The Three Funding Phases of a Startup

Some of the myths about raising money in a startup are all too familiar. “I just need to be introduced to the right person.” “I will put my idea on one of those crowdfunding platforms.” “Once my prototype is done, everyone will want to fund me.” Or, my favorite, “We will bootstrap with [students/interns/work for stock] people.”

Raising money for your startup is not the result of some elusive magical incarnation. It’s a step-by-step methodical process, just like any other business activity. Raising money is not complex, but it is a lot of work. Maybe that is why so many people cling to the myths.

The Three Funding Phases:

Most startups go through three distinct funding phases:

  • 3Fs (Friends, Family, and Fools)
  • Seed, or Angel
  • Venture Capitalist (VC)

There are funding rounds beyond VC, but for our purposes, a startup is not a company that just raised tens of millions of dollars.

Each phase has its own strategy, with a specific mission and method. The key is to accomplish those tasks that will qualify your startup for the next funding level and not get distracted with tasks related to the next round. The method is very similar to marketing and selling anything–fundraising is a marketing and sales activity.

People raise money at every stage of the startup. It is true that a VC will not invest in your company unless you have a proven, repeatable business process, but Angel investors might invest before this stage. It is a myth that there is a funding gap. There are, however, entrepreneurs who will never raise any money, and the funding gap is one of the excuses they use to make themselves feel better.

The 3 Fs:

Let’s be real, shall we? In the beginning, you have nothing but an idea and ideas have no monetary value unless they are acted on (execution). Yes, maybe the idea will one day become a successful company, but that does not mean you will be the person who started that company. In all likelihood, several other people have the same idea. If they don’t, then your idea might not be viable. Your original idea will likely evolve, and many other important ideas will be added to it before it gains real value. Thinking an idea is worth money is one of those terminal mistakes a startup can make.

In the beginning, when you just have an idea, but no evidence of your ability to execute, the only investors you’re going to close will be friends, families, and fools. Friends will write a check because they feel obligated. The family will write a check because love is blind. Fools will write a check because they are ill-informed. Most 3Fs will write very small checks, which is a good thing for them. Fortunately, at the 3Fs stage, you do not need much money. Typical 3Fs funding is less than $100K, and sometimes zero.

Your mission in the 3Fs phase is Market Validation. You need to provide empirical evidence that you can turn your idea into a repeatable business system. For more info on how to do this, read our white paper: (How to Raise Money for Your Startup).

Seed Round:

Once all the checks clear from the 3Fs and you have used this money to validate the market, you’re ready to start working on the seed round. Typical seed rounds are $500K to $2M. Generally, several Angel investors will write checks for “smallish” amounts ($50K) Sometimes they are syndicated in some way, like an Angel group or private family office. Sometimes seed money comes from strategic–companies that stand to gain significantly if you’re successful.

Your mission in the 3Fs round was Market Validation. You need to convince an Angel investor:

  • You are solving a problem people will pay money to solve.
  • What they are willing to pay is enough for you to make a profit.
  • You have the ability to create and execute a business system that generates repeatable revenue.
  • You will be able to spend $1 on Sales and Marketing and generate $10+ dollars in revenue.
  • You can develop the product for some reasonable amount of money.
  • You can make the unit for $X and sell it for significantly more.
  • You can raise a VC round.

VC Funding:

Once we have closed on the Seed round, our mission is to build a prototype business that generates a repeatable profit, or would generate a profit if scaled. A VC invests in companies that, if scaled, will grow rapidly for an extended period of time and make a profit. They are not interested in theoretical businesses; they want to see proven businesses with customers and profits. They need to see:

  1. Satisfied customers
  2. High margins (or if not, would be if it were scaled)
  3. Repeatable Sales and Marketing processes
  4. A repeatable, well-controlled operational process (how you serve the customer)
  5. Ability to scale to a large business

Getting to this point is the hard part, but if you create such a business, finding a VC will be much easier.

Once you start getting traction (growing revenues, satisfied customers, fewer fires each day), you are ready for a VC round, assuming you need VC money. This part is not very complicated. If you have done your job correctly, VC has already found you. If they have not found you, it is easy to get their attention. First, do research to determine which VCs will invest in your space (don’t waste your valuable time if they do not). If you really have traction, they will meet with you.

Get at least two VC, and try to get them to compete for you. Sometimes they will “co-invest,” which means they are trying to limit competition. That might not be the best way to get the best price for your equity.

Finally, remember that you will need a good lawyer, one who specializes in startups and knows how to negotiate term sheets outlining the deal terms.

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