Seed Round Funding – All you need to know
A startup’s first external forte into fundraising is the seed round of funding.
The startup funding scenario is highly competitive and distributed into stages. Founders and investors alike ponder over the nuances of each stage and try to optimize them to the fullest. In this article, we focus on different aspects of seed round funding and try to understand how it differs from the other stages.
Seed Round Funding
Startups typically bootstrap into the market. A founder with a brilliant idea gathers the necessary funds from personal investments, friends, and family to create a basic structure that sets the business idea into motion. However, personal funds can only take a company so far. After a certain point, a substantial chunk of funds is required to scale-up the operations. Seed round funding is that first step into the professional world of funding.
What is a seed round of funding?
A startup’s first external forte into fundraising is the seed round of funding. Otherwise known as the ‘angel investor round’, this is the stepping stone towards advanced funding stages in a startup’s lifecycle. Seed rounds normally begin with a small amount and expand exponentially based on the startup’s performance and subsequent financial needs.
It is also worthy to note that seed round capital investments are a risky affair. Only a specialized section of investors known as ‘Angels’ and ‘Venture Capital’ firms agree to play this game. Traditionally seed funds were worth less than $500K focused to support formative activities such as the development of a business plan. As the startup culture gathered momentum, especially after the year 2000, the startup marketplace exploded, creating vibrant opportunities for young entrepreneurs to give their business ideas a shot towards success. This changed the face of seed fund investments. Today seed rounds can range anywhere between $500K – $2M.
But why is the seed round so important for a startup? Let’s explore.
Why should startups raise a seed round?
In simple terms, seed round funding lays the foundation for more advanced stages of funding such as Series A, B, and C, to be discussed in later sections of this article. The seed fund is not just about initial monetary investments. This particular period is important for first-time founders to do a test run and fill in the gaps in every front of the business operation. No other advanced stages of funding will offer this flexibility to make mistakes and learn from them.
Here are some basic reasons in favor of seed rounds:
- Creation of MVPs – Money from a seed round primarily contributes towards creating an MVP. With the funding from this stage, a startup manages to transform their business idea into a saleable product. This is followed by setting the wheels in motion for a successful product launch.
- Understanding the marketplace – After a product is launched, the next step is to invest in the necessary steps to create traction. Seed round funding facilitates this process. This is a good time to invest in market research, understand competition, identify the niche customer base, and arrive at the best company selling points.
- Team expansion – Seed round capital plays an important role in enabling a startup to hire the right talent to expand their operations. Until now, the business mostly rides on the humongous efforts of founders and maybe a small team of temporary staff. Seed money changes that scenario and prepares the startup to step up their activities for the next round.
No founder is expected to know-it-all from the beginning. Apart from a quick profit, one part of Angel’s interest in an early-stage startup is to mentor the entrepreneur and share their journey. So the ‘seed round’ is in many ways a preparatory stage, where the founder learns the ropes of fine-tuning their business along with the investors and engages in knowledge sharing with peers. Let us now understand some basic terms founders need to know before discussing seed round capital.
Terms You Should Know Before Taking Seed Round
The startup marketplace is extremely competitive. Every entrepreneur has a brilliant idea and the drive to be the next unicorn. On the other hand, there are only a handful of Angels and early-stage micro VCs who provide seed funding for startups. These investors receive hundreds of pitch decks every day and only a handful would be granted an audience. So a startup founder needs to be armed with as much professionalism and technical knowledge (about the product and fundraising) possible to create a lasting impression amid a crowd.
Here are some basic terms to start with:
- Pre-money valuation – This is the valuation of a startup before new funding has been granted. This value is a baseline on which investors decide how much funds are worth investing in this startup.
Pre-money valuation = Post money valuation – Investment amount
Thus, if the post-money valuation of a startup is $10 million after a seed round capital of $2 million, its pre-money valuation will stand at $8 million.
- Post-money valuation – This is the possible valuation of a startup after a new round of funding. Investors use this value to determine their equity stake in the startup post-funding. Outstanding shares pre-funding is also accounted for before entering this calculation.
- Convertible notes – It is common practice for Angels to deal with convertible notes for a seed round capital. Convertible notes are legally binding agreements in return for the investor’s fund which will be returned as equity in the startup at a later stage. Angels and early-stage VCs sometimes use convertible note agreements to negotiate equity during the next funding round.
- Valuation cap – This is the maximum price that a convertible note or SAFE will convert into equity during subsequent funding rounds. This is a way of rewarding seed rounding funding investors for risking investment in the early stages of a startup.
Share price = Valuation cap / Series A valuation
Valuation caps for early-stage startups range between $2 million – $20 million.
- SAFE – Simple Agreement for Future Equity is a standardized legal document created by Y Combinator. It is a type of convertible note and gaining popularity as a seed round funding option for startups. Like normal convertible notes, this document states how much equity the investor must receive at subsequent funding rounds. They have 4 versions:
- Cap, no discount
- Discount, no cap
- Cap and discount
- MFN, no cap, no discount
- KISS – Keep it Simple Security is a model convertible investment document created by 500 Startups. It serves a similar purpose as SAFE with few differences in features. The idea with KISS and SAFE is to standardize seed funding for startups. These documents create a basic checklist of agreeable terms, leaving less room for variable negotiations. KISS offers the following versions:
- For Equity – Cap, discount, no interest, no repayment
- Debt – Cap, discount, accrues interest, repayable at maturity
Seed Rounds vs Series A, B, C Funding
Seed rounds as the name imply plants a ‘seed’ in the business. But further rounds are identified with the category of equity investors would receive in return for the seed round capital. Series A, B, and C indicate the investor’s entitlement to Series A, Series B, and Series C shares in the startup.
