Financial support is essential not only for newborn startups that struggle to get off the ground and become cash flow positive. It usually starts with pre-seed funding. But, capital infusion is also critical for startups at later growth stages. Mature startups that work intensively towards increasing their business revenues, need that support, too; but, for different reasons. As a matter of fact, it’s these funds that help them build from scratch — or rejuvenate — different departments, to speed up their growth. That’s where a seed investment comes into play.
Learning all about investing fundamentals is critical for startup founders-in-the-making; especially since this knowledge helps them make the right decisions, at the right time.
What is a Seed investment?
Seed investment — looking at it from a startup’s perspective — is the earliest official investment a startup manages to receive, in their early stages of development. This type of investment usually takes the form of equity-based financing; meaning that founders get capital in exchange for an equity stake in their company.
How do Seed investments work?
Seed investments are, perhaps, one of the riskiest types of investment. Especially since the investor is investing in an early stage company; which, essentially, has not produced revenues yet. To become a viable option for an investor, it calls for some complexity; to place some safeguards, but still remain manageable.
How and why would you get a Seed investment?
To get their hands on some seed investment funds, startups need to demonstrate the unique value proposition of their product. On top of that, they need to convince investors of their determination to push their business further; that is, with a go-to-market strategy and a clear plan, as to how they’re going to build a viable and profitable business. All these efforts take the shape of a seed presentation — or pitch deck — as we call it.
Capital infusion secured via a seed investment is substantial for a startup at this initial stage. To elaborate, the funds will be used to conduct additional market research; and accelerate both product development and other business operations. More specifically, startups will focus on expanding their teams further to support the development of the product, itself; and they will also enhance their teams, with additional roles to multiply the sales volume and further accelerate the business development.
How does a Seed funding round work?
Startups in search of seed investment need to demonstrate some kind of product market fit. And, by the same token, they also need to have some traction. Both of these achievements clearly show that the startup has already begun to level up and is about to enter the growth stage. And it’s these signs of growth that will help them secure a significant amount of money to move forward.
This time — contrary to the pre-seed funding round — the capital raised is based on the estimated value of the company. That is to say, since there are numbers to work on, the projections and forecasts of the startup’s future are not that vague. And as a matter of fact, it’s the valuation of the company, along with the financial instruments available, that are used to seal this deal between investors and startup founders; and that defines a seed funding round.
How much should you raise?
The amount of capital a startup will manage to secure by raising a seed investment round varies. More specifically, it may range between $500K – $2M; but again, these amounts are dependent on both the industry in question and the location — and local economy — where the investors and investees are active.
Now, regardless of the financial potential, in terms of secured seed investment, startups need to focus on pitching to investors; that is, to get the amount of money that will allow them to get to their next business-critical milestone. That is to say, they need to secure an investment that will allow them to either get to the next funding round — Series A — or achieve profitability; so that they won’t need to depend on external funding any more.
Apart from the aforementioned goal, the pitch needs to include a well-defined plan, as to how the startup will leverage the capital secured. And, as such, it increases the odds of finally closing a deal with seed investors. Investors need to know how the startup will spend the money, to produce value.
How much is your business worth? (Valuation)
One of the most critical questions to answer during a seed investment round has to do with the value of the company. The pre-money valuation, as it is usually called, is a rough calculation of the company’s value; and it takes place right before investors add their own money. And, though there is no formula to use and get that number, both the investors and startup owners will attempt to perform an informed guess; that will be part of the negotiation process — a ballpark figure, of sorts.
Most of the time, they will use comparable startup companies, as a point of reference, while they take into consideration any numbers that justify their traction up to this point. The agreed valuation number between investors and founders will determine the final funding amount. Note here that neither a high valuation — and, consequently — nor a high amount of capital increases the likelihood of success for a startup. The capital raised is a “vehicle” that allows startups to perform the business actions that will get them closer to profitability.
A huge amount of capital is not — or at least should not — be the ultimate goal for a startup in any fundraising round; let’s not forget, capital infusion is given in exchange for a good part of the company’s equity stake. And, it’s not something that anyone should negotiate away that easily.
