Among the most important phases of founding and running a startup is obtaining funding that will facilitate further growth and development. At the early stage, this is called “early-stage funding”.
The task of raising early-stage funding (especially equity financing) for your startup will - almost certainly - prove to be stressful and arduous. It is difficult to place the future of your endeavor in the hands of someone else. At the same time, it could prove to be the first step towards making your entrepreneurial dreams a reality if you successfully secure a windfall that’s right for you.
Most founders have lived and breathed their businesses for some time before seeking capital. Therefore, the fact that startup owners typically underestimate the complexity of the financing process is unsurprising. Even in the best-case scenario, where you’re convinced that your venture will fructify as a resounding business success, getting early-stage VC firms in the same boat as you could be an entirely different probability.
For startups (as with everyone else but especially for startups), time really does mean money. Therefore, at such a delicate time in a new company’s lifespan, waiting on decisions for long can be a surprisingly costly process.
With that said, several startups successfully meet their funding target every year despite the long waits and potential negotiations over equity. This demonstrates that even though it can be a source of great stress for business owners, venture capital funding remains one of the best options out there for scaling your business.
If you are raising (or plan to raise, in the future) capital for your startup, you should know that funding comes in various stages - as shown in the image below.
Two prevalent forms of early stage funding that nurture a startup in its early days are pre-seed and seed funding.
Pre-seed vs Seed funding
Pre-seed funding typically comes from the founder(s) of the startup or/and their family members, close friends, or supporters, and is designed to help a startup achieve liftoff (or get off the ground).
Seed funding, on the other hand, is meant to aid the startup with its initial growth via market research and product development. Types of seed investors include family members, incubators, angel investors, and even certain venture capital firms.
Both pre-seed and seed funding often occur so early in a business’s lifecycle that they are seldom acknowledged as a formal stage of raising capital.
It is recommended that you first develop a minimum viable product that you can show to potential investors in case you are unable to convince them to provide you with the early stage funding required to optimally grow and develop your startup. If even the MVP doesn’t seem to budge them, perhaps you’re not engaging with investors in the right way. Go through these key 5 pointers on engaging with investors that can help you arrive at a strategically advantageous position.
Let us quickly understand the intricate details of these two crucial funding rounds.
Pre-seed Funding
In evolving from the Idea stage to the pre-seed funding stage, the onus is on the founders to work on building some form of product-prototype or proof-of-concept. It is for this reason that the pre-seed round is also known as the “proof of concept” round.
Raising money to develop the aforementioned product is a task that the founders need to work out on their own. Early stage funding at this stage is most likely to arrive in the form of family, friends, personal savings, angel investors, crowd funders, or/and incubators.
Without a doubt, the money required at the pre-seed stage varies depending on the business or the type of services/products that the company plans to provide.
Seed Funding
Seed funding comes after the pre-seed stage. Also known as the “institutional angel” round, the seed stage will most likely be the first instance of early stage funding that your company formally raises. The ‘seed’ represents the early finance that is instrumental for growing your company.
Seed funding (much like the case of pre-seed funding) can be raised from a wide array of sources. These include friends and family, as well as crowd funders. However, the most common kind of investors at this stage tends to be angel investors.
Here’s an interesting trend:
Emerging businesses, in recent years, have increasingly begun to identify a definite appeal in spending more time and thought on seed funding. To many founders, this approach is appearing to be a robust investment. This is because when a startup jumps to the Series A funding stage, there is little room for negotiation to bring relevant, knowledgeable, and experienced investors who could help guide the company’s progression.
This means that for most companies that want to use innovation as a USP (for instance, in the FinTech or SaaS industries), it could be more beneficial to conclude the seed round by transitioning into a “Seed Plus” state for a while before deciding to jump into Series A.
The best part?
The median age for startups that are still busy raising early stage funding at the seed or angel level has risen from approximately 1 year to 2.85 years. This rise is partially facilitated by large investors who are willing to show patience in watching their investments develop.
Why raise early stage funding?
A vast majority of startups will die without early stage funding.
In nearly all cases, the sum of money required to boost a startup to sustainable profitability is well beyond the financial ability of founders or their family and friends. Before achieving profitability, high-growth companies almost always need to burn capital to sustain their growth. A few startup companies do successfully fund themselves.
Cash not only allows a startup to:
- Grow
- Mature
- Sustain itself
But a significant war chest can give the company a competitive advantage in ways that matter. This includes hiring key staff in areas such as marketing, public relations, product, and sales. It also helps in extending the startup’s runway.
As a result:
Most startups will almost certainly want to raise funds at various junctures in their journey. Fortunately, there are lots of investors that are hoping to give their money to the right startup and the right team at the right time.
When should you raise early stage funding?
For some founders, it is enough to have a reputation and a story to get investors to write checks. However, for most, it requires a product, a convincing idea, and some amount of customer adoption, a.k.a. traction.
Fortunately, the software development ecosystem today is such that a mobile product or a sophisticated website can be developed and delivered in a remarkably short period at minimal costs. In fact, hardware, too, can be rapidly prototyped and tested in this day and age.
