Fundamentals of Venture Capital

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 Venture capital is a form of private financing through equity that is provided sometimes by high net worth individuals but, more typically, associated with institutional, for-profit/return-oriented venture capital firms that typically create a series of time-limited funds (usually 5-year investment periods) to invest in startups at three distinct stages, a) the early-stage, b) emerging-growth, and c) later-stage private equity companies.  The first two stages typically encompass companies that are deemed to have high growth potential or which have demonstrated high growth, and usually are still prioritizing growth over profitability.  The latest stage, private equity can include a variety of strategies, from companies transitioning from high growth and ready for listing on a public stock exchange to more traditional roll-up of industries (achieving lower costs through economies of scale) to credit opportunities employing debt to more traditional free cash flow profit oriented businesses.  The latest, and most traditional private equity, is usually reserved for and characterized as profitable companies that prioritize free cash flow and are well situated to take on greater leverage and, thus, pay off such debt with free cash flows from the operating business.  These businesses may be growing but growth is of lesser importance than predictable, stable cash flows to pay down the extra debt that has been assumed.  The exit potential for these sorts of companies are either a sale or public listing on a stock exchange.

The various stages of investment include the Pre-Seed, Series Seed, and Series A, Series B, and Series C (or even further culminating in some public listing or M&A sales event).  Each of these funding rounds are merely stepping stones in the process of turning an ingenious idea into a global company that is ready for a public listing on a public stock exchange e.g. IPO

First, there are the individuals hoping to gain funding for their company. As the business becomes increasingly mature, it tends to advance through the funding rounds; it's common for a company to begin with a seed round and continue with A, B and then C funding rounds.

The earliest stage of funding a new company comes so early in the process that it is not generally included among the rounds of funding at all. Known as "pre-seed" funding, this stage typically refers to the period in which a company's founders are first getting their operations off the ground. This usually begins with a ubiquitiously called "friends and family" funding e.g. finding money from previous jobs or exits and is otherwise known as "bootstrapping".  A more advanced form and the next stage is commonly referred to as high net worth "angel" investing, which adds greater capital but also often brings a more sophisticated investor that seeks greater insight and influence.  The most common "pre-seed" funders are the founders themselves, as well as close friends, supporters and family. Because the company is still at a nascent, and likely noncommercial stage with limited market traction, setting a valuation for investment is challenging (and could be damaging to the long-term viability of the company) so it is typical that investors at this stage are allowing the company to continue to progress with a sort of IOU agreement, and not making an investment in exchange for equity in the company, with investors accepting a SAFE or a Convertible Note that does not yet set a value for the early company.  However, these are still valuable and are intended to convert into equity at a later, post-valuation stage of the company.

The Seed stage of funding (also known as Series Seed) is the first official equity funding stage. It typically represents the first "official" money that a business venture or enterprise raises. Some companies never extend beyond seed funding into Series A rounds or beyond.  Seed funding helps a company to finance its first steps, including things like market research and product development. With seed funding, a company has assistance in determining what its final products will be and who its target demographic is. Seed funding is used to employ a founding team to complete these tasks.  One of the most common types of investors participating in seed funding is a so-called "angel investor." Angel investors tend to appreciate riskier ventures (such as startups with little by way of a proven track record so far) and expect an equity stake in the company in exchange for their investment.  While seed funding rounds vary significantly in terms of the amount of capital they generate for a new company, it's not uncommon for these rounds to produce anywhere from $10,000 up to $2 million for the startup in question. For some startups, a seed funding round is all that the founders feel is necessary in order to successfully get their company off the ground; these companies may never engage in a Series A round of funding. If a valuation is set and the early IOU converts into equity based on a set valuation.  Most companies raising seed funding are valued at somewhere between $3 million and $6 million.

Once a business has developed a track record (an established user base, consistent revenue figures, or some other key performance indicator) the company will then seek a true Series A financing round to further cement it as a viable business and iterate and optimize its customer base and product offerings.  Opportunities may be taken to scale the product across different markets. In this round, it’s important to have a plan for developing a business model that will generate long-term profit. Often times, seed startups have great ideas that generate a substantial amount of enthusiastic users, but the decision on how to make money e.g. how to monetize the interest emerges near or around the Series A financing round that involves true professional institutional investors.  Typically, Series A rounds raise approximately $2 million to $15 million, but this number has increased on average due to high tech industry valuations. The average Series A funding as of 2020 is $15.6 million.  Investors at this stage are freuqently savvy, sophisticated professional investors and demand commensurate protections for their investments like inspection rights and control rights and pro rata ownership rights to continue to maintain their ownership stake in the company at later stages of the companies growth and funding. Rather, they are looking for companies with great ideas as well as a strong strategy for turning that idea into a successful, money-making business. For this reason, it's common for firms going through Series A funding rounds to be valued at more than $20-23 million.

