10th December, 2021
Raising capital via private equity is an established process for funding startup businesses. Here’s how it works.
When it comes to running a startup, the saying “it takes money to make money” could not be more relevant.
Research has found that around 90 percent of all startups fail eventually. Some fail in their early years, while it can take others more than five years to reach the end of the line.
Running out of cash and lacking a product-market fit have historically been the most commonly cited reasons for startup failure, and of those two, data suggests that failure to secure enough capital is more prevalent.
With access to funding being such a crucial factor in a startup’s ability to succeed, knowing the ins and outs of the capital raising journey is key for any would-be founder looking to bring their startup idea to life.
Capital raising is all about appealing to other parties to put funds towards a business and incentivising them to do so by offering something of value in return.
Generally speaking, there are two forms of capital raising: ‘debt’ and ‘equity’.
When it comes to the debt model, the capital is considered a loan to the business, and is paid back with interest.
Capital raising through equity, on the other hand, is when the investors are given a percentage of the company’s shares in return for their capital.
For the purpose of this write up, we’ll be focusing on the equity model of raising capital, and more specifically, ‘private equity’ — where the capital is raised through private investors who focus on investing in high growth potential startups.
Raising capital through private equity begins with the startup founders pitching their business idea to select investors (or groups of investors) who have expressed interest in investing into their startup.
Assuming the pitch goes well, the private investor offers money in exchange for a stake in the company – which is generally calculated based on the most recent valuation that the startup underwent.
Once all of the details have been finalised, an investment term sheet is prepared, and once executed, the investors effectively own a portion of the startup.
Most investors will only be willing to offer funding to businesses with some sort of track record. They generally want to see a pipeline of customers or a very impressive offering.
But creating such an offering and building a decent pipeline takes a lot of time and effort, and also requires capital.
That’s where Pre-seed and Seed investment comes in.
This round is for the founder to begin their market research, product or service wireframing, begin their recruitment efforts and other business setup costs.
It generally comes from a group of people who are referred to in the startup world as the ‘Three Fs’ – being friends, family and fools – as professional investors will generally be too risk averse to offer funding in such early stages.
Often, Seed funding can be received from accelerator or incubator programs, which generally accept multiple cohorts of early stage startup founders each year and offer them a vast range of resources in exchange for equity.
Seed rounds will generally be anywhere between $100,000 and $2 million
For instance, a Kiwi startup called Segna recently closed a $125,000 (USD) seed round, which it received from a prominent accelerator program in the US called Y Combinator.
After raising seed funding, some founders opt to end their entire capital raising journey. These founders are generally confident that they can begin to generate enough revenue to start turning over a profit at this stage and reinvest their profits into the business. Growth under this model may occur more slowly, but it is also far less risky and allows the founders to retain a larger stake in their company.
For those founders who are looking to grow quickly and on a large scale, their burn rates tend to see their seed funds run out quickly and their revenue generally barely covers costs – which leads them to undertake a Series A round.
Series A rounds, which are generally between $2 million and $15 million in size, tend to attract early stage investors who see great potential in the new venture.
This is not always the case though. In fact, Melbourne-based hospitality startup Mr Yum just announced that it closed its Series A round at $89 million, breaking all sorts of records for an Australian startup.
Generally speaking, a Series A round will only attract investors if the startup is able to demonstrate genuine traction – which can be in the form of revenue (and revenue projections), customers, expressions of interest, or any other convincing metrics.
Data from CB Insights has shown that most ‘high growth’ startups do not make it past the Series A phase, making this particular round particularly difficult to secure – a phenomenon known as the “Series A crunch”.
But if you can make it through this crunch, then sooner or later you’ll be looking for some more funding to satiate that growth appetite and scale even further, which is when the next rounds start to become relevant.
If your business is exploring these rounds, it means that it has matured from the ‘startup’ stage and is now in the ‘scaleup’ phase, where major expansion efforts are ready to kick off.
Series B rounds generally attract investors who are there to help the business strategically increase their reach through additional customers, whether they be locally or internationally. Series C rounds take this growth one step further and are generally geared towards purchasing and absorbing other businesses and making other strategic business shifts that enable the business to capitalise on the market share they have successfully captured.
These rounds tend to span from $10 million to $30 million, and once a Series C round has been secured, the founders are normally in a fairly strong position to start considering an Initial Public Offering (IPO), or even a buyout.
Seed to Series C rounds are all about building and growing to a point where a company is in a strong enough position to sustain itself through its own profits, whereas Series D and E rounds serve a different purpose.
Founders tend to entertain Series D or E rounds if they have identified a new opportunity in the market that requires additional funding to bring to life.
Reasons for why a founder may consider a Series D or E round instead of heading straight to an IPO may be to increase the value of their company prior to going public, or if they are looking to remain private for a little longer and need a capital top up to do so.
Raising capital privately will only take a business to a certain point, and once that point has been reached, the next phase of the journey is listing the company on a public stock exchange.
This allows the public to purchase shares of their own in the company, and as the company succeeds, dividends are paid to these shareholders.
However, going through an IPO is a complex process that requires professional guidance and support.
Recent examples of startups that wrapped up their capital raising efforts and subsequently underwent IPOs include Australian Fintech startup Butn – who recently listed on the Australian Stock Exchange, and TradeWindow, who also recently went public on the New Zealand Stock Exchange.
Once a company is publicly listed, it needs to prepare and release a series of public reports on a regular basis to ensure that complete transparency is maintained to all current and future shareholders.
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Naturally, startup valuations tend to be more like estimated valuations, or projections – especially in the earlier stages of the business. And like with most estimates, they can be conservative, neutral, or aggressive.
Given the importance of cashflow, it can be tempting for startup founders to take an aggressive stance with their valuation and inflate the number as much as possible to attract larger amounts of capital.
One only need turn to WeWork’s heavily inflated valuation back in 2019 to understand the risks associated with such practices. In that instance, what was promising to be one of the largest capital raises in history led by high profile investors with very deep pockets, ended up hitting a brick wall and ultimately scuttling completely.
From the Pre-seed phase right through to IPO, capital raising is exciting and potentially rewarding, but is also challenging – which is why seeking the right guidance is really important.
Those undergoing this journey need to be counselled with the right guidance at every step. Good accountants are needed to help with business valuations, sharp lawyers should be reviewing all contracts and term sheets, and the guidance of business owners who have successfully seen startups through these growth phases is extremely important as well.
If you can get the right team together to walk you through the journey of capital raising, your startup will be in a strong position to reach its genuine growth potential.