| There are several customary stages in venture capital investments, which will be discussed in this section. All of the stages are affected by several characteristics that change from one investment round to the next: the condition of the company, the sources of financing, the company's value, the amount of capital raised, the designation of the capital raised, and problems related to the specific stage of financing. Obviously, these are general characteristics that change from one company to another and also depend on the condition of the given market. For instance, the value of seed companies rose immensely in the years 1998 1999 and dropped sharply, beginning in the second half of the year 2000. It is also important to note that several rounds of investment are possible within one stage before the company moves on to the next stage. Distinguishing among Preliminary Rounds of Investment The distinction among the different rounds of investment at the first stage pre-seed, seed, and first round is not simple. There are many differences which are sometimes a little artificial. Nevertheless, we shall now attempt to explain these differences according to the development axes described above. It is customary to use different terminology for seed and pre-seed investments according to the progress achieved in proving the feasibility of the idea. When the idea has not yet been proven, an investment is required to prove the technology (or even the existence of a market), and the company usually does not yet exist, the investment is considered pre-seed. If, on the other hand, the company plans on developing a product whose feasibility is proven, although the company itself may still be in its infant phase, the investment is considered a seed investment. Furthermore, a company in the seed phase is expected to be an actual company (even if it is just starting out) and not a project a status which is perfectly acceptable for the pre-seed stage. What is meant by a "company" is more than just legal incorporation; mainly it implies the existence of a preliminary managerial team in the company as opposed to a single entrepreneur in the pre-company stage. In other words, the main differences between seed and pre-seed financing lie along the R&D axis and perhaps also on the leading team axis. The main difference between seed financing and first-round financing is the progress of the company, mainly on the business axis, but also on the leading team axis. In the first round, the company will probably have a thorough familiarity of the market and its characteristics and the competition, an understanding and conception of its product with respect to its definition and market fit, as well as a visible management team, or even one significant leader. It is quite possible for a company to go through all three stages of preliminary financing, or it could skip directly to the first round. A more detailed discussion of each of the three stages of preliminary financing, and of the subsequent stages of financing, now follows. Pre-seed Financing The condition of the company At this phase, talk of a "company" is still premature. What usually exists is an immature idea and an incomplete management team, and there is no guarantee that the idea is technologically feasible or commercially viable. Sources The preliminary financing in the first stage is obtained from individuals who are close to the entrepreneur and know him or her personally (family and friends), private investors who are not organized in investing institutions, or incubators. Use The money is needed to support the development of the idea in order to promote the product at least to the stage in which its feasibility is proven and to write the business plan. Seed Financing The condition of the company At this stage, there already is a company with a basic team of managers and/or entrepreneurs and possibly also a demo and a basic business plan. Sources Once the feasibility of the idea has been proven, capital can also be raised from private investors (angels) who specialize in preliminary investments and from entities who invest in companies in their early phases, such as incubators and specialized funds. The financing process and the investors' involvement The process of raising capital from private investors is relatively short, since private investors do not require more than several weeks to reach a decision. However, the entrepreneur should be prepared to present his or her project repeatedly since he or she must try to reach as many investor groups as possible, be they angel clubs, angel associations, or key persons who can influence other private investors because they have faith in the former's ability to screen investments. If the investors are funds or associations of investors, the process takes the form of institutional financing (see below), but this is still done in relatively short time frames. At this stage, investors are primarily involved in providing general advice. A large amount of capital is channeled to this field, although the amounts are much smaller following the decline in capital markets, but due to the multitude of new ventures, many investors find it hard to evaluate all the business plans that are sent to them, and without a good reputation of the entrepreneurs, or referrals and assistance by outsiders, a startup's chances of obtaining financing are slim. Use At this stage, the money is applied toward recruiting a broader management team and employees, completing the business plan, and developing the product to achieve a beta version that will operate at a beta site (a working model at the customer's facilities) or at least an alpha version (a fully operative preliminary model). First-stage Financing As mentioned above, the focus of many funds on seed financing has blurred the distinction between seed financing and first-stage financing. We shall, however, attempt to point out several characteristics of first-stage financing. The condition of the company The conditions for an investment are generally the existence of a functioning company with a reasonable understanding of the market and a product under development (at least a working prototype). In the past it was customary to expect a product that is ready to be launched on the market, but in recent years this type of financing has been provided at earlier stages. Sources The source of finance at this stage is usually venture capital funds. The financing process and the investors' involvement An investment is usually made after a vigorous due diligence process, designed to corroborate the assumptions underlying the business plan submitted by the company, and after the signing of a detailed contract regulating the terms of