This blog post is the second in a three part series covering the different rounds of startup funding from an investor’s standpoint. The first one covered the importance of seed round, this one is on Series A and stay tuned for our upcoming blog post on Series B funding.
Series A funding is a critical fundraising stage for most startups. It is usually the second round of funding in the capital raising process and the first round of venture capital fundraising. Like the seed round, founders raise money by selling their company shares, but there are some key differences.
What is Series A Funding?
It is common for companies to issue preferred shares during the Series A round. These shares convert to common stock at a predetermined future date. Recall that Seed stage fund-raising typically occurs via Convertible Notes, SAFEs, and only in some cases via preferred shares. At the Series A stage, the company has customer traction and some existing customers. The goal of Series A funding is to establish and prove a business model before they move on to a Series B capital raise.
Series A Funding Investors
The investors in this stage can still be angel investing individually or through an SPV. However, it is common that the founder finds a lead investor so that other groups, like family offices, will follow. Typically, that lead investor is a VC fund. Top tier VC funds may invest at this stage, but micro VCs are growing in importance, too.
The Series A round is significant because it gives the company the opportunity to demonstrate a business model, remove any remaining technology risks, and establish a growing revenue stream before they move onto their Series B.
How Series A Funding Works
Having a lead investor to set the terms of the round is important for getting follow on investments. The lead investor will typically take 20-30% of the round, and after they have committed, the startup management typically has 90-120 days to fill out the rest of the round.The Series A is a priced round, so there must be terms. These terms are negotiated by the company and the lead investor. While it is common to issue preferred stock, there may occasionally be SAFEs or convertible notes at this stage as well. You need to read the offering documents carefully so that you understand what is being offered.
From the startups’ perspective, rather than scramble to get other investors interested in a short period of time, it is better to give soft pitches ahead of the Series A to gauge interest. Once that lead investor is on board, the startup management already has an idea of who might be interested, they have honed their pitch, and they can pitch hard to gather the rest of the funds rapidly.
Why Series A is Important
The Series A round is significant because it gives the company the opportunity to demonstrate a business model, remove any remaining technology risks, and establish a growing revenue stream before they move onto their Series B. The Series A round is usually larger than the seed round and could be anywhere from $2M to $15M, perhaps more. These days we hear that there have been Series A rounds of $50M. But our best guess is this is a passing phenomenon.
When to Raise a Series A Funding
If the founder can secure this investment, they can establish a foundation for growth, and their chances of raising a Series B or finding success are increased. However, it is important not to start raising the Series A too early. If you start too early, without having the required metrics, it will be much harder to fund-raise. While annual recurring revenue may be a valuable metric for many VCs, it is not the most important factor. What is important is that there is customer traction and the company can demonstrate the potential for increased revenue after establishing a successful business model. Founders should raise a Series A once they have demonstrated some form of customer traction.
Successful decks often go into great detail and share metrics about customer numbers, future pipeline information, revenue projections, and may also include other relevant operational metrics such as on customer retention and customer experience.
How to Find the Right VCs
Founders often spin their wheels analyzing spreadsheets and searching for lists of VCs who might be interested. One way to find the right VCs may be to take advantage of your existing connections. Checking connections on LinkedIn and even looking through current investors’ connections for potential new investors is a great place to start. Founders should network with angels who participated in the seed round to get warm introductions to VCs who typically invest in startups in the industry. Soft pitching and seeking feedback from anyone and everyone will give the founder a better idea of who is interested and how they can improve their pitch to get it ready for hard pitches and the Series A. Attending local startup or large networking events focused on the industry is also a great way for founders to meet new people with mutual interests.
Successful decks highlight the market demand and demonstrate how the company is unique. There is no formula set in stone for how a deck should look. There are templates everywhere, but the most important thing to note is whether the company really understands their market and how they are solving the problem in a new way. The company’s story should be unique and should instill confidence in investors for the long term. The deck should include how they plan to build on their existing traction and grow to dominate the market. Successful decks often go into great detail and share metrics about customer numbers, future pipeline information, revenue projections, and may also include other relevant operational metrics such as on customer retention and customer experience.
Term Sheet 101
The term sheet for the Series A round should include a number of key terms. Here is a quick overview of the key terms:
Valuation: It is important that the valuation is not too high or too low. Companies that are valued too high without good traction face the risk of having a down round in their Series B, which devalues an investor’s Series A contribution. Look at comparables in the industry to better determine a company’s valuation to ensure it is not too high or too low.
Liquidation preference: Liquidation preference is usually set at 1x. Series A investors are preferred stockholders who are entitled to receive their money back before anyone else. Anything higher than 1x may indicate that the company is having a hard time fund-raising. You might want to read our blog on Liquidation Preference to learn more about the subject.
Participating Preferred (or not?): Ideally, from the founders’ perspective, shares should be preferred rather than participating preferred. Straight preferred shares convert directly to common stock, whereas investors with participating preferred shares first get their liquidation preference and then also convert to common stock.
Anti-dilution: Partial anti-dilution provisions are fairly standard. If the startup is pushing for no anti-dilution provisions, investors should be very wary. Anti-dilution provisions protect the investor in case there is a down-round at a lower valuation.
Governance and Board seats: Governance is another important item in the Series A discussions. Typically the lead investor may ask for a board seat. As an investor, you should understand the proposed governance mechanism and your rights before making the investment.
How to Prepare for Due Diligence
Once a startup has secured a term sheet, they should prepare to go through the due diligence process. Good housekeeping is essential for a well organized and pain-free due diligence. It includes verified accounting practices, ready access to formation documents, various versions of the company charter, the cap table, board resolutions, employment documents, historical financials, material agreements, and everything else that may be uniquely important for your business.
Pro-tip: From a startup perspective, having a good accountant is critical. Even if you have to spend a little bit more for it. From an investor’s perspective, you should be reviewing all due diligence materials carefully. For example, review the financial statements and particularly the balance sheet to identify any liabilities you may need to be aware of. And do not forget to review the cap table to make sure that after the Series A round, the founding team still has an incentive to continue the project.
How much is Series A funding?
Most companies raise between $2M and $15M in their Series A, but some companies raise a lot more. It could be as much as $40-50M, depending on the needs of the startup and the industry.
How do Series A investors make money?
Series A investors make money when the company goes public or is purchased by another company. For an investor investing in the Series A round, it is important to have an understanding of the potential exit strategies at the time of making the investment – this should be part of your due diligence.
How much equity is given up in Series A?
Founders typically give up 20-40% of their company in the Series A, but the exact amount will vary by company and industry. Founders need to consider dilution, share price, and many other factors before determining how much equity to offer in the Series A.
How long should Series A funding last?
A company should lay out the target milestones at the time of raising a Series A financing. The funds raised by a company in the Series A round should last as long as required to hit the target milestones. The company should lay out the roadmap to hit milestones along with a timeline.
As a Series A investor, the potential to make money lies in the exit. It is important that the company demonstrates a large potential exit relative to investment. Analyzing the pitch deck, discussing the roadmap with the startup management, getting the advice of experts, and conducting thorough due diligence will ensure that you can make an informed decision as an angel investor in this larger fundraising round.
It is important to keep in mind that there is no guarantee that any exit strategy will occur.