Choosing the right type of financing is essential for entrepreneurs as it can impact the overall returns of their venture. The most popular types of venture capital include equity, debt, and mezzanine financing. Venture capital firms invest money in companies with high growth potential. They often get preferred equity in the company, which comes with certain benefits, like a liquidation preference.
In the early stages of starting a business, it is common for entrepreneurs to utilize their savings to get started. However, this method has its drawbacks and can lead to financial issues down the road. Seed funding is one way to help alleviate some of these concerns for new businesses. Seed funding is the first official equity investment round that a startup can raise. It is generally offered by angel investors, syndicates of angels, and, more recently, crowdfunding platforms. It is often the most difficult of all funding rounds to secure. Some larger companies also support seed rounds by establishing venture arms or funds. This is becoming more common as they seek to develop innovative solutions and build their brands.
Early Stage Financing
At this stage, a company has a business plan and may have a product prototype. Investors like Brad Kern often use this funding round to test if the business concept has market potential, referred to as finding product-market fit. In this stage, a company has a product, is gaining customers, and preparing for an official launch. It’s a good idea for businesses to establish sales and marketing strategies during this time to manage their cash flow better and prepare for growth. Investors in this stage are looking for consistent revenue and evidence of a product that can be scaled. This financing stage typically comes in convertible preferred equity or an alternative instrument like a simple agreement for future equity (SAFE). A skilled business attorney can help entrepreneurs decide on the most appropriate structure.
You’ve made it through venture capital’s early stages and established a management team, a product with market potential, and repeatable sales processes. Now it’s time to expand. Venture capital in the expansion stage can help you scale your business, increase sales to the breakeven point, or enter new markets. Investors in the expansion stage are usually large institutions like pension funds, financial firms, and insurance companies that invest a small percentage of their overall portfolio into high-risk investments such as venture capital. These investors seek a better return on their investment than they can achieve in traditional investments, so they offer larger check sizes at this stage.
Late Stage Capital
Venture capital is equity-based and doesn’t involve a lot of debt. It is typically long-term and has a higher liquidity risk than standard investment instruments like stocks or bonds. Investors in the late stage are looking for a strong market presence and a clear path to profitability. They may invest in multiple companies to spread out their risks. They may also be more likely to invest at lower valuations as they seek to promptly cash out their earlier investments. These investors are usually numbers-driven and focus on growth rates, margins, and customer acquisition costs. They are also more likely to think (and assess investment opportunities) like a public market investor. They often lead rounds or participate in syndicates. They also act as bridge capital to mezzanine financing.
Friend and Family Financing
Many startup entrepreneurs obtain early-stage financing from their networks of friends and family. These individuals invest their money into the business in exchange for a specified equity share. This is often known as a Friends and Family Round or angel investment. Friends and Family investors are usually in it for more than just the return on their investment. They may also act as mentors, support figures, and cheerleaders, which can benefit a young company. However, the drawback to taking an FFF investment is that if the company fails, it can put a significant financial strain on the relationship. Having written legal documents and agreements for these investments is always wise. This will prevent future problems and ensure all parties know their obligations and responsibilities.