At some point, almost every startup (it’d be neat to have that stat) seeks additional funding to grow. Whom do they typically turn to? Different types of venture capital, the go-to source for numerous entrepreneurs who believe they have high and long-term growth potential on their hands.
Just like there are different types of venture capital companies and investors, there are also various types of venture capital financing, and there seems to be some confusion around it. Here’s my stab at this particular topic to try and help sort this out.
There are three main categories of venture capital financing, each with its own subcategories:
- early stage
- acquisition/buyout financing.
Early-stage financing is also divided into three parts:
- Seed capital
- Startup capital
- First stage capital
Seed capital is initial funding typically sought by entrepreneurs who are just starting out and don’t have a product of organized business yet. There aren’t many venture capitalists willing to fund at this stage since they aren’t very inclined to invest large amounts of money in an idea that still exists only on paper. Unless you are an established serial entrepreneur – then, you’re golden.
Therefore the money often comes instead from the entrepreneur’s personal assets, friends, or family. The sums are generally modest, just enough to help an emerging entrepreneur cover the essentials. It may assist them in creating a sample product, financing market research, covering administrative costs, or becoming eligible for a startup loan. This helps an emerging business get the attention of startup capital investors.
Startup capital refers to a sum of money (larger than seed capital) given to a startup so it can launch its business, e.g. recruit initial staff, acquire office space and permits, further market research and testing, and finish the development of its product or service. Companies seeking this type of funding already have a sample product available and at least one executive working full-time.
That said, this type of financing is rare as well and you have to put in some really serious effort to sell the idea (like creating a solid business plan or building a prototype). More often than not, multiple rounds of startup capital investment are necessary to succeed in getting a new business truly off the ground.
First stage capital is intended for businesses that have gotten off the ground and have been operating for two to three years, have a management team in place, and their sales are growing. At this point, they are moving toward profitability as they push their products, services, and even advertising to a wider target audience.
Since such startup have spent all their starting capital by now, they need further financing to intensify business activities, enhance productivity and marketing, and/or increase efficiency.
Expansion financing is divided into three subcategories:
- second stage financing
- bridge financing
- third stage financing
Not quite imaginative terms that are also sometimes used interchangeably. Anyway:
Second stage/mezzanine capital is provided to well-established firms with a multi-functional team and commercialized product, as well as a reasonable sales momentum under its belt. The purpose is to add the fuel necessary to take the business to the next level.
In other words, VCs that specialize in this type of finances help these businesses begin major expansion, accelerate the growth curve, enter new markets, and/or expand their marketing efforts.
Startups are not expected to reach high levels of internal return rate but rather achieve sustained growth. Mezzanine financing can be structured as preferred stock or debt, and implies an obligation for the company to pay interest promptly.
Bridge financing refers to financing in between full VC rounds with the objective to raise smaller sums of money instead of a full round. Existing investors are usually the ones participating in this type of funding.
You may use this interim method to solidify your short-term position until you get the opportunity to arrange a long-term funding option. Just like its name says, such financing is meant to “bridge” the gap between the time when you are expected to run out of money and the time when you can expect to receive major funds.
Third/late stage financing happens when a startup has reached massive revenue, has a second level of management, and is now seeking funds to grow capacity and working capital, and/or build up marketing efforts even more.
Late stage financing has become popular due to the fact that venture capitalists prefer to invest in ventures with lower failure risk (as opposed to the early stage companies).
3) Acquisition & buyout capital
The last of the venture capital funding types is divided into:
- management/leveraged buyout financing.
Acquisition capital is the provision of the immediate resources used specifically to assist a company in acquiring certain parts of another business or the entire business for itself. Through such a purchase, the smaller company can grow the size of its operations and benefit from the larger scale economies.
Management or leveraged buyout financing includes a significant amount of money that helps a particular management group to conduct management or leveraged buyouts. Management buyouts provide a preferred exit strategy for companies looking to sell off divisions outside of their core business or for private businesses whose owners plan to retire.
Leveraged buyouts use massive borrowed funds, with the assets of the target company (the one being acquired) regularly used as collateral for the loans. The buyout company may also sell parts of the target firm to pay down the debt. This high-risk, high-reward strategy requires the acquisition to realize high returns and cash flows so that the interest on the debt can be paid.
The more you know…
Venture capital and investment finance in general are large and dynamic spheres that are always developing. This is why it comes as no surprise that there is so much, often conflicting information on the good ole Internet about all the types of venture capital out there. This post is an attempt to clear up this confusion once and for all and create a go-to manual for this subject. At least that’s the hope – let me know if things are a bit more understandable now.