A guide to raising capital for startups
This guide was created in collaboration with:
Raising capital is a critical stage for most startups. We created this guide to demystify the capital raising process and explain in plain terms all the information you need to know around this important topic.
Stages of funding
When and why you raise capital will be unique to your startup. You may be looking to stay liquid while you further work on your business model, you might need funds to create or take a minimum viable product (MVP) to market, or you might be ready to rapidly scale: ready for not just the money, but the experience, knowledge and contacts that can come with investment. Whichever it is, it helps to have an understanding of the common stages in startup funding.
Pre-seed is the earliest stage of equity funding, when founders are still working independently or with a small team, and are yet to develop a prototype or proof of concept. Pre-seed funding often comes from family and friends, occasionally from an incubator or accelerator program or perhaps an angel investor.
Typical raise: up to A$150,000
As a startup works through the problem-solving phase and identifies potential market fit for their proposed product, seed capital might be sought to fund further development. Seed funding can come from angel investors or VC funds focused on early-stage investments. While determined by the traction, value proposition and commercial model, a seed round should raise roughly 12–18 months of operating runway. Seed funding is a key milestone for startups, but also the last stage for many, as those that don’t gain traction before their seed money runs out will most likely fold or pivot.
Typical raise: from A$150,000 to A$1,000,000
3. Series A
Series A funding rounds are undertaken after a startup has obtained some product traction and user base, and has demonstrated potential for exponential growth through revenue, KPIs or other metrics. The money raised in this round often comes from angel investors or venture capital (VC) funds and can be used to scale internationally, improve and optimise product, add to operational capability, and increase customer acquisition.
Typical raise: from A$1,000,000 to A$5,000,000
4. Series B
Series B funding rounds focus on scaling the startup. Capital is used to increase market share, grow the team and continue expansion. Series B funding often comes from VC funds and often from the same investors who led the previous round. It may also attract investments from later-stage VC funds.
Typical raise: from A$5,000,000 to A$20,000,000
5. Series B+
Further funding rounds are designed to continue scaling the company, whether by developing new products, making acquisitions, increasing market share, expanding internationally or preparing the company for exit. Series B+ funding rounds generally come from large VC funds, private equity firms, hedge funds and investment funds.
Different ways to raise capital
Startups that ‘bootstrap’ start lean and grow without the help of external capital. Bootstrapping relies on a founder’s personal finances and the reinvestment of revenue back into business operations. Common in the early stages for most startups, some choose this option ongoing as founders retain 100% ownership and control and can focus on rapid idea generation and building the business without the pressure of meeting the milestones and demands of investors.
However, without external capital, startups can’t scale as quickly, which might jeopardise their market position. In the innovation space, the ‘first in’ can leverage a bigger market share before competitors enter the market. It can also be difficult to grow, develop, iterate and expand unless the founder is independently able to fund marketing and acquisition activities.
Advantages of bootstrapping
- Ability to execute quickly
- Develop a lean mindset
- Easy to pivot
- Maintain central ownership
- Founder able to spend more time on business rather than fundraising activities
Disadvantages of bootstrapping
- Lack of external support
- Fewer opportunities for mentorship
- Limited access to networks
- Personal financial risk
- May limit ability to drive exponential growth
2. Equity-based fundraising
When startups raise equity funding, they issue new shares to investors in exchange for capital. Negotiation in an equity round centres on the company’s valuation and the rights and entitlements of the investor.
A valuation determines how many shares the investor will receive in exchange for the capital invested and their percentage shareholding after the raise.
A simple example of an equity investment equation for startups
If all investors stay in and gain equity on investment, as external investment goes up the founders’ share goes down (diluting ownership and sometimes control). But as the valuation of the company will increase over time, ultimately the value of your stake will also increase.
Example: If your share as a founder goes down from 50% to 20.4%, but the valuation increases from $50K to $10M, your financial stake goes up from $25K to $2.04M.
3. Family and friends
Friends and family can be an important source of early, seed-stage capital to help get an idea off the ground.
