Raising your Seed Round — a Playbook for Israeli Entrepreneurs
After discussing how much to raise in Chapter #1, the various sources of funding in Chapter #2, VC organizational structure in Chapter #3, securing face-to-face Partner meetings in Chapter #4, guidance on how to prepare for these meetings in Chapter #5, meeting dynamics in Chapter #6, due diligence process factors in Chapter #7, people and market due diligence in Chapter #8, in Chapter #9 I’ll discuss the remaining risk factors that VCs aim to manage via the due diligence process and how you can address their concerns in an efficient manner.
Since last chapter I waxed philosophical on the due diligence process, this chapter I’ll jump right back in.
Solution due diligence aims to better understand your back-end (technology), front-end (product, UX, and UI), the value it creates for customers / users, and how unique, appealing, and defensible the value proposition is when compared to internal and external solutions.
If your solution is built on deep technology, investors will care less about your front-end at the seed stage, and spend their time validating your back-end claims. Furthermore they may not even require any front-end development before investing in your company. On the other hand if your solution is a glorified excel, investors will care much more about the status of your front-end, because this represents your initial value proposition and design philosophy.
To validate how unique and appealing your solution is, investors may take their “problem” due diligence checklist to existing and potential customers/users. They may ask you for these introductions, speak with industry experts and potential customers/users in their network, and introduce you to potential customers/users, listening to the conversations you have to better answer their questions.
To understand how defensible your solution is, VCs will analyze five well documented defensibilities — brand, scale, high switching costs, IP, and network effects. In my view, the less well documented, but perhaps most important moat is company DNA, or culture. During the seed stage, brand, scale, and switching costs are irrelevant, while IP, network effects, and DNA are critical for VCs to understand.
IP can take the form of scientific breakthroughs, domain expertise, trade secrets, difficult technology integration, and non-trivial innovations. Investors typically care less about patents and more about unique knowledge that has been developed over a significant period of time, making it so difficult for your competition to build a similar offering that they won’t even try, or they’ll spend time building something that cannot provide the same level of value.
I cover Network Effects with James Currier in this podcast, so I won’t go into great detail here, but the key point to keep in mind is that network effects are about retention, not growth (viral effects). As more users use your product, it should become more valuable to all of your existing users, and you should be able to articulate the critical mass your solution requires to lock in the effect.
Although DNA / company culture can also be seen as part of the “People” due diligence, I consider it a key part of what makes your solution unique, appealing, and defensible, since culture is very difficult to replicate. VCs will infer your company culture based on the way you and your team behave throughout the due diligence. The way you interact with each other, the way you respond to questions, emails, phone calls, and texts. The office space you’ve chosen to work in, the logo, your deck, the way you handle yourself during negotiations, the way your references talk about you, the way you tell your story; these are all data points the VC will use to understand the type of culture you will continue to build once you get funded. Ultimately your company values create value for customers, as evidenced by Amazon’s story. Be prepared to discuss the type of culture you want to create and why it will attract and retain top talent.
Typically for the seed stage the most difficult part of solution due diligence is striking a balance between focus and vision. You need to show investors that you are laser focused on solving a specific pain for a specific subset of customers/users and how you address this pain differently, all the while articulating your mission and vision, demonstrating that your solution will grow in scope as you get more customers/users and more resources.
Monetization & Go-to-Market Strategy
Similar to market sizing, seed stage monetization is less about output and more about thought process. While sometimes you can derive your business model and pricing from existing market standards, other times you may have developed a product for an emerging market, or a 10x improvement in an existing market, which will give you much more flexibility regarding how to monetize. I recommend Tony Saigh’s foundational post, “Get Customers to Love Your Pricing in 10 steps” and a16z podcast, “Pricing, Pricing, Pricing” to brush up on the fundamentals of business modelling and pricing.
Since the way you model/price your offering impacts your sales cycle and adoption curves, monetization intersects with your go-to-market strategy. You’ll need to walk investors through the logic of both, the relationship between the two, and prepare to defend and justify your assumptions based on the market research you’ve conducted. Notice the word “strategy”. Becoming a category leader is like beating 10 opponents in chess… at the same time. Sometimes you need to bait your opponents by exposing a pawn or bishop so you can swiftly take their queen. This could translate to giving your product away for free or at a large discount, so you become embedded into a business process, and then leverage your stickiness to charge a significant premium at renewal.
