By Samantha Pederslie
When should a startup founder consider a seed investment for their company? A great startup idea is truly exciting and invigorating. However, to make that idea a reality, one needs to purchase things like equipment, rent offices, and hire employees. With any startup, there’s typically very little capital (or none) to make these purchases. Besides that, the company needs additional capital to actually grow. This is where outside capital comes in.
When a startup company decides to fundraise initial capital, it’s called “seed” capital. This article illustrates everything that startup founders should generally know about securing seed investments to get their company up and going.
Why Raise Money?
It’s highly probable that a startup without any kind of seed funding will collapse. A common mistake that many founders make is underestimating the sheer pace and nature of a startup -- the high rate of growth requires a substantial amount of capital to eventually achieve profitability. Typically, that kind of capital can’t be raised from the founder’s family and friends. Of course, there are some companies out there who have managed to bootstrap (self-fund) themselves, but it’s generally wiser to focus on the common situation rather than the anomalies.
Cash is truly the lifeblood of a company. Besides securing a baseline for the company to actually survive, cash enables a competitive advantage in countless ways. Whether it’s attracting key talent, handling public relations with adeptness, or creating relevant marketing and sales strategies with marksmanship, money is what makes it happen. While there are many investors out there who want to put their capital into the right startup idea, the hard truth is that fundraising is no simple process. Many would describe fundraising as a brutal journey that may involve some ego deflation along the way. It’s a necessary challenge that all founders must face at some point or another, so when exactly should one decide to raise seed investments?
When to Raise Money
As a founder, you need to be able to communicate your story and vision with vividness and sincerity. Investors don’t just want to be excited by your idea, they want to be assured that you and your team are setting forth a real and sizable opportunity. Be ready to tell your story.
Of course, besides a vision and reputation, you will typically also need an idea, a product, and some kind of pre-established traction with your target customers. Fortunately, in the software development sector, a viable product can be engineered and implemented in a relatively brief period of time for a low cost. Methodologies such as Agile development allow for rapid prototyping and testing with constant feedback.
The tangibility of your startup’s idea is an enriching sight for many investors, but they don’t just want to see the product. They want to be persuaded -- Will your product fit the market, and is it experiencing real growth?
These questions mean that a founder should only start to raise money when they have also defined the market opportunity, as well as the target customer. The product at hand must address the primary needs, and it needs to be proven that it’s being adopted at an appealing rate. Of course, “appealing” varies depending on the situation, but generally a rate of 10% per week with recurrency is considered impressive. Impressing your investors leads to checks being written.
How Much to Raise?
Theoretically, once you raise enough money to reach profitability, you’ll never have to fundraise after that point. Not needing to fundraise generally makes it easier to secure investors, and your company will be able to weather constrictive events in the funding environment. However, some startups will still require a “follow-on round”, such as those who are building tangible hardware. In that case, the objective should be to raise enough money to reach the next milestone that requires funding. Usually, that timeframe is 12-18 months.
How do you choose the size of seed investment to seek? There are multiple variables to consider: how much progress the capital will purchase, your credibility with the investors, and dilution. Giving up 10% of your company would be ideal. Realistically, though, most rounds of funding will require up to 20% dilution, and anything over 25% should be avoided. Whatever amount you ask for, you need to tie it to a viable plan that investors can believe in (thus creating credibility.) It’s a good idea to create multiple plans beforehand correlating to different seed investment amounts. As a founder, see the investment amount as the speed that you can grow -- not the thing that opens or closes the door on whether you can achieve your plan. Communicate this to your investors, and show them that you’re confident in success whether or not you can raise the full asking amount.
Many may be intimidated about deciding upon an optimal amount to raise in the first round. First, decide on how many months you would like to fund the company for. For simplicity, you can assume that the cost of an engineer (the most common employee in tech startups) is approximately $15k per month. Then, simply multiply $15k by the number of engineers, and the number of months. This generalization accounts for hiring other types of positions as well, since it’s meant to be an estimation. You should also consider multiple growth scenarios with more/less months, as well as a range for the asking amount.
Early companies vary by a lot in how much they raise initially. They seem to average around six hundred thousand dollars, but can be up to two million. However, this average amount is trending upwards. Seed investments have been growing over the past few years, thanks to buzz from investors.
A founder should know about the basic concepts of venture capital financing. It’s a legal matter, so unfortunately it can’t be completely summarized in a succinct way. This is a high-level explanation, but you should take the time to research further about the various types of financing, as well as the different key terms that you may encounter in your deals.
Venture capital financing typically occurs in “rounds”, and they have names and an order. First, the seed round. Then, Series A, Series B, Series C, and so on until the eventual acquisition or IPO. None of the rounds are required to happen, and sometimes companies can begin at different rounds. Of course, here we are focusing on seed investments, which is secured in the first venture round.