the investment, the relationship between the shareholders, and the conditions of the fund's exit. On average, this process lasts between three and six months, and during its course entrepreneurs are required to dedicate many efforts to the capital-raising process while continuing the daily management of the company. At this stage, investors (most of whom are, as mentioned above, venture capital funds) make important decisions for the company, supervise the development activities and the recruitment of employees, and monitor the management's performance closely. These investments are also made in consideration for shares in the company (usually preferred shares which confer priority in distributions at the time of dissolution). Use First-stage financing is used to complete the development and commercialization of the product, to expand the managerial team, and to commence the marketing efforts, including recruiting an initial marketing team and sometimes also a sales team. Concerns Although the vast majority of the funds dedicated to venture capital investments are directed at first-stage financing, a company wanting to raise capital from venture capital funds for this stage still faces many problems: Lengthy investigations Since at this stage the company is still risky, venture capital funds perform lengthy investigations into the existence of a market for the product and into the company's chances of successfully completing the development of its products (most of the investment in this stage is dedicated to R&D and to preparing the ground for a managerial and marketing infrastructure). The entrepreneur is assessed at this stage on his or her ability to recruit employees, meet operating targets (he or she is usually not yet required to meet sales targets), and to present the company's vision. Structural and expensive changes The introduction of institutional investors at this stage usually results in a structural leap in the company's management, for example, financial reporting and a full-fledged board of directors. This transition, which is made during the course of the negotiations for an investment contract, is lengthy and requires considerable managerial resources. Second- and Third-stage Financing The condition of the company A company seeking this type of financing must demonstrate that it has a marketing system, solid management, and existing or pending sales. Sources The investors are usually funds, institutional investors, and corporate investors who invest in companies whose business is close to their own. The financing process and the investors' involvement Second-stage financing is usually a long and tedious process which requires considerable managerial attention. On average, it starts about one year after the first-stage financing and is followed by a reduced involvement by the investors in the daily management of the business (although they will still require the achievement of certain goals). Use The money is used for working capital to enhance the marketing system, buy fixed assets required to support the growth of a company in the stage of active production, and to expand its sales and support teams. The ultimate aim is to reach the stage of sales and typically lead the company to profitability. Concerns At this phase in the company's life cycle, it usually enters the stage of marketing and sales. These activities require vast financial and managerial resources that often exceed those available internally to the company. Companies therefore find themselves facing the need to raise more capital immediately, shortly after they finish their first-round financing. In this state of affairs, the company's value for purposes of the second-stage financing has usually not risen substantially, and the need for a large amount of capital may result in a considerable dilution of the existing shareholders, who would rather see a leap in scale in the value of the company. Pre-IPO Financing Sources and uses This round of financing is relevant to companies 12 18 months before an IPO. The amount raised depends on the company's needs until the IPO, and may range between several millions and tens of millions of dollars. The value of the company is derived from its anticipated value in the IPO. This round is usually designed to provide bridge financing until the IPO is completed. The investors in this stage are often passive investors who expect to sell their stakes after the IPO, and venture capital funds, which have already invested in the company. In recent years, they have been joined by private-capital divisions of large investment banks, mutual funds which also invest in the private sector, and other financial institutions such as insurance companies. In the months preceding an IPO, many companies want to secure interim financing to reduce the uncertainty with respect to the timing of the IPO. Such interim financing, which is becoming more and more popular, reduces the company's dependency on the condition of the stock exchange when determining the timing of the IPO and allows the company to wait for the optimal timing. This interim financing allows investors who are deterred from investing in startups in their early phases to take part in promising private placements. This type of financing is sometimes provided by potential underwriters seeking priority or exclusivity in the role of underwriters for the company's upcoming IPO. Along with direct investments in consideration for preferred shares, the private sector has in recent years exhibited a sharp trend toward issuing convertible debentures before an IPO. Such securities are issued both to groups of institutional investors and to commercial banks, which have recently been expanding their activities in this field (see Chapter 11 for a more detailed discussion). Concerns Companies in need of bridge financing are companies which can demonstrate increasing sales and a well-functioning marketing system, but are not yet ready to go public for various reasons, such as the absence of past experience in a consistent growth in sales or unfavorable market conditions. However, these companies are growing and require ever-increasing investments to finance their high cash burn rate. In these situations, companies sometimes face the problem of having to raise capital with shareholders who object to being diluted other than according to a value that is close to the company's forecasted value in the IPO. Companies in this phase can sometimes receive financing from underwriters, with the disadvantage of having to make a long-term informal commitment in advance to a particular underwriter, thus losing their flexibility to choose the appropriate underwriter when the time comes to go public. |
