In simple, every newbie entrepreneur needs funding and they wants more funding for their business but mostof them don’t know how funding works (how to fund a startup properly), they also don’t understand the other specific terms as equity distribution in company, stages of funding, and IPO etc.So make you understand it, here, I have made a brief guide on funding a startup with a very practical example.But before going to the examples, there is a piece of lesson that would prove helpful.
First of all, you should understand, every time you get funding, you have to give up a piece of your company. The more funding you will get, the more you will have to give up. But if you think this is like barter system for you then you’re totally wrong here.
Because at the start you’re 100% owner of zero value company but at IPO stage of funding you have approx. 35% of Billion Dollar Company.
But, you also have to consider, always controlling bigger stock of the company.
Now, let’s come to the example.
I am going to define how funding works for a startup with the example of Mr A,
At the idea stage
Mr A is a brilliant guy who is techie and very new at business. But he has an innovative idea that he has been developing since last 4 months. He has also completed market research and other analysis procedure.
In fact, he is in the idea stage of his future firm and here the resource of funds for research and idea developing procedure is only himself. After conforming the idea.
At the Bootstrapping stage
Finally, he comes out with his idea. He knows after developing the idea he has to bootstrap his idea to create a working prototype, which will help him to raise seed funding ahead.
“Actually, business prototype is the working or practical model of entrepreneurial idea that shows potential of product or service. There are three types of it,
- Presentation prototype
- Pre-production prototype
The prototype also depends on three factors, first is your idea; second is your budget; and third is the goal of business.
Finally, the goal of your prototype is to prove that your concept works, in the easiest, quickest and most-affordable way you can possibly do it.”
For more: What is a prototype, in brief, three steps to transfer your business into a prototype.
For bootstrapping a business idea, there are some common ways,
1. Finding co-founder(s)
But now the problems begins to arise, he has just $1000 (for Indian context, let’s assume INR 30000) in his account and the work load has also increased. In this case, he needs to find a person who will help him financially and physically for growth of idea. Now Mr A calls his friend Mr B who is equally enthusiastic about the idea and ready to work on it.
Mr B also has just $1000 to invest with his friend Mr A. Here, Mr A thinks about how much should he give; just 20%, 40% or 50%? The answer is clear. 50%. But if you ask why then read below,
“In fact, this is very notable that the idea is only yours;it is your idea that even made this startup happens. But you should realize that your startup is worth practically nothing at this point, and your co-founder is taking a huge risk on it. You should also realize that since he will do half of the work, he should get the same as you – 50%. Otherwise, he might be less motivated than you. A true partnership is based on respect. Respect is based on fairness. Anything less than fairness will fall apart eventually. And you want this thing to last. So you give your co-founder 50%. And being the first person of the startup, you can be the CEO and chairman of board easily”
According to the research, 95% startup fails because of partnership issue or because of less motivated partner. So always find a partner who is trustworthy and can invest equally.”
2. Bootstrapping by relatives
But the problems don’t terminate here; they both have just $2000 that is not enough for making the prototype and renting the office.
So they want to go straight to angel or VCs (venture capitalist) but they realize that the VCs invest in only proper working products and angel investors want a proper prototype. And they don’t have either.
There is some another way for them. It is to go to relatives, crowd funders, and Bank loans etc. but they get success in convincing their one rich uncle by their business plan.
They raise $15000from their uncle in the lieu of 5% of the company. Now they can afford the working prototype for their idea and also rent an office for 6 months.
“Actually, above all funding projections are just notional that will change in different situations. It is not sure that any uncle will give 15000$ for 5%; it depends on your business plan and convincing strategy.
And also the funding need for working prototype will change according to your idea.”
For more: list of 14 ways for bootstrapping the startup right now.
Incorporation stage of startup
Now, to give the uncle 5% they have to incorporate the company and divide the stocks between them. According to a pact with the uncle, they give up 5% of company them and also save 20% of stocks for the future employee.
“Actually, future employee’s stock is an option pool that is largely fateful for upcoming stages of funding. In-fact, all VCs and angels want an option pool.
