Stage Financing

Stage Financing refers to a method many investors use to reduce their risk when funding companies. Funding a company in “stages” means providing the money that has been committed in pieces as the company meets pre-established goals. Customarily, the company doles out the shares to the investor as the money is received.

For example, an investor might agree to provide $800,000 to a company by paying $400,000 down, $200,000 when the company gets its first order, and $200,000 when it receives its first payment from an order. The stock sold to the investor might be issued in increments of five thousand shares upfront, fifteen hundred shares when the first $200,000 payment is made, and one thousand shares when the last $200,000 is put in. (The earlier dollars buy more shares because there is more risk at he beginning.) Often, these goals are tied in some fashion to the financial projections contained in the company’s business plan.

While the commitment is to fund the entire amount, the later stages of funding are contingent on the company attaining its goals. If the company fails, the investor is relieved of his obligation to provide additional funds. In this way, the investor can cut his losses when a company does not meet expectations. At the same time, the company gets a commitment for its full funding, which it can obtain by meeting its goals.

Stage financing also refers to the fact that most growing companies need funding at various points in their development. At each point, or stage, the company solicits new investors to fund the next phase of company growth.

Usually, a company goes through two or three venture “rounds” of financing before it is large and successful enough to sell its stock on the public market. Each stage of financing can reduce management’s percentage ownership in the company. As the company progresses, however, its stock should command a higher price in each successive stage. The reason for this is that the investor’s risk decreases as the company succeeds and meets its goals. As a result, if management gave up 30 percent of its company’s stock to attract $500,000 in venture capital the first time around, it may only cost an additional 15 percent of the company’s stock to raise $1 million in the second round of financing.

The first stage of financing is commonly called “seed financing.” This is money raised to make an idea for a product into a working prototype. Quite often, seed money is invested by an individual or by the company’s founder and management.

Seed money is the hardest to find, and the most expensive (in terms of equity). Because it is so expensive, many entrepreneurs try to forestall asking for equity investments from outsiders as long as possible. Investing his own savings is one way for an entrepreneur to delay or avoid this stage of financing. Borrowing against the equity in his house is another.

Start-up capital usually refers to money raised to modify a working or almost-working prototype product into a product that can be manufactured at a cost that allows the company to make a profit. It can be the first or second stage of a company’s financing. Start-up capital is used to test-market products and prepare companies for their first round of product sales. This money is more readily available than seed capital.

Second- and third-tier financings come next (if they are needed). These are traditionally used to finance inventory and company expansions. If a second- or third-tier financing is used to fund a company expansion that enables the company to later conduct a public offering, it is referred to as a mezzanine financing.

In the dynamic world of venture capital and start-up companies, no two companies have the same capital needs or grow in the same way. If management delays the need to acquire seed money until its prototype is almost ready, one venture capitalist might consider the proposed investment a seed investment while another might consider it an early start-up financing. There is no magic to the labels. They are conventions that are casually observed in the industry to describe financings.

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