They’re a good, fast source of funds as they don’t necessarily require the formality of due diligence involved in commercial loans or investments. The associated risk gives the category its name – the 3Fs, with ‘fools’ added to ‘family and friends’ to indicate the potentially foolish nature of early investments. All parties need to be aware of the risks so that should your great idea fail, your relationships aren’t ruined.
It’s important that founders still apply a formal approach to confirm expectations and accountabilities. Before seeking funding, founders should know what kind of deal they want – whether equity or debt, what amount, interest rate or return – and it should be clearly included in your business plan. Startups should provide family and friend investors with at least a professional business plan as well as a SWOT (strengths, weaknesses, opportunities and threats) analysis. Holding multiple meetings to explain the business proposition and negotiating terms gives potential investors time to think it over. We recommend following formal protocol and using clearly defined term sheets and investor agreements.
4. Angel investment
Angel investors provide capital to startups in exchange for an equity stake during seed funding rounds. Angel investors might be professional investors, business executives, or high net worth individuals looking for investments with a possibility for a high rate of return. They might be a successful entrepreneur with skills and experience in the same sector or field as your startup. As a result, in addition to financial investment, angel investors can offer intellectual and network capital, providing startups with expertise, mentorship and growth opportunities.
Angel investors fill the gap between small-scale 3F funding and VC funding. They’re more willing to take risks than institutional investors and provide capital for early stage startups. However, they may require higher equity stakes in return, which represents ownership dilution for founders. Issuing convertible notes and simple agreement for future equity (SAFEs) is also becoming increasingly popular for angel investment.
As individual, unregulated operators, angel investors can be hard to find, unlike VC funds which are openly advertised and easy to research online. However as angel investors are less restricted, they can write cheques quickly and without lengthy compliance and investment committee protocols.
Angel investors sometimes form a syndicate to share due diligence and risks across their investments. Syndicates allow individuals to pool funds for smaller investments and share skills and subject matter expertise between their member base. Sometimes called investor-led crowdfunding, there’s more on this in the crowdfunding section.
Typical raise: from A$25,000 to A$100,000 for 5–15% equity
5. Venture capital
Typically the first institutional investment in a startup comes from a VC fund. VC funds manage investments from their investors, called limited partners (LPs). A VC fund makes investment decisions for its LPs, most aiming to make a 3x return as the end result.
The focus of a VC fund may be specific to an industry, lifecycle stage, or location. For example, a VC fund might only invest in Australian fintech startups, or fintech scaleups for international expansion. It’s therefore important to research the VC’s investment focus to ensure it aligns with your pitch.
The best way to approach a VC fund is through a warm introduction by someone engaged with the startup ecosystem. VC funds like to build relationships with startups well before they’re looking to raise capital.
Therefore it’s usually recommended that you begin approaching VCs about 12 months before you anticipate actually needing money. This can be as simple as an email with a summary of the problem you’re solving and a promise to stay in touch. This allows VC funds to interrogate the growth potential and veracity of the startup over time and better assess its chances of success.
6. Corporate venture capital (CVCs)
While most venture capital comes from an institutional venture capital firm making investments on behalf of individuals and groups invested in the fund as limited partners, a substantial amount of venture capital in Australia comes from corporate venture capital funds.
CVCs can provide startups with funding along with the opportunity to gain strategic leverage from an established industry player.
CVCs can either be set up internally drawing investment capital directly from the balance sheet, or as a fund managed by an independent manager. CVCs often look for synergistic investment benefits for the corporation they represent. CVCs invest throughout the venture cycle, although some funds have a specific preferred stage range. By investing in startups, CVCs benefit from fresh market insights, disruptive technologies and emerging products and services.
Founded in 2011, Telstra Ventures was the earliest of the current crop of venture funds, both corporate and institutional. Australia’s big banks began investing in corporate ventures early in this current cycle with Reinventure and IAG Firemark Ventures kicking off in 2014, NAB Ventures at the end of 2015, and ANZi in 2018.
