The Startup Founder's Guide to Seed Rounds

I've fundraised a lot. Tactically, fundraising is a skill like any other. You get better the more you do it. But practicing gets you nowhere if you don't have a strong foundation in understanding a fundraising round's core components.

As a founder, you will understand less than investors when it comes to fundraising. For investors, negotiating with founders is their full-time job. For founders, fundraising is just a small part of building your business. Understanding the basics of venture financing can help founders raise on better terms.

Read this article to avoid common fundraising mistakes. In this first article, we'll cover:

  • How financing works- SAFEs vs equity rounds,
  • How to determine how much to raise, and
  • How to arrive at your valuation.

This is our second installment in our 4-part guide on how to start a company. Read the first installment on how to incorporate here.

1. How does fundraising work - SAFES vs equity rounds

Venture financing takes place in rounds. The first stage is the pre-seed or seed round, then a Series A, then a Series B, then a Series C. You can continue to raise funding until the company is profitable, gets acquired, or goes through an IPO.

We will focus here exclusively on seed-stage funding - your very first funding round.

SAFEs

Post-money SAFEs are the most common way to raise funding. These documents are used by Y Combinator, angel investors, and most early-stage funds. You should raise on post-money SAFEs using standard documents created by YC. Standard documents have consistent terms that have been drafted to be fair to both investors and founders.

By using the standard post-money SAFE, your negotiation can focus on the two terms that matter:

  1. Principal - This is the amount you want to raise per investor.
  2. Valuation cap - This is the value of your business.

An alternative to post-money SAFEs are pre-money SAFEs. They were used until 2018 when post-money SAFEs were introduced. The difference between pre and post-money SAFEs is how they convert at the series A. This is not really something to worry about. What you should know is that difference in dilution is minimal.

Equity Rounds

You can think of a SAFE as an IOU for future equity. In contrast, an equity round occurs when you sell shares (aka equity). Beyond the financial terms of how much do you want to raise and your company's valuation, you also need to answer important questions around who controls your company through your board.

Although you may think of your company as ‘yours’, it is a separate legal entity. A company is controlled by stockholders who vote on a board of directors. This board of directors chooses a CEO and other leaders to manage the company - who may or may not be you.  At the equity round, investors who own a large percentage of your company can vote on the board and have greater control over the direction of your company.

If managing a board sounds complicated, it's because it is complicated. Raising funding on an equity round is always more complicated, expensive, and time-consuming than issuing a SAFE. The average pricing for an equity round is around $30,000 - $50,000 and takes over a month. Raising on a SAFE is free and can close the same day because you can defer questions around control to the equity round.

Deals have momentum. Closing quickly means you can go back to focusing on building your business. Equity rounds can prolong your fundraising and are not recommended for the seed stage.

Plan your fundraising

Plan your fundraising before you start. You should be able to answer questions like "how much dilution will I take if I raise $500,000 or $1m? How do different valuations affect your ownership?

You can plan your fundraising using a spreadsheet or a fundraising tool like Pulley. A spreadsheet is easy to get started and works for basic cases. A fundraising tool is better to accurately account for multiple investors with different terms, pro-rata, future equity rounds, and option pools.

2. How much should I raise?

One of the first questions investors will ask you is how much are you raising. Funding rounds can be anywhere from $100,000 to more than $5,000,000.

The amount you want to raise must be tied to a plan. This plan buys you credibility and persuades investors that you will be able to grow their capital.

To create your plan, start with your goals and work backward. If you're building a software product, focus on building a hiring plan because people will likely be the largest cost center. If you're building a physical product or you're in biotech, you'll need to create a runway plan that includes your other significant expenses.

For your hiring plan, determine how many people you need to hire to build and sell your product. Can you get to your goals with two engineers in six months? Do you need five engineers and a sales team to prove people want your product? A rule of thumb from Y Combinator is that an engineer costs about $15k / month. If you need 18 months of funding with five engineers, then you will need to raise at least 15k x 5 x 18 = $1.35mm. Add another 20% to this figure for operational costs like office rent.

Create multiple hiring plans for different amounts of funding raised is a good idea. You want to give investors the impression that you will be successful regardless of whether you fundraise. If you raise $1m, you can hire 3 engineers. If you raise $2m, you can hire twice as many and build the product faster.

In choosing how much to raise you are trading off between dilution and capital. The more you raise, the longer you can put off your next fundraising round, but the greater dilution you'll take. If you can manage to give up as little as 10% of your company in your seed round, that's great. Standard dilution at the seed stage is between 15 - 20%. Avoid going over 25% dilution in the seed stage. You want to keep enough equity for future rounds to motivate employees in the future.

3. How do I determine how much my company is worth?

Founders often want a concrete formula for determining their valuation. You want to know you're not priced too low (taking unnecessary dilution) or priced too high (turning away investors). In practice, your valuation will come down to supply and demand. The more investors are interested in your business, the higher your valuation.

The reason a valuation at seed is so hard to determine is that there's not much to value. Seed stage rounds are investments when the company is laughably early. Often there are no metrics or customers. Even if you have some traction, valuation does not work as a formula where you get $1m in additional valuation for every 1,000 customers on a waitlist.

Late-stage funding rounds in contrast are driven by metrics and profit margins. By the time of your Series B, founders are expected to have hit significant revenue and growth goals to prove their business works. At the seed stage, often there is no data to value businesses objectively.

What to do then? The practical advice is to research valuations for similarly staged businesses. TechCrunch announcements are a great source. If you have friends who are investors, talk to them and get a gut check on your company's valuation. Depending on how many investors you will contact, you can also test your valuation live. If you're finding that no investor is willing to write a check you can lower the valuation on your next meeting.

The important thing is not to over-optimize your valuation. The objective is to find a valuation that will allow you to raise funding. When asked for your valuation, don't hesitate. The market changes quickly and investors can be as unsure about your valuation as you are. Investors are taking a cue from you and your confidence in your ability to raise on those terms.

Don't compare your fundraising to others

The path to closing your fundraising is often littered with rejections. It can feel like an impossible task. Managing your psyche during this process is one of the hardest parts of the job.

You'll read a lot of articles about successful fundraising rounds from other startups. It can be easy to start thinking "Why wasn't this me? We've made more progress. Why is our fundraising so difficult?"

When you have these doubts, remember that investors are often wrong. This especially the case at the seed stage where funding is almost entirely based on future promise. Building a successful business without raising funding is even better because you receive less dilution. Calendly has been self-funded only until very recently. And Atlassian bootstrapped its way to a $4 billion valuation cap.

Remember that fundraising is not the goal. Building a successful business is. Don't lose sight of the bigger picture!

As originally seen in TechCrunch: https://techcrunch.com/2021/07/19/founders-how-well-do-you-really-understand-seed-stage-financing/

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