1. Introduction

The logic behind staged financing is rather simple. For most ventures, the path to success can be described with a series of milestones that the firm needs to reach. For a software company, for example, these defining stages of the lifecycle could be:

  • Idea
  • Proof of concept
  • Prototype
  • A number of letters of intent from potential clients
  • Stable beta version
  • Market entry
  • Reaching a predefined sales volume (or number of users)
  • Break even 
  • etc.

 

Instead of providing the necessary funding for the whole project upfront, staged financing ties the financing schedule to the firm's major future milestones and then injects the capital bit by bit. A company, therefore, usually goes through various rounds of financing during its early life. These rounds have catchy names such as:

  • Seed financing
  • Start-up financing
  • Early stage financing
  • Expansion financing
  • Etc.

 

The various financing rounds are shorter early on and in rapidly developing industries. Moreover, the capital invested (that is, the "size" of the round) tends to increase in later rounds. A structure of a staged capital contribution could be as follows:

  • The entrepreneur and the investors first agree on a target amount to be invested in the company.
  • The entrepreneur and the investor then clearly define the relevant milestones milestones and how to measure their achievement (e.g., what are "letters of intent"? what does "market entry" actually mean? etc.)
  • Then, they define the target capital investment that is triggered as the company reaches the next milestone.

  

Let us look at a hypothetical example to see how staged capital contribution works and why it is so popular in venture financing.