A seed financing round represents a major milestone for a startup and its founders. “Seed” financing usually denotes a company’s first round of financing from an outside, unaffiliated party — usually professional venture capital investors. This round often comes after a startup has “started up,” when the company has a core team in place and a developed idea or product that is ready — or almost ready — to go to market, but before significant revenue generation or growth at scale (i.e., before Series A, B, or C financing rounds).
Seed rounds have different flavors and can be structured as classic equity financings (i.e., preferred stock), convertible debt financings (i.e., convertible promissory notes), convertible equity financings (i.e., SAFEs), or a combination of the foregoing.
This piece focuses on equity financing rounds. The pros and cons to the various structures will depend on several variables, including a startup’s current growth stage, projected financing needs, appetite for dilution, and desire to lock in a hard valuation for the company. For more information on the pros and cons of equity financing, convertible debt financing, and convertible equity financing, see: 3 Most Common Seed Financing Alternatives – Weighing the Pros and Cons. For more information on growth debt, another alternative way to access capital, see: Growth Debt and Structured Equity Primer.
The process of outside fundraising can be complex, tedious, and frustrating, but is ultimately an exciting time for founders and — if done right — can propel a company successfully into the next stage of growth. Below are seven important considerations that founders should keep in mind when planning for a seed financing round.
A seed round is likely appropriate when a startup needs to raise outside capital in amounts that are typically not readily available from individual angel investors, founders, or friends and family — typically in the range of US$750,000 to US$3 million (though amounts can vary depending on the startup and its near-term cash needs).
The question of how much money to raise is never easy and depends on the nature of a startup’s business and its future growth plans. Founders and their advisors should spend the time and energy required to realistically evaluate the current state of the company and its future plans. While some startups may be looking for one round to take them to profitability, more often than not a seed round will be a bridge to future, larger financings. Founders should seek to raise as much money as needed to reach their next fundraising milestone, often 12-18 months following the seed round closing. Among other capital needs, founders should consider their projected overhead costs, hiring needs/costs, planned expenditures, and projected overall burn rate during that timeframe.
The size of the round will usually impact valuation and will certainly create dilution. Founders should expect to give up — on average — 10-20% of their company in a seed round. Outside of unique circumstances, founders should try to keep that percentage as low as possible and, in any event, not over 25%. Importantly, a higher valuation is not always a better valuation. Founders should keep in mind — if contemplating future financing rounds — that their equity will be diluted again (and probably again and again…). Founders should aim for a healthy valuation and raise an amount that (a) provides the capital necessary to achieve a startup’s goals until the next fundable milestone, (b) keeps founder dilution at a reasonable and acceptable level, , and (c) position the company for success.
Prior to engaging with outside investors and negotiating terms, founders should ensure they have their core team in place. Investors will want to ensure that a startup’s core employees are fully dedicated to the company. To that end, founders should be able to clearly articulate each employee’s specific role and the value they bring to the company and its primary objectives. Similarly, planning for a seed round is the time to fully engage experienced outside advisors, including lawyers and accountants.
At the seed stage, founders are dealing with professional investors who will generally expect to see thoughtful and organized pitch materials. As a general rule, before formally engaging with investors, founders should prepare and fully vet the following documents: (1) a concrete business plan, (2) a short (1-2 page) executive summary regarding the business plan, and (3) a pitch deck. This information should be appropriately detailed, but concise and geared towards busy, fast-moving investors (who may very well digest the materials on their mobile phone).
These documents should, in short, tell the startup’s unique story, provide an overview of the founders and current core team, describe the startup’s current status, describe the product or idea and the issues it addresses, include information about the relevant market/industry, and convincingly portray the startup’s opportunities and projections for growth. Above all, the founders’ vision and purpose should be clear and convincing. At this stage of the company, an investor is investing in the founder itself (or founding team) as much, if not more, as they are investing in the specific idea or business.
Additionally, prior to engaging with prospective investors in earnest, founders should ensure they have a complete understanding of their company’s capitalization table and that their corporate diligence documentation is in order. While diligence should not be burdensome at the seed stage, files regarding company formation, board and stockholder actions, key customer contracts or order forms (if any), employee and advisor relationships, and all capitalization/equity matters should be documented, complete, and readily available. Founders should work with their lawyers to ensure that everything is in order — if it is not, now is the time to get organized and clean up any mishaps. Any “handshake” agreements should be papered, and all dollars received and equity granted should be documented and accounted for. Unorganized or spotty records may deter investors from closing a deal that they otherwise would have completed.
Founders should consider the universe of investors they would like as partners. Sometimes founders will already have promising connections with suitable seed investors, but not always. Founders should create a target investor list and consider factors such as industry focus/expertise, investment stage/typical check size, other investor portfolio companies, cultural fit, and geography. Utilizing existing networks is key and accelerators and other venture capital/startup communities can be a beneficial resource. While founders should engage in as many meetings as necessary to secure capital, they should— if possible — focus on a select number of investors that meet their ideal criteria and offer the most certainty to provide financing on the terms (and timeline) that the startup seeks. Founders should be mindful that meeting with too many investors can potentially dilute the company’s brand and create an impression in the investor community that the company is unfundable.
While a fast closing is always preferred, founders should not immediately accept the first offer the startup receives. Founders should consult with their lawyers throughout the term sheet and definitive documentation process. The majority of terms that experienced venture capitalists and investors will ask for will be reasonable, but lawyers are an essential partner to conduct a thorough review, to negotiate in good faith, and to ensure that the terms are understandable and acceptable with respect to control, dilution, and other important considerations. Importantly, founders want to strike a collaborative tone with investors and avoid acting overly aggressive at the seed stage. Form financing documents — like those published by the National Venture Capital Association here — have developed over time to not only reduce transaction costs but to establish a broad set of “market terms” that should help reduce the amount of negotiation between the company and the investor. That said, founders should look out for their own unique interests, consult with their lawyers about current market trends, and whether any business- or industry-specific terms are warranted. Experienced startup lawyers will be able to guide founders to the right point so that a startup can efficiently close a seed financing deal and get back to building the company.
Embarking on a first outside financing round is no small feat for a startup, and many factors outside of a founder’s control can dictate the ease with which they can secure funding. Founders should stay focused, be prepared, and never give up. For many startups, securing the first major outside funding round can make or break a company’s prospects at a critical stage of growth. The first money in the door is generally the hardest to secure. So founders should approach this process with confidence and focus on what they can control.