Understanding the Different Startup Financing Stages

Characteristics, dynamics and priorities entrepreneurs need to know along the company’s journey

Photo by Maria Angelova

Summarizing a brief list of key points in each financing stage of a typical startup company’s journey based on my view within Thailand and Southeast Asia. This post also highlights the venture terms which I think are particularly crucial in each phase.

1) Seed — the first money & early rounds

Photo by Markus Spiske

Labeled as: Pre-Seed, Seed, Pre-Series A

Done by: founders, friends & family, angel investors, microfunds

Focus on: Business validation (‘direction’)

• The first investment(s) into the company as the company is still testing around and figuring out the direction to pursue like navigating in a desert.
• Mostly comes with almost no or very low due diligence activities, rather in a ‘trust and guts’ fashion.
• Also involves least negotiation and lowest legal cost. Most of the deals are done with very simple, standardized documents as the company’s core priority is on validation and survival.
• Terms are expected to be concise and straightforward, including valuation, which basically uses a rule of thumb price range, determined by a simple grading/scorecard system and competition level among investors.
• However, here is where the most critical mistakes frequently happen. Founders are often stuck with some bad terms as they are desperate for a first external cash to give a boost the company’s morale, impacting subsequent financing over the life of the company.
• Always keep in mind that good deals at the moment can become the bad ones for the company later on, because high price always come with high expectations, and failing to deliver such performance will be a problem in the next round financing as founders will find it almost impossible to make both existing investors and new investors happy. For example, unhappy seed investors may try to block the new financing of the company if there’s unsatisfactory upside relative to the earlier risks they took.
• Angels will often play a more active supporting role than microfunds as they make personal investments into fewer companies which they are comfortable in adding value from their domain expertise, and more importantly, personal network which can be highly valuable in this region of Southeast Asia. Microfund managers, on the other hand, do a lot of deals (20+ companies) and focus more efforts on helping the company secure the next investment.

Key Terms:

• Financing Amount — be realistic and get the capital needed as least as possible (contingencies reserve is good, but never too much) because company valuation at this stage is still small, generally set within the range of like $0.3–2.0M.
• Investor Number — the cap table can get ugly easily especially when seed rounds often involve the founders’ own network of friends and families. Only accept smart money, and don’t ever let the round become a party feast. A messy cap table and board of directors will only cause problem to the subsequent fundraising rounds where the investors will have to negotiate and clean up for the company.

2) ‘A’ round — the first institutional investment

Photo by Igor Son

Labeled as: Series A

Done by: VC funds, CVC funds, super angels

Focus on: Revenue growth (‘momentum’)

• The first institutional round into the company as the company went through a few trials and errors, started to hit on a good signal and is moving with a clearer sense of direction (in startups there will always be moments of pivots and turnings but it won’t be a total hectic like in their early days)
• In this region, it is relatively common to have participation from corporations/CVCs for Series A rounds, so this can be considered as a big back-office clean up as formal due diligence takes place, including the financial and legal aspects. This will likely involve external auditors and lawyers who will assist with both due diligence for the investors and critical advisory for the company going forward.
• First major financing round also comes with the finer details for all important terms negotiated and filled up. In contrast to seed rounds where the only goal is to keep the agreement simple and compact, this is probably the most important round where founders should put efforts to ensure the details of all key terms are proper for the long run.
• It is very important to keep in mind that terms in Series A agreement will mostly set the standards for all subsequent rounds until an exit in a typical company life, including the progress of founders gradually having less control of the company and right to pay out priority.
• The process of formal terms negotiation can also be looked at as a chemistry test between the entrepreneurs and investors, whether going forward they would be a good fit and enjoy working together or not.
• If there’s any problem or difficulty working with seed investors, this will be the time to fix that up if the company can secure a good investor who’s willing to help. Any mistake in this round won’t be an easy fix anymore.
• Ideally, it is better to structure the round with a lead investor having the highest stake and clear ownership of the round, rather than a syndicate of party round (i.e., each investor putting in similar, minor investment amount). The problem of a party round is there will be no investor that feels a real ownership and commitment to actively support the company through this most challenging period.

Key Terms:

• Liquidation Preference — This term is very commonly found along with investors’ preference shares and should be treated carefully. It may seem like a small matter at the early rounds but all subsequent (and larger) rounds will always require at least the same right, which will only stack up and severely reduce the return of the founders’ common shares. There are a lot of exits which look good on the news but in fact the founders received very minimal pay because most of the proceedings went to the investors due to this term.
• Protective Provisions — Similarly, this term tends to add up as it carries over to all future fundraising rounds. Founders have to prioritize and negotiate out the items which may negatively affect their control and agility of the company. As the company grows and issues new classes of shares, it’s wise to try to group all preferred shareholders into voting altogether. Failure to optimize this may result in the entrepreneurs having to ask for permissions on almost every little things before the company’s able to take any action. Having a good track record and building mutual trust with investors can help in negotiating this.
• Redemption — This term is not very frequently seen, but can show up from time to time with various conditions such as time period, milestones or major changes in nature of business. Depending on the conditions and details, this can be a red flag or accumulate over subsequent rounds and should also be treated with care.

3) Post-A — subsequent growth-stage rounds

Photo by Irene Davila

Labeled as: Series B, Series C, and so on

Done by: VC funds, CVC funds, Corporations, PE funds

Focus on: Profitability (‘fundamental’) or Hyper-growth (‘domination’)

• Growth and Late-stage is when the company finally finds the road and speeds up to see how far its maximum potential can go.
• Post-A rounds are, in fact, less hassle with due diligence process as most of the data room are pretty much in place since the Series A round, and critical legal and financial issues should have already been addressed (subject to the standards of previous investors).
• Also provides a ‘reality check’ when the later rounds expect to foresee a sensible exit plan. With exception of hyper-growth scenarios, company valuation usually becomes less impulsive over time because the party needs to stop at some point.
• Terms from the Series A round will be the baseline for negotiations and most of the talks will involve asking for the same or superior right in each term for the new investors. A few new terms may be added and existing investors may assist the founders with the decision.
• One of the major challenges for the more mature stage is the composition and complications of the board of directors. Founders will have to protect their control and interest of the company while keeping the increasing faces of investors happy. Ensure the chemistry between the investors is positive, or a bad blood among the directors or shareholders can cause a huge headache for the entrepreneurs and adversely affect the company.
• Nonetheless, it is very important for founders to keep in mind that the board of directors are not devils in suits. Their primary objective is to increase the value of the company on behalf of shareholders, and in the end it is about trust, being open and having empathy to each other.

Key Terms:

• Board of Directors — Board composition and voting control becomes increasingly important as the entrepreneurs want to maintain the control while the lead investor in each round will normally demand a board seat. In good scenario, understanding investors will try to behave well (balancing between their own interests and the company’s value) but in bad ones the founders will unavoidably be spending more time with the board and less on the company. Increasing the board size too much will practically kills the efficiency, so the key is to keep the board compact along with alternative approaches such as setting a cap on the number of directors from investors or set up a new tier of committee.
• Valuation — Understandably, after a considerable journey the nicest numbers are always tempting. Founders need to keep things rational, or they will find the probability of a happy ending (e.g., getting bought out or listed) very less likely, with the craziness of the price tag coming back to haunt the company.

This post is a part of my Venture Fundraising Basics series where I will try to share the fundamentals of raising venture capital for entrepreneurs and some local perspectives from my experience in Southeast Asia. For the complete outline and links to other posts, please visit here.

Note: All contents and opinions expressed in this story are humbly of my own and do not represent those of any of my current or previous employers.