A seed round is one of the most important rounds of funding and one of the most exciting!
Seed funding provides the initial traction for proof-of-concept, developing your prototype, and initial spend for promoting your product/service to potential customers.
In this blog post I will cover the sources of seed funding available, how much money is raised in a seed round, the types of options available for raising money, and things to keep in mind when completing your start-up's first fundraiser.
Who Can Provide Seed Funding?
The seed money can come from family, friends, angel investors, accelerators, seed funds, and potentially super angels, VC's, and corporate funds. It all depends on the amount of money you are looking to raise, the industry your venture is in, and your network.
How Much Money Can Be Raised In A Seed Round?
There is no limit per se. However, usually a seed round refers to enough capital to get the business going. The amount depends on the type of investor, and how much you are looking to fundraise. However, for the sake of oversimplification, Crunchbase reported that the average seed round was just over $1 million dollars. Keep in mind that this usually comes from a variety of investors, not just one.
The following list will provide you a better idea of how much money is usually made available by each type of investor in a seed round:
- Friends and Family: They will usually provide you with $5k to $50k.. In some cases, it can go significantly higher than that.
- Angels: It depends on each individual, but you will typically see investments range between $20k to $150k.
- Accelerators: They provide access to capital, office space, and mentoring, with most seeking 2-6% of common stock in return.
- Seed Funds: They tend to invest $50k to $750k in a round.
- Super Angels, VC's, Corporate Funds: They will invest $50k all the way up to $1.5 million.
Types of Options Available For Raising Money
- Common Stock: Providing common stock to friends and family is popular, but you are not as likely to get angel investors to be interested in this option. Common stock has a high risk of dillution from having to value the company so early in its life.
- Preferred Stock: Preferred stock will be what most professional investors will be looking to get. This will allow them special rights such as a board seat, veto rights, control rights, and liquidation preferences. As an entrepreneur, you are not going to be giving away preferred shares to anybody with money, and you should think as to what they can contribute from a strategic perspective. Remember that a decision made early, will impact all future rounds... and it is likely you are stuck with these investors for many years to come.
The process of assigning preferred shares can also get pretty complex, time consuming, and expensive. While there are options for a standardized Series Seed form that simplifies the paperwork and negotiation, it is not always to both parties' benefit.
- Convertible Bonds: Convertible bonds have become very popular in recent years. They are simple, effective, and the paperwork is cheap. They give you the option to fundraise quickly, and close the round in a couple of days with just a few thousand dollars worth of legal costs spent on a promissory note, a note purchase agreement, and other minor details.
So what is a convertible bond? A convertible bond is basically a short-term debt instrument issued in a seed round that converts into preferred shares after the closing of a Series A round. Another way to think about it is that it is a loan, that becomes equity in the future. One of the great benefits is that there is no need to negotiate a valuation for your start up so early on, leading to faster negotiations. The only big negotiating point is the conversion valuation cap, which is the conversion price of the bond. In essence, this protects investors from being dilluted if it turns out that the company's future valuation skyrockets.
Entrepreneur and Investor agreed on a convertible bond during the Seed Round, and put a cap of $4 million dollars on the deal.
...A year later, the entrepreneur is raising his Series A, and the pre-money valuation agreed with Series A investors is $8 million dollars.
Regardless of the new valuation of the company, Seed Round investors will still convert their bond into shares at a $4 million dollar valuation.
The effect of this is that they are getting a share of the company for 1/2 of the price than what Series A investors paid, rather than what the company is now worth. This not only protects investors, but rewards them for having taken a risk on the entrepreneur so early on.
One thing to keep in mind when negotiating the cap is that you should try to find a happy medium. If you negotiate a very low cap (let's say 1 million dollars) but you are almost sure you will raise money next year at a 20 million dollar valuation... then you are essentially selling the shares of your company 20 times cheaper than you should. Not only that, but it gives the impression you are desperate. On the other hand, if you try to push the cap too high (20 million dollars) you are going to drive the investors away because there will be no upside for them.
At a point in time when valuing your company is usually quite ambiguous, a convertible bond can typically be the most prudent choice for both entrepreneurs and investors.
Things To Keep In Mind When Fundraising
- Advisory Boards And Lawyers Are Important: Before you kick off the fundraising process outside of family and friends, build an advisory board that can provide you with genuine advice, connections, and ____. I would also recommend hiring an experienced law firm to help you with the process even if it runs you a few thousand dollars. Remember that in the long run, this few thousand dollars can help you save millions.
- Have Proof Of Concept: At the very least have a Minimum Viable Product (MVP), well-researched evidence about your industry and the desire and need for your product, and some strong proof of traction through focus groups, interviews, or other primary data. Ideally, you will have sales/customers, can show growth, and have an operational, technical, and marketing/sales plan for the coming year.
- Make An Investor Fall In Love With Your Venture: Find a lead investor that believes in your venture more than even you do. This lead investor will be your cheerleader, and will help bring on other investors who might have been in the sidelines waiting before jumping in. Once you bring other non-lead investors into the picture, make sure they are adding value to your venture and not just money.
- Fundraising Takes Time, Plan Ahead: As the entrepreneur running your company in what is probably an overworked, small team... you will struggle both running the operations and fundraising. For that reason, it is important you plan ahead. Fundraising is a full time job and for atleast 6 months it will be where the majority of your time will be going. Make sure you have someone highly qualified to take over you. If you don't, your business could suffer.
- Develop A Sales Approach To Fundraising: Be organized when looking for potential investors. This means gathering investors' information, setting up a CRM-type system, tracking potential investors over time, and setting up phone conversations and meetings.
- Time Can Kill A Deal, Be Decisive: Once you receive a term sheet you will usually have a predetermined amount of time to make a deal. You do not want to make an investor wait too long. The best way to avoid that is to know where you stand from the beginning. Make a list of what is negotiable to you, and what are 'deal killers' and this will allow you to be quick to respond. Make sure you know what is the lowest you are willing to go on a valuation, and what is the minimum investment you are looking for.
I hope you enjoyed some basic information on raising a seed round. In the next blog post, I will take a break from venture capital to discuss start up marketing.