Table of contents:
- What is Seed Funding?
- Financing Options
- Rules to follow when fundraising
- Friendly advice
- How far can you take the business with the money raised?
- How much of your company are you willing to share at this stage (you should avoid giving up more than a quarter of your shares)?
- How keen investors are on your pitch?
The most difficult element in managing a business is creating something that people want, that’s why most businesses fail because they do not achieve this. However, the second most difficult aspect of launching a business is raising funds. This is a hard process.
What is Seed Funding?
Here's a quick explanation: Seed funding is a type of early-stage investment that startups get from investors in exchange for a stake in the firm. Following pre-seed financing, the first official funding round is seed funding. The fundamental objective and purpose of seed investment are to get the business up and going. It must encompass the early stages of product development, significant market research, and other early-stage operations.
In other words, seed capital is a component of the first investment in new businesses. The monies are then utilized to fuel the company's expansion. There must be some form of return value to the investors as part of the seed funding for the startup process.
What is Bootstrapping?
Bootstrapping = a situation in which an entrepreneur starts a company with little capital, relying on money other than outside investments. An individual is said to be bootstrapping when they attempt to found and build a company from personal finances or the operating revenues of the new company.
Bootstrapping seems fantastic in theory, but few firms make it out alive from this seemingly lush land. The fact that bootstrapped firms are well-known for this should raise red flags. It would be the norm if it worked so well.
Bootstrapping may become easier if the cost of launching a business decreases. But I doubt we'll ever get to the stage where most businesses can survive without outside capital. Technology is becoming increasingly affordable, but living expenditures are not.
Why raise funds?
Startup businesses must buy equipment, rent offices, and hire employees. More significantly, they must develop. To execute these tasks, they will almost always need outside cash. Some would-be founders may be wondering why they should interact with investors at all. Why bother soliciting funds if it's so difficult?
One simple reason is that you need money to survive. In theory, funding your firm with its earnings is a good concept, but you can't manufacture immediate consumers. To break even, you must sell a particular amount of your product. It will take time to increase your sales to that level, and it is difficult to anticipate how long it will take unless you attempt.
The great majority of businesses will fail if they do not receive startup capital. The amount of money required to get a business to profitability is frequently well above the founders' and their friends and family's abilities to fund. A startup is a firm that is designed to expand quickly 12. To continue their expansion, high-growth enterprises nearly always need to burn cash before reaching profitability. A few startups successfully bootstrap (finance themselves), but they are the exception. Of course, many excellent businesses are not startups. Managing capital requirements for such businesses is not discussed in this document.
A war chest not only helps companies to survive and develop, but it is nearly always a competitive edge in all areas that matter: employing key personnel, public relations, marketing, and sales. As a result, most businesses will almost likely wish to raise capital. The good news is that many investors are looking to invest in the right business. The bad news is that "fundraising is cruel." 1. The process of raising such money is frequently long, laborious, complex, and deflating to one's ego. Nonetheless, it is a route that practically all businesses and entrepreneurs must take, but when is the ideal moment to seek capital?
When to raise funds?
Investors send cheques when they are convinced that the concept is attractive, that the founders' team can accomplish their vision, and that the potential outlined is genuine and significant enough. When the founders are ready to tell their tale, they will be able to gather funds. And, in most cases, you should raise funds.
For some entrepreneurs, having a narrative and a reputation is sufficient. However, for most, it will take a concept, a product, and some level of client acceptance, often known as traction. Fortunately, today's software development environment allows a complex online or mobile application to be produced and deployed in a surprisingly short amount of time and at a very cheap cost.
However, investors must be persuaded as well. A product that people can see, use, or touch is usually insufficient. They will want to know if there is a product-market fit and that the product is growing.
As a result, entrepreneurs should solicit funds only after they have determined the market opportunity and who the client is, and after they have developed a product that meets their demands and is being adopted at an unusually quick rate. How fast is it interesting? This varies, but a weekly rate of 10% for several weeks is outstanding. And to obtain funds, entrepreneurs must wow. Congratulations to founders who can persuade investors without these items. For everyone else, focus on your product and communicate with your customers.
How much to raise
Ideally, you should raise as much money as is required to attain profitability, so that you never need to solicit funds again. If you succeed, you will not only find it simpler to raise funds in the future, but you will also be able to survive without fresh financing if the funding situation becomes tight. Their objective should be to generate enough money to reach their next "fundable" milestone, which is normally 12 to 18 months later.
When deciding how much to raise, you must weigh numerous factors, including how much advancement that amount of money will buy, credibility with investors, and dilution. If you can give up as little as 10% of your firm in your seed round, that is fantastic; but, most rounds will need up to 20% dilution, and you should attempt to avoid more than 25%. In any case, the amount you are requesting must be linked to a credible strategy. That strategy will provide you with the credibility you need to persuade investors that their money will have a chance to grow.
