Financing in Stages

Startups require outside financing for their activities throughout their life spans until they command sufficient financial resources of their own. Since almost no new startup is capable of raising capital by traditional loans (see below for detailed explanations of various methods of financing), they are required to do so by means of equity, i.e., by joining investors in their capital stock or by issuing convertible debt. Typically, only at more advanced stages can a startup combine investment rounds with financing by straight debt.

Startups almost always raise capital in several consecutive stages, according to values that are supposed to rise consistently (sometimes, due to difficult market conditions or internal problems in the company, the value of the company does not rise from one round to the next). The reason that investments are broken up into rounds is that the significant risk involved in investing in a startup decreases as the startup progresses and manages to prove its technological concept, develop a product, establish good management, market, and sell. The value of a startup increases with its development as a natural outcome of the company's progress and the decrease in the riskiness of the investment. With time, the startup's projected cash flows, both positive (inflows) and negative (outflows), can be forecasted with more certainty and, as a result of this diminished uncertainty, investors use a lower discount rate when valuating the company (see Chapter 9 for a discussion of valuation).

The process of financing in stages that are linked to the company's progress, the reduction of its riskiness, and the increase in its value operates in favor of both investors and entrepreneurs. Considering the many risks, investors are usually prepared to risk at first only a small amount of money and prefer to invest the rest as the project demonstrates visible progress. From the entrepreneurs' perspective, an investment that is very large in proportion to the company's (low) value at an early stage would cause an immediate and sharp dilution of the entrepreneurs' equity. They therefore prefer to raise only what is necessary for that stage, in addition to a certain margin of security, and to continue raising capital later on based on a higher value.