However, investors also need convincing. To this end, a product that they can touch, see, or use will usually not be enough by itself, no matter how effective.
Investors typically seek answers to questions like:
- Is the idea compelling?
- Is the product effective?
- Can the founding team realise its vision?
- Is the product experiencing actual growth?
- Are the market and opportunity real and sufficiently large?
- How strong is product/market fit? How strong is it likely to become?
How can you actually use this?
This implies that founders should raise money only when they have:
- Figured out what the exact market opportunity is
- Figured out who the customer is (or the customer profile)
- Delivered a product that matches their ideal user’s needs
- Delivered a product that’s being adopted at an interestingly rapid rate
How rapid is interesting, you ask?
Well, it’s extremely variable - but a rate of about 10% per week for several weeks is certainly impressive. And founders need to impress to raise money. For founders who can persuade investors without these things, huzzah. For everyone else, talk to your users and work on your product.
When are you ready for pre-seed funding?
If you are trying to determine whether pre-seed funding is right for your startup, identifying your funding needs is the best way to properly answer this question.
Here are some of the factors that you should take into consideration and check if they apply to you:
- If you are currently developing something that shows a small amount of function or a minimum viable product, perhaps you could further this development with the help of seed-funding.
- You are probably ready to seek some of this early stage startup funding if you believe that your product can fit into a specific market.
- If you need full-time employees to help you develop your initial idea, you will likely require some early stage funding to convince these people to leave their current jobs.
On the other hand, if none apply to you, this post excellently outlines how you can move forward from the Idea stage to the pre-seed stage by derisking the team, product, market, and traction.
While seed funding may seem right for your business, you should not consider obtaining it until you are ready to start conducting eventual product development and market research.
Want a better understanding? This post discusses 3 very realistic examples of pre-seed-ready companies and what each of them will have to do to advance to the seed stage.
Raising a pre-seed/seed round for your startup
Raising pre-seed and seed funding will enable you to get your startup off the ground and envision the company’s growth potential. In fact, the basic operations for your company (such as initial hiring, building the MVP, etc.) should start as a result of the early stage funding that you receive (usually in the form of pre-seed capital).
You are most likely in the early stages of developing a minimum viable product. Therefore, the funds you receive could come helpful in assisting you with the further development of this product - which will subsequently help you to secure future funding. Some additional elements of this funding include growing expenses, identifying a market opportunity, and the need to make a few hires.
At least in Silicon Valley (and increasingly everywhere else), most seed rounds are now structured as convertible debt or simple agreements for future equity (SAFE’s). While some early rounds may still be carried out with the use of equity, these are a rare occurrence when compared to convertible financing and SAFEs.
Convertible Debt
A loan that an investor makes to a company using an instrument called a convertible note is called a convertible debt. The loan consists of a principal amount (the investment amount), a rate of interest (usually around a minimum rate of 2% or so), and a maturity date (when the interest and principal must be repaid).
The intention of a convertible note is that it converts into equity (thus ‘convertible’) when the company does equity financing. These notes also usually have a “Target Valuation” or “Cap” and/or a discount. And although investors are often willing to extend the maturity dates on notes, the convertible debt might be called at maturity, at which time it must be repaid with earned interest.
SAFE
Convertible debt has been almost completely replaced by the SAFE (Simple Agreement for Future Equity) at major startup accelerators like Imagine K12 and YC.
A SAFE serves as a convertible debt without the:
- Maturity
- Rate of interest
- Repayment requirement
The negotiable terms of a SAFE are normally simple. They will almost always be:
- The cap
- The amount
- The discount (if any)
Check this article out for further details on SAFE financing documents.
Equity
An equity round means setting a valuation for your company (a per-share price) and then selling and issuing new shares of the company to investors.
Equity financing is nearly always a more expensive, complicated, and time-consuming process than a SAFE or convertible note, which explains the latter’s popularity for early-stage funding. In fact, when issuing equity, you will always want (and need) to hire a lawyer.
Once you have progressed to the seed stage and have been able to secure enough funds in the seed round, you should be able to finance further market research and product development. While you may not yet have made any profits, it is at this stage that you should show some gains in revenue.
Keep in mind:
Seed funding usually occurs after you have built a minimum viable product. The funding received can subsequently be used to turn the minimum viable product into a market-ready product.
The Beyond
You will soon have access to several additional rounds of funding once you have obtained the amount of pre-seed and seed funding that you need to develop the initial aspects of your business. These additional funding rounds include:
Throughout their Series A, most startups raise $2-$15 million. Series A funding is perfect for you if you have been thinking about turning your startup into a money-making business that yields profit. If you’d like a quick confirmation of it, this post discusses the boxes that a business needs to check in order to truly be ready to raise its Series A.
Series B funding is ideal for companies that have a successful product and want to expand their market research. This funding is typically used for bolstering tech, business development, support, sales, and advertising efforts.
Designed specifically for the scaling of a business is Series C. If you want to start acquiring companies, developing new products, or expanding into new markets - this round of funding might be right for you.