What are your financing options?
Part of the negotiation process is the selection of the financial legal instrument that will be used to set the seal on the investment agreement. To further explain, investors and startup owners need to come to an agreement as to how their deal will materialize; and what would be the details of their contract. The most common financial instruments they may use are convertible debt, equity and SAFEs. And though most of the time it’s the startup that — kind of — determines the preferred instrument to use — that best fits their needs — it’s not unusual for the investors to lead the way in that aspect of negotiation, too.
Convertible debt
Convertible debt — or convertible note, as it is alternatively called — is the most common financial legal instrument used to complete a seed investment round. To further explain, it’s an investment loan; which will be converted into equity — shares of stock — during the subsequent funding round. These convertible notes usually come with a Cap or a discount; that allows current investors to take part in the next round of funding with the privilege of buying shares at a lower price. Convertible debt favors seed round investors that have participated in an earlier — and, thus, riskier — funding stage.
Equity
Convertible notes and SAFEs are financial instruments created by lawyers to make the seed investment much easier, as a process. As a matter of fact, they were created to resolve issues that arise when seed investments involve equity. On one hand, under an equity investment, there is no debt for startup owners to pay off in the distant future. And that’s simply because investors buy shares at the time of the investment. This may be the way to go for some startups.
On the other hand, under equity investment, investors are, once and for all, granted with significant control rights. And, on top of that, there needs to be some sort of valuation of the startup, in order for the investment round to be completed. Both evaluation and legal documents, including fees and terms to negotiate, may hinder the progress of the seed investment; and it may take longer than expected to complete.
SAFE
SAFEs — or Simple Agreements for Future Equity — were introduced by YCombinator in 2013, as an alternative to convertible notes. SAFEs are simple to draft; and act as standalone agreements, in that the startup is able to sell them to individual investors. That is to say, they do not need to coordinate with other investors that may participate in that seed investment round, before they can sell. The terms included in a SAFE are simply the amount of capital, the Cap and the discount; that is, in case there is one. Now, as for the cons of using a SAFE, it’s the coordination challenges the moment the conversion takes place; if there are multiple investors as participants, they need to consent, in order to proceed. Additionally, there may be multiple valuation caps that also hinder the process, ambiguities regarding taxes, and so on.
What makes a good Seed investor?
The major objective for startups looking for seed investment funding is the amount of capital itself; and the sealing of the final agreement, of course. However, funding, alone, as a resource, does not guarantee the success of a startup in the future. The investment agreement itself — including the terms and milestones agreed — and, generally, the nature of the cooperation between the two parties, are also critical for the startup’s future.
Hence, startups need to carefully examine the available options. More specifically, they need to make sure the investors they’ll approach are, indeed, a good fit for their own venture. Therefore, they need to examine and evaluate the profile of the investor they’re about to trust; and their perspective, in general. Previous track record (success ratio) and portfolio preferences (industries/domain) — along with their positioning, in terms of involvement (passive/active) in their portfolio startups — are only some of the things startups need to have in mind; and try to answer these questions themselves, before they make their decision.
Types of investors
Startups that are in search for seed funding, may target the following types of investment resources:
- Incubators and accelerators that provide startups with funding and mentoring; and access to a wide list of services, critical for business development.
- Angel investors and angel groups often include investors from a range of industries and markets that usually use convertible notes; and speedup the investment process, in that they postpone valuation till the next funding round.
- Angel syndicates, which include a large number of smaller investors; and give the opportunity to startups to target a larger investment pool.
- Early-stage venture capital firms or micro venture capitalists that provide capital to early-stage startups; and fill in the gap of funding for a newborn startup, till it reaches a mature funding state. These firms build portfolios of smaller bets; or get involved with larger rounds and get a small piece of the total fundraising round.
Domain expertise
Now, as for their focus in terms of industries, some investors have strong domain preferences when investing. To further explain, investors generally do not tend to hold fully diversified portfolios. Some of them lean towards specific sectors, such as fintech, for example. In this case, investors are highly likely to favor a startup that trades in that domain — against another, during the selection process. But, this approval benefits the startup in question, in many ways. To elaborate, it can be a win-win situation for both parties, as they may offer startups extra network opportunities; by making strong introductions to key contacts in their industry of focus.