You need to bear in mind numerous factors, such as:
It is always a good idea to construct various plans based on different amounts raised and to thoroughly communicate your opinion that the firm will be successful whether you raise the whole amount or anything less. The difference is how quickly you can grow.
Consider how many months of operation you intend to support when determining the appropriate amount to raise in your first round.
1. Convertible Debt
What is convertible debt? Convertible debt is also referred to as convertible loans or convertible notes. Convertible debt occurs when a corporation borrows money from an investor or group of investors to convert the debt to equity at a later point. Typically, the method for converting debt to equity is established at the time the loan is made. Sometimes compensation is provided in the form of a discount or a warrant. Sometimes there is, and sometimes there isn't. Sometimes the valuation at which the debt will convert is limited. Sometimes there is, and sometimes there isn't.
There are several reasons why investors and/or the firm may want to issue debt rather than stock and convert the debt to equity later. The reasons are evident for the corporation. If the corporation feels its equity will be worth more in the future, it will dilute less by borrowing debt and eventually converting it. It is also true that the transaction expenses, mostly legal fees, are typically lower when issuing debt rather than stock.
For investors, the choice between debt and equity is less straightforward. Sometimes investors are so anxious to participate in a firm that they will put their money into a convertible debt and allow the next round of investors to choose the price. Finally, debt is senior to equity in liquidation, so holding a debt position in a corporation rather than an equity position provides some additional security. However, this is not very useful for early-stage firms. When a startup fails, it frequently has little or no liquidation value.
How does convertible debt work?
Convertible debt is frequently used for friend and family rounds. It stands to reason that friends and relatives would prefer not to engage in a hardball bargain with a founder, preferring to wait until professional investors join the picture.
Warrants or Discounts are common kinds of remuneration for making a convertible debt.
The Warrant in a normal convertible note will be an option for whatever security is sold in the future round. The Warrant is commonly represented as a "warrant coverage percentage."
A Discount is easier to understand but frequently more difficult to implement. A discount will be presented as a percentage as well. The most commonly used discounts are 20% and 25%. The discount is the amount of money that convertible loan holders will save if they convert in the following cycle.
Why use a convertible debt?
Typically, startups consider obtaining financing through convertible debt early in their life cycle. They want to move quickly, keep transaction costs low, and a convertible note makes it easier to close the investment. While these are all valid reasons to contemplate convertible debt, we are not fans of it at this stage in the life of a firm. I feel it is best practice to establish the equity value early on and begin the process of growing it round after round after round. On the other hand, convertible debt can make a lot of sense later in a company's existence.
What is this?
A simple agreement for future equity (SAFE) is a fundraising mechanism developed in 2013 by the well-known Silicon Valley startup accelerator, Y Combinator. Originally designed to assist entrepreneurs in raising seed finance, SAFEs have subsequently evolved into a common pre-seed and seed-stage alternative to the convertible note.
How does a SAFE work?
A SAFE, unlike a convertible note, is not a debt instrument. A SAFE is a convertible equity instrument that gives investors the ability to acquire stock at a later period and under certain conditions. They are often substantially shorter in length than convertible notes.
Why use a SAFE?
SAFEs have several important benefits over debt-based alternatives. Because it is not a loan, the startup does not incur debt as a result of the investment. This feature assists in preventing a startup from going bankrupt if it is unable to develop momentum, shift to a different business plan, or accrue interest over time.
Another significant advantage of SAFEs is their simplicity. SAFEs were intended to be basic so that entrepreneurs could save legal expenses and reuse them. Only the value capital will need to be discussed for a conventional SAFE (if at all). Because the agreement is not a debt, there is no need for startups and investors to negotiate maturity dates, extensions, or interest rates. They also do not have to haggle with other investors.
However, the concept of SAFEs is not universally welcomed. One particular source of concern is that a business may fail before investors can execute their stock options. In that circumstance, the investors have few options because the firm owes them nothing.
What is this?
Setting a valuation for your company (generally, the cap on the safes or notes is considered as a company's notional valuation, though notes and safes can also be uncapped) and thus a per-share price, followed by issuing and selling new shares of the company to investors, is what an equity round entails. This is usually more difficult, costly, and time-consuming than a safe or convertible debt, which explains their appeal in
How does equity work?
When your firm conducts a pricing round, you must be aware of numerous critical components of an equity round, such as equity incentive schemes (option pools), liquidation advantages, anti-dilution rights, protective covenants, and more. These elements are all negotiable, but if you have agreed on a valuation with your investors, then you are typically not too far off, and there is a deal to be done. I won't go into detail on equity rounds because they are so infrequent for seed rounds.