A Primer on Seed Funding for Startups

Introduction

Startup ventures often find themselves in need of essential resources like office space, equipment, and a dedicated team. But beyond these basic necessities, their primary goal is growth. Achieving this almost always necessitates external financial support.

The first round of financing a company secures is commonly referred to as “seed” funding. This guide aims to equip startup founders with the foundational insights required to navigate the early stages of fundraising.

It’s important to clarify that this document doesn’t cover every facet of fundraising. Rather, it distills the essential knowledge most founders will find useful. The insights shared here are drawn from my own experiences working with, investing in, and advising startups through my time at Y Combinator and Imagine K12. The collective wisdom of YC partners, enriched by extensive fundraising endeavors, and the in-depth analyses by YC founder Paul Graham (PG) in his essays, form the basis of this guide. PG’s writings delve deeper into many topics discussed here and are highly recommended for further reading.

The Imperative of Raising Capital

A stark reality for most startups is their reliance on funding to survive and thrive. The financial demands of reaching profitability are typically beyond what founders, along with their friends and family, can support. By definition, a startup is designed for rapid growth, and such growth trajectories usually entail significant upfront investment before they can become profitable. While there are rare cases of startups that successfully self-finance, they are exceptions rather than the rule. It’s worth noting that this guide doesn’t address financial management for non-startup businesses.

Beyond mere survival, having a substantial financial reserve serves as a strategic asset, enabling startups to attract top talent, and to fund marketing, sales, and PR efforts. Consequently, most startups will find themselves seeking investment at some point. Fortunately, there’s no shortage of investors looking to back promising startups. However, it’s crucial to recognize that fundraising can be a daunting journey, often marked by complex negotiations and challenges to one’s resolve. Despite these hurdles, navigating the fundraising landscape is a necessary journey for most founders. But when is the ideal moment to embark on this journey?

Timing Your Fundraise

The decision to raise funds hinges on a startup’s ability to craft and convey a compelling narrative. Investors are looking for convincing ideas, a capable team, and clear evidence of a significant market opportunity. When founders are ready to present this narrative convincingly, they are ready to seek investment.

While some founders may secure funding based on their vision and reputation alone, most will need to demonstrate their concept with a tangible product and some level of market validation or traction. Today’s tech ecosystem enables rapid development and deployment of sophisticated products at a fraction of previous costs. This is true for both software and hardware projects.

However, having a working product is often not sufficient to persuade investors. They will be looking for evidence of product-market fit and growth metrics. Founders should aim to raise funds when they have a clear understanding of the market, identified their target customers, and released a product that meets market needs and is gaining traction. What constitutes significant traction? While this can vary, a growth rate of 10% per week over several weeks can be particularly compelling. To secure funding, founders must aim to impress potential investors. For those who can achieve this without meeting all these criteria, well done. For all others, the focus should be on refining the product and engaging closely with users.

Determining Your Funding Needs

The optimal strategy is to secure enough funding to reach profitability, thus eliminating the need for further fundraising. Achieving this not only positions you better for future fundraising endeavors if necessary but also ensures your venture can withstand funding dry spells. However, it’s acknowledged that certain types of startups, like those in the hardware space, will inevitably require subsequent rounds of financing. The objective for these startups should be to secure sufficient capital to reach the next milestone that makes them attractive for further investment, typically spanning 12 to 18 months.

The decision on how much to raise involves balancing various factors, including the progress that the anticipated funding will enable, the establishment of credibility with potential investors, and the impact on equity dilution. Ideally, founders would want to limit equity given up in a seed round to about 10%, but a dilution of up to 20% is common, and efforts should be made to cap it at 25%. Crucially, the funding request should be anchored to a plan that convincingly demonstrates how the investment will facilitate growth, lending you the credibility to assure investors of a return on their investment. It’s prudent to prepare several projections based on varying funding levels to convey your confidence in the company’s success under different scenarios, highlighting the impact of funding on growth velocity.

A practical approach to gauge the amount needed for your initial round is to estimate the funding required to cover operations for a desired period, commonly 12 to 18 months. For example, in Silicon Valley, the cost of an engineer (often the first hires for startups) is roughly $15k per month. Therefore, a startup aiming to run for 18 months with a team of five engineers would need about $1.35 million (15k x 5 x 18). If you plan on diversifying your team beyond engineers, this formula remains a reliable estimate. This calculation method offers a straightforward response when asked about your fundraising goals: you are seeking $X to fund N months of operation, with X typically falling between $500k and $1.5 million. Offering a range for both N and X, based on different growth scenarios, can articulate your strategic foresight for varying levels of funding success.

