Understanding the Financing Stages
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.
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.