July 28th, 2022 | By: Sarah Humphreys | Tags: Funding
Funding a startup isn't easy, and anyone that has launched a startup knows this to be painfully true. You need money (like yesterday) and raising funds is "a process" — to state it simply. There are so many details to know and questions to ask before a round can even begin, and once the startup funding round is ready to rock, there are additional questions every founder needs to know the answer to before they take the plunge.
One of the most common questions asked — and arguably most important details to know is how much equity do you give away in seed round? With the help from members of our community, we are going to get into this question in further detail to demystify the information about raising seed capital and the amount of equity each round will cost you.
Setting the valuation for a startup isn't too complicated, at least it shouldn't be the most difficult part of your fundraise journey, assuming you are working with an established business that has trackable revenue, growth rates, cash flow, and other financial metrics to help decide the startup's worth.
For a young company without any of these things to go by, it can be much more difficult – if not impossible – to set a price on them, particularly when you factor in competition, customer demand, and brand strength (which could very well make or break your new venture). But no matter how good or bad you are at setting valuations, chances are you’ll eventually need one – either as part of funding negotiations with investors, or perhaps later, once you’ve sold your company.
Guiliano Senese from our community weighs in on valuing your company in order to raise money:
"The question of how much equity should I give away differs for every start-up. I remember with my first company I gave away 30% because I wanted to get it off the ground. This was the best decision I ever made. Don't over-valuate your company as having 70% of something is big is a whole lot better than having 100% of something small. You have to decide your company's value based on Assets/I.P(Intellectual Property)/Projections."
Under-valuing: a mistake that can be made without any ill intent! The more dilutive the round, the lower the valuation must be to not miss out on future funding rounds (or even later stage funding). You know what we mean: VCs like to think they’re very sophisticated about valuations, but all too often, they don’t really understand how much money they want back or what their exit strategy will be in 2–3 years' time.
Take it from our community member, Chesley Chen:
"A very good and age-old question. The others have provided good benchmarks that I've seen recently. I'm working with a few start-ups right now that are Pre-Series A.
From a number crunching perspective, you should build a financial model with discounted cashflows to arrive at a valuation. A good model will let you fiddle with your key strategic assumptions to give you a range. Potential investors will run the numbers so you're better off having your own as their starting point.
Have you considered using a Simple Agreement for Future Equity (SAFE)? It's an instrument born out of Y Combinator for early-stage companies. Like it says, it simplifies the process and doesn't force you to go through valuation negotiations and gyrations just yet even if there is an implied valuation.
Another thing to consider is limiting the investment that any single investor can put in. I am assuming that the last thing you want right now is to yield control to others."
For more information on equity financing, check out this section of our funding playbook — we break down all the complicated investment terminology to help new founders understand the basic concepts of raising capital while leveraging equity.
If you are embarking on a funding round as a budding startup without any traction, it's likely that you are in the friends and family (and possibly Angel investor) round. Your pre-money valuation will help you determine the amount of equity stake that is going to be leveraged.
The pre-money valuation is calculated by subtracting the investment amount from the post-money valuation. With this, the ownership of the initial shareholders will thin out. This is called dilution. For example, say that a company with $20 billion market cap has a post-money valuation of $20 billion and an investment amount of $1 billion, this would mean that the pre-money valuation is $19 billion.
Community member, Christopher Ziobehr, dives into this in more detail:
"If you get into techstars they take 7-10% for $118k which is about a ~$1M valuation. If you're pre money, Seed investors usually cap their valuation at $4-6M, so depending on how much you need is how much they are going to get. That said VC's tend to have a much better run rate then angels. They tend to help you more with further rounds. Really good incubators (only a handful of them exist) can also help further your secondary raises, startups tend to raise on average $2m after graduating.
But the real question is why do you need funding? Are you ready for funding? What is the use of funds directed into?"