Venture capital comparison
It’s worth noting that not all funds fall neatly into this table, it’s simply to provide a general overview.
|Differences||Institutional VCs||Independent VCs||Balance Sheet CVCs|
|Examples||Carthona Capital, Rampersand, Right Click, Tempus Partners, AirTree, SquarePeg||Reinventure, Telstra Ventures||NAB Ventures, ANZi, Macquarie Direct Investment|
|Objectives||Prioritise a high financial return||Prioritise a high financial return but look for some strategic relevance to corporation||Balance financial returns and strategic objectives of the corporation|
|Strategic leverage||Offer expertise in building companies and driving financial results||Combine company building expertise with industry knowledge and access to corporate assets, distribution etc||Offer in-depth industry knowledge and access to existing customer base|
|Follow-on investment||Typically reserve capital for follow-ons into each investment over the life of a fund||Typically reserve capital for follow-ons into each investment over the life of a fund||Can be subject to their balance sheet and the strategic direction of the company; changes in economic conditions or leadership may jeopardise future commitments|
|Exit options||Prioritise strong financial return on exit whether through an IPO or trade sale, liquidating their sale within a specified time frame, potentially via a secondary market if need be||Prioritise strong financial return; seek to engage the corporation as a potential acquirer where relevant but always as part of a contested sale process||Prioritise investment as an acquisition target, an original equipment manufacturer (OEM) partner, a channel for additional product sales or product integration|
|Source of capital||Third-party limited partners||Committed fund from the corporation often alongside a commitment from the manager and sometimes third-party funders||Often funded by the company’s balance sheet alone|
What do venture capitalists look for?
Is there a market need for the product? Is there an acute problem to be solved with evidence of its existence? Is the problem acute, recurring, recent and emotional? Is it a big enough problem to build a global business around? What is the size of the market and growth potential? Is it large enough to create a ‘10x business’ and deliver high returns?
How is the product different? Is the company solving a problem in a unique way? Can it defend against competitors entering the space? Does the company have an IP its competitors don’t have? Is the product resistant to economic cycles, protected from obsolescence and mitigated against downside risk?
What are the skills and experiences of the founding team? Have you run a startup previously? What experience and insight do you have in entrepreneurship and the founder journey? Is it an A team or B team? Investors generally prefer an A team with a B idea rather than a B team with an A idea because an A team will iterate and find the A idea.
What are the growth metrics? Monthly revenue, user acquisition, units sold, downloads, referrals?
What is the profit margin/cash-burn rate? What is the annual recurring revenue? Do you have reference investments?
Chances of cash-out? Are there opportunities for exiting? Who are the potential buyouts?
7. Debt-based fundraising
Equity-based fundraising exchanges capital for a stake in the company with which an investor recoups investment, whereas debt-based fundraising follows a classic borrow/return model, where money lent now is repaid to the lender later at a predetermined rate.
Most debt funders require an established cash flow or the use of fixed property as collateral. Valiant Finance offers a simple tool for qualifying your ability to access debt across more than 80 lenders in the market. Note though, the majority of startups, especially those in the early stages, will not have the option to raise a debt round because they aren’t attractive borrowers.
Raising debt at Series A stage is however becoming increasingly common in Australia through specialist venture debt funds which look for startups with consistent and clear cash flows and a clear investment plan which can lead to profitability in the medium term.
- Existing shareholders’ stake isn’t diluted and ownership is maintained
- It can be cheaper to raise debt than to raise bridging funding between major rounds
- Debt raises generally move faster than equity
- Business debt can create more tax deductions
- Repayment can be a huge burden on a startup yet to generate profit
- Too much debt can also impact profitability and valuation, impacting future equity raises
- Debt raises require the company to be a lot more confident with regards to future cash-flow
When to raise debt
A company’s creditworthiness is the highest immediately after raising a new round of equity. If startups are raising a combination of equity and debt, they should consider engaging with a lender once they have a few equity term sheet agreements so that the debt financing syncs with equity fundraising. However, if raising debt is the sole financing option, the best time to engage with lenders is during periods of sufficient liquidity and operating runway to increase bargaining leverage.