It’s important to note the wide range in the size of seed rounds, from a few hundred thousand to two million dollars. While the average initially hovered around $600k, there has been a noticeable increase in seed funding amounts recently, driven by a growing interest from the investment community in early-stage startups.

Understanding Venture Financing Basics

Navigating the world of venture financing is crucial for startup founders, though grasping its complexity is no small feat. Ideally, the essence of venture financing could be distilled into a succinct explanation. However, the intricacies of legal frameworks surrounding it demand a more comprehensive exploration. Here’s a brief overview, but delving into the specifics, from the advantages and disadvantages of different financing methods to the critical terms of such agreements, including preferences and option pools, is essential. The following articles provide a solid foundation:

• Venture Hacks / Babk Nivi: Should I Raise Debt or Equity?

• Fred Wilson: Financing Options

• Mark Suster on Convertible Debt

• Announcing the Safe

Venture financing unfolds in stages or “rounds,” traditionally following a sequence from a seed round to Series A through C, leading up to an acquisition or IPO. This sequence isn’t set in stone; for instance, some companies might commence with a Series A round. Our focus here is on the seed stage, the initial round of venture financing.

In recent times, especially within Silicon Valley, seed rounds are predominantly structured as either convertible debt or simple agreements for future equity (SAFEs), with traditional equity rounds becoming more of an exception.

Convertible Debt

Convertible debt signifies a loan provided to the company through a convertible note, which encompasses the principal investment amount, an interest rate (typically around 2%), and a maturity date by which the loan must be repaid. The core purpose of this financial instrument is to convert into equity when the company undergoes an equity financing round. Features such as a “Cap” or “Target Valuation” and/or a discount rate might apply. The Cap ensures that the note’s holder pays no more than a maximum valuation at conversion, often resulting in a lower price per share than other investors in the equity round. Discounts offer a reduction on the round’s valuation price, serving as an incentive or “premium” for seed investors. While convertible notes are due at maturity, with all interest, investors frequently opt to extend these dates.

SAFE

The SAFE has largely supplanted convertible debt in environments like YC and Imagine K12, functioning similarly but without the interest rate, maturity, or repayment clauses. The negotiable aspects of a SAFE typically include the investment amount, the cap, and possibly a discount. The complexities of any convertible security mostly arise at the point of conversion, and it’s beneficial to understand these nuances thoroughly. The SAFE primer on YC’s website, which includes detailed examples of conversion scenarios, is an invaluable resource for grasping how both convertible debt and SAFEs operate in real-world applications.

Equity Financing Insights

Embarking on an equity round entails determining a valuation for your company, which typically involves setting a cap on safes or notes as the company’s notional valuation, though they can also remain uncapped. This process, inherently more intricate, costly, and time-consuming than opting for a safe or convertible note, elucidates their appeal for early-stage financing. Hence, it’s imperative to enlist legal expertise when contemplating equity issuance.

Illustrating the outcome of new equity issuance through a simple scenario elucidates its mechanics. Let’s assume you raise $1,000,000 with a $5,000,000 pre-money valuation and have 10,000,000 shares outstanding. This translates to selling shares at $0.50 per share, resulting in the sale of 2,000,000 shares, thereby increasing the total shares to 12,000,000 and establishing a post-money valuation of $6,000,000, accompanied by a dilution of 16.7%, not 20%.

Equity rounds encompass several crucial components, including equity incentive plans (option pools), liquidation preferences, anti-dilution rights, and protective provisions, all subject to negotiation. Typically, once a valuation is agreed upon with investors, the variance in negotiating these components diminishes, facilitating a feasible deal. Equity rounds are relatively rare in seed financing, hence not extensively elaborated upon here.

It’s paramount to utilize reputable financing documents like YC’s safe, regardless of the financing method chosen. These documents are widely understood by the investor community and are designed to be equitable while favoring founders.