Discovering when, and more importantly, IF you are ready for startup funding is the million (or billion!) dollar question. If this is something you don't know the answer to, we highly recommend checking out our Online Startup Accelerator.
Seed funding, also known as seed money or seed capital, is when an investor exchanges an equity stake or convertible note stake in a business by investing capital in a startup company.
A seed round refers to a series of investments in which various investors (typically no more than 15) participating in the fundraise provide early funding to a new company. The typical range for this type of funding round is $50,000—$2 million and usually goes toward market research and product development in exchange for convertible notes, preferred stock options, or seed round equity.
Seed money gives a startup a solid foundation and the runway to hit the ground running. Keep in mind that a safe or convertible note has a maturity date (which is a provision when the notes are to be repaid with interest) that is typically anywhere from 18-24 months from the convertible debt investment.
Prasanna Krishnamoorthy from our community shares these thoughts:
"Very tactically, at the early-stage valuations are mostly arbitrary. Typically it goes by the market rate, geography, relative strengths of the investors vs founders, growth rates, ARR, etc. For a $1M seed round (similar to filament):
A VC firm will look to get 10%-20%
A group of angel investors/seed will look to get 15-25%.
This is assuming you have some traction with good growth. Your negotiating position and skill will determine which end of the scale it will be. The funding scene is also quite variable based on who you are, and hence YMMV."
In early seed rounds, the investors participating would likely either be angel investors and/or venture capital from private investors. This type of financing round is one of the most common for early-stage startup founders since quite frequently (more often than we'd like to admit) this could be one of the only equity rounds most companies even go through.
After all, raising additional funding after an unsuccessful seed funding round is even more difficult than starting the initial fundraise, to begin with. Most investors won't invest in future rounds if they see the company couldn't complete a seed stage funding round.
Imagine: the business model is on point, the market opportunity of a lifetime, the company worth is causing buzz in the industry, the team is excited to step it into 5th gear, but the investment vehicle is out of gas because nobody has the cash to fill the tank. If a startup does not have the funds to help itself grow by way of product development, making key hires, marketing, etc, then all you have is a small private company that won't ever turn into the profitable company of your dreams.
Joy Broto from our community shares helpful insight for those ready to raise capital and how much equity to offer during various seed rounds:
"If you are a business that is not in need of massive amounts of capital to stay relevant (think, hyperlocal delivery, food start-ups, etc.) then my advice is to ensure Founders dilute no more than 30% for Investors during a Series A round. Given that in almost all cases you would be required to set aside a bare minimum 10% towards an ESOP pool before the Investor comes in, as a founding team you are left with slightly more than 60% of the company.
There are some caveats though, firstly, do your due diligence on the Investors you are taking the funds from, and make sure you talk to their portfolio companies and even senior-level employees within these firms. Ensure the referral loop includes the so-called duds in their portfolio.
To get a better handle on how things continue to change as you continue to raise from seed to series A and beyond this is a great primer."
Like most any big decision while building your startup, there are various pros and cons to raising seed capital (or raising capital at all). Let's take a look at it from a list point of view:.
Equity financing typically doesn't come with any rigid repayment requirements. There is an expectation of a return on investment, but the return isn't expected for about 5-10 on average.
Money raised gives a competitive advantage and means the company can reach other milestones that could in turn attract future equity from additional investors, or existing investors that are already invested in the business model.
New investors will be more excited about your business which can mean bringing in well-connected investors that can advise you on how to develop your business, and make important introductions.
Running a business can be downright draining. Having professional business people such as venture capitalists on your side can provide confidence.
Many times, investors want stock ownership in exchange for capital invested in the company known as preferred stock. With this detail in play, the business must reorganize. This means a lot of revisions to the articles of incorporation and creating updated or new bylaws that explain the rights of all stockholders.
Accepting an investment creates many additional expensive transactions within the company. For example, hiring an attorney to advise it on the investment transaction deal, and that doesn't include the attorney representing and drafting for the venture capital fund. The entire process typically generates extensive legal fees that many don't realize before getting into it. All of the fees are paid from the capital invested in the company, so make sure to consider that from the outset: the company won't have as much money to work with post-completion of the deal.
