30 companies.

Now, it is very likely, if not inevitable, that regardless of the thoroughness of due diligence and the VCs own contribution during the holding period, some companies will go under or perform only moderately. This means that out of those 30 companies, a handful needs to perform so well that they can carry the risk of the less well performing ones.

In other words, returns are spread unevenly across the portfolio. A handful of superhero companies will generate the great majority of the total returns.

Scaling

Now we can get into the topic of scaling. How do companies that are valued at €50 million or €500 million differ from one another, and what have the ones with higher valuations done in order to generate such a significantly higher value?

Companies valued at around €50 million usually have proven customer traction and an established product/market fit, and the company is likely to operate in a couple of key markets. All in all, they are usually solid, often even profitable businesses with a steady cash flow. However, often at this stage several companies start to see stagnant growth – usually because the total addressable market proves to be smaller than initially thought, new competitors have entered the market and challenged the product/market fit, operations aren’t efficient enough, or the business can’t grow without significantly increasing their costs. These are common problems for example in hardware and service businesses.

Companies with a 10 times higher valuation in contrast generate significant (at least three-digit) annual revenue growth from a very large addressable market, have figured out a way to expand without increasing their overheads in proportion, have unit economics that produce a positive gross margin, and the management team works seamlessly together with a complementing skillset.

The move from €50 million to €500 million valuation can be best explained with the so-called Anna Karenina principle. In order to succeed at scaling, a company must be successful at each and every possible criteria including: product/market fit, team, revenue model, unit economics and operational efficiency. Failure with any one of these leads to stagnation. (Some might be inclined to ask if the difference is all a matter of luck? The short answer is “yes”, a big portion of it is.)

In the words of Peter Thiel, ”the biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.”

The crude generalizations above illustrate how venture capitalists think about scale. Scaling a company from zero to a €50 million valuation requires a significant effort and can produce nice returns for the owners. However, due to the venture capital business model, VCs need to be after the ones that have the product, market, operations and enough luck to go beyond that. This is why companies with stable growth, proven business model and a solid team might still not be the right fit for a VC to invest in. This is also why businesses that target a small niche or a demographic with low disposable income are often passed over by VCs.

Due to the VC business model, they often have to say “no” to good teams and great companies. Fortunately, there are other excellent sources of capital – such as business angels, crowdfunding and corporate venture capital – to support the growth and expansion of new business ideas.

Insights from an entrepreneur – RELEX Solutions

Johanna Småros is the co-founder and CMO of RELEX Solutions, which provides solutions for retail optimization. RELEX is a great example of a bootstrapped startup. RELEX raised their first equity funding in the growth phase in 2015, when the company was already generating over €10 million in annual revenue.

Why did you decide to bootstrap the company?

“We didn’t think about bootstrapping too much, but it was an explicit decision not to raise early-stage equity funding. We got a €100k startup loan and that was one of the reasons why we decided not to look for equity funding. We estimated that we could maybe get a few hundred thousand euros from equity funding and thought that with the same effort we could get the money from paying customers instead – and simultaneously develop our company. We didn't raise much salary in the beginning, so in a way we funded the company from our own savings. We also did some consulting in the beginning to get some cash and quite quickly we achieved profitability. The first time when we were not profitable was when we raised funding for scaling.”

What are the pros of not raising early-stage funding?

“I think that the benefit of not raising early-stage funding is that you have to all the time prioritize and do things that someone is ready to pay for. You don’t end up building an extensive product before you are sure that it matches customer needs.

“In our early days, there was a similar company that raised funding – and we could see how they messed up their business as they started scaling before they had all the fundamentals right like what is the product, how is it sold, and so on. So we decided that we didn’t want to start expanding before we have the core of the business figured out. I think you should have a certain level of maturity before you start to scale.

“When we raised our funding it was because we thought that now we are ready to expand to the US. We knew that this would be hard and costly and if you don’t have the proper resources, you will not succeed. We also looked for an investor in the US as we were not well known there and we thought that having a US investor would make us more credible – we were looking for other benefits besides just the money. Of course, we maybe could have raised funding earlier and start to expand earlier but that is just speculation.”

What are the advantages of raising early-stage funding?

“In some businesses you need to reach critical mass very quickly to become a kind of a dominant player – and if you don’t, you’re nothing. In those situations, having more early-stage funding is smart.

“When we started expanding abroad, first in the Nordics and the UK, we did it very carefully – basically with no fixed costs. We were trying to be careful because we weren’t sure how it would work. Of course if we had known that it would succeed, we could have raised funding and invested heavily from the beginning to have faster results.

“My personal opinion is that raising funding is a bit too highlighted these days. Of course for some businesses funding it is important, but for me it feels that many focus on the wrong things, for example how much money you are able to raise from VCs. At the end of the day, the viability of a company is based on creating something that others are ready to pay for.”

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III. Investment process

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