Net worth and past investments
Another parameter startups must take into consideration, when exploring their options — with respect to the investors they should approach — is the net worth of the investment firm. The Net worth — or shareholders’ equity of a company — is the value of the total assets (liquid or not), minus the total liabilities. The higher the net worth of an Angel investor or investing firm, the better their financial health. In the same fashion, this parameter also increases the probability for the investor in question to participate in a subsequent funding round for the startup.
This, as expected, works both ways. That is to say, investors will be equally interested in knowing all about the startup’s net worth. A positive — and, much more, an increased — net profit, translates into increased profits; whilst, a negative one, will not help investors feel confident in the startup’s ability to repay their convertible notes or other loans, in the near future.
Network opportunities
The seed investment round may be the first official funding round for some startups. To further explain, there may be founders who bootstrapped their startup and managed to finance it — thus far — using their personal savings. As expected, these startups may have gone through a more introverted pre-seed stage; and, thus, they may have not yet managed to build a wider support network.
Apart from funding, fundraising efforts help in that direction too; building a network. That is to say, apart from capital, startups typically need to also build strategic partnerships; and, generally, make the most of any network opportunities that will contribute to their growth. In that spirit, efforts to approach — and finally get seed funding from — investment firms with access to a network that has a global impact, is definitely a wise use of perspective.
How to get a Seed investor’s attention
Before they make their final decision to invest in a startup, seed investors review and assess a list of parameters that help get a better understanding of the risk involved. The most crucial factor they mainly focus on, is the profile of the team; and their experience in the domain they’re trading in, of course. Similarly, they will also be interested to know all about the cost balancing plan and the traction earned so far. All of these aspects serve as proof of concept; and help seed investors understand whether the business idea they’ll be involved into has merit or not.
Build a competent team
To get investors’ attention, startups need to have already assembled a powerful and competent team. To elaborate, seed investors want to see that the startup team has — among other things — attributes such as commitment and trustworthiness; and that they’re also open to learn and cooperate, when needed. These attributes should characterize not only the founders themselves, but all the members of the startup team; and any new members that will gradually join them in the future.
Inevitable challenges that will come their way, along with hurdles; which will require the startup team to demonstrate the appropriate mentality and perspective. Experienced seed investors are aware of these upcoming challenges and, thus, are interested in building long-term relationships with their investees. In any case, a good quality team reduces the risk of their endeavor; after all, they’re putting their money, time and prestige on the line for this new team.
Expertise in your domain
Startups are also likely to get investors’ attention if the investment firm focuses on the same domain of expertise. To further explain, it’s not unusual for investors to decide, in advance, what they want their portfolio companies to achieve; and be persistent to this decision.
These investors will potentially have influence in that industry; or they’ll, at least, be well informed. And this will prove to be a great benefit for startups that will come under their umbrella; as they’ll probably get — among other things — support with setting up their distribution and media channels. Finally, startups that focus their capital raising efforts with this perspective in mind, are also highly likely to not only attract investors’ attention during the seed investment round; but also have them as participants — or allies — in subsequent financing rounds. This is what’s known as a “follow-up investment”.
Traction
In considering investing in a startup, investors are willing to closely and thoroughly inspect data and stats that justify its progress. To elaborate, they need to be sure that the startup in question has already achieved considerable product demand; sufficiently backed with numbers that prove said traction. Among other things, they’ll examine the number of registered users, the number of active users and the website’s traffic; and other clues that prove customer engagement. On top of these, they’ll also want to know how the startup progresses, in terms of profitability and revenues. All of these elements are success indicators that help investors reduce the risk of failure; and increase the promise of a large return, in the near future.
Cost balancing
To attract investors’ attention and finally clinch a deal, startups’ capital needs should be crystallized and well communicated. More specifically, startups longing for seed investment must have a clear idea of how much capital they need at each development stage; and how any amount will be broken down and spent. Investors will require a solid financial plan that justify these needs; and they will also require that founders provide realistic projections of revenues and growth. The latter will be examined in market numbers and stats to get a better understanding of how the startup’s vision fits into the current market.
