Many startups begin with bootstrapping—the founders financing the business themselves—or with the contribution of family and friends. However, as the business grows, so does the need for more financing, and the funds available from these sources are now insufficient. It may therefore become essential for the startup to seek external funding sources.
Equity financing involves investors financing startups that have the potential for long-term growth. In exchange for this funding, the investors receive shares/stocks in the startup. These investors could be angel investors, private equity firms, or venture capital firms. Angel investors are usually wealthy individuals who invest their capital in the early stages of a startup. Venture capital firms are typically larger institutional firms that invest from a fund of pooled assets from their investors.
Equity translates to ownership. Generally, equity financing rounds begin with the seed/angel round, continue with Series A and B (as many rounds as necessary), and conclude with an exit. A funding round can take three months to a year, depending on certain factors. Usually, specific goals need to be met after a round before subsequent financing is provided in the next game.
The Series A -Z rounds (labeled as such to signify the order of the round) are for the growth of the company as the company takes off and expands in operations. It is typically expected that the startup shows considerable progression in between rounds. The end goal for many startups is either going public or getting involved in a merger or acquisition (the exit). Not all startups must go through Series A – Z to raise sufficient funding. Many typically stop at Series C before going public.
A direct equity round typically begins with the founders sourcing for investors. After research and careful selection of the investors to approach, the next step is usually preparing a pitch deck, executive summary, and financial statements.
A Pitch deck is an opportunity a startup has to convince potential investors to invest in your startup. It should include information about who you are, the problem you have identified and the solution, how you plan to make your investors’ money, market size and opportunity, and how you plan to grow your market. Other information on who your competitors are, what differentiates you from your competitors, and what you need from your investors will be helpful in a pitch deck.
You can incorporate live demos, photos, charts, graphs, infographics, and screenshots into a pitch deck. More importantly, You should tailor the pitch deck to suit the requirements of the investors; the research earlier conducted on the investors will come in handy here.
After presenting the pitch deck, many venture capitalists will require the startup to conduct Alpha and Beta testing—internal and external testing of the startup’s product or service to validate its functionality and compatibility. After the investors have been persuaded and begin to consider funding, the next stage is usually negotiations with term sheets. A term sheet is a non-binding formal agreement between a founder and an investor before executing a more definitive agreement that legally binds the parties. Some clauses in a term sheet include the company valuation, drag-along and tag-along rights, investor consent rights, board approvals, confidentiality rights, etc.
Other documents needed include the Stock Purchase Agreement (SPA), Investor Rights Agreement, Certificate of incorporation, etc. Unlike the term sheet, the SPA is a legally binding contract that establishes all the terms related to the sale of company stock and transfers ownership of the stock.
Before investing, the investors also conduct due diligence (DD), which involves verifying information and documents of the startup. In executing a DD, investors typically utilize many professionals, such as accountants, lawyers, business analysts, etc., to identify risks or inconsistencies and ensure that they make a guided investment decision. The investors typically request a list of documents and requirements from the startups to conduct a DD.