These seed rounds are usually structured as either convertible debt or simple agreements for future equity (otherwise known as a safe.) In Silicon Valley, early rounds done with equity are considered an exception.
Convertible debt is when the investor makes a loan to a company using a convertible note. The loan has a principal amount, which is the actual amount of the investment. Additionally, it has an interest rate, and a maturity date (when the principal and resulting interest must be paid back.) The interest rate usually has a minimum of about 2%. The note will convert to equity when the company performs equity financing, which explains the term “convertible” in the name. The note will also have a “Cap”, which is the maximum effective valuation that the note owner will pay (regardless of the valuation of the round that the note is converted in.) As a result, investors that use convertible notes will usually secure shares for a lower price than other investors in the equity round. The note will also have a “discount”, which is the lower effective valuation which is calculated as a percentage off the round valuation. This is seen as the investor’s “seed premium.” Often, investors are willing to extend the maturity dates on their notes instead of collecting repayment.
A safe acts similarly to convertible debt, but there is no interest rate, maturity, or repayment requirement. Only the amount, cap, and discount (if any) are discussed as terms. Of course, any convertible security has some additional complexity to it when considering the context of the conversion, which you should research accordingly for your company’s situation.
When a company holds an equity round, they’re setting a valuation for the company as a whole. Usually, the cap on safes and notes is seen as the company’s notional valuation, but these can also be uncapped. This translates into a per-share price, and then new shares are issued and sold to investors. It’s generally more complex, and costs more time and money to do this. You will almost always need to hire a lawyer whenever you want to issue equity.
There’s a number of things you should consider when conducting an equity round, such as equity incentive plans, protective provisions, anti-dilution rights, and liquidation preferences. Of course there are more components, and they’re all negotiable. Again, equity rounds are relatively rare for seed investment rounds, so it will not be discussed in-depth in this section.
Valuation: What is my company worth?
So, you’ve figured out how to start a company in the USA, you’ve had some months of software development, and you’ve earned a few thousand users. How exactly do you value your company? Of course, a simple equation can’t decide on this value. However, you need this value in order to talk to investors. Why are some companies worth several millions more than others? The difference is based on what investors think the company will be worth in the future. Therefore, you should let the market set your price, and locate an investor to set the price. There’s a positive relationship: The more investors you attract, the more your company’s valuation will increase.
In some scenarios, it’s hard to locate an investor who can properly tell you what your company is worth. You can always choose a value amount, and you should do so by comparing yourself to similar companies that have valuations. However, it’s important to realize your bias as founder, and to avoid being over-optimistic. The valuation should enable you to raise the proper seed investment for achieving your goals with a comfortable amount of dilution. Your goal shouldn’t be to get the best valuation, as it’s not a key driver of your ultimate success or failure.
Investors: Angels & Venture Capitalists
Angels and venture capitalists (referred to as VCs) are different based on their level of experience. Angels invest their own money on their own terms, and they’re considered amateurs. VCs are professionals, and invest other people’s money. While some angels can act very much like VCs, they are typically investing as a form of hobby. Their decisions inevitably occur faster and with more emotion, since they’re acting on their own behalf.
In contrast, VCs face lots of deals on a regular basis, and are responsible for other people’s money. They will require more time and meetings, and will involve multiple people in the ultimate decision. It’s important as a founder to truly stand out to the VCs, as they see countless similar deals.
The current environment for seed investments is much more multifaceted and complex than even just a few years ago. New types of VC firms have emerged, which are called “super-angels” or “micro-VCs”. These firms look specifically for extremely young companies to invest in. Additionally, many traditional VC firms invest in seed rounds, and there are angels who invest up to $100k in single companies. With these changes, new fundraising options have also emerged. Some firms allow angels to pool their resources together, and follow a single lead angel.
How do you meet investors and capture their interest? A demo day is a great time to meet lots of investors, as there are few other times when there’s such a large group of motivated people seeking to make seed investments. As with many business situations, the best way to meet a VC or angel is to simply give them a warm introduction. This opens up doors for angels to introduce your company to their own networks. It’s a good idea to find people in your own network who can introduce you to seed investors. Besides in-person greetings, you can also research individual VCs and angels, and send them a succinct and interesting summary of your business opportunity.
In recent years, there has been a rise of new ways to raise money. Crowdfunding sites such as Kickstarter, Wefunder, and AngelList have helped many startups to launch their product and get connected to venture funding. In some cases, these websites have served as evidence of demand and traction with the customer base. While it is rare to completely fund the company from crowdfunding, they are a useful tool to “fill in” incomplete rounds or reinvigorating a slow round. A founder’s use of these newer types of funds will typically depend heavily on how they succeed in traditional fundraising.