8. Venture debt
Venture debt is a flexible form of financing for high growth businesses. Cheaper and less dilutive than equity finance, venture debt can be used in conjunction with an equity financing round or between rounds to extend runway to reach your next business milestone. Unlike a loan from a bank, venture debt, like that offered by One Ventures, Partners for Growth and Investec, provides credit that’s covenant light, flexible with limited restrictions and is well suited to technology businesses. The lender may be able to reduce admin going forward and offer further assistance through taking a board observer role.
Venture debt providers would however take security over company assets and rank senior to equity, and as such be paid out first at a liquidation event.
Venture debt represents good value to existing shareholders as their stake won’t be diluted, improving their overall returns. All in all, with venture debt, you’re up for the cost of the loan, which includes interest during the life of the loan, plus a small piece of the exit proceeds via a warrant for having helped you on your way.
9. Convertible notes
Convertible notes are a hybrid of equity and debt, usually used during seed rounds or as bridge financing between rounds. Startups borrow money from investors and the loan will either be repaid, or it converts to equity in the startup on a predetermined trigger event, eg. raising a priced round or a liquidity event.
Convertible notes delay the need to value the startup, so a deal can be done quickly and with lower legal fees. It’s a particularly attractive source of funding for seed-stage startups with little upon which to base valuations. Some convertible notes come with a valuation cap (a maximum price at which it will convert into equity). They can also be useful for raising a bridging round.
As it can be difficult for investors to determine whether the terms of a note are fair or the risks are worth the return, and wary of foregoing shareholder rights (like voting rights, control rights, pro-rata rights, and liquidation preferences), a startup might offer higher discounts for converting loans to equity, eg. around 20–25%.
Example: if in the next round the company raises money at $1.00 per share, and you had previously invested $100,000 on a convertible note with a 20% conversion discount, you would receive shares at $0.80/share, instead of $1.00. That would mean receiving 125,000 shares, rather than the 100,000 shares your $100,000 would buy if you had waited to participate in the round directly.
Be aware though that if future equity rounds are not completed, a convertible note remains debt and requires redemption, which can increase the risk of bankruptcy.
10. Simple agreement for future equity
The Simple Agreement for Future Equity (SAFE) is a relatively new way of raising capital. Introduced by Y Combinator in the United States, SAFE is becoming increasingly popular in other countries including Australia. SAFE is similar to a convertible note without the debt component. An investor makes a cash payment (not a loan) to a company and in return receives a contractual right to receive equity when a predetermined trigger event occurs – usually a priced round and a liquidation event. The number of shares investors receive is linked to the up-front cash payment and the share price of the priced round or liquidation event.
SAFEs don’t come with a fixed term, eliminating the need to keep track of individual financing deadlines, and as there’s no interest payable, the complexity of converting interest into equity doesn’t apply. Unlike other debt instruments, they don’t have to be repaid and aren’t regulated, making them an attractive option for startups.
11. Revenue-based funding
Ecommerce businesses or startups with a high level of recurring revenue could look at revenue-based financing from new entrants into the Australian market like Lighter Capital and Clearbanc. Both US-based, Lighter Capital has soft-launched locally with Innovation Bay’s Ian Gardiner as business development manager.
Using data-driven risk assessment tools, a revenue-based model plugs directly into your revenue stream to map funding to your real-time revenue. This way, projections are used to structure the loan, and in the case of Lighter Capital, a percentage of cash receipts directly contribute to repayment to mitigate risk.
Crowdfunding is capital raised through the presale of products, experiences and/ or donations of money from the public. The most common way this occurs is online, through social media and other crowdfunding platforms.
Crowdfunding campaigns have two key components: raising capital and promoting your product or service. There are four models of crowdfunding: reward-based, equity-based, charitable, and debt-based.
