Why do start-ups require funding?
A start-up’s success doesn’t just depend on how great the idea behind it is – a start-up’s success is quite majorly determined by its ability to secure its funding and thorough study of start-up stages and investment options. It requires these funds to convert its innovative, game-changing ideas into a physical reality. A lot of businesses have been seen to fail because of their inability to generate funds and hence not being able to see their idea into fruition. After all, you need some money or capital to keep your business going at every stage. More than 60% of start-ups require external funding rounds in order to establish their ground firmly.
A great idea and a strong will to succeed are just not enough to succeed as a start-up. If you’re an entrepreneur who’s looking to grow and scale, it is essential that you look into funding your start-up business. A lack of capital is one of the most common reasons why small businesses fail. All current business giants like Apple, Amazon, etc. grew due to the funding they were provided.
To make their idea come alive, a start-up will need to hire more employees, attract specialists in the field, invest in production costs, and keep the operations running steadily, which will require funds. Fundraising and creating automated analytical reports increase visibility and attract the attention of the market. It adds value to the business and shows prospective partners and customers, as well as future investors, that the start-up is worth considering. Also, you can explore how to get funding for a start-up in India.
As a budding start-up owner, you must evaluate where your start-up stands and how much funding you can raise from external sources. Thus being aware and studying each stage of the start-up funding ladder carefully is vital.
Different stages of funding
1. Self funding stage/ pre-seed funding/ bootstrapping
In this stage, the start-up must use its resources to get the operations off the ground. They should ascertain how much amount the start-up can contribute from their own pockets. This stage involves assessing their investments and savings kept in multiple accounts and approaching friends and family. It involves fewer complexities and less documentation compared to the future stages.
This stage explores how feasible it is for the start-up to convert its idea into a physical product and start-up stages and investment options.
The potential investors in this stage are the start-up owners themselves as well as friends and family who are willing to lend money at a cheaper rate. Many entrepreneurs also seek guidance from founders who have been there and have gone through a similar experience as them.
Entrepreneurs should also work out any necessary partnership agreements, copyrights, or other legal issues during this stage, as such issues are easiest to resolve.
- Rewards of self-funding
The funds raised in this stage are used for market research and developing plans for the product launch. Self-funding your business means you only answer to yourself. You are free to do as you wish with the direction of your start-up.
During the risks, self-funding development stage of the start-up, entrepreneurs may have to work overtime or get a second job to invest their additional income into their new start-up. Entrepreneurs who use their own money or personal assets to get their start-up going incur a substantial financial risk, especially if the business fails. Likely, investors won’t make an investment in exchange for equity in the start-up as it is very risky since this is the earliest stage.
2. Seed funding
The funds raised in this stage determine the company’s final products and demographic. This helps the business identify and create a perfect direction for its start-up. Funds raised at the seed funding stage are used for knowing the customers’ demands, preferences, and tastes and then formulating and fixing their product or service accordingly. Most entrepreneurs just starting out raise this capital from friends and family, while some take up loans in exchange for some stock.
- Risks during seed funding: Because the investors are taking a huge risk by investing in the business, start-ups must provide them equity against seed funding. The stakes are even higher because, at this stage, start-ups cannot guarantee a successful business model.
- Rewards of seed funding: The money raised here is used by the start-up to raise and increase traction until revenue starts kicking in. It is also used in recruiting newer members into the team to work in an efficient manner and ultimately developing the product to work for the market. If it is successful, the returns are huge for the investors. The potential investors at this stage usually are angel investors, friends and family, micro venture capitalists, and crowdfunding.
3. Venture capital financing
When the company’s final products or services reach the market, venture capital funding comes into the picture. Regardless of the products’ profitability, every start-up considers using this stage that further involves multiple rounds of funding:
- Series A – It’s the first stage of venture capital funding. At this stage, start-ups have formulated a specific plan for their product or service. It is mainly used for marketing and improving brand credibility, and scaling the business. The start-up usually has a working model and the key team in place by the time this stage of funding is reached. The scalable market blueprint should be ready as the funds from this stage are used towards that. The potential investors are accelerators, super angel investors, and venture capitalists. They are looking for start-ups with a solid business strategy that can turn their great idea into a thriving, money-making organization, allowing the investors to reap the benefits of their investment.
