Making the Rounds: What investors need to know about the different stages of startup funding

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Facebook’s $19 billion acquisition of WhatsApp last month marked the largest recorded deal for a venture-capital-backed company in history. While the unprecedented price tag of the purchase was certainly a story in and of itself, what really garnered attention among venture capitalists was that Sequoia Capital was WhatsApp’s lone VC investor.  Although sources differ on the exact stage at which Sequoia first invested in WhatsApp, as well as the exact amount of the initial investment, the general consensus is that the company will reap a return of approximately 50x on an investment made as early as a Series A round of funding.

facebook whatsappHow is it that Sequoia managed to emerge from this deal with profits estimated to be in excess of $3 billion? The answer, though undoubtedly a combination of a variety of factors, is largely based on timing.

Jumping back almost three years to April 2011, when WhatsApp had just secured an $8 million investment from Sequoia, the newly-founded messaging service had all of 4,050 reviews for its Blackberry app. To put that into perspective, the Blackberry app now has over 300,000 reviews. When Sequoia made its Series A investment, WhatsApp, despite having a completed product, had yet to scale up its service and experience any real traction. Without the huge user base it has today, WhatsApp’s valuation was nowhere near the eleven-digit figure Facebook paid for it. As a result, when Sequoia made its initial investment in WhatsApp, it received an incredibly large stake of the company. Most estimate Sequoia’s stake in WhatsApp to be over 15%, while other estimates go as high as 20%.

What is Series A funding and at what other points in a company’s life can I invest?

Most successful startups follow similar financing paths from the birth of an idea to an IPO or acquisition. At each stage of a startup’s life, it attracts different types of investors who have various amounts of capital available to invest and different levels of risk aversion. The stage at which you can invest depends on the channel through which you’ve chosen to make your investment.

investingIndividuals who decide to conduct their own due diligence and invest their own capital will typically invest while the startup is still in its infancy stage, meaning the “product” is likely still just an idea. Investments by these angel investors generally bear higher risk as the startup has limited information to offer to investors at such an early stage in its life.

Those who choose to make their investments through more formal channels such as crowdfunding or venture capital (VC) will usually see their money go into companies that have, at the very least, entered the earliest stages of product development. While this can be seen as the general umbrella rule for VC investing, VC firms which are stage-specific, as opposed to stage-agnostic, may choose to further restrict their investments to startups that are in a particular stage of development.

Venture-round funding (or Series A investments)

Series A is the earliest stage of venture-round funding. Surprisingly, there are not actually any clearly defined milestones a company must reach in order to raise capital for a Series A, B, C, etc… round. In other words, they are — to some extent — arbitrary terms. During the earlier stages of venture funding, the startup is typically still in the process of developing and perfecting a product, though it may already have some unsteady revenue stream.

crowdfunding-piggybankAt this stage, capital often goes towards furthering product development to suit the needs of the market, hiring employees beyond the company’s founders and developing initial branding and marketing strategies. As financing progresses into later stages and the company starts to develop a more steady revenue stream, funds begin to go towards scaling up production and expanding into new markets. Later-stage funding may even go towards financing a strategic acquisition of another company that will assist in the development of the startup’s own product.

So what do the “investment rounds” actually mean?

It is important to also note that the different rounds of investment are not contingent on the size of the total investment round. For example, a series D round can be smaller, in terms of dollars, than a series A round. What the names of the various rounds do usually denote (which is somewhat abstract as mentioned before) is the order in which the funds are raised. A comes before B, B before C and C before D.

If things are going well and a company is growing/hitting its targets, investors who invested in earlier rounds typically are rewarded doubly: (1) The value of their investment is likely increasing and (2) they frequently get better terms than investors who come in later because they've assumed more risk.

To make this a bit easier to understand, here are a few examples from the OurCrowd portfolio that illustrate the idea and variety of investment rounds:

Thumb_2f92ad94-3439-4018-99ab-222e5009ea2bOurCrowd participated in Abe's Market's Series A (first round of investment post seed round) with an investment of $680,000 in October of 2013. Just last month, Abe's raised $1o million in their next round of investment — their B round — led by Mistral Equity Partners in which OurCrowd invested nearly $10 million. You can see Abe’s Market here on our website.

Thumb_5fb1ea18-6086-4e32-985b-cf2a1079b166Evigilo is currently raising a continuation of their series B round on OurCrowd's platform. The first raise of the Series B was a $350,000 investment — also in October 2013. This company's technology recently was credited with minimizing the damage from the massive Chilean earthquake last week.

Thumb_eb07b035-1112-4490-a2d0-56e7224e8c99Viewbix, another OurCrowd portfolio company, raised a $2 million series A with Canaan Partners and Longfellow Venture Partners in May 2012. OurCrowd participated in their series C round in October 2013 with a $1.1 million investment.

Thumb_3c9bad66-fca8-4f33-a397-bfee0fd1a55aA D round of funding, or a company's fourth raise, is usually the round that preempts an IPO or acquisition. OurCrowd invested $1.2 million in Argo Medical Technologies' D round of investment in June of 2013. Read more about the maker of  the bionic exoskeleton that’s helping paraplegics walk again here.

What if I stop investing after my first round? Can my share of the pie shrink?

A basic characteristic of startup investing is that your share decreases or “dilutes” as the size of the pie grows, relatively speaking.

money-pieFor example, if you invest $5 million in a company during a Series A round when the company is valued at, let’s say $20 million, you now effectively own 20% of the company ($5 million/[$20 million + $5 million]). A year passes and the company receives another $25 million in a Series B round in which you choose not to participate. The company’s “post-money valuation”—or its total value after these new investors have made their investments in the company—is $50 million. Your $5 million investment has just gone from holding a 20% stake in the company to a 10% stake.

That's what's known as dilution. You now own a smaller piece of a more valuable company.

If the WhatsApp story had unravelled something like this, Sequoia would not have emerged from the acquisition with profits of over $3 billion. That’s why most investment contracts will include a clause known as pre-emptive rights, which gives an investor the right to invest in subsequent rounds of investment before the startup gives new investors the opportunity to invest. (Click on this link to learn more about preemptive rights and anti-dilution protection)

What round is the right time to invest?

Sequoia’s success story certainly makes early-stage funding look appealing, but the optimal time to invest is not necessarily a “one size fits all”. With varying levels of risk tolerance and amounts of capital available, different investors may have different optimal investment stages.

Regardless of your personal investing preferences and tendencies, understanding what is involved in each funding round and knowing your investor rights at each stage is critical to long-term success when investing in startups.

Michal Lipsitz
OurCrowd Intern
Michal is an economics and finance student at McGill University. She is studying abroad at the Hebrew University and will be returning to Canada at the end of the year to complete her degree.

 

 

 

 

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