Reward-based crowdfunding platforms are a popular way for startups to pitch an early-stage idea and to validate a new product or service. Examples of reward-based crowdfunding platforms include Pozible, ReadyFundGo, Kickstarter and Indiegogo.
13. Equity crowdfunding
Equity Crowdfunding is a newly regulated way for everyday investors, people new to investing, or mums and dads and millennials, to invest in startups and early stage companies. Unlike other models of crowdfunding, equity crowdfunding gives investors an equity stake in the company.
There are over 10 licensed equity crowdfunding platforms in Australia and each operates slightly differently, so it’s worth looking into which would be the best one for your company and comparing the fees on the raised amount. Examples of equity crowdfunding platforms include Birchal, OnMarket, Equitise and VentureCrowd.
Equity crowdfunding’s main advantages over conventional equity-based investment lies in speed of acquisition and the value created from having a large community of advocates.
It has proven to be a viable option for all early stages of equity-based fundraising – pre-seed to series A. Investors get ordinary shares in the company as opposed to preferred shares typically issued to VC’s or angel investors.
With public visibility for the capital raise, the ability to generate significant funding provides social proof and early validation for the product or service. Similarly, a failure to raise your required amount can impact future capital rounds as it may suggest insufficient interest.
Although this financing option is growing rapidly overseas, locally its adoption was held back due to regulatory restrictions so it’s not mainstream just yet. Equity crowdfunding is open to companies with an annual takeover or gross assets of $25 million or less. The amount they can raise is also capped at $5 million annually. Retail investors (also known as Mum and Dad investors) are limited to investing $10k and there is no limit for wholesale and sophisticated investors.
One concern with equity crowdfunding is the impact of a large number of small investors on your share registry for future raises and handling requests for information.
Like all equity-based fundraising options, startups should try to avoid overvaluing the company and raising more than necessary. It’s important to hit milestones to avoid down rounds, where later investors pay less for the company’s stocks than previous investors, indicating an initial over-valuation or bigger viability issues.
14. Investor-led crowdfunding
The investor-led model of crowdfunding is an attractive option as startups and founders do not incur fees. Instead, investors in a syndicate pay a fee on top of their initial investment so as not to impinge on limited early stage funds.
Conducting commercial due diligence and risk analysis of investment opportunities better protects investors. Increasing confidence in the investment in turn aids completed raise rounds. Founders may also benefit from investor expertise to further accelerate growth.
Examples: Jelix Ventures, Eleanor Ventures and Scale.
15. Initial public offering (IPO)
Going public with an initial public offering (IPO) is a company’s first sale of shares to the public at large. The Australian Securities Exchange (ASX) considers a capital raising range of $10-20 million to be a good entry-level raise.
Advantages of IPO
- Raise a large amount of capital from the open market for a company’s current operations, refinancing, and expansion
- Create a market for the company’s shares: creating liquidity in the shares
- Raise the profile of the company with media, customers, suppliers and investors
- Provide an exit-strategy for early investors
- Ability to raise capital efficiently and quickly post-listing, eg. via a placement (approximately 2 days)
Disadvantages of IPO
- Dilution and some loss of control for owners
- Shareholders gain ability to form majority and remove a founder if unhappy with performance
- Increased regulations and corporate governance including reporting auditable accounting information on a regular basis and having a board of directors
- Total cost of going public eg. listing fee, underwriting, and prospectus preparations tends to be 5–9% of funds the company is looking to raise
- Risk of public failure to raise required funds if the public disagrees with IPO price, eg. WeWork’s 2019 postponed IPO
A possibly risky and roundabout way to list, a reverse takeover can lower the barrier to ASX and public access. An RTO uses an existing company (a possibly defunct or sleeping listing) as a shell company, e.g. neobank Douugh staged a takeover of telco Ziptel in 2020, buying a majority of its shares to essentially rebrand and reinvent itself from the inside out (all while gaining access to public investment).
