For many startup founders, what led them into the risky but thrilling world of starting their own company was technology, innovation, the ability to affect the world, and the freedom of being their own boss. Learning the ins and outs of raising startup capital, attracting investors and understanding how to comply with state and federal securities laws is probably not at the top of the list of a startup founder’s most favorite things. But, given that the vast majority of startups will rely on outside financing in their early years while they progress in stages of production and expansion, their founders are going to eventually need to do some real-world study in the basics of how raising capital works in order to grow their business while protecting their vision.
Types of Startup Capital
When we talk about capital raising in the context of startups, we are generally talking about raising money for non-public companies that do not have significant revenue. Oftentimes, these are companies that are developing a new product and/or technology, and so, in the absence of sizable revenue, money is needed to fund the company as it prepares its product or services for market.
For startups, most capital is either equity or debt that is convertible into equity. Equity capital is not debt, like a business loan, but rather an ownership stake in the company, which gives the financier rights to the future profits and value of the company as well as, in many cases, a say in how the business is run. Anyone who purchases stock in a company has capital in that company. Because of state and federal securities laws, it has traditionally been the case that only certain types of sophisticated and/or wealthy investors were allowed to invest their capital in a startup, but some of those restrictions are changing with the onset of crowdfunding equity rules.
Stages of Startup Capital
While no two startups’ path to getting funded is the same, startup financing does tend to have certain distinct stages. These stages may be referred to by a variety of names, but generally, they are as follows:
- Seed Stage/Seed Rounds: This is the earliest stage, and at this point the business may just be the founder and possibly a few co-founders or employees. The startup is still figuring out its product and business plan and needs funds for basic salary, research and operating expenses as it works toward finding a market. Seed stage rounds tend to be small and usually take the form of convertible notes, convertible SAFEs or common equity.
- Startup Stage/Angel Rounds: Here, the startup is moving out of its ideation and planning phase into actually beginning production and/or entering into the market. The startup may or may not be bringing in revenue but, in either case, is most likely operating at a loss, necessitating further capital funding by so-called “angel” investors looking for high potential returns on investment. Angel rounds are the most diverse and can take just about any form: convertible notes, convertible SAFEs, common equity, preferred equity, warrants, or something else entirely.
- Expansion Stage/Venture Rounds: At this point in a startup’s lifecycle, it is finding new business and/or revenue sources and expanding beyond its startup origins. Funding may be needed for increased marketing efforts, new retail locations, increased hiring and recruiting, etc. Venture capital firms and other institutional players often enter into the picture at this stage to provide increased levels of capital. Venture rounds are usually large and take the form of preferred stock.
- Bridge/Pre-IPO Stage: A successful startup at this stage is now moving towards self-sufficiency either in the form of sustainable revenue streams and/or through an exit event such as a sale of the company or an initial public offering (often known as an “IPO”). If the company does decide to go public, the IPO process can be lengthy and expensive, thus financing—often provided through venture capital firms—may still be necessary to fund this process and maintain the company’s growth on through to its next stage.
Founders Have More Startup Capital Options Than Before
For those startup founders who are just getting into the process of seeking outside capital, they are probably more in the seed or startup stages described above—either still developing products and/or services or still finding its bearings in the market. At this point, engaging venture capital firms may be premature, and even angel investors may not be available to provide sufficient capital on agreeable terms. The good news for startup founders is that recent changes in the federal securities laws now make equity crowdfunding (as opposed to rewards-based crowdfunding, a la Kickstarter) among so-called non-accredited investors (meaning those who do not meet wealth/income requirements) a reality for startups.
While these new rules have just been established and we’ve yet to see how they will play out in the markets, they should make the process of raising equity from new investors much easier. Under the Title III Crowdfunding Rules, businesses will be able to raise up to $1 million in a given year from investors (including investors who are not accredited investors) via crowdfunding portals. Crowdfunding strategies may also be used under Rule 506(c) to raise unlimited funds from accredited investors. Many states are also allowing startups to conduct crowdfunding equity within state borders (so-called “intrastate crowdfunding”). And while not technically crowdfunding due to more complicated registration requirements, new rule Reg A+ also gives startups the ability to raise up to $50 million in a given year from unaccredited investors.
Given these new rules allowing startups to reach unaccredited investors and employ new capital-raising strategies, it’s never too early for startup founders to begin assembling a plan to attract outside capital.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.