At Roompact, we enjoy sharing knowledge about our particular disciplines that we consider our "expertise", whether it be HigherEd, technology, or business. After a discussion about the growth and investment lifecycle of startups, I thought I'd jot down some of the concepts we talked about in case any other HigherEd Professionals are interested as well. This is a very high-level overview -- each of these concepts have many intricacies.
The first thing to know is that a company may seek investment (fundraise) many times throughout the company's life. When a company is in "fundraising mode", the full-time job of the CEO is to woo investors. The CEO will not have time for anything else.
Below are the several stages of fundraising a company may go through, in order of their occurrence:
Friends and Family Round
This is the initial round of funding in the early days of a company. At this point, the company has a very low likelihood of success. They probably don't have customers or even a fully-complete product. Anyone who invests at this stage does so out of loyalty for the founders.
A seed round is the first round of funding that may include investment from outside investors that don't have a close relationship with the founders. At this point, the company has a product, probably has a minimal number of customers, but is still looking for a true product-market fit, which means they're still adjusting their product to provide the most value to potential customers.
In the Friends and Family Round and the Seed Round, investors typically invest with a financial instrument called a convertible note. During these first two stages of funding, it's hard to put a valuation on the company because so much is still unknown. A convertible note is an "IOU" to investors that lets them know the money they invested will convert to equity (a piece of the company) at a rate relative to the upcoming Series A round of funding. They do this because theoretically, it's easier to valuate a company at the Series A stage.
Series A, B, C, etc.
These are BIG funding rounds. In each of these rounds, the company sells at least 20% of the company to investors for no less than a seven-figure sum. There is a lead investor, who purchased the majority of the 20% and who typically gets a seat on the board of directors. There are also follower investors who purchase smaller sums and generally defer to the lead investor. All investors in this round only care about one thing: rapidly growing the company and selling as quickly as possible.
The Series A, Series B, and Series C rounds happen sequentially. They might not happen at all if the company sells sooner rather than later. Companies can also go beyond a Series C. There are 26 letters in the alphabet, after all.
Sometimes a company isn't quite ready for the next stage of funding. When you raise one of the "Series" rounds of funding, your investors need a clear plan for how you will spend their $1,000,000+ and will give you a short time frame in which to spend it. You are obligated to grow as quickly as possible. If you're not ready to do that, you'll raise a bridge round, which is a "small" round to help you get to your next round.
And here are some other terms to be familiar with:
An "exit" is one of two things that ultimately result in the owners cashing out:
- the sale of the company to a bigger company
- an Initial Public Offering (going public)
The former is the most likely route. Very few companies grow large enough to go public. Overall, few companies that accept Venture Capital make an exit at all. The overwhelming majority die.
People who invested in the company at the Seed Stage and higher will have an investment portfolio. They invest similar sums of money in 10 or more companies within the same timeframe. Their goal is for 1 of those 10 companies to become wildly successful and give them a 100x return on their investment. Some companies in the portfolio will do modestly well, but the investors don't encourage modest growth. They push every single company to grow as fast as possible. If your company is not the 1/10 that gives them the 100x return on investment, you have failed.
Employee Equity Compensation
Most employees at Venture-funded companies receive equity compensation, meaning they own a little piece of the company. Well, they don't actually own the company. They usually get something called options that accrue over time. Options give the employee the right to purchase shares of the company at a favorable price. But they still have to purchase those shares for some money, and even worse, they will have to pay taxes on the shares according to the market value, rather than according to the favorable value they've received. In return for Equity Compensation, an employee's cash compensation is much lower than market standards. Because of all of this, the entire company -- literally every single employee -- is working towards and hoping for an exit.
Ultimately, it's rare for Equity Compensation to pay off for employees. Investors in the Series A rounds and higher require "preferred stock", which means that in the event of an exit, the company is legally required to give the big-money investors their money back first (and often, 2x, 3x, or even 5x of their money back). Employee Equity Compensation is paid out last. Between the lack of payout priority, the potentially unaffordable tax bill, and the very unlikely odds of an exit, employees are better off asking for cash rather than equity 99.9% of the time.
If you think all of this sounds absolutely crazy and unhealthy for a company, employees, and customers -- I do too. Thankfully, there's an alternative route to growing a company this way. It's called Bootstrapping. A bootstrapped company might get very modest funding from the founders, and that's it. The company grows organically at a modest pace. They might not have the sexiest marketing material or trade-show booths, but eventually they'll get there.
A company like this is able to prioritize client needs rather than big-money investor needs. A bootstrapped company is like an all-brick house that was carefully, intentionally built, rather than a house that was slapped together as hastily as possible in the pre-housing-crisis bubble of 2007. Which option can you count on for decades to come?
At Roompact, we're proud to be Bootstrapped. We're in this with you for the long term. With no exit in mind.