An option pool is a stock that is saved by founders for attracting the intellectual individual in future.”
So after 6 month, an actual working prototype is ready to go ahead,
“Here working prototype format may be different for different ideas; actually, if your idea is about a product then the prototype will refer to an elaborate data with great presentation and a testing model and if your idea is about service etc. Then the prototype may refer to a working model of your business that shows existence of the idea.”
And now, they realize that they need to start looking for the next funding source right now. So they opt to go to Angel investors.
Seed funding stage,
Actually, angels are called the best resource for seed funding a startup so both Mr. A and B plan to go to them.
But they realise, before going to investors, they need to figure out three terms,
1). the amount they require to grow to a point where they will show significant growth and raise the next round of investment.
2). and, value of their idea or valuation of the company.
3).and also,How much of the company to give to the investor for this deal.
But same as every newbie they don’t have efficient clue about “How funding works for startup”.so they meet with a business advisor.
1). Amount of the investment
With the help of business advisor, they calculate, the requirement for seed funding is nearly $200,000 and this is set in stone. Why? Because they are going to show that this is minimum amount to grow to the next stage and without it that is impossible to grow.
So let’s say, the investment amount for their business is set.
2). Next, The Valuation of their business prototype or startup,
“First Understand, why startup valuation matters?
Actually, valuation matters for both, entrepreneurs and investors. Valuation matters to entrepreneurs because it determines the share of the company they have to give up in lieu of investment.
And also this is an important term for an executor or investor because it determines how much shares they will get in return of their money.
Actually, at the early stage, the company value is close to zero, but not its valuation is same, that may be too higher.
Let’s assume, you requirement for seed round is $100,000 and you want to give away only 15% of your company. So as for deal, your post-money valuation is around $666K.
However, it doesn’t mean that your company worth is $666k now, in fact, valuation in seed stage is just a presumption about your growth potential and idea’s strength.”
So now, they both Mr. A and B start the valuation of their startup with their advisor.
The advisor tell them there are two ways for valuation,
A). Pre-money valuation:
When the entrepreneur figures out the valuation of their prototype before getting funds, then the valuation is called pre-money valuation.
It depends on some factors, i.e,
- The hotness of the industry: the industry hotness always motivates investors to invest.
- Pre-valuation revenues: the revenues before getting funds also ignite investors to invest in your prototype.
- Traction: Traction is basically quantitative evidence that shows customer’s demand. This term always gets more traction from investors.
- Status of team members: investors also look at the strength and status of the team member.
- Distribution channel: For example, if the entrepreneurs run a Facebook page related to their products with 15 million like, now that page might become a distribution channel for your business.
Now methods for doing pre-money valuation,
- Discounted cash flow method: A popular way to calculate valuation of a startup; this method free cash method takes free cash flow generated in future by a company and discounts them to drive a today’s value.
- Venture capital method: Here the investors are looking for an exit within 4 to 6 years and then estimate the expected exit price. Now they calculate back to the post-money valuation today taking into account the time and the risk.
- Market comparable method: That is simple and depends on how the comparable listed companies are capitalized.
- Decision tree analysis: this method is used to forecast future outcomes by assigning a certain probability to a particular decision.
“I know, this is hard to understand for newbie entrepreneurs, so don’t mind it because this part of your startup is supported by your accountant or business consultant.
The startup valuation at the pre-funding stage is not everyone’s cup of tea so it must proceed under an experienced advisor or CA.”
So after the first type of valuation, the next is,
B). Post-money valuation:
That is quite simple but more tactical way for valuation; actually, here in this stage, firstly the entrepreneur has to finalize the seed amount that he wants (let’s assume, that is $100,000). Then he also has to figure out how much company he wants to give up. That could be anything below 50%, because if it goes high then the founder’s authority will fall down.
“Here the thumb of rule is to give away up to 15% to 25% for the actual amount of seed fund that you want to raise”
So he fixes the equity “20% for $100,000”, then typical deal says the post-money valuation for the business prototype is $500,000; although, the actual worth of his business is too small.
