In most parts of the world, you can start a company with relatively little money; illegally, you can just set up a shop and start selling things. To make things legitimate, you’ll probably have to get a business license and register with the local government—this usually takes a couple hundred dollars and a few days or weeks. Then you have an LLC that, from a legal perspective, provides you as the founder of the company some legal protections.
Other startups require more capital to run. Even a simple mobile app requires funding for server fees and marketing at the very least—in most cases, many other costs make for a barrier to entry that simply can’t be overtaken without backing from investors. Thus the world of venture capital comes in.
The early stages are the most diverse; some companies will go it alone until they have a proof of concept or a demo which they will introduce to various potential investors. Others will raise money from friends and family. Others still will go to potential investors with an idea, usually presented in what’s called a pitch deck (really just a Powerpoint presentation). When successful, these people will be given what’s called seed money (in what’s called a seed round) in exchange for some share of the company. $100,000 is pretty standard, and for that many companies sell 10% of the company, valuing the startup at $1 million in total.
After the seed round there is a series of different and subsequently larger rounds with larger valuations (in most cases—in some notorious cases, like WeWork, a new funding round will have a lower valuation, known as a “down round”; this is one of the worst things that can happen to a startup). These rounds are delineated by letters, with Series A typically starting at about $3 million in funds raised to much larger amounts as we go through the alphabet—Series D and Series E rounds tend to be the final ones before a company goes IPO.
As these series get larger and the value of the company gets larger, the capital it raises is almost always used primarily to grow the business. A company only raises money in a round when it has a clear reason to do so like, say, investing in the current product or ramping up marketing or expanding to a new market. In some cases investors in an earlier round will sell their shares in the newer round, but it is rare for a fundraising round to exist solely for earlier investors to cash out.
After these rounds occur and a company’s value grows and grows, it may be large enough to warrant going public. This is a costly and time consuming business, although the use of Special Acquisition Companies (SPACs), which really kicked off in 2020, has made the timeline for going public shorter and made the costs of doing so smaller. SPACs have resulted in a slew of companies now going public that would not have been able to just three years ago; while SPACs have declined in popularity somewhat in terms of total companies going public this way, as a proportion of total companies going IPO, SPACs remain very popular.
Note that we are talking about equity in all of these cases—these rounds are raising of funds in exchange for shares in the company, and rounds might involve issuing different classes of shares (in other words, founders retain Class A shares but will issue a new type of shares (Class B) that have more limitations, less voting rights, and so on. These are typically valued less than Class A shares, and they’ve grown in popularity and controversy over the years.
Debt financing is possible too, however. A startup or private company with a positive cash flow can issue debt in the form of bonds or loans, and those debts can be traded amongst the creditors as they see fit. Raising cash in the form of debt is often attractive to founders and investors who do not want their ownership of a company devalued. And devaluation happens fast; a founder who owns 90% of the company and raises 10% in a Seed Round will find that worth just 81.1% if the Series A round sells off another 10% of the company. If each round raises just 10% in equity valuations, that 90% will be 60.9% by Series C; thus a founder can quickly find herself a minority shareholder by the time a company goes IPO!
Private equity financing does involve some financial math, particularly when it comes to managing accounting, the capital structure, and creating the term sheet, but when deciding whether a company is worth investing in or not, much more complicated technical issues and other kinds of due diligence. In part this is good; now startups can get decisions from potential investors within 10 minutes of meeting them. But it’s also a risk factor, because it means much more complex variables and an understanding of the markets those startups operate within matter much more than ever before. To read more about how this is changing, The Economist has written a great in-depth discussion of how VC and PE are changing.
