How do Startups Evolve Over Time?
If you google “startup life cycle” and search for images, you will certainly find many pictures describing the typical cash-flow of a startup company. You recognize it because at the beginning it starts with a negative curve (negative cash flow) and then it grows quickly until it settles towards the end. In these images you will notice that the cash flow trend is related both to the names of the phases of the life cycle of the company and to the types of investors active in each phase. Well, now you will also notice that different images have different nomenclatures for different stages and different types of investors! In my academic research I have come across this problem: which of these images is the “official” one? Which is the correct nomenclature of each phase? And when do the different types of investors take action at each stage?
In this article I’ll try to make some clarity about the different phases of the business life cycle of a startup company. In doing so I will consider the graph in the National Venture Capital Association (NVCA) reports so that an official source can be used as a reference.
I hope the reading can be useful. Ejoy!
Due to the high level of innovation, technology-driven startups are considered to be highly uncertain and risky business activities. To survive through the so-called “valley of death” and keep growing along their business life cycle, most founders’ personal financing is not generally sufficient. However, in most cases access to debt financing is not a viable option for such entrepreneurial initiatives. In fact, to provide a loan, banking institutions must assess the economic and financial soundness of the company, so as to ensure that the debt will be repaid. This evaluation is generally based on the analysis of the company’s past financial statements and therefore requires that a venture has already been in business for several years. Unlike assessments of small and medium-to-large enterprises, the evaluation of investment opportunities in startup companies cannot be based on economic and financial considerations, because of the lack of historical financial data (Miloud, Aspelund, & Cabrol, 2012). For this reason, traditional evaluation techniques are therefore less suitable for startup companies, given the specificity of this type of venture (Silva, 2004) and access to debt capital is not a viable option. In addition, the high level of risk associated with these companies does not allow them initial access to loan capital. However, being able to access to capital is a key element for startup companies, especially in the early stages of their life cycle. In this context, tech entrepreneurs must therefore seek alternative forms of financing. As can be seen in the Figure below, the choice of the most suitable sources of capital is closely related to the phase of the life cycle in which the company is operating. At each phase of the company life-cycle, different dynamics and strategies have to be managed, and the best support can be given by specific sources of financing.
1. Startup phase
In the startup stage, founders are developing their business idea with the aim of refining it as much as possible and prove its actual feasibility. To validate the initial concept both from a technical and business point of view, the team work to make a proof of concept (POC), a prototype and a minimum viable product (MVP) as well as a solid business plan. The company isn’t generally capitalized to hire any employee or other external resources and it is run by the founders themselves. As there is not yet a product or service available on the market, no revenue is generated. Considering the significant expenses to refine the initial idea, the cash flow is therefore strongly negative. At this stage the value of the losses depends strongly on the industry in which the new company operates. Think for example of the difference in capital needed to start a company in the ICT and biotech field. The sector itself also defines the duration of this phase. At this stage the sources of the company’s capital are generally the personal capital of the founders and those given by family or friends. The company can also start crowdfunding campaigns (explaining the potential of the project using the available online platforms) or participate in business competitions with monetary prizes.
When it comes to a semi-final version of the concept, the company enters the second part of the startup phase. At this moment, since the focus is in refining the product or service, the venture heavily invests in research and development (R&D). Referring to the Rogers’ curve (Rogers, 2010), the team identifies the first potential class of adopters (innovators and early adopters) and starts testing the target market. However, the cash flow is still very negative. In this phase specialized investors are also able to provide additional capital: startup accelerators, business angels and high-risk venture capital firms.
The shape of the cash flow curve in the startup phase recalls that of a valley, and is commonly called the “valley of death”. This term describes the period in which a startup is actually operating, but has not yet generated a positive cash flow. Many startups fail at this stage because they run out of financial resources to move forward.
To recap: what are the sources of capital at this stage?
Start with:
- Personal financing
- Friends and family
- Crowdfunding
- Grants
And then:
- Startup accelerators
- Business angels
- Boutique venture capital firms
2. Development phase
If the startup survives the “valley of death”, it can then enter the development phase. The company starts manufacturing and shipping its product or service, and thus begins to generate revenue. At the beginning of this stage, however, it is not yet profitable and has not yet reached the break-even point. The company is still unable to be self-sustainable and seeks for additional capital. From the moment profitability is achieved and break-even point is reached, the market is validated and the company can then focus on growing and expanding its business. Customer adoption grows over time and sales increases fast. The company spends mainly on machinery, inventory, human resources and promotion: all elements that allow it to keep growing. During the development phase, the company starts to attract the attention of venture capital funds and can raise the so-called round A. Having the support of a venture capital firm strongly validates the venture’s potential and determines a fundamental milestone in its life cycle.
To recap: what are the sources of capital at this stage?
- Business angels (individuals or networks)
- Venture Capital, series A round
3. Growth phase
As the company enters the growth phase, the cash flow trend, which initially grew rapidly, gradually reaches a stable value, and the company reaches its full operation. What was initially a startup, has now become a scaleup, and the risks are progressively reduced. However, to maintain and expand its market share and defend itself against new competitors, the company still needs further investment. At this stage venture capitalists carry out additional investment rounds (called round B, C, D) and given its maturity the company also has access to new sources of financing such as private equity funds and investment banks.
To recap: what are the sources of capital at this stage?
- Venture Capital — series B, C, D
- Corporate Venture Capital
- Private equity
- Investment banks
- Bank loans
4. Maturity phase
The final event that defines the end of the life cycle of the company is the achievement of the so-called exit. An exit can take place mainly in two ways: the company can in fact be acquired by a larger company through a Mergers & Acquisitions (M&A) or it can access to the public markets through an Initial Public Offering (IPO). In both cases shareholders (i.e. both the founders and investors who have gradually entered the share capital) can sell their equity stake and finally make a return on investment (ROI) which can however result in both a capital gain and a capital loss.
To recap: what are the main exit strategies you can plan at this stage?
- Company acquisition
- Initial public offering
So, what are the different funding rounds for?
Early stages
- Seed financing: to develop a concept
- Start-up financing: to develop the product and test the market
- First stage financing: to start production and sales
Later stages
- Second stage financing: is the working capital for firms that are producing and shipping products
- Third stage financing: to finance growing firms that are at least at the break even point
- Fourth stage financing: capital for firms expected to go public within six months
I hope this article has been useful to clarify the different phases of the business life cycle of a startup company. If you liked it, clap your hands and follow me to stay updated on the topics of startups, venture capital and data science.
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