Investing in a startup is divided into several rounds according to the stage and aspects of a startup’s development. Usually, a young company needs gradual financing that corresponds to its current tasks. Each funding round must be opened in alignment with whatever the project needed to implement business processes. At the same time, the structure of funding is quite flexible, so passing through all the existing rounds isn’t obligatory.
Purpose of investment rounds
An investment round is a round of project financing. The rounds are divided based on how developed a startup is at the time of raising capital. In general, venture financing solves two problems:
- acquiring funds to develop a new product,
- acquiring funds to improve an existing business.
In the first case, we are talking about the early stages of investment. The second case is all about the later stages.
Dividing investments into rounds allows you to streamline the process, minimize risks, and understand the stage of a startup’s development.
Each round is characterized by certain criteria (such as objectives, type of investor, funding amount, etc). When startups are looking for funds, these criteria steer them in the right direction.
For example, if the founders are looking for seed funding, there is no point in contacting a large venture capital fund. It simply won’t be interested in purchasing small shares. Likewise, investors usually focus on the most suitable projects as well, ignoring applications from irrelevant startups.
Types of funding rounds
The process of financing begins with analysis. A startup assesses its product, demand, market size, indicators or projections of financial performance, team skills and experience, risks, and other factors. Depending on the results, a startup then chooses a suitable investment round, investor type (business angel, accelerator, venture fund, etc.), and the amount of capital required. At each new stage, financing involves attracting more and more funds.
There are two categories of funding rounds:
- Early-stage rounds — pre-seed, seed, angel funding, Series A.
- Late-stage rounds — all other rounds with letter designations (Series B, Series C, Series D, etc).
The riskiest ones are the early-stage rounds since there’s a high chance of failure. But if such a deal succeeds, the benefits get to be the best. At the initial stage, when amounts of funding are moderate, an investor gets an impressive share in exchange for taking high risks.
However, as a startup develops, the chance of failure decreases while the company’s needs increase. A growing startup requires more funds to scale and capture the market. In later rounds, the amounts of funding are higher, but the risk is reduced. That’s why an investor’s share is significantly smaller than in the early stages.
The initial funding round falls on the stage of idea, hypothesis testing, development, and MVP launch. It is usually considered separately from the generally accepted classification of investment rounds. At this stage, the source of funding is often the founders’ own savings, as well as the funds of relatives, friends, and like-minded people (the so-called FFF — Friends, Fools, Family). But the money raised is quite often not enough, so the project needs external investments.
At this stage of development, the company is only joining the venture ecosystem. Suitable sources of funding are crowdfunding, business angels, startup studios, accelerators, and incubators.
Founders need to understand that the earlier a large investor is attracted, the larger a business share that has to be given in exchange for capital.
Crowdfunding platforms provide an opportunity to raise funds without allocating a share to contributors. For example, the shoe company Skinners managed to raise more than $1.6 million through crowdfunding. But still, in most cases, the funds raised are barely enough for the founders to start.
To receive funding, a project must meet a specific list of requirements put forward by investors. It is impossible to evaluate a company at an early stage using standard methods: there are no financial statements, objective data on market capacity, demand, or conversion. Therefore, a startup uses a checklist to describe the product, its competitive advantage, target audience, market niche, and team. It shows ways of monetizing the product, proves the demand, and so on.
At this stage, investors need to understand the project’s potential and possibilities of scaling. If the market is narrow, a startup’s growth will stop quite soon, so this is not a beneficial investment. In the preseeding round, a convertible loan instrument can be used. That is when an investor gets the right to further demand its repayment in one of the following ways:
- through the return of the invested money with interest rates,
- through transferring a share in the company’s capital to the investor;
- through transferring or selling securities to the investor.
The goal of the pre-seed round is to prepare a startup for rapid growth, finding potentially scalable sales channels.
With a seed round begins the generally accepted classification. This round is considered the most difficult since it includes testing the business model and analyzing to which degree the forecasts correspond to actual results.
The circle of investors in this round includes business angels, startup studios, accelerators, incubators, and venture capital companies. When deciding on financing, they need to assess the demand for a product, market size, the effectiveness of a business strategy, as well as the team’s professionalism, attitude, and ambition. The financial model is analyzed based on available data, startup development forecasts, market potential, and performance of similar companies in the same niche.
The total amount of invested money can reach from $25.000 to several million dollars. It depends on the needs, goals, and potential of the project. For example, in summer 2021, HR startup Pangea closed the seed round of $2 million.
At this stage, a young company is supposed to show its prospects and determine how much money it needs to attract
The seed round is also considered high-risk. The main reasons for that include:
- a flawed business model,
- high competition,
- consumer dissatisfaction with the product,
- lack of funds.
You can say that the seed round plants the seeds in the soil of a startup’s future, stimulating its exponential growth. At this stage, the startup should have a product, a formed team, and profitable sales channels (with calculated unit economics).
Seed funding allows the company to develop at higher rates, improve the product, expand staff (within reasonable limits), and widen the client base.
This round is often considered a variation of the seed round. It involves financing from a private investor, i.e. a business angel. In addition to financial assistance, they also provide other support (network, connections, experience) and act as a mentor.
Business angels invest in a startup in the early rounds in exchange for a significant share. They are ready to take risks if they expect the project to be potentially profitable and have high margin growth (more than 50% per year). You can find business angels on specialized online platforms.
For this stage of funding, massive venture capital infusions are characteristic. Evaluation of the company at this stage is no longer difficult. The startup has already found a working business model with proven sales channels, an effective strategy, a development perspective, a professional team, experience in market interactions, and a client base.
