The venture capital financing stage includes: formative stage financing, later stage financing, and mezzanine-stage financing. The three differ based on at which stage the capital is injected into the startup.
For example, formative stage financing provides funds at the formative stage, from developing the idea into a business plan and concept to the operation before commercial production and sales begin. Meanwhile, mezzanine-stage financing bridges the need to prepare startups before selling their initial shares to the stock exchange.
Each stage has a different type of capital. For example, investors usually provide money through common or convertible preferred stock in the formative stage. And management remains in control of the business.
Meanwhile, at the mezzanine stage, the capital injection could be equity and debt, such as convertible debt. However, this financing is used to go through the transition before the company goes public and does not become a permanent capital structure feature.
Before discussing the financing stages above, let’s break down briefly what venture capital is?
Venture capital is an investment by which funds from investors are allocated to finance young companies or startups. It is a type of private equity focused on investing in startups or young companies with high growth potential. Like other private equity strategies, investments are focused on private securities. For this reason, venture capital firms provide capital to startups before they go public.
Venture capitalists provide critical funding because conventional investors, such as banks, are often not interested in funding startups, considering the high risks attached to them. But, on the other hand, entrepreneurs need capital, more than can be met from their own pockets or loans from relatives or friends. So, their presence is required by entrepreneurs to grow and develop their business before it becomes viable and mature.
Despite the substantial risk, venture capitalists have the potential to make a lot of money. The startups they fund can become leading players by generating millions or even billions of dollars when they reach maturity. For example, Sequoia Capital invested $60 million into WhatsApp in a Series A to Series C round and raised around $3 billion after the acquisition by Facebook.
Formative stage financing
The formative stage is where the company is in the formation process. This is critical in determining how well a business can convince investors to secure the following funding rounds. Venture capitalists provide financing to develop business plans and concepts to build marketing efforts. Broadly speaking, financing in this stage comprises three different phases, namely:
- Angel investing
- Seed-stage financing
- Early stage financing
Angel investing provides capital to entrepreneurs in the idea stage, where they need money to launch their idea into a business plan and develop a business concept. They also need financing to evaluate market potential.
Funding at this stage is relatively small. Thus, financing generally comes from own pocket rather than venture capital companies. Or it comes from another individual, such as a relative or friend. Individual venture capitalists may also be interested in financing. They are what we call angel investors.
This stage is known as the first stage of venture capital. Sometimes we also call it the pre-seed stage.
Seed-stage financing provides capital to support product prototype development. In addition, funds are also used to support marketing efforts. Finally, owners also need funds to promote and convince investors to raise further funding.
At this stage, startup owners are trying to get enough funds to support the business. Then, they try to attract additional investors in the next funding rounds. Finally, they convince investors their product and business represent a viable investment opportunity.
Assigning management and hiring more executives is another job at this stage.
Typically, large venture capital funds enter at this stage. In addition, funding can also come from angel investors, startup owners, or relatives.
Early-stage financing provides capital to start operations before commercial production and sales begin. That could be Series A and Series B funding. Funding rounds could also involve Series C.
In Series A funding, investors are interested in financing because they see the startup potential. In other words, Series A investors are interested in measuring how potential startup businesses are financed.
Meanwhile, Series B investors are more interested in actual performance. For example, they assess whether products and businesses are commercially viable to support their next fundraiser.
In the Series A funding round, startups need quite a large amount of capital. They use it to hone the product and build a customer base. Improving marketing and advertising is another activity. The main goal at this stage is to show the business has an enormous potential revenue stream.
Meanwhile, the series B funding round funds were used to build operations. Startups need capital to create actual products and marketing efforts. Therefore, funding in this series requires a more considerable investment than the previous funding round, Series A.
The later stage sometimes referred to as the expansion stage, is the stage where a startup starts commercial production and sales but before the IPO. Startups need capital injections to drive more sales. In addition, capital is also used for aggressive marketing. Another focus is expanding production facilities and improving products. Long story short, this stage is where startups expand their commercial scale. For this reason, they need substantial capital.
Where will the funding come from at this stage, and what type? For example, startups may receive financing through equity and debt. And usually, management sells controlling interests to venture capital firms.
Meanwhile, funding usually comes from late-stage venture capitalists. In addition, investment at this stage may also come from banks and private equity firms.
Mezzanine-stage is also called the bridge stage or pre-IPO stage, where the startup has reached maturity and is feasible. Startups need capital to prepare companies to go public. In addition, they use capital injections for key corporate actions such as acquiring other companies. Or they use it to take steps to strengthen their market position and reduce competition.
And for venture capitalists, this is the stage where they will prepare their exit strategy. They try to dress startups as attractively as possible to attract the public when the initial public offering is carried out on the stock exchange. If successful, the public is highly interested in the startup’s stock and is willing to pay a premium, which means significant profits for them.
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