How to Fund a Startup

An original idea that benefits a burgeoning industry is potentially worth a lot of money, but most entrepreneurs will admit that innovation is merely one of the key factors behind launching a successful startup. Shrewd timing and sheer luck, particularly where venture capitalists and investors are concerned, are also crucial to the longevity of new companies.

There are generally five phases of startup funding as far as venture capitalists are concerned. The seed-funding phase comes first. These monies typically originate from the entrepreneurs themselves; other companies receive support from angel investors and/or crowdfunding efforts. Venture capitalists are not involved at this stage, but seed money enables the entrepreneur to build a competent, talented team and draft a business plan; both of these components are all but required to receive funding from VC firms.

Most venture capital firms are created when a group of investors agrees to pool their available funds. During the first round of funding, the firm will invest roughly one-third of their budget in a variety of promising companies or projects; successful venture capitalists understand that they may not see any ROI on any of their investments for up to 10 years.

Once a group of solid ventures have been selected to receive funding, round one ends and the second round of funding commences. At this time, the VC firm will typically sift through its various investments and decide which ones to further support — and which ones to let go. Companies earmarked for more funding typically receive additional support three to five years after the first round of funding begins.

Assuming there are no unpleasant developments, startups that make it past the second round of funding are on the fast track to success. The expansion stage kicks off when the company is close to independently making a profit and funding is generated from subordinated debt and/or preferred equity — not venture capitalists.

Once a startup is able to generate a tidy profit without VC assistance, company leaders can begin to consider initial public offer (IPO) or sale. This final stage represents a major payday for venture capitalists; typically, they rake in a 700% return on their original investment for companies and organizations that go public.

Corrections: @2:05 in the video, the board reads 3- 5 years. It should read 5 – 10.

Video Transcript

The key to wooing venture capitalists (other than having a great idea in a promising industry) is to ask for money at the right time in a VCs lifecycle. Here are the funding phases for a start-up and how they correlate with a VC's lifecycle:

1. Phase 1: Seed Funding Seed funding usually comes from you - the entrepreneur's bank account, angel investors - potentially mom and dad - or crowd funding. Seed money allows you to solidify a talented team and a business plan which is required when it comes time to talk to VCs. Right now, a company called Neptune is raising seed money through Kick Starter with plans to beat Apple to making a smartphone the size of a watch.
2. Phase 2: Round 1 of Funding VCs start when a group of people agree to put money in a pot and not see returns for 10 years. If the VC is worth $100 million, then in Round 1 they will invest about 1/3 of the fund in a variety of companies. As an entrepreneur, this is when you want your business idea to be noticed and funded. Square Trade Inc., a start-up offering warranties for your tech gadgets, recently disclosed receiving $238 million in round 1 from 11 different funds.
3. Phase 3: Round 2 of Funding Provided your business is doing well, you may receive a second round of funding after 3 years. At this point in the VCs life cycle, the firm will look at all their investments, weed out the ones that went belly up, and invest more in the companies doing well. Photobucket recently went in for an additional (and they claim last) round of funding from VCs for somewhere between $5 and $10 million.
4. Phase 4: Expansion Now, your start-up is 3-5 years olds and hopefully close to turning a profit on its own. At this time, funding will come from subordinated debt or preferred equity. This is the expansion phase. Twitter appears to be in Phase 4. After receiving $15 million in 2008, it's waiting to IPO until it can earn steady profits for an entire year. This "growth" money doesn't come from VCs, but helps start-ups push past the funded phase into the next level which is...
5. Phase 5: IPO or Sale By now, your start-up is 5-10 years old; you've either made it or folded. Now the venture capitalists are ready for their payday when you sell or go public. Most VC firms enjoy a 700% return on their investment in companies which go public - however many of their investments won't make it to phase 5.