“Here the equity value for investors depends on how other investors value similar companies and also how well you can convince the investors”
So now, the both newbies Mr. A and BB Decide to evaluate the pre-money valuation of their business. And with the help of their advisor, they figure out their pre-money valuation,
That is $1,000,000;
“Do you need a high valuation that helps you to raise high capital?
No, I never agree to this; when you get the high valuation for your seed stage, then for the next round you need a higher valuation.
So that is simple, always raise the amount that you need,”
3). Now dividing the equity with investors,
Now, they have fixed their need that is $200k and if they also convince investors for their pre-money valuation amount that is, $1 MN, and the investor is ready to invest $200k then,
The post-money valuation is,
$1,000,000 + $200,000 = $1,200,000;
And then angel investor get ($200,000/$1,200,000)*100= 16.7% of company.
“Actually, finding the post-money valuation and divide the equity in start is looks simpler than finding the pre-money valuation in start, but this is more tactical also”
Now, after getting funds in seed stage, they work hard and run their business properly for 18 months. And in this 18 month, they grow 10 times more.
Now they need more money to scale up their business, so their advisor advises them to go to Venture capital stages.
Actually, VCs funding is divided into 3 series, that is, series A, B, and C.
Series A funding,
“Here is a rule of thumb, for VCs funding, startups need to show the 10 times growth within 18 months after seed round. That ensures VCs to invest undoubtedly.”
Here, they both Mr. A and B realize that,
“In this stage, the main metric is only growth. The valuation of the company is now calculated on basis of the growth rate that you get in last 18 months. Also, the traction and revenues play here the vital role.”
In fact, they did grow up 10 times more within 18 months after the seed round so, they plan to approach VCs.
Now, they realize they should find out the present valuation of the company to negotiate the value of equity, they have to give up in lieu of Series A funding.
So, their advisor tell them,
“Inasmuch, at this stage we already have a revenue so, to evaluate the company, investors use the multiple methods, also it called the comparable method.
So according to this method, we have to find out how many times valuation is bigger than revenues of your comparable companies or in other words what the multiple is. And once we get the multiple of our comparable companies, we multiply our revenue by it, which produce the Valuation of our company”
Then after comparable method, they figure out the pre-money valuation that is near $4,000,000.
Then they go to VCs and start to convince them for funding. At this stage, they calculate the need of amount for this stage is $2 MN.
“Actually, need of amount for Series A stage is only dependent on how much you want to grow and elaborate your business in the time frame of next 6 months.
There also, you have to raise the actual amount that you need”
After some calculation VCs agree to $2 million investment because of their growth rate and market value and other effective terms.
Now allocation of the equity,
Same as the seed stage, they calculate Post-money valuation,
“Post-money valuation is the sum of pre-money valuation and amount of funding”
So Post-money valuation is $4mn +$2mn = $6mn
Then the share percentage of VC is,
($2mn/$6mn)*100 = 33.3%.
At this stage, Mr. A and B, each have 19.2%, Angel has 10.33%, uncle has 2.6% and VC has 33.3%.
After 6 months of great growth, they go to Series B and then Series C respectively. So finally, after Series C funding they go to Public (IPO).
Initial public offering stage (IPO),
Here the advisor tell them,
“This is also known as stock market; actually here the investors in your company will be individuals who want to buy your minimum single shares.
There is technically two reason behind going to public, first, that is an easier way to get funding because here the company can sell stocks and anyone can buy them. It is simpler because here, you don’t have to go to an individual and convince them for investment.
And second, there the founders don’t lose the authority after funding.”
So, to go public they again evaluate their company here the valuation again depends on your growth rate and also exit amount for next 5 to 8 years
So their CA evaluates the valuation of their company that is approx., $2Bn. So they raise $235,000,000 in the IPO stage in the lieu of 7% of equity.
And it goes on till the company’s existence.
I hope, you have understood the specifics of “How funding works” here. In this article, I have included an example to clarify the startup funding procedure for every stage. But after all, if you have any doubts here about the topic “How Funding Works: Startup Funding Procedure with Example” you can ask below in the comment.