Valuation: Determining Company Worth

Determining the worth of a company, especially in its early stages, is inherently nuanced and devoid of a definitive formula. The perceived value of a company, whether $20mm or $4mm, is predicated on investors’ conviction regarding its present or future worth. Consequently, it’s prudent to allow the market to dictate your company’s valuation and seek an investor to ascertain the price or cap. Increased investor interest typically augments your company’s valuation.

In cases where identifying an investor to determine your company’s worth proves challenging, you may opt for a valuation by assessing comparable companies with existing valuations. However, it’s crucial not to over-optimize during the valuation selection process. The aim is to secure a valuation that aligns with your objectives, facilitates the necessary fundraising with acceptable dilution, and resonates as reasonable and appealing to potential investors. Seed valuations typically span from $2mm to $10mm, but prioritize finding a valuation conducive to your company’s goals rather than fixating on achieving the highest valuation, as success isn’t contingent upon a lofty valuation.

Investment Landscape: Angels vs. Venture Capitalists

The fundamental contrast between angels and VCs lies in their approach: angels invest personally and independently, while VCs invest on behalf of others, leveraging institutional funds. While some angels exhibit a level of professionalism akin to VCs, many operate more informally, akin to hobbyists. Angels typically make quicker decisions, often autonomously, and emotions often play a significant role in their investment choices.

On the other hand, VCs tend to follow a more structured decision-making process, involving multiple partners and requiring more time and meetings. Given the sheer volume of deals they evaluate, standing out amidst the competition is imperative.

The landscape of early-stage financing has evolved significantly in recent years, with the emergence of new entities like “super-angels” or “micro-VCs” targeting nascent startups. Traditional VCs also increasingly participate in seed rounds, alongside numerous independent angels investing varying amounts, typically ranging from $25k to $100k or more per company. Additionally, alternative fundraising platforms like AngelList Syndicates and FundersClub offer novel avenues for securing investment.

Building investor interest often hinges on networking and warm introductions. Demo days present invaluable opportunities to engage with a concentrated group of potential investors. Alternatively, leveraging personal networks or seeking introductions through mutual connections can facilitate meetings with angels or VCs. In the absence of such avenues, direct outreach to investors with a concise yet compelling business summary remains a viable option.

Emergence of Crowdfunding Platforms

The landscape of fundraising has expanded with the rise of various crowdfunding platforms like AngelList, Kickstarter, and Wefunder. These platforms offer diverse opportunities, ranging from launching products to conducting pre-sales campaigns and even securing venture funding. In some notable instances, entrepreneurs have relied on these platforms as their primary source of funding or as compelling evidence of market demand.

Typically, crowdfunding platforms are utilized to complement existing fundraising efforts, filling gaps in rounds that are nearing completion or reviving stalled fundraising endeavors. As the investment ecosystem continues to evolve rapidly, determining the optimal timing and approach for leveraging these platforms often depends on a startup’s success in navigating traditional fundraising avenues.

Engaging with Investors

When you’re meeting investors, remember that your primary aim isn’t to seal the deal right then and there—it’s to secure the next meeting. Rarely will investors commit on the spot, regardless of how compelling your pitch may be. Therefore, aim to schedule numerous meetings and focus your efforts on those investors who are most likely to follow through. Always prioritize securing funding at the earliest opportunity (in other words, be proactive).

There are some straightforward guidelines to abide by when preparing for investor meetings. Firstly, ensure you understand your audience—conduct research on their investment preferences and try to discern their motivations. Secondly, streamline your pitch to the essentials—explain why your product is exceptional (demos are often indispensable nowadays), why your team is ideally suited to execute the vision, and why collaborating could lead to the creation of the next groundbreaking company. Additionally, attentively listen to the investor’s feedback. If you can encourage the investor to share their insights more than you do, your chances of striking a deal significantly increase. Similarly, endeavor to establish a connection with the investor. Investing in a company is a long-term commitment, and most investors evaluate numerous opportunities. Unless they feel a genuine connection with you and are invested in your success, they are unlikely to invest.

Your personal narrative and how effectively you communicate your vision are crucial factors in convincing investors to commit. Investors seek out charismatic founders who present a plausible vision supported by compelling evidence. Find a presentation style that suits you, and then dedicate ample effort to perfecting your pitch. Pitching can be challenging and may feel unnatural, especially for technical founders more accustomed to screens than crowds. However, with practice, anyone can improve, and there’s no substitute for extensive preparation. This holds true whether you’re gearing up for a demo day or an investor meeting.