Issuing equity: what to know
When you issue equity in return for a financial investment, you essentially hand over partial ownership of your startup to the investor. This ownership can be big and influential or relatively small and have minimal impact. But issuing equity is the start of the founders’ dilution of ownership and control. So, you need to think carefully about why and how you’ll issue equity and make sure you’re aware of the terms and conditions that come with it.
1. Term sheet
A term sheet is an important document that outlines the specific terms and conditions of a raise between an investor and founder. The term sheet is often prepared by the VC or other investor and presented to a startup’s founders. It’s generally non-binding and details what the company is giving and receiving in return; it’s like a blueprint of the relationship between the investor and the founder. Term sheets can vary depending on what type of funding round you are embarking on, how much is at stake and who’s involved. Templates can be accessed to use as a guide from the Australian Investment Council.
What to consider
- Round terms: how much is the investment and how big is the round
- Valuation: the startup valuation both before and after the investment (pre- money and post-money)
- Board seat: will the investor/fund gain a board seat
- Voting rights: on incorporation amendments and board appointments
- Employee share option plan (ESOP): what portion of the company is set aside for employee share options
- Liquidation preferences: order of proceeds/distribution on liquidation
- Anti-dilution rights: whether new shares can be released in future
- Pro-rata and right of first refusal: what entitlements will existing shareholders have to invest in future rounds on a pro- rata basis or to purchase any shares sold to a third party at a price agreed to by the third party.
2. Shareholders agreement
A shareholders agreement is a crucial record for founders to have in place from day one, which keeps track of investment and other ownership interests in your startup. So, once a new term sheet is agreed and signed, the next step is revisiting your existing shareholders agreement, drafting and negotiating the operative, binding, deal documents and updating the status of shareholders’ stakes. A shareholders agreement sets out the relationship between the company’s shareholders as well as the division of power between shareholders and directors. It covers matters such as issuing new shares, selling existing shares, how board and shareholder meetings should be conducted, how decisions should be made and how disputes should be resolved.
3. Share subscription agreement
A share subscription agreement formalises the terms of the investment with a specific investor. It details how many shares the startup is issuing, conditions the shares are subject to, the price for the shares and when the startup will issue those shares. It will also include warranties for the investor’s benefit.
A share subscription agreement is necessary when an investor requests one, otherwise it’s not in the company’s interest to make the offer.
Alternatively, a share subscription letter, a shorter document outlining key terms and conditions but not the company’s warranty, may be suitable and the investor can conduct their own due diligence. Share letters are often used in seed/angel investment rounds.
If raising from a VC, it’s more likely they will insist on having a share subscription agreement. Once parties have signed share subscription agreements, the investor and company will pass a resolution approving the issuance of shares, the investor will pay the subscription money, companies will issue share certificates and notify ASIC of its shareholdings.
4. Intellectual property assignment agreement
Intellectual property (IP) is critical to your startup’s value. Founders may have personally owned their IP in the early stages. When assigning IP over, do so in the same company or legal structure in which your investor is investing. An IP assignment grants ownership in intellectual property from one person or company to another. It’s common in employment agreements to ensure that intellectual property created by employees is owned by the company.
They can also be used to assign pre-existing intellectual property to a new company.
5. Types of shares
Generally, early investors like angels and friends and family invest in ordinary shares, whereas VCs usually invest in preferred shares with a 1x liquidation preference. But there are other terms founders should be familiar with, and wary of. Non-standard terms might include participating preferred shares, capped and convertible options. Always read the fine print and avoid overly complicated agreements where possible.
As the most basic type of shares, ordinary shares tend to be issued to founders, early investors and employees. Ordinary shareholders have a share in the company, generally have voting rights, and can benefit from future company profits.
Preferred shares provide additional rights to ordinary shares, giving preferred shareholders seniority and therefore a greater claim on a company’s assets. Preferred shareholders have voting rights, and are paid dividends before ordinary shareholders. If they have liquidation preferences, they will be paid out first in the event of liquidation.