Given the limited resources of a seed stage company, working with distribution partners to help with marketing and sales seems like a magic shortcut to significant revenues. Yet this “shortcut” often prevents you from establishing a direct feedback loop with early customers, a communication channel that can help significantly with product development. Be prepared to defend your chosen path to revenue — as the VC may challenge you to find a balance between efficiency and sustainability.
Another magic shortcut I often see in the go-to-market plan is to have $0 allocated to marketing, and give the CEO responsibility for selling the first $1m. This shortcut usually doesn’t work too well because Series A VCs want to see initial signs of scalability. As mentioned in Chapter #1, the Seed round is just a means to a Series A round, and thus your initial go-to-market strategy should be designed to prove to Series A investors that their investment will go towards executing a marketing and sales strategy that has already shown signs of scalability. If you’ve spent $0 on bringing leads through marketing, the Series A VC will need to take a much larger leap of faith that you’ll be able to use their capital efficiently, since it takes time & experimentation to learn which channels have the highest ROI. To further your knowledge of marketing, I highly recommend “Traction” by Gabriel Weinberg, the CEO of DuckDuckGo.
Financial & Hiring Plan
Your financial and hiring plan are two critical elements of fundraising that can make or break the due diligence process. As mentioned before, seed money provides you with the resources to build the assets necessary to raise A money. How you allocate and convert these financial resources into human and technological resources will determine whether or not you attract follow-on financing, which is what your seed investor cares about most. Thus, you must be prepared to rationalize the amount of capital you’re seeking by walking the VC through the people you’ll need to hire and what your team will achieve.
Sometimes founders respond to the question, “What will you achieve with this capital?” by saying, “We’ll have a team of highly skilled engineers and our product will be GA after 12 months”. Other founders respond, “$1m ARR”. While the second reply is more impressive than the first, the first lacks business orientation and the second lacks depth. The key to passing this part of due diligence is to have both business orientation and depth in the plan.
For example, if you expect to reach $1m in ARR in 12 months, but your developers won’t get to productivity for 3 months and sales cycles are 3–6 months, you most likely have an issue achieving your plan. If you expect to reach $1m ARR in 18 months but will run out of cash in 15 months, you may not have sufficient assets to raise an A round, and will most likely have an issue achieving your plan. Often times founders assume they’ll need less capital because they plan to generate revenues. Be careful — as revenue forecasts at the seed stage are highly volatile and it may take you six more months than you planned to begin seeing cash flow from customers. Speaking to both successful and unsuccessful entrepreneurs about their respective journeys can help you learn about the assumptions and decisions that either proved to be accurate or fatal. This research will help you build a more economically sensible plan that you can defend against the criticisms of the VCs.
Company history helps the VC better understand the trajectory and motivation behind your start-up. If you started 4 years ago and are now raising a seed round, you should have convincing reasons as to why it took you 2–3x longer than your competition to get to a point where you felt comfortable raising. If you are still working full-time at Intel and don’t have enough faith in your company vision to take the financial risk and dedicate all your energy and resources so this venture, you should have convincing reasons as to why. If you are a single founder, be prepared to explain why you chose not to work with a partner. When investors are listening to the backstory behind your company they are looking for anomalies — things that may indicate a higher probability of failure. If you have skeletons in the closet, build trust through transparency, rather than plead ignorance. This shows maturity and your ability to take responsibility, two factors that go a long way in building a successful company.
This final element of due diligence aims to understand any previous financings and the way you’ve negotiated ownership between your co-founders, early employees, and existing investors. Once again, investors are looking for anomalies and misalignments of interest. If you took $100k and gave up 40% of your company, this is problematic. If you took $1m from a strategic investor and gave up 40% of your company, this is also problematic. Your seed investors want to make sure that the economic incentives are aligned around the table to build a huge business. If by the time you raise a Series A you and your co-founders each have 5% ownership, you may not be incentivized financially to stay determined. On the flip side, if you and your co-founders each have 25% at Series A, you may not be incentivized financially to build for the long run. Be prepared to discuss the ownership situation in detail and realize that certain capital structures at the seed round are incompatible with the VC model — you may have no choice but to restructure your company’s ownership in order to raise.
Congrats! If you’ve made it this far you definitely have an advantage over other founders when it comes to raising from VCs. And I hope that this advantage has gotten you to the stage where you’ve received your first term sheet! Next week, my colleague Ido Bar-On will walk you through the ups and downs of term sheet negotiations and help you avoid the common mistakes first time founders tend to make in the final stages of the fundraising process.