We’ve all been inspired by stories such as that of Apple and Microsoft, when a few people started working in a garage and in a few years they were the owners of a booming corporation that printed money, so to speak.
Nowadays, we have Facebook, Snapchat, and Uber, as modern examples of unicorns, with valuations into stratospheric billions of dollars of all value. The question that we ask now is: What do they all have in common? How did their business achieve such growth?
From an Idea to a Billion Dollar Business: The Development Stages of Startup Funding
The one factor that every successful business has is the production of Value: a great product, an excellent service, which makes a vital contribution for supplying the needs of society. When a company produces value, it will readily grow by way of Equity: sharing the ownership of the company amongst a group of investors who provide funding and also receive a part of its income.
Now let us take a journey through every step of the way in which value grows into equity, and in so doing we will draw a clear map for the funding and development of our own startup business.
A small idea and a great motivation: The mind of a professional might be teeming with ideas, always musing of new and exciting things to create. Perhaps this stage represents the tallest step of all: taking the plunge from contemplation to action. Value begins to be produced when we reach the confidence and the motivation to start working on one idea, and any progress will depend on the drive that each person has for developing it. There are no benefits, yet, and the owners of these fledgling businesses are those who are nurturing them voluntarily.
Two’s company and so much more: To find a motivated and talented colleague is the next step in the development of a startup company. Someone who will work with us for free, to start making a prototype of the product or to take the first customers for our service. Now is the moment to think about equity, because the effort our colleague is doing will add value to our business, and we must compensate that effort with a fair share of equity. A fair partnership implies an even partition of the company’s ownership among us, regardless of who can claim the creation of the original idea. This is the difference between having partners (in this case co-founders) and having employees: my partner will work for free, betting on the success of our company and waiting for benefits when and if they come to be; whereas an employee is someone we pay cash in exchange of some service and who does not take any other risk in our company beyond getting the paycheck. The value that a good partner adds to our company will compound tremendously in the long run, so 50% equity is exactly right.
Finding our first investors: work is thriving in our little company, we have an exciting product and people look interested in it, and unless our bank accounts are overflowing with money we will soon need funding in order to continue in business. But the Law says that an unregistered company cannot go on a public solicitation for funding. In this stage it is legally allowed to receive funding from our own family and friends, which we may compensate by offering equity in exchange for their money. Besides family and friends, another lawful possibility to get funding during this stage is to find an accredited investor: someone who has a $1 million balance in their bank account or earns more than $200,000 a year. This option comes down to networking and finding the right person to talk to.
Becoming a registered company: In order to provide equity to our first investors we must do the paperwork, which can be made with the help of a lawyer or an online service. Upon legal registration we can then issue common stock and provide a percentage of it to our investor friend. It’s also a good idea to set aside a number of stocks as an option pool, which will keep a balanced equity among the co-founders while setting aside stock for new investors to buy in the future. Let’s say that we give our investor friend 3% of equity, and we set aside 25% of stock for the option pool. Both our co-founders would then get 36% of shares each, therefore keeping equal ownership of the company.
Growing up and away: With our initial funding we might go so far as to start production, but in order to stay in business we must get more funding and this implies diluting the shares of the company. This might sound displeasing because it means having less control over our company as well as giving away dividends, but we must remember that owning a smaller part of a larger company is way more profitable than having a big share of a little company. And if we do not grow as a business, we might just disappear from the market. During this stage of expansion we have two options and either way we go, it is important to carefully consider the source and the purpose for every round of founding we do, always choosing respectable investors and never accepting more cash than necessary:
- First and foremost is the Angel investor, an individual who will give our company a substantial amount of money in exchange for equity. The exact amount of money will be determined by his valuation of our company. For example: we own a company that currently has $150,000 in capital, and we find an Angel investor who sees our product and believes that our company is worth $2,000,000. He will agree to invest $250,000 in funding, and we should give him equity for the amount of the investment divided by the sum of the initial worth of our company plus the new valuation. Following our example that would be: $250,000 / ($150.000 + $2,000,000) = 5/43 of the company would be his property now, so %11.63 of the shares go to him.
- Another alternative is to become part of an incubator or an accelerator, and by giving them 5-10% in equity we would get money (not as much as the average Angel investor, though), space and equipment for working, and consultants who can provide valuable guidance to our enterprise.
The entrance of Venture Capital: When our startup has made progress on the marketplace and the buzz is out, powerful people will want to buy-in on our business. With investments of $500,000 or more, the VC funding round comes with the same deal as the Angel investor: there is a new valuation and the same formula applies to calculate the equity to be issued, which also entails a new dilution amongst the previous shareholders. In this stage our company has become a recognized player in the field, and we can try several more rounds of VC offerings, as needed, which ultimately will lead to one of three possible outcomes:
- After several rounds of funding our business flourishes and we decide to enter the stock market. That would be the next stage.