Liquidation preference dictates the order of payout in the event of liquidation. It determines who gets their money first and how much they get so it’s important that founders understand any liquidation terms proposed and the risks and results if triggered. Liquidation preference is only relevant when a company is sold through a merger or acquisition, or when assets are sold during a bankruptcy process. In general, preferred shareholders get their money back first, before anything is paid to ordinary shareholders. When a company goes through an IPO, preferred shares are converted into ordinary shares, and the division becomes irrelevant.
Liquidation preference multiple
The multiple determines how much money should be paid to the investor with preferred shares before ordinary shareholders. For example, a multiple of two means that the investors get their investment back, times 2, before the remaining proceeds are divided among the ordinary shareholders. A lower multiple is better for founders and other early investors.
Participating preference shares
Participating shares entitle investors to a specified payment upon liquidation as well as a share in any remaining liquidation proceeds on an as-converted to ordinary shares (pro-rata) basis.
Non-participating preference shares are preferred for founders, with a conversion ratio of 1-to-1.
Convertible preference shares are fixed-income securities that guarantee pre- defined interest on investments. An investor can convert these securities into shares after a certain point in time, which the investor will do once this option becomes financially viable based on the conversion rate.
If dealing with participating preferred shares, a founder should ensure a cap is added to the term sheet. If there’s a cap, then participating preferred shareholders will stop sharing in the proceeds once they reach the capped amount. They start participating again once the common shareholders have received the same amount per share as the preferred shareholders.
VC terms usually include a 1x liquidation preference
Example: if the VC invests $500k for 50% at a $1m valuation, but the company subsequently sells at only $600k, the VC will get $500k and the founder (and other ordinary shareholders) will get the remaining $100k. But if the company sells for $10m, the VC will get $5m and the founder $5m.
Standard seniority executes payouts for the latest round of investments first and first round investments last. This is the most used seniority structure, since earlier stage investors often rely on later stage investors for the startup to survive.
Pari passu (equal footing) seniority provides all preferred shareholders with the same seniority, with proceeds divided pro-rata to their committed capital, not pro-rata to their stake in the business. Any decisions start with investors with the highest conversion point, as the outcome for one investor depends on the decisions of other investors to convert or exercise liquidation preference.
Pari passu is almost exclusively used for unicorns with prominent founders, as they attract significant funding options and later stage investors have no claim to demand seniority.
Determining the value of your startup is a daunting task, but it’s an important step on the path to capital raising. The valuation will not only help determine how much you might subsequently raise, but how much the startup is subsequently worth. This post-money value indicates an investors’ potential return and ultimately helps establish a price on exit or share price in any future IPO.
How investors value an early-stage startup
Many factors influence a startup’s pre-money valuation. If a startup is generating sustainable revenues, the method used for valuation will look a lot like the established models (revenue and earnings multiples) used to value mature companies. Ideally the business can demonstrate increasing revenue streams, reducing the financial risk of failure and increasing the prospect of a big exit.
Without years of financial data to refer to, startups and prospective investors have to rely on creative and subjective determinants. It might be easiest to tackle the issue of valuation by investigating what an investor looks for when valuing an early stage startup.
What investors consider
- How ‘hot’ is the industry/sector?
- How much investment money is in the market?
- What’s the status of the supply and demand of capital?
- What’s the valuation of a comparable startup in the same/similar sector?
- What’s the comparative size of similar exits locally and internationally?
- Can current competition with other startups and investors help create FOMO (fear of missing out)?
- How long is the remaining business operating runway and how desperate is the founder for money?
- What kind of traction is there? Is the customer base growing and revenue stream increasing?
- How good is the team, is it an A team?
- Do they have significant industry knowledge?
- Does the company have unique IP? Eg. proprietary tech, algorithm, etc.
What investors don’t consider
- How much the founder thinks the business will be worth in the future
- How much time, money or effort the founder(s) have put into the business already
- ‘Interest’ from potential customers, without signed purchase orders or written commitment
Different ways to value your startup
Valuing an early stage startup is particularly difficult, but investors have subject matter expertise that provides a mental picture of the average size and price for a particular stage/round relative to other startups and deals in the marketplace at any given time. They have their finger on the pulse of the industry, but might broadly apply the following thinking to sense check a valuation.
