Chapter #2: Funding Sources — Understanding the Landscape
Raising your Seed Round — a Playbook for Israeli Entrepreneurs
After discussing how much to raise in your seed round in Chapter #1, this chapter describes the various sources of funding in Israel and the impact they can have on your business. You always want to understand for each funding source, what type of ownership they seek in exchange for their capital and how much control they want over key decisions such as hiring, budgeting, selling the company, and many others I will discuss in later chapters.
Properly aligned incentives increase the probability your company will succeed. When it comes to raising capital at the early stages, make sure you understand that giving away too much of your company early may make future investors afraid that you lack the economic incentive to take the company the distance.
Naturally once you take funding, your ownership will decrease, but ideally the equity value of your company will increase, so that even though you have less equity, your holdings are worth more. Each time you fundraise, ask yourself — how will this change the incentive structure of the company, and will the net impact be positive?
For the purposes of this segment, I’ve outlined the key considerations you should make yourself aware of before pursuing each funding source.
The Israel Innovation Authority (previously known as the Office of the Chief Scientist / OCS)
Provides non-dilutive funding from the Israeli government that can help you cross the riskiest phase of your start-up. This funding will come with conditions, such as a requirement for matching funds, keeping your IP in Israel, paying a revenue royalty, and/or paying an exit fee.
IIA funding is seen as a positive for VCs assuming they are the one doing the matching, but many times Incubators (discussed below) do the matching, giving them a significant amount of equity in the company for a small check. Before you go find a “matcher”, you must understand the conditions of the IIA’s offer and make sure it is within industry standard ranges, or you may have too risky of a deal for the next investor to swallow.
Make sure you explore the various programs and conditions thoroughly rather than take the first shiny deal that looks reasonable. The IIA is notoriously inconsistent with their decision making timelines, so always have other options.
High dilution funding, often leaving the founders with 60–75% of the company. VCs may see incubators as a negative signal for any company that doesn’t have extremely interesting IP since it will be harder to align economic incentives because the founders have already given up such a significant part of the company and still have limited commercial traction. Furthermore, if the incubator has a Micro VC attached to it and that Micro VC passes on your seed round, this will send a negative signal to other investors.
On the flip side, some incubators have an expertise, be it a domain, technology, and/or access to initial design partners that can significantly reduce the cost of R&D or getting your first pilot secured. Sometimes the value-add of the incubator justifies high dilution, but judge each situation independently and do your due diligence before accepting an offer.
Low dilution funding, often leaving founders with 90–95% of the company in exchange for $50k-$120k. Israeli VCs usually see acceleration as a positive signal if the accelerator is based abroad. There are also some solid Israel-based accelerators but it’s important to do your homework by checking with other entrepreneurs who have graduated and hearing their sentiment.
High dilution funding, often leaving founders with 60–80% of the company in exchange for $50k-$500k. If the angel/angels provide significant value and have a great reputation (check with entrepreneurs from their existing investments) — completely worth it, especially in cases where angel capital can get you preferred treatment from VCs.
Moderately dilutive funding, often leaving founders with 70–90% of their company in exchange for $250k-$2m. In this case, these investors are not professionally investing in start-ups but are more opportunistic, maybe coming from the target market, have synergistic business interests to what the company is building, or possibly want to diversify their holdings into tech.
While taking money from targeted business professionals can provide an advantage, taking money from less experienced “diversifiers” may decrease the likelihood a VC or Micro VC will invest in your company. VCs, in general, don’t like to deal with investors who aren’t accustomed to the types of situations early-stage companies face — such as pivots, illiquidity, bridge rounds, uprounds, and a variety of documents that need to be processed quickly in order to effect changes in economics, control, and/or governance. Unless this private investor has given your company a clear competitive advantage, it is likely to be seen as a negative.
Extremely high dilution funding, often leaving founders with 10–50% of the company. In this case, founders are incubating a company within an existing service provider or holding company, and leveraging their resources to access customers and/or accelerate R&D. VCs and Micro VCs dislike these types of deals because they require a complex dance to rebalance the cap table and realign incentives, as well as all sorts of potential IP complications. If you are starting a company within another company — the chances of getting VC funding for your seed round are close to 0… but that doesn’t mean it’s a bad situation — it just limits your potential for venture capital.
Donation-Based Crowdfunding Platforms
Non-dilutive funding, essentially allowing you to finance your development costs with prepayments from your early adopters. Very low risk, but increasingly challenging to break through the competitive noise which requires upfront capital to attract the attention of the crowd. In addition, not a valid fundraising channel for b2b or software, mostly focused on consumer hardware.
Equity Crowdfunding Platforms (ECPs)
Moderately dilutive funding, often leaving founders with 75–90% of their company in exchange for $250k-$2.5m. In this case, you are dealing with an online intermediary that is investing on behalf of a group of accredited investors. In some cases, the platforms have committed capital that allows for full or partial financial commitment to founders. In other cases, the platforms need to run a marketing campaign to their investor community to secure all or some of the capital, meaning that you lack visibility into the timing and amount of funding you will receive.
ECPs can have a positive impact on your business because their audiences may serve as a marketing channel. Consumer facing businesses that raise from ECPs immediately get their product/service in front of potentially thousands of users as part of the fundraising process. B2B, B2G, and B2D businesses have lower synergy with the ECP’s investor community — but with the right algorithms or analysts, matching with a helpful investor in the ECP’s community can accelerate your progress in a number of ways.
