There’s an old adage that you have to have money to make money. It often takes enormous amounts of capital to launch a new business successfully and cross the wide frontier from founding to profiting. While many entrepreneurs prefer to bootstrap it, investing their own money and perhaps taking personal loans, this approach often involves slow growth and financial pressure. Raising capital through rounds of investment can be a more efficient way to find investors, raise capital, and move the business forward.
Seed rounds are often the first formal financing endeavor in a company. It may be the first time founders and directors seek outside investment, offer equity, or conduct a valuation. It can be challenging and, yes, expensive. But how much do seed rounds cost?
What Is a Seed Round?
A seed round (also called seed funding or seed money) is the very earliest round of formal investment in a company. Founders typically seek investment in the form of convertible notes, SAFEs, or equity and use that money to fund the research and development that provides “proof of concept” of their business plan.
Why Raise Money?
For many founders and small business owners, the idea of seeking outside investment through financing rounds is a challenge. Founders may be intimidated by the prospect of pitching, worried about the consequences of debt, or unwilling to diminish their control over their company.
On the other hand, raising money typically provides more capital quicker than the founder can provide on their own. Generally speaking, here are the pros and cons of raising money from venture capital investors:
Pros of Fundraising
- Reduced financial risk. Raising money not only provides capital that can help a business survive an unexpected setback, but it also reduces the financial risk. If the business fails, having outside investors reduces the personal damage to the founder and provides some protection.
- Increased credibility. A business that has successfully raised money from established investors has greater credibility and a better reputation. It will be easier to raise money in the future.
- Greater support. Investors, especially those willing to invest in a young startup, often offer support beyond simply financing. These investors may have important connections, relevant experiences, and other means of supporting and mentoring a new company.
- Faster growth. After a successful fundraising round, business goals are reached more quickly, with fewer distractions, than when money comes in slowly over time. Founders can take advantage of greater capital to create economies of scale and grow more rapidly.
Cons of Fundraising
- Loss of ownership and control. For many founders, company ownership and control are incredibly important. For founders who retain ownership of the company, they reap all the benefits of success, which feels like a recompense for all their hard work. Retaining control of day-to-day operations without having to compromise with investors is also a benefit of being self-funded and independent.
- Increased debt. Fundraising often means taking on debt, and most debt instruments have a maturity date. Even if the date is some distance in the future, the obligation can often cause additional pressure and stress.
- Requires time and money. Although fundraising eventually increases capital, the process can be time-consuming and expensive. Controlling how much seed rounds cost is challenging, and requires experience many entrepreneurs don’t have. The process of crafting your pitch to investors, preparing the company for due diligence, and negotiating the terms of the investment agreement can all be slow, expensive, immersive processes, leaving the founder no time to work on the business itself.
Founders who choose to self-finance and start their company with no outside investment are called “bootstrappers.” Bootstrapping allows founders to remain owners, limit debt, and retain control of their company. Famous companies like Spanx, Patagonia, GitHub, and Mailchimp were all self-funded. However, most founders will want or need to reach profitability more quickly, which means engaging in fundraising and seed rounds.
How To Value Your Company During a Seed Round
Seed round valuation is notoriously difficult and a source of endless negotiations between founders and investors. Most companies, even startups, are easy to value: you simply look at factors like cash flow, revenue, growth rates, and other metrics to objectively assess the worth of the company. For an early-stage startup with none of these financial metrics, valuation can be largely speculative. A higher valuation is beneficial for founders, while a low valuation is better for investors. Here are some of the factors to consider when valuing your company during a seed round:
- Percentage of equity in the round. Most startups sell 20-30% of their equity during a seed round. Therefore, the valuation determines how much can be raised during that round. If you value your company at $5 million, for example, you would typically seek to raise ±$1 million during the round. Choose valuations and equity percentages that make sense to investors.
