Figuring out the financials as a start-up founder is no easy feat. Getting started in entrepreneurship can be confusing when you are unfamiliar with the complex fundraising terms.
As part of the EWOR Academy, we make sure that every student understands the basics of fundraising. Based on a lecture given by Alexander Grots, CCO of EWOR, this article will help you better understand start-up financials and fundraising terms.
The two ways to raise money for a start-up are bootstrapping or funding. If you bootstrap your company, don’t turn to outside sources for funding and use your own money instead.
This strategy encourages organic growth through business activity, but it’s a rare route for most businesses.
For the second financing option, founders turn to investors or venture capitalists (VC) to fund their start-ups. External funding is the most common strategy for entrepreneurs because it’s easier to grow and scale your business.
Some entrepreneurs initially invest their own money to attract external investors later.
Valuation is an estimation of how much your company or business idea is worth on the market. It’s hard to gauge that value in conversations with investors due to different biases or perceptions of your company.
However, there are objective factors that make up the economic value of a business. The longer you work with your company, the more evidence of assets you will gather. Such criteria include patents, proof of concept, prototypes, and the founding team.
Pre- and Post-Valuation
These two terms refer to the valuation of your company before and after an investment round. Pre-money valuation is the value of your start-up before any investor signs a deal with you.
The post-investment valuation includes your investors’ assets and, thus, raises the value of your company.
To sell parts of your company to an investor, increase the share capital by offering new shares. Be mindful of laws that complicate this paperwork, depending on your location.
Whenever an investor wants to buy shares, you have to increase the number of shares by that amount. For example, you have 3,000 shares and increase by 1,000 because an investor wants 25% of equity. Instead of giving them part of the original 3,000 shares, increase your capital and assign those shares to the investor.
By increasing their capital, the old shareholders dilute their ownership. In other words, dilution means that by offering more shares, you own fewer percentages of your company.
Sticking with the previous example, you owned 100% of those 3,000 original shares. After increasing your capital by 1,000, the investor now owns 25% of your company and you own the remaining 75% of the shares. However, it’s possible to buy new shares to keep your percentage.
Every funding round has its own name and function. Some investors are particular about naming these stages, so there can be overlap between rounds with no clear definition of these fundraising terms.
This is the idea stage of your venture’s journey. At this point, it’s unlikely that you have a marketable product, but instead focus on prototyping. You haven’t completed your customer discovery yet and are looking for initial funding to kickstart your venture.
At the seed stage, you’ll have product market fit and interact with your first customers. Your venture generates the first revenue streams and there’s a clear growth trajectory. The exact progress at this stage depends on your product and industry.
At this stage, your funding efforts support an aggressive growth strategy through VC money. It’s the first fundraising run after initial expansion during the seed stage.
During a series B funding round, you’ll either fund the road to an initial public offering (IPO) or prepare for an exit.
It’s possible to go for a series C round and secure even more VC money to launch IPO and stocks. This depends on your venture’s journey and industry.
This fundraising term describes a loan that usually doesn’t require an immediate exchange of equity. Instead of buying shares right away, investors can offer loans to start-ups that help with valuation.
Preparing for funding rounds is easier with convertibles because you work with numbers. Thus, it doesn’t rely on gut feelings and estimates, but facts.
Term sheets are documents that lay out the conditions between founders and investors. It’s a pre-contract before signing the shareholder agreement. After both parties negotiate the details, these non-binding documents are the foundation for the legal agreement.
Once you have convinced an investor of your company’s worth, they will send you a term sheet. It’s up to you and your co-founders to negotiate the details of the deal and set the cooperation up for success.
Some investors insist on exclusive term sheets that prevent you from talking to other investors until the final decision.
Investors have a long and detailed due diligence process to review all aspects of your company. They need to confirm your assets, valuation, and internal structure before agreeing to invest in your start-up.
The more time you’ve spent building your venture, the longer due diligence will take. Investors like to check the legal side of your start-up in great detail, which takes more time with a bigger organisation.
Venture capital firms raise funds from individual investors’ contributions. VC money is a high-growth option for start-ups because it’s usually a large amount and VCs like to scale quickly.
VCs enter your funding rounds at different stages in your journey, depending on your product and industry. Be aware of the long VC cycle and legal loopholes that influence your control over your company.
Angels are investors who use their personal funds to support founders in the early stages of their businesses. The majority are experienced entrepreneurs who join projects to help the next generation.
Angel investors offer resources, a broad network, and financial investments to start-ups. Some angels are emotionally invested and consult the founders, while others prefer to only help financially.
At the beginning of your start-up journey, look for experienced angels to kickstart your company’s growth.
The pitch deck is the backbone of your company’s fundraising efforts. Pitch decks are tools to describe your idea and assets to investors to convince them of your value.
Pitch decks evolve with your company. It’s important to adjust your pitch deck every time your start-up pivots or adds assets.
If you’re struggling with this document, check out our CEO’s step-by-step guide to creating a strong pitch deck.