For a lot of investors, participating in a seed round is a positive experience for many reasons. But there are things you should know about how they work and their importance before diving head first into the pool.
What is a Seed Round?
A seed round is one of the earliest rounds of funding that an entrepreneur enters. If we consider pre-seed, which is typically a monetary investment from friends and family, seed round funding is the first round that usually includes angel investors. The purpose of this step is to acquire additional funding for business operations beyond the friends-and-family round. Typically, startups doing seed financing are new companies with a concept and some traction in the market. They have developed a potential solution and now need to determine market demand. Some angel investors will also ask that they see a prototype or market data before committing to a seed round. However, the business may not have proven market demand or a working business model at this point in time, and that is where the investors come in. If you are interested in what a company is doing, you can help them prove market demand, develop a successful business model and encourage growth. In cases where the entrepreneur does not yet have a prototype, funding may also be used to design and create one, as well as conduct market research, obtain office space, and purchase infrastructure, if needed.
One of the goals of a seed round is to secure enough financing to create the infrastructure needed to reach subsequent funding rounds such as the Series A. The funding goal for a seed round was traditionally $500,000 or less, but in recent years, that number has increased. Seed rounds today often look to raise more than the initial amount needed. It is important that you find out how the entrepreneur plans to use these funds. A potentially successful company will save these excess funds for later stage business development traditionally associated with Series A funding. Assuming all goes well, according to the Angel Resource Institute report published in 2016, you can expect to have, on average, a 2.5x return and a holding period of 4.5 years. Importantly, the study also notes a failure rate of 70% i.e., 70% of all investments returned less than 1x capital. This is important for all angel investors to recognize and understand – out of every 10 investments you make at the seed stage, you could expect to lose some or all of your capital on 7 of them.
Importance of the Seed Round
While the seed round investment is the hardest to raise, it is also very important to the entrepreneur and to the investors participating. If a company can raise a seed round and get some fundraising momentum going, they are more likely to be able to raise subsequent rounds. Investors at this stage can be essential to helping the company in many ways, including offering advice and direction, making introductions to potential Series A investors, and being a key player in decisions that impact the future of the company.
How to Raise a Seed Round
The difficulty in raising a seed round is that not only are angel investors typically valuation sensitive, but the entrepreneur is valuing a company before knowing the demand at that price point and what the market for the product is. One of the most important things you can do is ask how the company valued their seed round. Setting milestones for certain amounts of time, defining an equity pool, and calculating the pre-money valuation are critical steps in determining the valuation. Start up companies struggle with this step more than any other, because it is difficult to determine what the valuation should be. Many cannot face rejection, get discouraged, and eventually give up. An entrepreneur with a vision and stamina may be worth taking a second look at. Here is a quick look at how Swati Chaturvedi, an experienced entrepreneur and investor, recommends raising money. She has some important advice for entrepreneurs and it is useful for investors as well.
Seed Round vs. Series A
As an investor in a seed round, you are part of a small group of investors usually contributing anywhere from $50,000 to $2M total. The money is used to support market research and product development. In exchange for your investment, you could receive equity, convertible notes, SAFEs, or preferred stock. Your ownership upon exit, if any, will be further diluted in a seed round vs. Series A, but your investment gives the company more time to fine-tune their business model and connect with potential business partners which may contribute to the future success of the company. Companies at this early stage also have more flexibility to pivot based on market demand, which improves the chances for a positive outcome. Holding off your investment until a Series A means you are part of a smaller group of people usually contributing $2-10M. Your money may be used to prove out a business model. Your investment may not be nearly as diluted, so you may potentially own more of the company at the time of exit, if any. With start-up companies an exit strategy is never guaranteed. You will usually receive equity at this stage, and your investment is supporting scalability with larger partners, because the company now has more cash. Helping the company to achieve recognition in the market ensures a better potential success rate for your investment at the Series A stage.
Key Investment Terms in the Seed Round
Participating in the seed round involves understanding some key terms, and how they apply to the investment instrument you are using – typically SAFE or Convertible Note at this stage. We have already touched on the benefits and risks of SAFEs and convertible notes, so read up on the anatomy of a SAFE, as well as SAFE vs Convertible Note. Valuation caps apply to SAFEs and convertible notes. These instruments have valuation caps to protect investors. These pre-money conversion caps of the investment also enable the company to postpone setting a valuation because it is often difficult to estimate at this stage. In priced rounds where a company exchanges equity for an investment at a specified valuation or price (hence the term ‘priced round’). Typically, priced rounds offer Preferred Equity. Preferred equity usually has terms like pro-rata rights, information rights, anti-dilution provisions, and additional terms that do not apply to notes. When you own a portion of the company, you often get additional rights and terms that other investors do not. Here is a quick overview of Common Stock vs. Preferred Stock. The pre-money valuation is the valuation of the company prior to any investment. Once the company successfully raises capital, it moves to a post-money valuation, which is equal to the pre-money valuation plus the amount invested.
Process for Calculating a Seed Valuation
Swati Chaturvedi has written extensively in the past about valuations. Given the investor expectations we already discussed, the startup should consider aiming for at least an 8-10x exit multiple of initial valuation, so that after any capital losses, the investor still ends up with a potential 2.5x return i.e., 2.5 times the initial capital invested. Please keep in mind that no return is guaranteed and past performance is not a guarantee of future performance. So, if the Management Team values their company at $10M, the exit potential could be $80-100M. It is easier to value a company by working backwards from exit potential to find out what an appropriate valuation would be. Of course, finding the exit potential involves studying a history of the industry and trends, which can also prove difficult.
When calculating the valuation, the company should consider setting milestones and using the invested cash to reach them. By determining which milestones the company wants to reach, the management team can determine how much money they need to do so. These milestones could include a certain number of customers in the next few years, a pilot project, a monthly revenue goal, and expanding the team.
Defining an equity pool
For any company, the incorporation documents define how many shares are authorized. A company can issue this equity in any round. They can also increase the authorized equity by amending the incorporation documents. However, part of thinking through how many shares to authorize in this first round also usually includes setting aside stock for an employee incentive plan. Not only should the company think about saving equity for future rounds, but they often set aside 10-15% for their employees as part of the Employee Incentive Plan.
Investing in a seed round involves a high level of risk. The company has not raised any money yet, some may not even have a prototype, and your investment stands to get diluted – a lot. But the payoff may also be a lot, if everything works out. You also run the risk of losing the entire capital invested. Keep these factors in mind when considering whether to invest in a company raising a seed round.
Investing in a seed round is risky, but it can be rewarding. Fostering a company’s growth, especially one you believe in strongly, creates more than just a great return. It is fulfilling to be a part of something bigger than yourself. You may also want to read up on how to start angel investing. Consider the risk/reward when evaluating companies in their seed round to ensure you understand the scope of your investment and its potential.