Don’t Get Lost in the World of Startup Funding

The startup space has always been a place with a lot of fast changes, but lately, it’s changing with a new sense of ferocity. Just a year ago, investments in seed-stage companies averaged $1 million to $3 million, Tamara Steffens, general manager of Microsoft’s venture fund M12, told Built In. Now the average is between $3 million and $5 million.

“Right now, there’s plenty of money in the market, so founders can get really good terms,” Steffens said. “It’s a very founder-friendly environment.”

Investors who never used to participate in venture capital, such as universities and other large institutions, have jumped in too. Alda Leu Dennis, a general partner at Initialized Capital, a fund that focuses on seed-stage startups, said an example is the University of Chicago, which invests part of its endowment in venture funds.

“What we have seen from our LPs [limited partners], who are the ones that invest in our funds, are institutions and endowments putting more and more capital into this sort of sector, which they call ‘alternative assets and venture,’” Dennis said. “Over the last 10 years these types of institutional investors are allocating more and more capital to the private markets.”

And it’s not just the number of investors with deep pockets that has increased, she said — the number of emerging startups has also grown over the last few years. Cloud computing services have lowered the barrier to entry for entrepreneurs by making it easy to rent server space instead of setting up your own and no-code solutions enable fast website creation without much programming experience.

All these trends mean that startup founders have more power and choices when it comes to financing their companies. There are accelerators, venture capital firms, angel investors, banks — even newfangled types like equity crowdfunding.

Here’s a rundown of the ins and outs of these financing methods and what they mean for a company in the startup space.

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The ‘Friends and Family’ Round

All startups have to start somewhere. For many founders, that means raising some money to subsidize them while they build a proof of concept. Raising money at this stage is considered the “friends and family” round of funding because a lot of founders turn to close friends who want to support the founder in their vision.

Dennis estimates that a startup might raise $1,000 from each funder, up to a total of $100,000 — but as with all stages of startup funding, the amount of money raised varies from company to company.

Founders who have personal savings may choose to self-fund this stage of their startup instead. But either way, this initial financing round can be a significant hurdle for many entrepreneurs, especially those who don’t have personal savings or family and friends who can easily part with $1,000.

“Entrepreneurs are typically expected to bootstrap or to raise a friends and family round at the pre-seed stage.”

That’s why Shelly Bell, CEO of Black Girl Ventures, founded her company to allow women founders of color to take advantage of crowdfunding — where anyone can contribute money to support startups — for raising capital during the initial phases of their companies.

“Entrepreneurs are typically expected to bootstrap or to raise a friends and family round at the pre-seed stage. For many Black and Brown women founders, this is not a realistic option,” Bell told Built In. “Black Girl Ventures, through our crowdfunded pitch competitions, functions as the friends and family round that Black and Brown women founders do not have access to.”

Startups raising money through Black Girl Ventures don’t have to give up equity, although many equity crowdfunding platforms do require that. Bell said startups can use crowdfunding to start building a customer base, but run the risk of having their idea stolen if founders don’t have a patent or copyright.

Pre-Seed VCs and Angel Investors

From an investor’s perspective, the earlier a startup is, the higher the risk and the higher the reward. While investing early in a startup can result in astronomical returns on investment, there are fewer signs to help determine whether the startup will be successful. A startup is basically still an idea in someone’s head.

“An early stage company doesn’t even have an MVP [minimum viable product], they’re not ready to demo,” Steffens said. “They have this idea, they have a framework and they’re going to go try to build something.”

That’s why venture capital (VC) investors used to only start investing at the next seed stage, when startups at least have a proof of concept. But, in a sign of how competitive the space is, a new phase of venture capital has emerged within the last few years: pre-seed.

“They have this idea, they have a framework and they’re going to go try to build something.”

“There are many, many institutional firms that are in that pre-seed space,” said Bianca Caban, principal at seed-stage fund Heartland Ventures. “They’re writing anywhere from 100,000 to 250,000 checks to a founder and usually that pre-seed round is around 500,000 — a million would be a little bit larger pre-seed.”

Angel investors are wealthy individuals who also invest in this pre-seed funding space, which shares some overlap with the friends and family funding round. When founders choose between angel investors and pre-seed firms, they should weigh the non-monetary benefits each type of investor brings.