ECPs can lead rounds or follow rounds, depending on their investment philosophy, and like all other funding sources, make sure to speak to other entrepreneurs and get feedback before you sign any documents.
Strategic / Corporate Investors
Low dilution funding, often leaving founders with 90–95% of their company in exchange for $500k-$1m. In the seed rounds it’s unusual for corporate VCs to participate as usually the traction threshold is too low and check sizes too small for them to pass it through their investment committees. There are some exceptions to this rule of thumb, but if you do include a corporate investors in your seed round, better aim to have two, with each having less than 5% so they don’t have any control or influence over key board decisions, and do your homework to understand if having their name in your cap table may cause some issues with your target customers or future acquirers.
Micro VCs (Followers)
Moderately dilutive funding, often leaving founders with 80–95% of their company in exchange for $250k-$1m. In this case, you are dealing with professional investors who are investing their own personal capital and potentially on behalf of a small number of external investors (limited partners). In some cases, these followers can also bring a lead VC to the round. Again, the key to prioritization should be based on the follower’s reputation which you can validate through their existing portfolio. If it’s a new fund and has no existing investments — do your diligence via the CVs of the Partners and through your mutual linkedin connections.
Micro VCs (Leaders)
Moderately dilutive funding, often leaving founders with 70–85% of their company in exchange for $500k-$2.5m. In this case, you are dealing with professional investors who are primarily investing on behalf of a meaningful number of external investors (limited partners) and leading seed rounds. There are only a handful of Micro VCs in Israel that have been around for more than a few years, so again, do your homework by speaking to founders who they’ve invested in to make sure you are partnering with funds who will be there for you in both good times and bad.
When working with leaders and followers, make sure to understand the preexisting relationships between the fund’s partners. The last thing you want is to have two investors in the round who have a prior conflict, as this will cause dysfunction at the board level and/or in strategy decision making. Usually, discussing the round construction with the lead investor will help you gain clarity on the types of co-investors the lead prefers. Also keep in mind that some leading Micro VCs are open to following or co-investing depending on the situation, so make sure to understand each investor’s policy before engaging an in investment process.
In the last decade it has become much more common to syndicate rounds, which has even created rounds without a lead investor; the capital comes from a bunch of smaller funds. The jury is still out on whether or not this strategy is helpful or harmful, but it’s important to consider both strategies.
High dilution funding, often leaving founders with 60–80% of their company in exchange for $2m-$5m. In this case, you are dealing with professional investors who are primarily investing on behalf of a meaningful number of external investors (limited partners) and leading A rounds and sometimes, B, C, and beyond. However, in the last two years, as A rounds have become more competitive and expensive, many of these traditional A players have moved upstream to buy less expensive equity. In addition, a number of funds have identified as “Seed & A” round investors, further blurring the distinction between traditional VCs and Micro VCs.
Raising seed from VCs is generally more challenging, since these funds have to deploy a lot of capital and in most cases they want to spend time evaluating deals where they can invest at least $5m if not more. In addition, they have the flexibility to wait 12–18 months and pay a higher price in the next round, at potentially a much lower risk. Micro-VCs, in contrast, have a dedicated focus to seed — which means there can be a greater urgency and speed of process.
If a VC does the seed but doesn’t lead the A, it could mean one of two things to other follow-on investors. First, the VC has enough ownership to satisfy his/her return expectations and doesn’t want to have too much control over the company, as this may make it harder for a new VC to feel comfortable joining the board or working with the company. Second, the VC isn’t excited enough about the company’s prospects to lead the A round. Since VC is a game of outliers with a power law, the winning strategy is to go all-in on the one or two winners, which would logically require the VC to lead the A if the company was the “one”, or “two” in the fund. Unfortunately at the A stage, it’s still very difficult to estimate a company’s future performance, so sometimes the VC could choose to lead the A in one of the losers, and fail to lead the A in one of the winners.
Either way, having a VC lead your seed but not your A may present a bad signal you’ll need overcome in order to secure follow-on funding. This could create a suboptimal outcome for the company — raising money from a lower quality investor, or closing up shop.
Traditional VCs may also have less experience guiding seed entrepreneurs to the A round — because historically they would wait until the company achieved relevant business traction before evaluating them. Unlike Micro VCs which live and breathe the chasm between seed & A and have hopefully learned a few lessons that they can share with their portfolio, VCs may share theoretical advice that makes sense, rather than practical advice that has been derived from watching their seed investments evolve. If you raise from a Micro VC then you have the flexibility to fundraise from all of the Tier 1 VCs. If you raise from a Tier 1 or even Tier 2 VC, you may limit your options for the A.
On the flip side, if you need time to pivot or you have a longer than expected sales cycle, your financial projections will crumble pretty quickly, and you’ll need an additional infusion of capital. VCs have more financial patience and can provide healthy bridge rounds, presuming they believe in you. Micro VCs by definition have less money to risk, which makes them stingier in bridge situations.
Based on the above, it should be evident that only three funding sources have both the policy and the financial resources to lead your seed round. Equity crowdfunding platforms that have committed capital, Micro VCs, and VCs. So while the other funding sources are important to acknowledge and engage with, the next chapter in the series assumes you are a stage where you’ve chosen to persuade one of these investor types to lead your seed round. But before you can begin marketing to them, you’ll want to first understand how they make decisions.