05/07/2019 12:00:00 AM
Different Startup Funding Stages Explained
As a startup founder you need to understand startup’s characteristics in terms of product’s organizational status and important stakeholders in the investment process. Also, how your raised capital should be deployed based on your startup’s development and funding stage. Putting the below guide in mind will help to be more strategic and seize the initiative in your startup journey by working on your investment readiness early-on.
So, what are the different stages of Startup funding?
- Pre Seed Stage:
- Provided by 3Fs (friends, family and fools J).
- Usually this is the very first investment a startup gets and this stage of funding is also called: “The idea stage”.(meaning you are still doing your research and building your idea)
- The raised funds are used to finance the early development of a product, market research and building a management team.
- Seed stage: (Angel investor funding)
- Provided by high-net worth individuals or groups of individuals.
- The raised funds are used to support initial marketing for early traction and product development.
- Venture Capital financing:
- It includes Series A, Series B rounds, etc…).
- Provided by venture capital firms (investment funds).
- The raised funds are used to support fast growth. VC funds are expected to add value that is more than just funding and usually have a strategic role with the startup (mentoring, connections, new deals, etc…).
- Mezzanine: (bridge financing)
- In essence, the Mezzanine round is a milestone to finance the step of going public.
- The Initial Public Offering stage is when the startup decides to get listed publicly.
What is the target return on investment (ROI), investors would require?
The answer to this question is highly dependent on the investment stage; the earlier the investment, the higher the return required as early investors are exposed to the highest risk & highest dilution throughout the multiple rounds of investment. Inversely, the return required gets lower as you go later in investment stages which involves less risk as the startup is more sustainable and has predictable revenue. By nature, the VC business is very risky as the success ratio of startups is usually between 2 to 3 out of 10!
Check the first article in this series to know the average expected returns by investors.
Is startup valuation based on quantitative methods only?
In general, there is no right and wrong in startup valuation as it is both a science and art and each investor has her/his own unique methodology. The first rule in startup valuation is “your startup is worth whatever you and the investor agree it is worth”.
In so, startup valuation is partially quantitative and partially qualitative. Whether is it 50-50 or 60-40 that would always remain debatable. That’s why additional qualitative methods of assessment arose to help give more insight about a startup success prospects and potential value, aside from numeric-based methods.
The below methods will help as guide and framework while conducting the valuation exercise for your startup.
- Risk summation:
- Identifying risk factors:
- Stage of the business
- Political risk
- Sales risk
- Competition risk
- Technology risk
- Each element is assessed as follows:
- +2 very positive
- +1 positive
- 0 neutral
- -1 negative
- -2 very negative
Every +/-1 gets +/- $ 250 K, the total is then added or subtracted from the average valuation for similar same industry/same region startup.
- Berkus Method:
The Berkus Method is relevant and applicable to pre-revenue startups:
This method is based on assigning a range of values to the progress a startup has made in each specific area:
- Idea $ 500 K
- Prototype $ 200 K
- Quality of the management team $ 300 K
- Strategic relationships $ 100 K
- Sales $ 0 K
- Scorecard Method:
The Scorecard Method has a very similar methodology as Risk Summation Method:
This method is based on assigning a score for each factor (assumingly 80% as low, 100% as average and 120% as high) and calculating a weighted average based on the below weights:
- Strength of the Management Team– 0-30 percent
- Size of the Opportunity– 0-25 percent
- Product/Technology– 0-15 percent
- Competitive Environment– 0-10 percent
- Marketing/Sales Channels/Partnerships – 0-10 percent
- Need for Additional Investment– 0-5 percent
- Other – 0-5 percent
Then multiplying the sum of factors by the average valuation of similar startups.
How to defend your valuation?
- Use more than one of the mentioned startup valuation methods to get the most accurate valuation possible.
- Prepare 3 business plans/projections (conservative, base case and aggressive).
- When using multiples valuation techniques, do your homework and try to find as much multiples as possible.
- When using multiples valuation technique, make sure to exclude outliers.
- Prove your growth potential and explain main drivers.
- Build good negotiating skills, work on being convincing and passionate about your startup because, investors, sometimes, invest in people rather than the business idea itself.
- Highlight the strength of your key management (team branding).
In the end, I want to leave you with this idea; as you might conclude there is no universally accepted method for establishing early-stage startup valuation. In so, whatever the method(s) that you will be using or even if you design your own method; make sure that the resulting valuation can be easily explained and is aligned with the facts of your startup so you are able to defend it wisely and correctly when raising funds and ultimately, scaling.