The investors involved in the Series A round come from more traditional venture capital firms. Well-known venture capital firms that participate in Series A funding include Sequoia Capital, Benchmark Capital, Greylock and Accel Partners.  By this stage, it's also common for investors to take part in a somewhat more political process. with a few sophisticated investors vying to become the "lead" investor and set the terms of the venture financing round for all others.  If it has a number of interested parties capable of investing a sufficient enough capital to "lead" the financing round, it is up to the company to decide which negotiated "term sheet" to accept from the group of suitors.  As such, a single investor often serves as an "anchor", with subsequent investment typically easier to attract once one investors has committed to lead and served as a signal to the market that this startup is credible by putting their money and reputation on the line and the commensurate investment of time and resources from the investor's fund.  While angel investors may continue to invest at this stage, their investment check sizes tend to get priced out by more institutional, professional investors and tend to have a reduced level of influence in this funding round than they did in the seed funding stage.

Series B Series B and later rounds are tyically focused on scaling the business.  Thus, this round is about taking businesses to the next level after the company has proven its business is viable and beyond the testing, development phase.  Investors help startups get there by expanding market reach to new verticals and/or connecting with new clients. Companies that have gone through seed and Series A funding rounds have already developed substantial customer bases and have proven to investors that they are prepared for success on a larger scale. Series B funding is used to grow the company so that it can meet these levels of demand.

Building a winning product and growing a team requires quality talent acquisition. This usually involves siginficantly greater hiring of business development, sales, advertising, tech, support, and professional employees. The average estimated capital raised in a Series B round is $33 million. Companies undergoing a Series B funding round are well-established, and their valuations tend to reflect that with most Series B companies being valued at between $30 million and $60 million. 

Series B invstors tend to mirror or be similar in nature to the institutional, professional investors of Series A in terms of the processes and expectations. A Series B round is often led by many of the same investors as the earlier round, including a key anchor investor that helps to draw in other investors. The difference with Series B is the addition of a new wave of other venture capital firms that specialize in later-stage investing.

Businesses that make it to Series C funding sessions are already quite successful. These companies look for additional funding in order to help them develop new products, expand into new markets, or even to acquire other companies. In Series C rounds, investors inject capital into well-known, proven businesses that are accelerating in growth and interest to gain even greater clout.  This is more than scaling, it is professionalizing every aspect of the business and may involve growing the employee headcounts to hundreds or even a thousand. Series C funding is focused on scaling the company, growing as quickly and as successfully as possible.  Speed is coveted and the company begins to look at paths to exit and return capital to the investors through either a sale to an even larger, often publicly traded company, or for some a public stock market exchange listing themselves.  One possible way to scale a company could be to acquire another company. Imagine a hypothetical company  that reaches a Series C stage of funding, it has likely already shown unprecedented success when it comes to selling its products, perhaps in the US, and has reached milestone targets for sales from coast to coast. It needs further fuel to grow beyond either the US region to become a global brand - which still has many risks - and can begin to even look at growth through acquiring a competor in a different region or industry, which gives it scale and immediate new market share without the costly and challenging aspects of attempting to building such operations itself. As the operation gets less risky, more investors come to play. In Series C, groups new investors, often well-beyond the stage of earlier venture investors, such as hedge funds, investment banks, large secondary market transactions of buying off-market stakes from earlier investors, and even traditional private equity firms - even those with leverage buyout strategies tending to pursue cash flow and profitability - become possible.  The reason for this is that the company has already proven itself to have a successful business model; these new investors come to the table expecting to invest significant and further success of the company that is already viewed as thriving.

Most commonly, a company will end its external equity funding with Series C. However, some companies can go on to Series D and even Series E rounds of funding as well. For the most part, though, companies gaining up to hundreds of millions of dollars in funding through Series C rounds are prepared to continue to develop on a global scale. Many of these companies utilize Series C funding to help boost their valuation in anticipation of a listing on a public stock exchange e.g. an Initial Public Offering. At this point, companies reflect valuations in excess of $118 million, or even considerably higher. These valuations are also founded increasingly on hard data rather than on expectations for future success. Companies that have received Series C funding demonstrate established, strong customer bases, revenue streams, and proven histories of growth.  Companies that do continue with Series D funding tend to either do so because they are in search of a final push before an IPO or, alternatively, because they have not yet been able to achieve the goals they set out to accomplish during Series C funding.