All in all, capital requests are strongly connected with the milestones set and the respective commitment and ownership to see them through. Missed milestones would eventually create the need for further funding; and, the greater the amounts of capital provided, the greater the percentage of company ownership given away to investors.
Negotiate the deal
Seed investors assess all the aforementioned parameters; competent team, traction, cost balancing, domain expertise and, generally, the orientation of the startup in order to come to an agreement. Startup founders, on their part, get to illustrate all of the above; and can, thus, justify their position — using a pitch deck. This presentation tool helps create a connection of trust and confidence between the investor(s) and the startup owner; and will spark the interest in the investors to learn more. All in all, once the founders get the opportunity to present their ideas and their plan in front of seed investors, there will be follow up discussions; and negotiations, till they finally close a deal. The pitch deck is only the beginning of the game.
How does a Seed investor get their investment back?
To get their money back, seed investors will, typically, invest in a series of startup companies; their portfolio companies. Statistically, some of these startups will fail and some will return part of the initial investment; only a few will be the “winners”. As a matter of fact, it’s the winners that will manage to make most of the returns for the seed investors. According to the Angel blog:
In a typical VC portfolio, most of the returns are from 20% of the investments. This is just a statistical fact – a law of nature. Statistically, if a VC makes ten investments, two will be winners and create most of the gains in the fund.
This is not a new concept. For many outcomes, roughly 80% of consequences come from 20% of causes. And that’s known as the Pareto principle.
Now, as to when this return will come into being, one of the scenarios refers to a liquidity event; and that’s when investors are able to convert their equity into cash. This scenario might take place when there’s an “exit” — the startup company has been sold; that is, merged with or acquired by another company — or when there’s an IPO; an Initial Public Offering that allows the startup to (re)raise capital, from public investors this time.
How is Seed different from Pre-seed investments?
Startups take part in sequential investment rounds that normally bring increasing amounts of funds to the table. The differences between a seed investment and pre-seed investment round does not only refer to the amount of capital startups raise, during each one of these rounds.
A seed round may lead to a startup securing anywhere from $500K to $2M; depending on the industry, the location of the VC firm etc. On the other hand, during a pre-seed round, startups raise money in the range of $50K – $250K. But again, a seed investment does not necessarily come after a pre-seed round. As we have previously explained here, some startups begin their journey with bootstrapping; i.e., they get their initial money from friends, family members or simply by making the most out of their own financial resources.
These two funding rounds differ, also, in terms of the target runway, business goals to achieve during each stage — along with milestones achieved up to this point — as prerequisites to secure each funding. To elaborate, seed investors require startups to have already launched a product version that brings in some sort of traction, before they attempt to pitch.
Furthermore, startups aiming to get seed funding, need to have built a fine-tuned team — that is ready to grow further; that is, to ensure they hit critical milestones, henceforward. On the other hand, a small — but quite competitive — team that works towards launching their pre-product company from scratch, is sufficient for startups aiming to get pre-seed funding. As for the target runway, based on capital received and business actions to be performed during each stage, it may be 12 to 18 months for seed investment; as opposed to 3 to 9 months of the pre-seed round.
TL;DR
Seed investment is the earliest official investment a startup manages to receive in their initial stages of development. To get access to a seed fund, startups need to have a clear strategy, as to how they plan to further accelerate their business development. And the amount of capital they’ll usually secure during a seed investment round, may range between $500K – $2M.
Startups and investors use various financial legal instruments — created by lawyers, for that purpose — to make the seed investment process much easier and seal the deal. Convertible debt, equity and SAFEs are among their viable options; and some of them may include a valuation of the startup company, as a prerequisite. The value of the company and the legal instrument of choice are part of the negotiation process.
Finally, both startup founders and investors use their own criteria — such as expertise in the domain of interest — to evaluate the opposite contracting party. And with this toolset under their belt, seed investments are almost routine operations; easy and accessible to anyone with a great idea and the drive to realize it.