1. Stage and Berkus approach
This approach values startups by their stage of development and growth. The further down the pathway, the lower the startup’s risk and therefore the higher its value.
- Early stage business concept: $250k–$500k
- Lean experiments and MVP built: $500k–$1m
- Product launched/revenue stream/management team in place: $1.5m–$2m
2. Raise restricted approach
This approach works on the basic assumption that the amount of money startups need to raise and the equity they’re prepared to give up determines the valuation range. Going outside of this range starts to impact the commercials of the investment.
A startup wants to raise $500k to give it a 12-month runway to grow and achieve its set milestones and gain traction. Any amount lower than $500k would only constrict the business, increasing the risk of failure and loss of investment. Giving investors 50% would leave founders with too little equity and incentive for hard work. A standard equity sale ranges between 12–25% per round. With the raise amount set at $500k, the post-money valuation would range from $4.16m (at 12%) and $2m (at 25%). Typically ventures raise sufficient funds for 9-12 months runway in their seed round, 12-18 months in their Series A and 18-24 months in Series B and beyond.
3. Incubator’s approach
Some incubators have navigated the challenge of valuing early stage companies by simply applying a standard valuation of $1m or $1.5m for all companies in their program, with their investment of $50k to $150k representing a 5% to 10% stake.
4. Venture Capital approach
The venture capital method calculates value based on a process whereby investors, say, looking to exit within 3 to 7 years, first estimate an expected exit price for the investment. Then, calculating back to the post-money valuation today, they take into account the time and the risk made by the investors to determine an expected return on investment.
Get ready for capital raising
It’s crucial that startups can articulate their value proposition concisely and convincingly. Startups should have solid, succinct presentations ready to entice investors. There are two main versions every founder needs: a pitch deck and an investor deck.
1. Pitch deck
What you use when pitching on stage or to an audience:
- Supports your in-person presentation
- Very visual, tells a story, often slides have just an image
- Focuses on problem, unique value proposition, and differentiation from competition
- Introduces the market opportunity, team, and future plans
- Tells your story and vision in simple human terms
- Slides contain only very basic info, with images and graphics for support
- For an audience with no prior information
2. Investor deck
What you send (usually via email) ahead of time to get the meeting:
- Can be read by itself, with no additional context or explaining needed
- Introduces the problem and covers the key value proposition
- Focuses on the market opportunity and unfair advantage of the startup
- Focuses on the team and their relevant qualifications
- Discusses go-to-market strategy in detail
- Talks about your vision in mostly business terms
- For an audience with some (or more) prior information
Best practices for creating your deck
- Cover/Intro: Name of your startup and your purpose in a sentence
- Key insight story: How you discovered the need/problem and why you’re serving/solving it
- Concise problem statement: What is it and how are existing players approaching/neglecting it (highlight the resulting limitations)
- Relevant market opportunity: The market, target customer, target market size
- Competitors: Demonstrate the depth and extent of your homework in the competitor space and where your company is positioned among it all
- Your solution/USP: What is your unique selling proposition and why is your product a game changer?
- Competitive advantage: What have you got that will be hard to replicate?
- Your team: Expertise, shared history, resilience and startup experience
- Traction: Timeline, milestones and customers
- Business model: Financials and revenue streams
- Financial status: Historical and projections linked to product roadmap
- Raise: How much are you looking to raise and for how much equity?
Disclaimer: this is a general guide only, written for an Australian audience. All dollar amounts are in AUD and provided as examples only. It does not constitute and should not be relied upon as professional, financial or legal advice. While every effort has been made to ensure the information in this guide is correct at the time of publication, Stone & Chalk takes no responsibility or liability (including, without limitation, for any direct or indirect or consequential costs, loss or damage or loss of profits) arising from anything done or not done by any party in reliance, whether wholly or partially, on any of the information contained herein. Any party that relies on the information contained in this publication does so at its own risk.