The first stage of financing (outside investments made by the entrepreneur) is called angel financing. Angel financing may occur very early in the life of a company. In fact, such financing (or at least commitments to provide financing) may occur before a business plan is formally developed and perhaps before a company is legally created.
These investors are called angels because they invest despite the high risk of failure at this nascent stage and often demand less favorable terms than would be expected by the investment risks present with the new company.
Frequently, an angel is a relative or a friend of the entrepreneur. In any case, the investor relies heavily on the confidence in the entrepreneur in some cases more than the business prospects of the company.
The second frequently identified stage of venture capital finance is called seed capital. This is the earliest stage that venture capital funds will invest. By now, part of the management team should be in place.
The business plan is not complete but key decisions have been made. A prototype product may be complete or may require seed capital to finish the product development. Seed capital is used to test the prototype with customers and perhaps begin to market the product.
The next venture capital state is the early stage investing. This investment is still early in the course of creating the new business and may provide funds to refine the prototype. The company prices and sells this beta prototype but revenues do not cover all costs.
Production moves from the garage to the newly acquired manufacturing space. Most investors avoid making early stage investments because investments made this early frequently fail to develop and losses of some or all of invested funds occur frequently. As a result, early stage investors extract favorable terms.
Entrepreneurs often have trouble ceding as much ownership as early stage investors demand, but experienced entrepreneurs realize that the early stage investors bear much of the risk of failure and must be motivated by a share of the upside potential to accept the risk.
The fourth stage of venture capital investment is called late stage financing. This stage generally requires more funds than either angels or earlier stage investors, but the risks of failure are considerably lower.
By the time of the late stage financing round, the company should have substantial revenues and may have reached breakeven point. Rapid growth creates a need for cash that cannot be generated fast enough internally. Many venture capital funds invest in late stage venture funding.
The fifth stage of venture capital financing is called mezzanine financing. By now, the company may be producing and possibly distributing the second production version of the product. The company may be creating its own manufacturing facilities for the first time. The company may be seeking to expand internationally.
Mezzanine financing is sometimes called bridge financing as the company grooms itself for sale. Mezzanine financing is frequently in the form of debt or preferred stock, although lenders often get options to buy stock or convert their interest into common stock.
The next stage of venture capital financing is often an initial public offering of equity. U.S. securities laws require a formal registration process (including substantial financial and risk disclosures).
Not every new company issues publicly traded common stock. Instead, the entrepreneur may sell the operation to a larger competitor or a company in a related industry without registering securities and making a public offering.
A strategic acquisition by another company may be the best way to maximize the potential created with the new company. This exit strategy may leave the entrepreneur with a smaller role to play in the combined company, which may or may not appeal to the management team.
These stages exist for the benefit of both the entrepreneur and the investor. Early stage investors extract more favorable terms from entrepreneurs, so are often seen as expensive sources of financing (at least by the entrepreneur,who is convinced that the business will defy the odds of success).
The stages also force some control or accountability on the entrepreneur because the company may be prohibited from additional financing until certain business milestones are achieved.
Likewise, investing in stages also benefits the investors who have observed the past success ratio at different stages and have decided to limit their risk somewhat by investing in late stage companies.