- We use the funds to grow our business and we attract the attention of a larger company, which will acquire us.
- The funding does not come about, the cash runs out and we must file for bankruptcy.
Going public: In our hypothetical example, our business is booming and so far we have been raising money by issuing restricted stock, which are shares that cannot be traded directly for money. In order to achieve our Initial Public Offering the company must be verified by the government, which will entitle us to issue unrestricted stock and to sell them in the stock market to anyone who will buy them. This opens excellent prospects for us to easily get funding, and the investors get to own shares that can be readily converted into cash according to their market price.
Perhaps our previous shareholders, including the co-founders, will want to convert their holdings into unrestricted stock as well. Also we might get the attention of investment bankers such as Morgan Stanley or Goldman Sachs, who will offer us to be our lead underwriter: they will prepare the paperwork for the IPO and will also find clients interested in buying our new stock. In return, the lead underwriter gets 7% of the money raised in the IPO itself, which could amount to $100,000,000 or more.
From this stage on, the value of our company will be tied to the market price of our stock, which in turn depends directly on the ongoing valuation that the public does on the quality of our product and the overall state of the industry.
How Startup Funding Works: A Basic Guide
You Have a Startup & You Want Money.
Any business has to start at virtually the same place. They begin their startup journey with a set amount of capital and wish to grow their business with what they have, but the initial capital is not always enough. Unless you have an endless stream of money from an already successful business venture, you are going to have to look for outside sources to fund your growth potential.
Outside investors are not going to take your word that your business will grow. They need something else to back up your claims. They need to know that they are making a sound investment in a company that will ultimately make money even if it is currently not. Here is how startup funding works.
Seeking Out Potential Investors
When starting up a company, your first likely form of investors will come from your own personal family and friends. This will increase your ability to further your company, but it is limiting and can be quite stressful when family gets involved in your business. Once you have exhausted these investments and wish to grow even further you have to seek out potential investors into the company.
Attracting investors is not easy, but if you are looking to compete with big business down the road, it is a step that must be taken. Throughout your business career you will be making contacts with individuals that have influence with high end clients.
Using that influence to garner meetings with them is how you will initially get your name into their minds. It is vital that you present your business along with the investment opportunity in a tactful way. These investors have seen many different pitches throughout their business careers and are not going to waste their precious time just talking to anyone.
How They Will Value Your Investment
It is vital to understand every part of how startup funding works. It is not just about the pitch to the potential investor. If your company has not been in business for many years and therefore do not have the past record of growth to entice the investor. They will evaluate your company based upon its individual valuation. (On a sidenote, you can wear your company’s startup logo on a T shirt and impress investors that way).
A company’s valuation is not based on the past, but on the perception of the future. An investor will look at your company from an idea point of view and evaluate based on what you have already established within the company and what you need to grow further.
A savvy investor understands that the growth of a company is not just about what has been accomplished, but the value of getting involved with a company with a ground floor investment. The investor also looks at the business owner’s past business ventures. Those that have been successful in the past are looked upon as a sound investment and can be trusted with much larger sums of money in the beginning.
The amount of money you are able to gain is not as important as what you plan to do with it. An investor desires to see growth within the first 18 months after they have invested into the company. The investor is given a stake into the company in return for the upfront investment. The growth is dependent upon how the money is allocated and the marketing of the product being offered.
How to Determine Startup Valuation
It is common for people to believe that every idea they have has value, but in the value that you hold for your startup is not as important as how the public will view it and how the investors see the potential for growth. Valuation is actually based upon your competition that sells similar products. To calculate and determine your valuation, you have to find those companies that are similar to your own and look at their past history.
You need to see how many times their valuation determination was larger than their revenue by taking the enterprise value and dividing it by the earnings of the users. This gives you your multiplier which you can use to multiply your revenue by. Using this multiplier, you are able to take revenues from this month, year, and next year and also factor in your best as well as worst case scenarios. When you triangulate the three cases and project when the startup will exit you can discount the earnings by the time value of the money and the final result is your overall valuation.
The entire process may seem a little complicated, but the investors have to know that your company is a sound investment before they are able to release the funds that you need. Understanding how startup funding works is necessary if you are going to attract the right type of investors and get your company off of the ground floor. Once you get funding going, you can invest in a startup accountant and become much more legitimate in the eyes of investors.
Knowing your company’s valuation will show investors that you know how the process works making them realize that you are a hard worker and willing to do what it takes to grow the company. The investors are out there and knowing how to attract the ones that you need will ultimately take you startup to heights you would have never previously thought possible.
Additional Startup Funding Resources
- Berkeley startup resources
- Caltech funding opportunities
- Kaust innovation fund
- Georgia Tech research using evidence-based entrepreneurship
- USC entrepreneur ecosystem