Startup companies aim for rapid growth and disruptive innovation. Founded by entrepreneurs, startups (and their investors) absorb substantial risk in return for potentially staggering rewards. Below, we’ve answered common questions on the subject of startups.
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A startup company seeks to fill a market need, create an innovative product, and/or shake up an industry. Startup businesses have high growth potential, and startup founders often (though not always) seek substantial money from investors in order to get their product to market.
Startup companies are idea-heavy—viable products are typically produced well after the business has been formed and some funds have been procured. Because of this, startup founders initially have to sell themselves to potential investors and customers just as much as they sell their products. Most startups are ultimately in search of an initial public offering (IPO), which transforms the company from being privately held to publicly held.
Startups are traditionally associated with the technology sector, but the term has evolved to include businesses arising from numerous industries. A major difference between startup companies and other small businesses is the ability—and the goal—to achieve fast, sizeable growth.
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Choosing a business structure is an important early step in the process of forming a startup company. Common small business types include sole proprietorships, LLCs, and corporations. However, most investors and venture capitalists will be interested in one entity type: the corporation.
There are a few main reasons that corporations (taxed as C corps) are the most attractive option to investors, including limited liability, taxes, and ownership transferring ease.
On the other hand, LLCs are pass-through entities, meaning profits and losses pass directly to members (owners). This option is often less appealing to investors because it means that—even if they didn’t receive any dividends—they have to pay taxes on the business’s earnings. While some LLCs can elect to be taxed as C corps, investors are generally still more drawn to corporations, in part because of ownership transferring ease (see below).
Startup companies may go through several rounds of funding, including pre-seed, seed, series A, series B, series C, and beyond. Each round will likely attract and draw funds from different types of investors.
When startups take investor funding, it is usually in exchange for shares—equity—in the business. This is known as “equity financing.” Some startups may try to operate with as little equity financing as possible because the founders can retain more equity. Thus, not all startups will run through the full gamut of equity financing funding rounds. Some startups may raise tens of millions and still falter—other startups may keep investments minimal and thrive.
In addition to (or instead of) seeking investor funding, startups may choose to take out business loans.
Below is an overview of what each funding round may bring, but keep in mind that these definitions and numbers are in constant flux.
Pre-seed funding occurs in the earliest stages of a startup company’s inception. At this stage, the startup has likely created a proof-of-concept or minimum viable product. The market opportunity for the product is identified. The founders may be starting to hire employees, but the team is small.
Money usually comes from the founders or from friends and family, but generally not from investors like venture capitalists. Because of this, money raised in the pre-seed round is typically in the thousands, rather than the millions.
Seed funding is the first time many startup companies seek outside investors. Family and friends may continue funding in the seed round, but founders will focus more on generating investments from incubators, angel investors, and venture capitalists.
By this point, the product may be ready for the market, and a strategy for entering the market may be in place. Money raised in the seed round might be used to expand the team, conduct market research, continue product development, and bring the product to market.
As with all funding rounds, money raised through seed funding can vary widely: founders might hope to raise anywhere from $100,000 to $2 million (or more).
Series funding encapsulates the later stages of funding rounds. We discuss rounds A, B, and C below, but some startup companies may never reach series funding (by choice or by circumstance). Conversely, some startups may fundraise into even later rounds, such as series D or E.
Successful series A rounds can bring in $5-20 million. Valuation is increasingly important by series A, even though calculating an accurate company valuation is difficult.
Series B financing can generate $10-30 million from investors. Since startups are theoretically more stable and developed by series B, the company’s value is easier to calculate.
An initial public offering (IPO) is the final hurdle many startups are trying to clear, the shift from being a private company to a public one. Few startups reach this stage.
Benefits of going public include raising more capital and an opportunity for founders and early investors to make returns on their investments in the company.
Disadvantages include a loss of company control, potential disclosure of company secrets, and a focus on stock price as opposed to company operations.
Startup companies and other new businesses largely differ when it comes to their attitudes around growth and impact. The founders of a standard new business might be happy making enough money to keep the business running and pay themselves reasonable salaries. Startup founders, on the other hand, likely have the goal of procuring enough funds and creating a bold enough product to completely shake up their industry.
A minimum viable product (MVP) is a product in the earliest stages of consumer-ready development. While MVPs are useable and customers might purchase them, founders will use customer feedback to alter the product and take it to the next level.
Yes. Investors generally want to see that you’ve mapped out how the business will operate and find success. Even if you’re not seeking venture capital or angel investments, a business plan can still be helpful, as it forces you to think through and explain how your startup company will function.
A company is no longer a startup once it reaches a certain level of growth, profitability, and stability. There’s not necessarily a specific set of numbers that prove a business is out of the startup stage, but stability is especially important. Stability means the company is making good hires and is secure in its market niche.
All startup valuation involves a fair amount of educated guesswork because the companies are in the early stages of development. A few valuation methods include: market multiple, which compares the startup’s value to that of similar enterprises; discounted cash flow, which uses a formula to determine present worth based on future potential earnings and investors’ return rates; and valuation by stage, which places higher value on companies that have reached later development or growth stages.
Startup companies often authorize 10 million shares at incorporation because, by authorizing such a large number of shares, it is unlikely that more shares will have to be created in the future. The large number can look attractive to prospective investors because more shares can be held for a lower purchase-price per share.
Dilution occurs when a business issues new shares, thus reducing the ownership percentage of existing shareholders. If a company is a pie, dilution represents shrinking slices.