Seed Stage Startup Funding -- Three Avoidable Pitfalls

I’ve written before about various startup funding fallacies that I frequently encounter. http://bit.ly/2mC29Fb and http://bit.ly/2oY3jtp. I’m returning to the funding topic because I think there are some special issues for seed stage companies.

Getting external funding for a startup is hard work, especially at very early stage.  It will take a disproportionate part of the time of at least one co-founder. And it is an unceasing process.  There is no sure-fire way to make it go smoothly, but there certainly are some mistakes that one can avoid.

Don’t seek external equity funding too early

I don’t think one can make a categorical statement about bootstrapping. http://bit.ly/2mC29Fb. 

However, I believe that, for a very early stage venture, bootstrapping is likely to be best – in most places, most of the time. Generally, it isn’t a good idea to ask for external equity funding until, at the very least, you have a minimum viable product and, preferably, some indication of traction.  Why not?

• You will spend a disproportionate amount of time seeking funding as compared with the money that you can raise. This will detract from the time that you can spend developing the business
• You may need to give away a disproportionate share of the company at an overly-low valuation (but see below)
• You are more likely to wind up with disappointed investors due to your failure to develop a business plan that works
• Your investors will expect a return on investment within a reasonable period of time. Conversely, you are likely to have a long path to success, given, for example, long corporate sales cycles.  If your business is proceeding well, you don’t want to be pressed for an exit prematurely. You increase that risk if you have raised external funding too early.

So, what are the alternatives if you can’t afford to bootstrap?  

First, any available grant funding, while it imposes certain burdens, may be a good way to bridge an initial development period and build value without dilution.

Second, true friends and family funding may work so long as your friends and family understand the high likelihood of loss.

Third, accelerators may provide funding, as well as the support and network that you need to develop the business.

That being said, you should start making initial contacts with potential investors as soon as you have something compelling to show them.  It typically takes four to six months to develop a relationship with investors before they are ready to invest, since they need to get comfortable with you (and you, with them). Consequently, if you expect to need investor funding in that time frame, you will need to start early to build those relationships.

Don’t overvalue, especially in your first seed round/s

I’ve said this previously, but it is really important.

Founders sometimes are focused on obtaining a high valuation of their business. While it is right to be concerned about dilution, an overly-high valuation can be fatal in early rounds. Why is that?

If you were only going to need to raise external equity finance once, you might want to seek the highest valuation possible. 

However, most startups will need to raise more than a single round of investment.  In that context, keep in mind the following:

• Your very early stage investors, especially if they are friends and family, will not know how to value your startup. They therefore may depend on you to set a market valuation. These are folks who are betting on you at high risk – treat them fairly.
• You will minimize dilution, have happier investors, and increase the likelihood of successful subsequent rounds, if each of your investment rounds is at a materially higher valuation than the prior round. If you require a down round (or even a flat round) in order to secure follow-on funding, the follow-on round will, at best, be expensive. More worrying, the follow-on round may not happen at all, and you will have killed your company. Investors are looking for success, and getting them to invest in a business that appears to have stumbled is a difficult task.
• If your insistence on an overly high valuation limits the funds that you can raise, and you therefore need to return to the market with a follow-on round in order to achieve your initial milestones, the cost in terms of dilution is likely to be higher than if you had raised a higher amount in the first place at the lower valuation.

Use of a simple agreement for future equity (known in the UK as an advanced subscription agreement), or convertible debt, may help you avoid the need to put a premature valuation on your company. The funds invested will convert into equity at a discount to a subsequent round, and with a cap. While negotiation of the cap, in particular, does require some consideration of valuation, it is less specific than negotiating a present value (and is also future focused).

When you do a proper raise, don’t raise too little

When you raise your first serious round of external equity financing, i.e., a super seed or Series A round, try to secure at least an 18 month runway. I previously suggested 12 – 18 months, but several VC’s told me that 12 months is too short, and I think they are right. Most startups cannot rely on multiple rounds of early stage venture capital finance unless they start to generate results.  The time that it takes to develop traction, whether by securing contracts with large corporates, building a consumer base, or otherwise, is longer than one expects. Too short a runway may put the company in a position of needing to return to the venture capital market before it has enough traction to support a follow-on round.

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This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected] or via LinkedIn here.

You will find Bob’s other weekly blogs for emerging and growth companies on US issues, international expansion and early stage financing here: http://bit.ly/2lP5uMP