What are the differences between the seed round and Series A, B, C funding?
Seed funding for startups is a must. The only scenario when this stage can be skipped is when the founder has been a serial entrepreneur and has prior experience of successful exits. They possess the skills and knowledge to create a company and bring it to speed. So for such startups, skipping the seed round makes sense. But for a new entrepreneur, it is always advised to go through the seed fund round to test waters. Also, startups must be mindful of equity dilution with every round. It is thus logical to approach the process step by step. Here are the other 3 stages of funding:
- This is the first external funding round for startups
- Investors of this round fall under the category of ‘Angels’ or ‘Micro VCs’
- Other sources of seed fund could be crowdfunding, close friends & family, accelerators & incubators, or corporate seed funding
- Seed round funding is in the range of $500k to $2 million
- Investors receive convertible notes, equity, or preferred shares in exchange for their investments
- The seed fund is used for activities related to product identification, market orientation, demographic testing, and team expansion.
- This is the immediate funding round after the seed fund.
- Investors of this stage are large venture capital firms. Sometimes, select Angels may also participate.
- Series-A funding is in the range of $2 million – $ 15 million
- Investors are rewarded with Series-A shares in the startup in exchange for their investments
- Series-A funding helps to imbibe the learning from a seed round funding experience. These could be in the form of changes/modifications to the business plan, analyze distribution patterns, and if possible consider new geographies to expand in.
- Series A round is followed by Series B
- Investors of this stage are traditional venture capital firms or the ones specializing in later-stage venture capital. It is often seen that the firms leading Series A lead Series B as well
- Series-B funding is in the range of $7 million to tens of millions
- Investors are rewarded with Series-B preferred shares in exchange for their investments
- By the time a startup reaches Series-B funding, it has become an established business, with all wings of operations in full motion.
- The focus of Series-B funding then is on business expansion in every form such as expanding the team to include experienced experts, globalization, new business/IPO acquisitions, and expansion of the customer base to the best of potential.
- Series-C funding is done only for specific needs. It is not part of the usual charted funding path
- Investors at this stage are later-stage VCs, private equity partners, hedge funds, and investment banks
- Funding can range between $10 million to hundreds of millions
- Series-C funding is usually used for new acquisitions and foraying into international markets in the continuing efforts of rapid expansion.
Let’s now cover some specific strategies for funding prep.
How to Prepare Your Startup for Seed Round?
Seed round funding is the foundation for your startup’s financial future. How a startup presents itself during the pitch will go a long way in creating a reputation in the industry.
Here are some basic steps a startup founder should be mindful off before pitching for a seed round:
- Clarity of purpose – A startup’s clarity in its purpose of existence and vision for the industry is the starting point. Only when a founder sufficiently represents the startup’s authenticity in purpose will the investors find a context for their association. The business proposal must carry a concise purpose statement of what the startup is trying to achieve.
- Solid plan – Seed round capital is generally raised for the next 12 – 18 months of startup operations. Create a map to check progress. This includes setting objectives, outlining metrics, and identifying assumptions. Plan in a way that on one hand it justifies the seed fund and on the other hand does not limit future expansion plans owing to finance. Think big and source the required funds. Not the other way round. Once this is in place, involve a trusted, experienced third party to review this plan for loop roles. Be open to receive feedback and incorporate them.
- Required funds – Once a plan is in place, analyze every bit of resource required to achieve this plan. This must be a reasonable exercise. Base your assumptions on a ‘worst-case scenario’. This will help the business account for additional resources needed to cushion an unforeseen fall. Demanding for too many funds will result in dilution beyond norms. Asking for too little will limit your growth. Hence arrive at the best possible seed round capital value after consultations with experts if need be. Take as much time as needed to perfect the pitch deck. You will have just one chance with an investor. Nothing can be left to chance.
- Investor referrals – Now that you know how much to raise, do thorough research of investors who support such figures in your industry. Network extensively and find common contacts. Cold calling or cold emails get lost in the chaos. Being introduced by a common contact from your network is a more authentic way to approach investors.
- Plan a runway period – Even if you are introduced to a potential investor, assuming that they are interested in your startup, it will take a considerable amount of time to close the deal. Hence you must account for this waiting period. Investors do not appreciate desperation and will not fund a cash-dry startup. It reflects badly on the startup’s finance management. This waiting period is called the ‘runway’.
- Legal – State and federal security laws and regulations apply for all rounds of funding, including the smallest sum of seed round capital. From the very beginning, care must be taken to maintain all the necessary legal documents governing shares, equity, debt, gift, etc. in a startup. Investors want to see a clean capital structure. Any issues regarding violations of state or federal securities laws can disqualify a startup from funding initiatives or may cost a heavy fine to rectify these issues.
Create and Manage Your Startup Cap Table on Eqvista
As we can see, starting from the seed round, a startup has to start dealing in equity. Managing cap tables becomes an essential part of a startup operation. However, with further funding rounds, manually maintaining this will become challenging.
Eqvista provides the best solution for this scenario. Our sophisticated software and easy to use technology help entrepreneurs manage cap tables and company shares with ease. We also support cap tables for all jurisdictions. To know more, reach us today!