“Individual investors, like angel investors, they might be well networked and bring a certain expertise to the table based on their own expertise,” Caban said. “But really getting the backing of an institutional VC firm that specializes in pre-seed opens up another opportunity to access that [investor] network.”

Banks and Equity Crowdfunding

No matter how startups raise their early capital, it’s not designed to last very long. Steffens estimates that the pre-seed phase of a startup typically lasts a year to a year and a half — at that point, startups have an MVP and are ready to move to the seed stage, where they court the big bucks.

But before jumping into venture capital, founders should know they have plenty of choices for financing. Startups can also try equity crowdfunding — sort of like Kickstarter but where investors buy a percentage of the company instead of a presale product — or even a more traditional route like getting a loan from a bank.

One drawback with loans is that banks are usually much more cautious and reluctant to give large loans to early stage companies, so they’re a better bet for later-stage startups, Caban said. On the other hand, equity crowdfunding is a relatively recent phenomenon. When Caban worked with AngelList, an equity crowdfunding platform, people used to ask her whether the company was trying to replace VCs.

“What I would always say is, we’re not replacing venture capital — we are complimentary to venture capital,” Caban said. “Equity crowdfunding and raising capital from the crowd will never replace the strategic relationships that VC firms bring to the table and the strategic value add that they bring.”

“What I would always say is, we’re not replacing venture capital — we are complimentary to venture capital.”

Caban said crowdfunding can also help consumer-facing companies gain traction.

“Let’s say you have a thousand investors in your campaign — [that means] you have a thousand potential customers of your product that you can go to for product feedback,” she said. “The crowd brings product feedback and branding, and a very passionate, engaged user base.”

Crowdfunding may not make sense for other types of startups. Most potential startup clients Dennis sees are software-as-a-service (SaaS) vendors whose target customers are businesses. Those companies wouldn’t generate the same sort of excitement with crowdfunding.

“Crowdfunding for startups worked better when there was a physical good attached to them,” Dennis said. “But if you had an enterprise SaaS company, it might not be as easy to market it on a crowdfunding platform and create a cool sizzle video and get people to pre-order. It doesn’t have quite as much marketing ability.”

Should You Join an Accelerator?

For many startups, financing means venture capital. But venture capital has its own hurdles — it’s hard for the average founder to know which firms to talk to or how to get in contact with them. With venture capital, it’s all about networking.

That’s where accelerators come in. Accelerators provide support and a certain amount of cash investment in exchange for equity. Y Combinator, one of the most well-known accelerators, takes seven percent equity in a company in exchange for $125,000 and a support system.

One of the main advantages of joining an accelerator is that founders get plugged into the accelerator’s network of investors, who they can pitch to. Dennis said they can be a great way of bridging what she calls the “network gap.”

“If you don’t have people that can introduce you to professional angels and funds, then you need a way to build that network.”

“Because you know your friends and family, but if you don’t have people that can introduce you to professional angels and funds, then you need a way to build that network,” she said.

Especially during a pandemic when events are limited, it’s not easy to build new connections, so accelerators can help do a lot of that work for founders.

“It takes time to get intros, it takes time to meet people, it takes time to build rapport with them, such that you can ask them for a favor, like, ‘Hey, do you know if there’s anyone you can introduce me to who might want to invest?’” Dennis said. “Going to an incubator can help short circuit that network building process.”

Seed, Series A and Beyond

The first big round of investments in startups is the seed round, which Steffens estimates to be an average of $2 million or $3 million. Funders look for startups that have a product built out and a small number of users and try to determine whether the company has the magical product-market fit.

“Product-market fit is sort of an amorphous concept,” Dennis said. “The best description I’ve heard is that when you’ve found product-market fit, you’ll hear a sucking sound from the market — people want this product and you can’t catch up with the demand.”

At this stage, startups usually haven’t progressed very far beyond the proof of concept. Caban said Heartland Ventures only expect companies to have a few dozen users and no real revenue from the product.

“It’s more about user engagement and a demonstration that the customer actually is getting value from the product and there’s a huge market to attack from there,” she said. “We’re really looking for that customer traction.”

“When you’ve found product-market fit, you’ll hear a sucking sound from the market — people want this product and you can’t catch up with the demand.”

That’s different from the following round of funding: series A. Startups that are at the series A stage should already be earning revenue and are looking to grow even faster.

