A Beginners Introduction to Seed Funding
October 5, 2017
While seed funding is often the easiest round of funding to obtain, it’s also the foundation on which you’re building your entire business. The first round is the most important, so make sure it’s solid.
If you’re completely new to the world of funding and startups, don’t worry. This article will cover everything you need to know about seed funding.
Investors only have one goal in mind 一 making money. They aren’t looking to invest in a company that will slowly generate revenue over the next 10+ years. That would make their investment illiquid, and the principal investor would likely be retired by the time the company is sold.
Generally speaking, investors are looking for either a company with a high likelihood of IPOing within the next 5-8 years or a company that could get acquired for a high price tag in the same period.
Most seed stage investors are looking to make a lot of small investments in companies that could potentially have a 100x return. In layman’s terms, if 95% of their portfolio fails, but 3% have 10x returns, and 2% have 100x returns ー ultimately, they will be up 230%.
So typically, investors are looking for ideas with huge upside potential. Many VC funds will make the majority of their returns on one to two companies if they can get in during the early stages the company (Facebook, Uber).
Investing in a startup with no financial statements, nonexistent corporate structure, and no assets or intellectual property to speak of is the very definition of high risk.
That’s why very few entrepreneurs can avoid relying on their networks for funding when first starting out. The key to making that work is to be deliberate, cautious and clear when setting expectations. Starting with a shaky foundation is setting yourself up for failure whether you’re talking code or organizing your company’s financing and legal structure.
That said, there are six essential things you need to do when it comes to raising the first round of funding:
Many entrepreneurs are focused on raising the next round of funding 一 not building an actual profitable business. The app startup market is saturated, and everyone thinks their app will be the next big thing. And this may be your case! However, you still need to know what you’re doing.
Yes, moving through funding rounds as fast as possible is important, but it shouldn’t be your only focus. At this stage, you need to know every detail of your company, industry, and the problem you’re solving. Once you cover your basics, you can shift more of your focus on the business aspect.
Here are the key things investors will look for:
Source: Your Startup is Overvalued
Overvaluation is typically one of the first mistakes startups make 一 it’s also the biggest. Entrepreneurs are optimistic by nature, so it’s not uncommon to overvalue your company, but fixing overvaluation after the fact is difficult if not impossible. It also comes with repercussions:
Research how what similar app startups are valued at and think about consulting an accountant or lawyer to estimate market rate. Start with comparables and conservative financial projections to determine a value and then test it. How much of an offer would you need to see, realistically, before you’d sell?
Another way to come up with a realistic valuation is to place a number on your current user base. To learn more, read “The Quick & Dirty Formula for Calculating your App Startup’s Valuation.”
Disclaimer: If you use a convertible note, you don’t have to worry about your company’s initial valuation, because your official valuation won’t be calculated until you go through a series A.
A rich uncle may look like promising, but if he’s never invested in a startup, you should cross him off your list. Well-connected friends and family are worth their weight in gold but experienced seed investors will be stepping stones for follow-on financing, and will get you further much faster. Optimize for speed, not numbers.
If they don’t share the same vision as you and your co-founders, you’ll set your company up for a world of arguing. And if they only have an end goal of exiting as fast as possible 一 not building a solid long-term business 一 consider that a red flag.
With that said, don’t rush to set up meetings with anyone and everyone. Limiting your list to accredited investors 一 those who earn a minimum of $200,000 per year or have a net worth of at least $1M 一 will also eliminate potential legal problems if it comes time for IPO.
“Investor relationships are similar to marriages. You’re legally bound to each other, for better or worse, till death do you part. It is important to understand what value the investor adds beyond capital as a founder. As an investor, it is important to look beyond the product at the founding team and understand whether this is the right team to deliver as much value as possible and dominate their category.” 一 Andy Ayim, startup advisor
Strive to get the most from your investors. Now, this doesn’t mean pestering them with questions every day; it means asking for guidance and practical advice 一 not just money. A modest investment is great, but relationships will help your company grow in the long-term.
Offering preferred shares is a way to offer a higher return on investment in exchange for limited engagement. However, having a bunch of different investors with different kinds of shares can be incredibly difficult to manage, especially when you’re focused on launching and maintaining a business. Unless you have a background in finance or have experience with those kinds of fee structures, it’s best to keep it simple.
Consider taking the route of a convertible note. Essentially, investors will give you money and then during your next round whatever the valuation is, they will get equity equal to appx. 5% less than that valuation. For example, say you raise $100k during your seed round and then eventually raise series A at a $1M valuation. In this situation, the seed investor will get in at a $950k valuation giving him 10.5%.
You have a ton of confidence in your business concept 一 as you should. However, the fact is, 90% of startups never make it out of the seed phase. It’s crucial to be transparent for the sake of all parties involved.
Honesty is always the best policy no matter how drastic the situation is. Investors actually want to see you list out potential problems that could arise in the future. They don’t mind if you’re pursuing something that seems risky. In fact, they like to see that, because the best startup ideas typically sound crazy to most people.
However, they want to see that you’re aware of the obstacles, and have at least a theory about how to overcome them. If they can see potential problems that you haven’t considered, that’s a bad sign. Why? Because it’s your idea. You’ve probably had months or years to think about it, whereas investors are only listening to an elevator pitch. They shouldn’t be able to come up with anything you haven’t already assessed.
Unless you have had previous success, expect to take tens or even hundreds of investor meetings to obtain the first investment. Persistence is key, along with being able to learn from experience and overcome rejection.