Don’t take seed money from someone who isn’t familiar with seed investing
I met a great founder last week. Let’s call her Jane.
Jane and her co-founder recently launched a company. They had exactly the attributes I look for in founders: passion, vision, complementary skills and a proven record of execution from 25+ combined years of directly relevant industry experience.
Our first meeting was going swimmingly. Jane had assembled a stellar team and, after just a few months, the company had initial traction, solid metrics, and strong unit economics. It was outperforming expectations on almost all dimensions.
At the end of the meeting, we began discussing the company’s funding needs. Jane had raised $1m in seed funding and was now looking for $5m to accelerate growth. Nothing unusual there.
I asked about the previous investors. Jane replied that they seemed happy and were looking to do some of their $3.2m pro rata. Great, I thought — it’s a good sign that your existing investors want to reinvest — they’re the ones who know you best.
But then it hit me. $3.2m!? Say what? I must have misheard … that’s more than half the current $5m round! That would imply that they already own more than half the company.
It turned out I hadn’t misheard. A little more probing revealed that the existing investors in this company were “some mates from university who work at a hedge fund”. In other words, a group of people who had probably never seed funded a company before.
Like many first time founders, when she was raising capital for the first time Jane knew little about early stage venture capital. Unfortunately, she took the first offer she received — on terms that are certainly not normal for a seed stage company. Jane gave away 65% of her business in her first funding round.
This is a problem. It’s so much of a problem in fact that, despite all of the positive attributes of Jane’s company, I felt that we couldn’t invest purely purely because of this wonky cap table.
As an early stage investor, I’m looking for businesses with huge potential. Perhaps equally if not more importantly, I’m looking for stellar teams and I want them to have the right economic incentives to realise that potential.
To achieve scale, Jane’s business would have required multiple, large funding rounds. Each of these funding rounds would have diluted the team’s ownership stake in the business. You simply can’t suffer that kind of dilution and still have a meaningful stake in the company if, as a group, you start with 35% of the company after the seed round.
My message to founders is fourfold:
- Shop around when you are raising your seed round. Don’t jump at the first cheque that’s offered to you. If you have a strong founding team and a high potential business, someone will fund you on reasonable terms. You just need to find them.
- Don’t, whatever you do, give away more than half of your company in order to raise a seed round! This will poison your cap table and turn off the best Series A investors.
- Raise a seed round from folks who specialise in making early stage investments. There are lots of good ones out there. Do your research. At the most basic level, you can figure out a lot about an investor just by looking at their website. Do they talk about seed funding? Do they have portfolio companies close to your stage of development? Do the Partners’ background suggest that they can be helpful to you beyond just money?
- Don’t be afraid to do reverse due diligence on your prospective investor. Ask to meet other entrepreneurs they’ve backed in the past and get the low down on how much value they really added.
To raise multiple funding rounds, you need a great business. The point I’ve tried to make here is that you also want good investors. The wrong ones early on will kill your chances of finding the right ones later.