How does venture funding work?

Overview

Weekly headlines on TechCrunch and other startup and fundraising blogs make raising several rounds of seven-figure-plus funding sound like a walk in the park. 

It’s easy to get the impression that a crowdfunding page is all it takes to land a million dollars to play with. But this isn’t the case, at least not for most startups. The truth is, when launching your startup, finding the initial capital feels nearly impossible. 

Here, we’ll teach you about each round of investment in detail, including what investors want their money to be spent on, opportunities, and pitfalls. We’ll also answer the following questions:

  • How does funding work?
  • What is Pre-Seed funding?
  • What is Seed funding?
  • What is Series A funding?

How does funding work?

First, it’s helpful to know what venture capital means. Venture capital is money from private investment funds or companies which is used for the development of startups in their very early stages. A venture capitalist (VC) buys an equity stake in the company being funded. Venture funds may invest in startups as early as the idea level, if it looks promising, in hopes of big profits in the future.

The distinguishing feature of venture capital investments is the high degree of risk. CB Insights found that “70% of upstart tech companies fail – usually around 20 months after first raising financing (with around $1.3m in total funding closed).” However, the venture-investment business model aims to find a single successful investment that covers the losses of all the investments that fail.

Venture investors are trying to find a company that may become the next Facebook, Amazon, or Netflix. When investing in this early stage, their aim is to generate a 100-times return on that investment: finding a small startup that might grow into a large company and turn a $100k stake into $10 million. That’s what makes venture investments most profitable – but also the most risky. To better put this into context, 6% of VCs’ deals produce 60% of their returns – but half lose money.

As a rule, venture investment occurs during the first seven to 10 years. Investors subsequently sell their shares in the company on exchanges or to strategic buyers. 

To understand how venture investment works, it’s necessary to be aware of the developmental stages that startups go through:

  • Idea development 
  • Early venture
  • Growth. 

Each of these is associated with an investment stage. Conventionally, there are several defined stages: Pre-Seed, Seed, Series A, B, C, D, and typically as far as E. In theory these stages can go on indefinitely but normally the startup is sold, goes public, or no longer requires investment.

More detail on the first three major stages of investment is given below. 

 

What is Pre-Seed funding?

The Seed round was typically the first stage of funding – but increased competition within the marketplace has led to the creation of a Pre-Seed round.

The founding team generally receives a small investment to achieve one or more of the milestones required prior to raising a larger Seed investment. Funding comes from founders investing their own resources to start their startup, including funds from family and friends. They may also investigate options including grant financing, funds from private investors (business angels) with expertise in the relevant industry, or a new generation of Pre-Seed-specific funds. 

Not everyone has access to funds from family and friends, or connections to Pre-Seed investors, and therefore may struggle to access sufficient finance. 

Startups raising Pre-Seed finance are still expected to have an initial product and revenues (even if only in the hundreds or small thousands of dollars). This investment allows the hypotheses of the startup to be fully tested, expanding the concept and product. 

By enabling an improved version of the product and access to more revenues, some of the assumptions in the business model can start to be proved. It’s common for the initial product concept to completely alter after the minimum viable product (MVP) release, creating a change in direction at this stage. 

Pre-Seed investors put a lot of emphasis on the startup team, not just its idea. If you or your co-founders have worked in a large company at a senior level, or already have experience in launching startups (if not necessarily successfully, at least ones with good prospects), they will invest much more willingly. Their main questions at this stage will be whether they trust you with their money, and whether you have a good understanding of the startup you’re dealing with.

Average valuation of Pre-Seed-stage startups:

  • Funding range: from £250k to £500k in the UK/EU, and up to $1m in the US
  • Valuation: from £1m to £2m (UK/EU), and $3m to $5m (US)
  • Equity and runway: Expect to sell 20% to 30% of your startup to fund 12 months of runway

What is Seed funding?