During your interaction, aim to strike a balance between confidence and humility. Avoid coming across as arrogant or defensive, but also don’t appear overly submissive. Be receptive to constructive feedback, yet stand firm in your convictions. Even if you don’t immediately sway the investor, leaving a positive impression increases your chances of securing another opportunity.

Lastly, ensure you conclude the meeting with a clear attempt to move forward or, at the very least, establish absolute clarity on the next steps. Avoid leaving things ambiguous or unresolved—seek closure before departing.

Negotiating and Finalizing the Deal

Closing a seed investment typically happens swiftly. Utilizing standard documents with consistent terms, such as YC’s safe, streamlines the process. Negotiations, if any, typically revolve around one or two variables, such as the valuation/cap and occasionally a discount.

Deals gain momentum through compelling storytelling, persistence, and diligent effort. You may need to engage with numerous investors before reaching a close, but securing just a handful of commitments can kickstart the process. With the first investment secured, subsequent closures become quicker and smoother.

When an investor expresses interest, you’re almost at the finish line. At this stage, prompt action using a handshake protocol is crucial. If negotiations falter at this point, it’s likely due to your approach.

Negotiating

During negotiations, keep in mind that investors typically have more experience than you do in this arena. It’s often better to defer real-time negotiations and seek guidance from YC or Imagine K12 partners, advisors, or legal counsel. While some terms may seem excessive, most requests from credible VCs and angels are reasonable. Don’t hesitate to ask for clarification on their terms and reasoning. When negotiating valuation (or cap), consider various factors, including previous deals you’ve closed. However, remember that the chosen valuation at this early stage rarely determines the company’s success or failure. Strive for the best deal possible, but prioritize securing the investment. Once you reach an agreement, move swiftly to obtain the investor’s signature and funds. The simplicity of closing mechanics, such as those offered by safes, facilitates this process. After an investor commits, the exchange of signed documents and transfer of funds should take only a few minutes online (for instance, via platforms like Clerky or Ironclad).

Documents You’ll Need

Don’t dedicate excessive time to crafting diligence documents for a seed round. If an investor demands extensive due diligence or financials, they’re likely best avoided. Focus on creating an executive summary and a slide deck to guide your discussions with investors, possibly leaving behind materials for VCs to share with their partners.

The executive summary should be concise, ideally one or two pages, covering your vision, product, team details (including location and contact information), traction, market size, and basic financials (revenue, if any, and previous/current fundraising).

Ensure your slide deck serves as a coherent leave-behind tool. Visual elements like graphics, charts, and screenshots are more impactful than lengthy text. Consider it a framework to present a more detailed version of your story. While there’s no fixed format or order, include the following elements:

1. Your company’s logo and tagline.
2. Vision: Your broad perspective on why your company exists.
3. The Problem: Identify the customer pain point you’re addressing.
4. The Customer: Define your target audience and your approach to reaching them.
5. The Solution: Describe your product and why it’s timely.
6. Market Size: Highlight the vast market you’re targeting, ideally exceeding $1 billion in Total Available Market (TAM), supported by compelling evidence.
7. Market Landscape: Discuss competition, macro trends, and any unique insights.
8. Current Traction: Present key statistics and plans for scaling and acquiring future customers.
9. Business Model: Explain how user engagement translates into revenue, including actuals, plans, and aspirations.
10. Team: Introduce your team, their backgrounds, and why they’re equipped for success. Consider including pictures and bios, specifying roles.
11. Summary: Provide 3-5 key takeaways, such as market size, product insights, and traction.
12. Fundraising: Detail previous funding rounds, planned fundraising, and financial projections. Optionally, include a summary product roadmap (covering up to 6 quarters) to illustrate the investment’s impact.

Tailor your pitch materials to reflect your style, presentation approach, and company representation. Remember, numerous templates are available online if you prefer alternatives to this format.

Moving Forward

It’s important to recognize that the landscape of startup investing is rapidly changing, and certain aspects of this guide may become outdated over time. Be sure to stay informed by checking for updates or future posts. There’s now an abundance of information available on the topic of raising venture capital, with various sources referenced and additional resources listed at the end of this document.