- Risks: They use equity crowdfunding to raise money as many companies, even those which have successfully generated seed funding, tend to fail to develop interest among investors as part of a Series A funding effort.
- Rewards: Once a start-up has secured its first investor, it’s easier to attract additional investors.
- Series B – When a business reaches this stage, it means that the product is being marketed correctly and the customers are actually buying the product or service, as decided earlier. It is the stage where the market share of the start-up will be increasing, and scaling up will be the goal.
- Risks: Start-ups need to develop a substantial user base and prove to investors that they are prepared for success on a larger scale. Series B funding is used to grow the company so that it can meet these levels of demand and thus involves more risk.
- Rewards: The funds are used towards building higher quality teams and outliving their competitors. This funding helps a business in paying salaries, hiring more staff, improving the infrastructure and establishing it as a global player. It allows the start-up to grow to meet the demands of their customers, which will be increasing. The difference here is the addition of a new wave of VCs that specializes in investing in well-established start-ups. Potential investors are venture capitalists and late-stage VCs.
- Series C and beyond – A start-up can receive as many rounds of investment as possible; there is no particular restriction.
- Risks: However, during Series C investment, the owners, as well as the investors, are pretty cautious about funding. The more the investment rounds, the more released the business’ equity.
- Rewards: This stage is focused on expansion, building new products, reaching new markets and even acquiring other start-ups that may not be performing well. It also helps put the start-up on the track to becoming an IPO. As the operation gets less risky, more investors come to play. In Series C, groups such as hedge funds, investment banks, private equity firms, and large secondary market groups accompany the type of investors mentioned above. The start-up has already proven itself to have a successful business model; these new investors come expecting to invest significant sums of money into companies that are already thriving as a means of helping to secure their own position as business leaders.
4. IPO (Initial Public Offering)
This stage is when a start-up decides to raise funds from the public, including institutional investors as well as individuals, by selling its shares. It is also referred to as a start-up ‘going public’ as the general public is now interested in wanting to invest in the company by buying shares. The company must submit information related to financial statements, the purpose of raising funds, etc., to the SEBI, although its not essential for the founders to disclose their financial statements before the general public if they go for an IPO.
This stage is when there is a growth-oriented team locked into place, the start-up has proper and stable financial statements, and good corporate governance has been developed along with having received positive market feedback.
When a start-up decides to go public, a specific set of events occur during the process. They include:
- Formation of an external public offering team comprising of underwriters, lawyers, certified public accountants, and experts.
- Compilation of the start-up’s financial performance as well as its expected future operations.
- An audit of the start-up’s financial statements generates an opinion about its public offering.
- The start-up files its prospectus with the SEC and determines a specific date for going public.
Risk factors involved while applying for an IPO
There is no guarantee of being issued shares as part of the IPO. When there is an oversubscription for an issue, there are fewer chances of issuance of the shares. For some of the first-timers in the industry, it shall be hard to determine how the company performs or how its peers have been doing. These IPOs may see sharp volatility in the first few days of their trade.
Rewards of an IPO
Raising funds for the start-up is not the only benefit; being public allows an organization to recruit better talent. Mergers are easier for a public organization as it can utilize its public shares to acquire another start-up.
As a start-up looking to grow funds for their company, understanding the distinction between these rounds of raising capital will be vital in evaluating your entrepreneurial prospects. All the different rounds of funding operate in essentially the same basic manner. Between the rounds, investors make slightly different demands on the start-up.
For taking your start-up to the next level, you should know which stage of funding you want to go for and for what purpose. Such decisions at the right time can take your business to the next level.