To begin to understand the terms describing the different
fundraising stages, think of the new venture on a timeline. On the
far left end of the timeline is the date the idea was created and
the business model conceived. The company then moves along from
left to right as the idea gains credibility and forward momentum.
Along the way are various milestones in the life of the enterprise,
and several of these are funding benchmarks.
The first funding benchmark is the seed stage. This represents
the initial capital used to do product and/or service development,
patent filings, market surveys and research and business partner
recruitment. The emphasis is on examining business idea feasibility
and getting the firm ready to commence operations. These funds come
predominantly from either the entrepreneur's personal savings,
a severance package from a prior job, or cash raised from friends
and family members. Many venture capital funds do not invest at the
seed stage because the risks are very high.
The second benchmark comes when the venture is ready to launch.
Also known as start-up financing, at this stage the business is
seeing its first revenues but has yet to show a profit. This is
often referred to as the series A round of investment and is
typically where the enterprise brings in its first
"outside" investors.
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After a successful launch proves the viability of the business
model, funds will be needed to further develop the marketing plan,
hire more staff and management, and establish strategic alliances
in the market. That third benchmark is often referred to as the
second-stage, or series B, round. I've sometimes seen the seed
round (all "internal" funds from the entrepreneur,
friends and family) referred to as the series A round, followed by
series B "start-up financing," then series C and so
forth. But for purposes of talking to investors, the first round of
external funds should generally be called series A and the second
external round series B. This way, each subsequent round of
external investors knows where they stand with respect to prior
investors who go in post-seed.
The fourth benchmark involves securing a line of credit from a
commercial bank at a time when revenues are gaining momentum. At
this point--when monthly cash flow is at break-even--the business
merits "working capital." No investors are involved at
this point.
When the fifth benchmark arrives, the firm is typically looking
to expand its operations at a faster pace. Internal funds (profits
and lines of credit) are insufficient to support the development of
assets and internal capabilities necessary for stronger sales
growth. At this point, the firm seeks to raise another external
round of capital from investors, the series C round. Here, capital
is used to substantially ramp up existing operations and move the
company into a significant position in the industry.
Many businesses will have a seed round, then series A and series
B rounds, followed by plans to be acquired or to make an IPO of
common stock. This next stage is usually all short-term debt and
referred to as "mezzanine," or "bridge,"
financing. Some firms may even have a distinct series D round
(I've even seen rounds E, F and G) to further grow the business
before considering a mezzanine round. This debt is used to support
continued growth opportunities while preparing for an acquisition,
a management buyout, a leveraged buyout or an IPO.
Remember that at each stage, the firm will need to be valued,
and too many rounds can overly dilute the founders' stakes in
the venture. But it is also important to avoid an IPO too early, as
the firm's positioning in the industry might not yet be
assured. Some firms bootstrap their growth with internally
generated funds only and avoid having to look for external
investors. The key is to know your growth track, determine your
sales and profit benchmarks, and be shrewd when it comes to valuing
each stage.
David Newton is a professor of entrepreneurial finance and head
of the entrepreneurship program, which he founded in 1990, at
Westmont College in Santa Barbara, California. The author of four
books on both entrepreneurship and finance investments, David was
formerly a contributing editor on growth capital for Industry
Week Growing Companies magazine and has contributed to such
publications as Entrepreneur, Your Money,
Success, Red Herring, Business Week, Inc.
and Solutions. He's also consulted to nearly 100
emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.