By definition, a seed round of finance is used to finance the genesis of a business. An entrepreneur has an idea and they need capital to validate the business model, develop a prototype, get a patent, attract advisers and management…basically to build a company. It is the riskiest of capital because any investor is really investing in the entrepreneur’s character and capabilities. If that entrepreneur has a history of dreaming of things and not completing them, then that is their “M.O.” and it will be very difficult to raise friends from those around them that are familiar with their track record. On the other hand, if that entrepreneur has been highly successful, in other things…as a community leader, executive in a company, or successful business owner, then those around him or her will be more willing to take a risk that the entrepreneur will execute. Angel groups rarely invest at the seed round. There are some that are set up for that and plan on actively participating in the company to help build it, almost as an incubator. Here again, there is the challenge on valuation.
Valuation really comes down to math. Most often this issue arises because an entrepreneur doesn’t understand the cap table and how valuation is built over time and how stocks are issued over time. It isn’t what the entrepreneur thinks the company is worth. It is a combination of what the entrepreneur’s perceived value of the company is and what the investor is willing to pay for their shares based on their belief that they can make a return on investment.
Entrepreneurs can get in trouble some time when they raise their seed capital and because the “friends & family ….and fools” buy into the company at too high of a valuation because they are all caught up in the CEO’s vision and excited declaration of potential. Most startups are valued out of the gate at less than $1M. So if you are raising a seed round and raise $250K but only give up 10% of the company for that initial round, that is putting your valuation at $2.5M. If you can take that $250 and get a product to market and customers in the back log, then you may be able to justify a valuation of higher than $3M when going for that next round of $1.5M, but likely that won’t be the case and your original investors are diluted as you give up 50% pre money.
This is where the emotional issues of “control” start to reek havoc on entrepreneurs. Often entrepreneurs doesn’t understand how control is actually handled in a company, and it isn’t solely based on who has the most shares. If the bylaws are set up properly on how board seats are given up and chairman is selected, you have two classes of stock, and maintain the greatest individual share holder amount of preferred and majority overall of the common, you can maintain directional control of the company…until your VC round that is :-).
The best way to avoid this whole issue and to increase the value of the company with the seed capital you raise before giving up equity is to use a convertible note. Investor accumulate interest on their investment and convert in the A round at the then valuation. You as the entrepreneur has the ability to take that capital and boot strap your way to getting a product in the market, a team built, and ready for cashflow. Now you can negotiate for higher valuation and more tangible aspects of your business to warrant the higher valuation of $3-5M as an “early stage” rather than start up company.
We have found that entrepreneurs have the most control over their valuation if they can be successful in raising a seed round from an affinity group of investors that are emotionally tied to their success, and using that money to launch their company, patent their product, produce a prototype, before going in front of angel investors that have a higher expectation. Angel groups, although risk tolerant because they actually play in the high risk game of early stage investing, are subsequently risk adverse if the company is more of an idea, a start up, than an actual company fully commercialized. To increase the valuation during an angel round a company needs to fill in its gaps….management team, advisers, joint venture partners, LOIs from customers, or actual customers, commercialized product and actual strategy to bring it to market.
Listen to how three companies raised seed capital and bootstrapped their way to the next round to maximize their value.