“If a founder is going out to raise a series A, that means they have demonstrated a certain amount of fast-paced growth month over month and quarter over quarter,” Caban said. “They’ve hit, let’s say, a million or two million in annual recurring revenue, and they want to add fuel to the fire to accelerate that revenue growth — and the series A will enable them to hit 10 million in revenue.”

Dennis said series B is seen as the cut-off between early stage and late-stage startups. By the time startups raise series B funding, they are already a big company and considered a later-stage startup.

“You know what you’re doing, people want it and you’re just trying to scale into different markets,” she said of series B startups. “If it’s an enterprise sales company, you know how many salespeople you need, so it’s like every salesperson brings in $500,000 or $2 million in sales. You kind of have a formula for repeatable sales.”

Non-Monetary Benefits Investors Can Offer to Startups

It can be hard to decide between different investors, so founders should learn as much as they can about potential investors.

“It’s more incumbent now than ever that founders do their research on VC firms,” Caban said. “Fundraising has always been very, very hard. And I think in some ways it’s even harder now because there’s so many more options.”

The research Caban refers to extends beyond figuring out how much money VCs are willing to invest. There are other benefits funders provide not limited to capital.

“In some ways it’s even harder now because there’s so many more options.”

“What value do they bring?” Caban said. “Do they have an expertise in the industry that you’re building? Or do they have access to a certain kind of skill set, like a sales skill set or a go-to-market skill set?”

For example, Caban’s company Heartland Ventures is connected to a network of potential customers in the Midwest, especially in the industries of construction, manufacturing and supply chain. The firm can connect those potential customers to startups it invests in, which can help startups build a user base more quickly.

On the other hand, Dennis’ firm Initialized Capital can help startups with branding, PR and marketing, and also with recruiting and hiring processes. Founders should look for investors who offer the right set of skills that can meet their startup’s needs.

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Always Do a Cost-Benefit Analysis

Founders should also consider what they are giving up when they accept funding. Equity-based financing is very popular among founders raising funds for their startups, but founders who pursue that type of investment should be aware of its disadvantages. By nature, all types of equity-based investments — whether it’s from an angel investor, an accelerator or venture capital — require the founder to give up a certain percentage of the company in exchange for capital.

“Every venture capital firm has their own ownership targets — how much they want to own in a startup at any given round, for any given investment,” Caban said. “For example, our ownership targets at the seed-stage range between five and eight percent. That’s how much we’re hoping to own in a company at that seed stage.”

Caban said founders should aim to still own at least 30 percent of their company coming out of the series A stage of funding — and hopefully closer to 40 percent.

If enough of the company is given away as equity, founders may also lose some degree of control over their company. So in addition to weighing the cost-benefit of giving up equity, founders should also choose funders based on who they feel comfortable working with long term.

“Once you raise one round of financing, you’ve sort of committed to this path of chasing growth.”

“When you take on venture capital, it’s like a marriage — it’s a very strong partnership,” Caban said. “How well do you mesh with the team at that venture capital firm? Because likely they’ll be serving on your board, and they’ll become a bit like your boss, in a sense.”

Dennis said some founders may not work well with the added pressure of having investors who will want to know how the company is progressing and may require frequent updates from the founder. The pace of growth is also accelerated — startups are pushed to grow the company in a way that would “return multiples” for investors. She said founders should know that venture-backed funding isn’t the only way to build a business.

“Once you raise one round of financing, you’ve sort of committed to this path of chasing growth,” Dennis said. “So you sort of cut off this very appealing path, in my opinion — I come from a family of restaurant owners — of real businesses that make money and that do very well and that you own and you answer to yourself.”

Founders should also consider whether a venture-backed startup lifestyle is even something they want. Caban said that VCs typically seek a timeline of five to seven years for a company to exit — meaning the amount of time between investment and when the company is ready to go public or to be acquired by another company. That’s a very hectic speed to grow a business.

“Taking in venture capital is not for the faint of heart,” Caban said. “Are you willing to be on that journey of very accelerated growth? Or do you want to build kind of slow and steady — which is fine too, but then you should not take on venture capital.”

She said that one of the most important things she looks for in founders is an almost unreasonable amount of passion. That has to sustain them during the long, intense years building and growing their company.

“It really starts from the idea and the problem that they’re trying to solve,” Caban said. “Are they obsessed enough or passionate enough about the problem that they’re going after and the solution that they’re building? That’s really important, because that kind of obsession is going to enable them to go for the long haul — because it is a very, very long, long journey.”