The second stage of investing usually stimulates more substantial growth for a startup. At this point, your startup will be showing strong signs of initial growth, and have not only a team and a product, but also one or more sales channels. 

The task of a startup at the Seed level is to accelerate growth (quantity of customers, client segments, geography, etc). New investments also help fund team expansion and take on additional talent, to grow beyond the founders and a handful of employees – as well as enabling further product development.

When the team is in place the expectation is that sales volume needs to be multiplied without further increases in staffing or overall costs to the company. 

By the end of the Seed stage, the aim is to establish a repeatable business model, and capture the largest possible market share in the shortest possible time. By the end of this stage, your startup should have proved its unit economics and achieved product market fit.

Average valuation of Seed-stage startups:

  • Funding range: from £750k to £1.5m in the UK/EU, and $2m-$3m in the US. 
  • Valuation: from £4m to £6m (UK/EU) and $6m to $10m (US)
  • Equity and runway: Expect to sell 15% to 25% of your startup to fund 18 months of runway

 

How to get Seed funding

Raising Seed funding is a major accomplishment for a startup. You need to convince investors of your team’s quality, but they will also now be looking for evidence of product metrics and traction. 

By this point, startups should have developed a product prototype, tested the market, and readied investor interests necessary for future financing rounds. Such steps require significant research and planning. In a nutshell, a Seed funding presentation should demonstrate the product’s unique value, the startup’s achievements, and the founders’ reasons for pushing their concept to market. Having done all this, you should be able to create a solid pitch deck. Check out a great template from Sequoia here

 

What is Series A funding?

The jump from Seed to Series A is often seen as the hardest transition a startup has to make. At the Series A stage, the startup should have a team, a product with verified sales channels, and significant amounts of money flowing into them. 

This is the stage of rapid growth. 

Reaching this point will allow you to attract not only money, but also expertise and connections; the ‘smart money’ that can help your startup hit big. 

By Series A, your startup must have developed a product and customer base with consistent revenue flow. Significant revenue growth needs to come from new customers, as well as an increase in the average revenue per customer. Main goals include the organisation of mass production, or 24/7 service work, 365 days of the year, with the recruitment of a fully fledged team. 

Marketing and sales become a major focal point at this stage, in order for the startup to:

  • Understand its customer base 
  • Develop new sales and marketing processes
  • Identify growth opportunities across different channels.

Average valuation of Series A-stage startups:

  • Funding range: from £3m to £10m (usually in the £4m to £6m range) in the UK/EU, and $5m-$10m in the US. 
  • Valuation: from £10m to £15m (UK/EU) and $20m to $25m (US)
  • Equity and runway: Expect to sell 15% to 20% of your startup to fund 18-24 months of runway

 

How to get Series A funding?

Before this stage, most startups generate only passing interest among large investors – whereas Series A funding creates competition between funds, and gives access to a new class of investor able to write larger investment cheques. 

To qualify for a Series A funding round, a network of contacts with potential business partners should typically already be well-nurtured among the people that founders have built relationships with. 

Lasting business relationships don’t happen overnight, since it must be possible to demonstrate that your startup is trustworthy and capable. Meeting potential investors ideally takes place as early as possible, to give them an idea of your future goals. This can be very time-consuming, meaning that founders spend the majority of their time doing this instead of building their startup. 

 

Beyond Series A

The journey continues after Series A:

  • Series B: Series B aims to grow the company fast enough to keep up with the demand generated in Series A. That might mean you need funds to hire sales teams to go after international markets, move into new lines of business, etc. 
  • Series C and beyond (D, E, F…): At this stage startups are gearing up for the exit and are now focused on accelerating activities beyond what was accomplished in Series B. Here, funds might go toward acquisitions, product launches, and other activities aimed at “winning the market.
  • IPO: At the initial public offering (IPO) stage, the focus shifts toward making shares of a private company available to the public on the stock market to raise additional capital. The benefit there is, companies can access more money faster, free up liquid capital, and attract top talent by incentivizing new hires with stock options.