What You Need To Know About Seed Financing
I cringe when any company that wants to work with me says they’re raising a $2m seed round…“We’re raising $2m.” I cringe. There’s nothing inherently wrong with raising $2m…UNLESS you have not thought about your raise strategically — which is true of 99.9% of entrepreneurs I meet with.
Most entrepreneurs understand on some level that fundraising is about messaging. But, most people only think about this in the context of storytelling. But, messaging how much you are raising and for what specific milestones are equally important.
Let me give you a concrete example. Here’s a tale of two companies. Same business; but different seed round amounts.
-Bootstrapped using sweat equity.
-Interviewed customers and found real pain or benefit they could deliver — and, even better, they convinced at least one customer to help pay for a solution or place an order.
-Raised a seed round of $500k-$600k.
-Now raising another seed round of $2m to capitalize what you have developed and the customer potential you have created.
-Had a great idea and built a prototype that investors loved.
-Had little or no company traction, but it all “makes sense” (they’re good story tellers)
-Raised a seed round of $2m (WOW, great job!)
-Now raising another seed round of $1m to expand the business
Should both companies successfully complete the funding, they would’ve raised about the same total amount of seed money — $2.5 — $3m.
As one of my most supportive investors always tells me; “the best decision you make is the second check you don’t write or the third on you do”. As an investor, company A’s situation sounds so much more appealing; I’d write that second check, maybe even at a higher valuation. Think about it, they raised a small seed round — and used the money effectively to get them to some initial milestones. They have been able to fill out the idea, get some initial market traction — maybe even a customer or two. And, now, they are ready to grow based on what they’ve learned; they just need some fuel to execute.
On the other hand, company B’s situation has warning signs all over the place. No matter what they did — or do, it is going to look to every investor like they burned through their $2m “Seed” and now are short of the milestones that would earn them a Series A. Now they need another $1m to bridge them through to get to something meaningful. That’s a desperate situation that no investor wants to sign up for.
I need to point out that, at this point, I’ve told you nothing about these businesses or even their product or market sector. We don’t know if they have a good product, a complete team, or effective management. But I’m willing to make some broad assumptions about their funding scenarios. Why? Because this is unfortunately all too common in what I see too often as an early stage angel investor; companies that sold the promise way too early and, as a result, raised a big Seed Round and still fall short of their potential. Even if Company B is truly able to grow quickly and is only just a couple of months away from gearing up for a strong Series A, I know lots of VCs who would not even take a meeting with Company B to hear them out. That’s just how it is. It is poor messaging of a different kind — and it screams poor management and poor understanding of funding dynamics.
As an entrepreneur raising a seed round, you need to think deeply about what your raise and your valuation signals if you are not able to hit milestones for the next round. If you are good enough and lucky enough to raise >$2m in a Seed Round, you had better be able to hit your Series A targets or get to profitability. I call >$2m Seed Rounds the “Red Zone” of fund raising, but unlike football, in his case the Red Zone is not a good place to be. In the startup world Red Zone, you need to score or die. Falling short means you get no points. There is no field goal, just a turn over in the game and that means you fall short and you will have a super tough time raising from external investors. Worse, you don’t get 4 tries. If you’re lucky you might get one; only one shot on goal!
Inexperienced entrepreneurs should be especially cautious — they always think “I can totally hit that milestone — No problem.” I know — because I’m that optimistic entrepreneur too and think that way too, even after I have failed to do it more than once. As an active Angel Investor, I’ve seen too many companies whom I met who can’t raise any money, or are ready to go out of business on the cusp of success (three-feet from the goal line), not because they didn’t raise enough money but because they raised too much to get them to an Series A or hot serious milestones that justify a much bigger valuation. In fact, many of them had businesses that were just beginning to take off, but because of poor fundraising “messaging” and strategy, these companies failed.
Consider this, Series A milestones go up ALL the time and are only going up — for example, I met with several B2B SaaS companies a year ago who were able to hit $1m/year run rate within a year and had fast growth. These companies ended up either dead or were acquired for cheap because Series A milestones were much higher than they had expected. Great deal flow early means bigger funding at subsequent rounds, at higher valuations — but for FEWER companies.
Lot’s of things change with investors, from the economy to personal situations to market dynamics (or investors perception of them); so, every company must show above-and-beyond customer traction to convince your investors you might be a winner; it’s not just about hitting milestones if you’re in a competitive space
So, if you’re early — i.e. still building product, early in your product-market fit, or don’t have a handle on your unit metrics, etc, you should consider raising a smaller round (say $500k-$1m) such that your next milestone is to hit post-seed milestones rather than a series A milestones. Your message is, we’re thinking strategically and we understand the dynamics an investor thinks about — and we will manage our company to hit milestones that matter. — David C. Robinson