Fundraising is an essential, albeit sometimes challenging, task that most startups will inevitably face. The ultimate goal for founders is to secure funding as quickly as possible, and this guide aims to assist founders in successfully navigating their first round of venture financing. At times, the fundraising journey may feel daunting, akin to scaling a steep mountain. However, once the fundraising process is complete, and the focus shifts back to the future, it becomes evident that it was merely a small foothill on the larger climb ahead. Now, it’s time to refocus efforts on building and growing your company.

Appendix: Fundraising Guidelines

Fundraising can be a demanding endeavor for any startup founder. Here are some rules to follow:

• Aim to complete fundraising swiftly, allowing you to refocus on product development and company growth. However, don’t prematurely halt fundraising efforts if they prove challenging; perseverance is key to survival.

• Adopt a “greedy” approach during fundraising, engaging with as many potential investors as possible. Prioritize those most likely to commit to your vision.

• Once you receive a positive response, expedite the process of finalizing documents and securing funding without delay.

• Maintain a proactive approach in generating leads. Even if you’re not the hottest deal, exert considerable effort to attract angel investors and venture capitalists.

• Uphold the highest ethical standards throughout your interactions with investors and team members. Integrity is paramount in building trust within the industry.

• Recognize the various ways investors may decline involvement and accept rejection gracefully. Maintain positive relationships for potential future opportunities.

• Develop a communication style that aligns with your personality and company culture.

• Stay organized by dividing tasks among co-founders and utilizing tools like Asana for deal tracking.

• Cultivate resilience, balancing confidence with humility, and avoiding arrogance at all costs.

Communication Don’ts with Investors:

DON’T:

• Engage in any form of dishonesty.

• Display arrogance or hostility.

• Come across as overly assertive.

• Appear indecisive, although it’s acceptable to admit uncertainty.

• Dominate the conversation, allowing no room for investor input.

• Delay follow-ups or deal closures.

• Violate agreements, whether verbal or written.

• Overemphasize detailed financial projections.

• Use inflated market size figures without valid justification.

• Falsely claim knowledge or hesitate to admit ignorance.

• Focus on trivial matters or waste time during meetings.

• Succumb to unnecessary distractions during discussions.

• Request non-disclosure agreements (NDAs).

• Attempt to manipulate investors unless you’re skilled in fundraising tactics.

• Engage in real-time negotiations.

• Fixate excessively on valuation or dilution concerns.

• Take rejection personally; maintain professionalism in all interactions.

A Concise Glossary of Essential Terms

• Angel Investor: A typically affluent private investor who backs startup ventures.

• Cap / Target Valuation: The maximum effective valuation for an investor in a convertible note.

• Convertible Note: A debt instrument that converts into stock, usually preferred but sometimes common.

• Common Stock: Capital stock typically issued to founders and employees, often with limited rights.

• Dilution: The decrease in ownership percentage due to the issuance of new shares.

• Discount: A percentage reduction from the pre-money valuation to provide safe or note holders with a lower price.

• Equity Round: A financing round where the investor acquires equity (stock) in the company.

• Fully Diluted Shares: The total number of issued and outstanding shares, including warrants, options, and convertible securities.

• IPO (Initial Public Offering): The first sale of stock by a private company to the public.

• Lead Investor: Typically the first and largest investor in a round who brings in other investors.

• Liquidation Preference: A provision allowing preferred stockholders to recoup their investment before common stockholders upon an exit.

• Maturity Date: The date when a promissory note becomes due or converts to stock in the case of a convertible note.

• Equity Incentive Plan / Option Pool: Shares allocated for grants to employees and consultants.

• Preferred Stock: Capital stock with specific rights, privileges, and preferences compared to common stock.

• Pre-money Valuation: The company’s value before adding investor funds.

• Pro-rata rights (aka pre-emptive rights): Contractual rights allowing holders to maintain their ownership percentage in subsequent financing rounds.

• Protective Provisions: Charter provisions granting exclusive voting rights to preferred stockholders, often required for major company decisions.

• Safe (Simple Agreement for Future Equity): Y Combinator’s alternative to convertible debt.

• TAM (Total Available Market): Estimated total revenue potential for the product(s) being sold.

• Venture Capitalist: Professional investor in companies, using limited partners’ funds.