Quite often, it’s the investors who are competing for the attention of the company because there are considerably fewer projects prepared for this round.
There might be lengthy negotiations and discussions, and the transaction alone can take several months to complete. Business angels no longer invest in this round. But venture capital funds and early-stage investors can team up to make a deal. The amount of funding starts at $1 million. An example is the Cloudflare service that managed to raise $2.1 million during Series A.
The goal of attracting funds is to keep growing rapidly, develop a product, capture the market or an impressive part of it. Series A is considered the first significant phase of venture funding; it completes the early stages of investment. In this round, preference shares are allocated to participants of the previous stages. These securities are often converted to common securities when a startup exits through an IPO or a sold-out.
A startup approaches Series B round with several investors (business angels, funds) in its capital. Funding is needed for further scaling, the total amount of attracted funds is $10–30 million. For example, the electronic payment system Square attracted $27.5 million during Series B.
When evaluating a company, investors are guided by the project’s dynamic, indicators of economic activity, business strategy, compliance with trends, and management efficiency. On the other hand, irrational teamwork, managerial mistakes, wrong scaling decisions, and no understanding of how to achieve new goals can only increase the risk.
Among the purposes of raising funds, there may be profit growth, conquering new markets, expanding to other countries, acquiring competitors at an earlier stage of development, and so on.
Series C and D
It is worth noting that all lettered rounds of investment have similar functions, structures, and goals. The main difference between them is the type of securities offered. Series A presupposes the issuance of preferred shares A, Series B — shares B, and so on. Each round’s securities have different denominations.
In the later series, C and D, the company is preparing for an IPO or sale to a strategic investor. The startup experiment succeeded and turned into a predictable business model that is stable and understandable for everybody. As a rule, the amount of funding increases with each stage, but in later stages, this rule may not be followed. The amount is based on the needs and objectives of the company. For the Russian market, the average check amounts to $40–50 million but can reach $100 million or more.
An example of a Series C company is Nest Labs, a self-learning smoke detector manufacturer that raised $80 million. The Series D was a success for the manufacturer of smart exercise machines Peloton that raised $75 million.
Later rounds of investments do not always favor companies. They may indicate that the startup is not achieving its goals within the limits of the amounts already raised.
When an organization has gone through too many rounds, investors may see this as a sign of stagnation. Besides, founders shouldn’t forget about equity dilution.
Do I need to follow the order of rounds?
Dividing the process of funding into rounds is only theoretical and does not require the company to go through all of them. It is possible to open some of the rounds or go through one round only.
Series A (B, C) can be the first for a startup if the previous tasks were solved at their own expense. Examples include the aforementioned companies Cloudflare and Nest Labs. The first startup began to attract investments immediately from Series A, the second from Series C. Companies can raise Series A, B, C several times (see Square).
Canva: Strategizing Your Rounds
The acclaimed startup Canva is one of the best examples of the right investment strategy. The company was raising rounds once in 1.5 years, aiming to receive the exact amount required to solve emerging problems. Let’s take a closer look at this project’s funding series.
Canva (website and application) is a graphic design platform with a simple and intuitive interface that is suitable for ordinary users and professionals. The startup was created by Melanie Perkins in 2012 and in 6 years has managed to achieve unicorn status, competing with Adobe and Microsoft. But at the beginning of the journey, everything was not so rosy.
In 2012, Melanie Perkins together with her co-founder Cliff Obrecht were actively looking for investors since they had no money to implement their plans. However, attempts to attract pre-seed investment were unsuccessful. For several months, Melanie was a regular guest at the offices of powerful capitalists of Silicon Valley. But all 100 pitchings failed.
The founders actively participated in thematic events, taking any opportunity to show their project to influential representatives of the industry. As a result, the guys met Cameron Adams, a former Google employee. In 2012, he co-founded Canva — and so the story began. Melanie was introduced to Hollywood stars Owen Wilson and Woody Harrelson, both of whom have invested in Canva. Then, at a meeting at MaiTai Maui, she attracted other investors. As a result, Canva received:
- $3 million in a seed round, including a grant from the Australian government.
- After that, the search for capital became easier since the investors themselves were visiting the Australian office of the company. In Series A in October 2015, the startup raised $15 million.
- A year later, the company raised Series B for the same amount.
- In January 2018, Canva became a unicorn startup thanks to a 40-million investment from Sequoia Capital during Series C.
- A year and a half later, the startup received $70 million (Series D).
- And in October 2019, another $85 million (Series E). The company’s value reached $3.2 billion in total.
- In June 2020, $60 million was invested in Canva, in April 2021 — $71 million. The valuation increased to $15 billion. In 2020, the startup grew 130% and reached $500 million in revenue. Founders Melanie Perkins and Cliff Obrecht became billionaires.
- On September 14, 2021, Canva raised $200 million during its new funding round, reaching a valuation of $40 billion. This series brought in new and existing investors (nine in total).
As of September 2021, the service has over 60 million active users in 190 countries, including large companies using corporate tariffs (Salesforce, PayPal, American Airlines). Canva plans to increase its annual revenue to $1 billion or more by the end of 2021. The new funding is aimed at doubling the staff till February 2022 and developing the product. The total investment in the company amounted to $572.6 million.
So, in this article, we ran through the main rounds of investments and included the example of a well-known startup. Dividing the financing process into stages gives an idea in which direction the company is heading, showing its dynamic and growth rates. In addition, breaking down funding into rounds allows investors and founders to find each other faster without wasting energy on irrelevant offers.