- Pre-money vs. post-money. A pre-money valuation refers to what the company is worth prior to the investment, while a post-money valuation is calculated afterward. Founders and investors need to be clear about what type of valuation they are referring to; founders usually think of the pre-money valuation, while investors usually refer to a post-money valuation.
- Paint a compelling picture. Because seed round valuation is often so abstract, it is up to founders to convince investors of the worth of the company, and value it highly. This means leaning on established factors like market value, competitor value, personal reputation, etc., but also means creating a persuasive vision that investors can believe in.
Generally speaking, you can create a financial model with your key assumptions and arrive at a valuation range. Potential investors will have their own models and assumptions, from which you can negotiate to reach an agreement.
Undervaluing Early Stage Companies
It is true that early stage companies are objectively worth less than companies with revenue, brand value, and other assets, so it’s easy to undervalue them. While investors prefer a low value for early-stage companies with higher risk, there are important reasons for founders to not undervalue the company at the seed stage.
Undervaluation can make it more difficult to attract investors, not just at the seed stage but during all future fundraising efforts. Investors who are looking for higher returns will avoid a startup with low value, which reduces your capital and resources for growth.
Undervaluation can also hurt founders and early investors by selling equity for less than it is actually worth, reducing the profit potential of investment, and diluting the value of ownership. During the early stages, when founders may be offering equity to investors, employees, and other strategic partners, undervaluation reduces the benefit of these arrangements.
When valuing an early-stage startup, it is important to work with an expert startup legal team. The valuation of your company influences many factors during the seed round and during later financial situations and decisions. It not only determines how much you can raise from venture capitalists but may also influence how much you can borrow or which grants you are eligible for. And naturally, it influences the company’s valuation during a merger, sale, or liquidation. A smart investor will try to negotiate this number down as far as possible; you need a lawyer to help you negotiate, understand your worth, and hold your ground.
What Do Seed Investors Look For?
Like any investor, seed investors look at a company’s finances and strategy to determine whether it offers a good return. Seed investors, however, are more tolerant of financial risk and are looking for some additional factors:
- Innovation and market potential. Seed investors want to see the market potential, including plans for how to scale the business over time. Seed investors tend to favor innovative products or services that reach previously untapped markets, rather than incremental improvements on existing products and services.
- Strong leadership team. Seed investors look carefully at the skills, experience, and reputation of a startup’s leadership team. They want to make sure the company is led by people with the ability to execute their strategy, withstand challenges, and provide value.
- Compelling vision. Finally, seed investors want to dream with you. They want to hear a compelling story that creates a vision they can support and believe in. Early-stage investors want to get excited about a company and its potential and to share the passion of its founders.
Seed-stage investors want to make smart investments and get a return for their money. But they also want to be involved in shaping the future, to get in on the ground floor of a great brand, and to be a part of the story. They are a special type of investor and can form special relationships with companies and founders.
Why Do You Need a Lawyer?
An experienced seed round lawyer can help you prepare for your first round of equity funding, create a more accurate valuation, negotiate the most favorable terms, and remain in compliance with IRS and SEC regulations during the fundraising process.
Seed round investors have excellent legal counsel and experience in negotiating the terms that are most beneficial for them. An experienced startup lawyer can advise you on what to expect during the fundraising process and where to push back. A lawyer can also help you save money during the seed round process, choosing more affordable financial instruments, negotiating more favorable terms, and streamlining the structuring and drafting of new governance agreements and contract language. Many of the costs of fundraising are unavoidable, but an experienced lawyer can guide founders who don’t know how much seed rounds cost to a more affordable solution.
If you are an entrepreneur or founder wondering how much seed rounds cost, how to raise capital, and what the right financial instruments are for you, contact the Fridman Law Firm. Our experienced startup legal team offers expert guidance in every stage of growth, from incorporation to fundraising strategy to compliance and regulatory, and we are passionate about supporting entrepreneurs. Contact us today or call 212-262-9823 for a consultation.