How Start-Ups Get Funded

By Markets Fool.com

HBO'sSilicon Valley goes to great lengths to accurately portray the start-up funding scene ... and poke some fun at its absurdities.

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In this clip from Industry Focus: Tech, Dylan Lewis and Chris Hill use the show as a launching pad to talk about the venture capitalist start-up funding process in Silicon Valley and Sand Hill Road. Listen in to find out about the different rounds of funding, from the seed round to series Z -- when each round takes place, what venture capitalists want from their investments in each, how much money tends to be raised, and how long they last.

A full transcript follows the video.

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This podcast was recorded on Aug. 5, 2016.

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Dylan Lewis: I think one of the things they do very well on the series is give a sense of how start-ups actually get funded, and that process. Most investors see the Twittersor Facebooksof the world pretty much from IPO on. They don't see the guts of what gets them into, "You have $X million in funding, you're working with that, how do you get to the next stage, and the one after that?" Very early on, the first episode, the founder of Pied Piper, this fictional company, Richard Hendricks, accidentally gets thrown into this seed funding opportunity. He pitches this music search app to this venture capitalist, Peter Gregory, who is the quirky venture capitalist that I think everyone imagines.

Chris Hill: Quirky billionaire who, among other things, is building his own island in the show.

Lewis: With automated robots, yeah. There's some background there [laughs]. And he shows some programmers at his office -- he works at this Google-type place -- this program as well, and ultimately, both the people at this VC firm and the people at Hooli, the Google-esque company, think that while his search app is very dumb and kind of useless, it's powered by this incredible data compression algorithm that is brilliant and potentially revolutionary. So, he faces two offers here: $4 million as an absolute buyout from the company that he currently works for, Hooli; or, $200,000 for a 5% equity in the company from this venture capitalist, Peter Gregory. And those deals shake out to the same valuation, the difference is, Richard actually owns the business in the equity option from the venture capitalist, whereas he would just be getting a $4 million paycheck from Hooli.

The $200,000 for 5% equity is what we would call a seed investment, or seed money. The reason they call them that is, it comes extremely early on in the process. Maybe some semblance of a business, very loose idea, a vision, but you basically have something incredible from the tech side, and the application isn't wholly there yet, but there's clearly a lot there under the hood and a lot of different ways you can use it. So, before a company can really generate any of its own cash, it needs some financing to get off the ground. That's where you see these investors come in.

Hill: One of the little points that comes up in the first season is -- and this is, of course, very much how the VC world operates -- that this venture capitalist, he's made his $200,000 investment in this data compression company. He's also made similar investments in other data investment companies.

Lewis: Like, eight other ones.

Hill: Right. And Richard, the protagonist on the show, is sort of hurt by that, like, "What do you mean?" It's like, "That's how VCs work." VCs work because they placed all of these small investments, and they know one out of 15 or so will hit it big and pay for all the others.

Lewis: And they can afford to do that because, what you typically see, especially in the seed funding round, is that the stakes tend to run somewhere between $10,000, and maybe $1 million. That would be a very large seed funding -- you don't see that too often. But, to your point, these are a lot of small bets that venture capitalists are making. We use VC a lot here in this discussion, seed money can come from other places. Founders can take out loans, raise money from family. There are also options like angel investors. Some people go the crowdfunding route with Kickstarters and things like that to get off the ground. I don't want to limit it to just VCs, but that's how you see it portrayed in the show, and that's how most people are familiar with it.

Early in season two, after they've been seed funded and had this successful TechCrunch appearance -- TechCrunch is a very well-known tech convention where people show off some of the very fantastic stuff that's going on in the tech space, some of these early-stage companies that are looking for more money. Pied Piper wins TechCrunch Disrupt, and multiple venture capital firms approach them about financing the company's series A round.

A series A round is what follows the seed investment. Basically, businesses go on to get financing through this round. It generally happens as the company has some proof of concept, and they need some additional funding to keep things going. Generally, this comes in exchange for preferred stock in the business. Typically, what you'll see in terms of funds being raised in this round, it'll be a lot higher than what you see in the seed rounds, typically somewhere between $2-$10 million, and they'll have a couple different firms involved.

There are a couple different reasons you see the higher amount of money being thrown at these businesses at this point. One, they've had some sign of success, they've gained some traction, there's a more fully formed idea of what's going on with the business. Two, the VCs want some significant skin in the game. For them to invest $10,000 or $50,000 in something, that's not going to meaningfully boost returns for them. They need to be throwing $1 million to be picking up a significant portion of these companies. That's why you see some of these investments start to scale out.

Just to give you an idea of one of these very successful publicly traded companies that went through their series A round, early on, Facebookraised $12.7 million from five different investors in their series A. That gave them an implied valuation, at the time, of $88 million.

Hill: Isn't that adorable to think about? [Laughs.]

Lewis: Yeah, they're now...I can't even do the math on how much higher they are now.

Hill: Yeah. Now it's the fifth or sixth most valuable public company in the world, something like that.

Lewis: Hundreds of billions of dollars.

Hill: Just past Berkshire Hathawayin market cap.

Lewis: Yeah. That's absolutely incredible. And the way that you get to that implied valuation is, you take the equity stake that's being offered up in the round and multiply it by the total funding raised during the round, and that gets you to the total valuation implied.

In the show, you see Richard and his colleagues go from meeting to meeting on Sand Hill Road. In real life, this is where a cluster of some of the biggest and most influential venture capital firms are in the Valley. This is where your Andreessen Horowitz are, anything that's getting backed that's really worth something is getting some financing.

Hill: I have been to Sand Hill Road.

Lewis: Oh, you have?

Hill: I have. Because, once upon a time, The Motley Fool took on some venture cap financing. I wasn't sitting in the room, I was sort of there with David and Tom Gardner and a couple other folks. I was along for the ride. I was not in the meetings, but I've been in those buildings before, and it's yet another great representation, a capturing of what it looks like in the real world.

Lewis: Yeah. I'm guessing high-priced art up on the walls.

Hill: Yes.

Lewis: Some nice distilled water, some sort of fancy snacks, things like that?

Hill: Absolutely. It's the kind of thing where you look around and say, "Yep, these people are doing well." [Laughs.]

Lewis: So, assuming everything goes successfully with the series A, you then work your way through series B, C, D, etc., as long as the company continues to seek financing through the VC side and opts not to go public. To give you an idea of how many different rounds this can go through, Twitteractually went from series A through G. They decided to stick around for a while; some companies don't go through that many, they do four or something like that, maybe they seek out some debt at some point and eventually go public. But, there's no real standard there, it kind of just depends on the company's needs and what management wants to do.

Chris Hill has no position in any stocks mentioned. Dylan Lewis has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), Facebook, and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.