Meeting investors can be a lot like traditional sales: Your goal isn’t to close them on the investor day -- you want to earn the right for a second meeting. Any smart investor will avoid committing to an idea the first time they hear a pitch, no matter how amazing it is. Therefore, you should book plenty of meetings, and remember that the most difficult part of the process is getting the initial investment into the company. Make sure to give the most of your attention to the investors that seem most likely to close (basically, be greedy.)
When you’re getting ready to meet with investors, there are some rules of thumb to follow. First, research what your audience likes to invest in, and why they do so. This means you’re creating a deep understanding of your audience before ever meeting them. Second, you should “slim down” your pitch to the absolutely essential details. For example, why your product is great (demos are a must), why your team is bound to succeed, and a rousing conviction for the investors to stand next to you in the building of your company.
Next, use active listening, and internalize everything that the investor has to say to you. Generally, if the investor ends up talking more than you, your chances of securing a seed investment increases significantly. At the end of the day, investors are human and want to be connected with. By conducting extensive research in the first step, you can show them that you’re committed to connecting them to your outcome. No matter how great the idea is, an investor will want to like the founder and their goals first before writing out a check.
Your identity and storytelling skills are extremely important when trying to persuade investors. They look for individuals who have a believable and possible dream, and have evidence to prove the reality of that dream. Find your personal style, and develop that as well as you can to make your pitch perfect. Like any presentation, pitching is often difficult for many people, especially founders who are more technical. The good news is that pitching isn’t an inherited skill; it’s learned and developed over time with practice. Take the time to engage in an extraordinary amount of practice, and it will be apparent in your pitches.
There are some personality traits that reflect well onto investors (find out what startup founder traits suit MassLight’s build-for equity program here!) Finding a balance between humility and confidence is one of the most ideal combinations to attract seed investments. One should avoid being arrogant, defensive, or being a pushover “yes-man”. Receive intelligent objections with grace, but stand up for what you believe in. Even if you haven’t persuaded the investor, this trait will leave a good impression on them (therefore opening up the door to more chances.) Finally, when exiting an investor meeting, make sure that you at least attempt a close. Otherwise, ask for complete clarity on the next steps to be taken. Leaving the meeting on ambiguous terms will benefit neither you or the investors.
Negotiating and Closing the Deal
When it comes to seed investments, they can be closed quickly when using standardized documents. Negotiation (if any at all) will revolve around one of two variables, which are the valuation/cap and discount.
Securing a seed investment deal tends to have a “momentum” that can be felt by all involved parties. There’s no simple way to build momentum, besides having perseverance, great storytelling skills, and the willingness to put in extra work. Sometimes, you may have to meet with countless investors before getting that coveted close. However, once that first money is in, each subsequent close will get easier and faster. Investors are much more open to following in the footsteps of others. Once an investor says that they are in, you should efficiently close by using the handshake protocol.
When negotiating with a VC or angel, recognize that they are most likely more experienced than you, since they encounter endless amounts of deals. Therefore, avoid negotiating in real-time, and involve a third party such as an advisor to navigate the request after the meeting. If the VC or angel is credible and worth their salt, their terms will be reasonable and non-predatory.
It’s a great idea to ask the investor to explain why they’re asking for those specific terms, and to get clarification on what exactly those terms are. If it’s revolving around the valuation (or cap), there are lots of considerations. At the end of the day, though, the initial valuation that you assign in these early rounds will rarely impact your company’s ultimate success or failure. Getting the best deal is amazing, but getting any deal at all should be your first priority.
Once you reach the verbal “yes” from the investor, don’t hesitate. Receive their signature and cash as soon as possible. This is why safes are so popular -- closing is as easy as signing a document, and then transferring money. This process shouldn’t take more than a few minutes, thanks to online wiring and document signing.
Documents You Need
For seed investments, you don’t need to spend a lot of time developing diligence documents. Investors that ask for lots of due diligence or financials in early rounds should be avoided. Ideally, you should come armed with an executive summary and a slide deck to give the investors a visual experience. Additionally, these documents can be left behind so that VCs can spread it through their key partners and networks.
At the end of the day, investors are especially attracted to startups that have tangibility. Many of the obstacles encountered during early fundraising are purely due to the fact that the investors are trying to ensure that they’re looking at an idea that’s believable and actionable. With MassLight, startup founders can bring their ideas into the real world without any software development experience -- thus eliminating one of the largest barriers to that initial seed investment. Learn more about MassLight’s build for equity program, check out our recent projects, or contact us directly for any questions you may have.