Losing ownership and control of the company. When investors provide seed investment to a company, they become part owners, and obtain some control over decisions. The founder is no longer the sole owner and cannot make decisions for the business's growth without the agreement of the investor.
Investing in a startup is a long-term commitment and most investors see countless deals, so it's important you prepare yourself adequately before ever meeting with one.
Research what the investor likes to invest in and the reason why (if you can find it). Knowing your audience can make or break your chance of investment. Make sure to simplify your pitch to only what is most important and crucial to sharing why this is a great company/product, why you are the right team to build it, and why you should all dream about creating the next massive company, together. Do what you can to connect with the investor, and listen intently to what the investor says. Getting the investor to talk more than you is a very good sign.
Investors are looking for interesting founders that have a believable story and evidence documenting the reality of their dream (the more evidence, the better). Craft your story appropriately and work hard to get the pitch perfect. Practicing a pitch before you are in front of investors is highly recommended, as many founders are not natural presenters.
During a meeting, try to keep a balance between confidence and humility. You want to be confident, but not arrogant. Flexible and open to intelligent questions, but stand up for what you believe and don't be a pushover. Respect goes a long way in the investor world.
Never leave an investor meeting without an attempted close or with some crisp clarity on what the next steps will be (at minimum).
If you're on the hunt for investors, you probably already know that not just any investor will do. Just like your startup fits into a specific industry, investors will typically stick within a niche group or industry of startups, so it's important to know this information before reaching out and wasting everyone's time.
Using tools such as Crunchbase can help you streamline the process and weed out the bad fits that aren't your "target investor." The process can be taxing because there is a lot of information out there. For busy founders that need an extra pair of digital hands, consider hiring a virtual assistant to help you in your search endeavors.
Whether you are tackling this as a team, or alone as a solo founder try to find information on the investors' previous deals and what will be expected of you and your startup prior to setting up a meeting.
Shishir Gupta from our community weighs in on how much equity to give to the "right investor":
"There is no set standard, the amount of equity will depend upon the valuation and amount raised. However, as a target figure, founders shouldn't share more than 33% of the equity in a seed round."
Angel investors invest in very early-stage startups in exchange for equity or convertible debt. This is a critical bridge between the startup financing needs and larger capital needs later on. Angel investors are high-net-worth individuals that invest their own money, so it can come from a variety of sources. They do not have to be an accredited investor, however, many angel investors are.
Venture capital is a great option for startups that are interested in scaling quickly. Investment sizes tend to be a lot larger than those from a friends and family round, or from angel investors. This is not for the faint of heart. Be prepared to take that money and grow — and that means a lot of hustle.
As mentioned above, venture capitalist firms come to the deal with a lot of institutional knowledge. They’re also well-connected with other companies that could help your startup, introduce you to employees, and other investors.
You should go after investors once you've proven your idea with enough initial market research. You should also be able to show some traction and growth trajectory. Your initial round of funding will pave the foundation for the startup phase and prepare you for institutional investors in future funding rounds.
There are many different areas of startup funding to understand before diving into a funding round. We hope this provided enough clarity when it comes to how much equity should be given away in a seed round, and where that equity will be dispersed.
Before you start on your funding endeavors, make sure you know your company's valuation and what kind of investor your startup funding will likely come from.
When you're ready to start reaching out to investors, practice your pitch so you can walk into those meetings with confidence.
And for all other questions about startup funding, explore our funding series here.
A long time ago, someone told Sarah that she was going to do great things. And even though that person was her own reflection looking in the mirror, those words have carried her through the thick of it all. You may find her singing in her car, cleaning things as stress relief, or using humor in uncomfortable situations. Sarah is a professional photographer, expert-level copy editor, copywriter, digital creator, and a nice lady to boot!