This is the year of the unicorns. In the first six months of this year alone we’ve seen 13 startups enter the prestigious unicorn club, meaning they have been valued at more than 1 billion USD. How do these valuations work? Who are these people who invest insane amounts of money into these nascent companies? What are these series A, B, and C? We’ll explore all these and more in our upcoming blogs.
You would have definitely come across the word funding if you’ve been in the startup scene. It’s the talk of the startup town. From a mere idea to a thriving company, a startup goes through several phases. Throughout these various stages, the company needs capital infusions that can propel growth–for salaries, equipment, and marketing. In business jargon, these fund infusions are called rounds–the angel round, the seed round, the private equity round, and the debt round. For now, let’s get started with seed funding and how it works.
What is the Seed fund?
Seed money is the money injected into a company that germinates the idea into a viable business in the early stages. It’s a direct analogy with the nurturing of a plant from the “seed” stage until it becomes a humongous tree. At the seed stage, the fund helps the business to get off the ground with the first steps and to finance market research and product development.
This is the earliest stage of funding (though there’s angel round and pre-seed; which are mostly funded by founders themselves or friends and family) that can be considered the first equity funding stage. It represents the official entry of VC money into a business.
The importance of getting a seed fund
When you start a business, you need to make a difficult choice that will determine your path several years into the future–self-funded or seed funded?
The hard truth is that without a seed fund, most startups die. Now, don’t get me wrong, there are several bootstrapped startups that are doing amazingly well. But, it’s not a viable option for companies that are looking at hypergrowth. They need to burn capital to grow at a faster pace; in terms of understanding the market, bringing talent onboard, office spaces, computer systems, and bringing the product to life. For them to achieve sustained profitability, some of them bootstrap but this may not be viable for most startups.
A few things happen after a firm receives the seed capital:
- The company moves from ideation to production
- The problems and solutions are validated
- The company starts getting its first customers
- The proven concept (beta, mvp, etc) is converted into a full-fledged business
The seed fund’s purpose is to keep the business afloat until it is capable of generating sustained cash flow and profits. It also reduces the founders’ risk and makes it easier to scale at a faster rate.
Getting the timing right
So at what point should you start to think about securing a seed capital (if at all you should)? The right time varies from business to business. One of the companies I used to consult with did not get the seed fund until after 3 years. Yet there are several businesses that secure the fund even before lift off. What works for one business might not work for another is what I’m trying to say.
However, it’s crucial to get the timing right; this can have a major impact on the future course of the business. As soon as you have a compelling reason as to why someone should invest in your reason, you should start booking meetings with investors. It can take a lot of meetings to secure that fund.
These reasons could be the validation of the problem-solution hypothesis, identification of a sufficient market, or your initial customers have received your MVP well. Once you have nailed all of these, get your business plan ready. You should also bring all your founding members onboard with the idea.
Who invests in the seed stage?
Seed funding can come from different sources. The most common are friends, family, incubators, VC firms, and crowdfunding. It’s also not uncommon for the co-founders to invest themselves to get complete ownership of the company.
Most venture capitalist firms are not as active during this time as they are in the later stages. However, this is not a maxim. There are several firms both private and government programs like StartupTN. In fact, if you’re an entrepreneur trying to get that initial capital to grow your business, we’ve got you covered. Click here.
Here’s also a list of VC firms that are active in early stage investments in Indian startups.
The foundations of securing a seed fund
Now that we’ve covered what a seed fund is, why it matters, and the various sources from which you can get the seed fund, we’ve come to the million dollar question:
WHAT MAKES INVESTORS GRAB THEIR CHECKBOOKS?
The answer to this question deserves an entire article to itself (which we will definitely do in the future). Nonetheless, we’ll cover the most important aspects briefly here. Seed stage investors take risky bets so they’d need to look at certain things that will assuage their fears and minimize their potential for loss.
Business potential
The number one item on any investor’s list would be seeing potential in the business idea, the product, or the vision. If an investor does not believe in the idea or see the potential, why would they invest in it? They need to be convinced that the founders can realize the vision.
Market opportunity
Investors aim to invest in companies that can generate massive returns at exit. So, you want to make sure the target audience is sufficiently large or has the potential to grow exponentially in the future.
You also want to ensure there’s a demand for your product. Once in a while you will see a product that will create a problem that their product solves but those are the ones that will die a quick death. Your product needs to solve an existing problem.
Minimum viable team
The team that’s building the company is the cornerstone of any business; their reputation and credentials will play a critical role in swaying an investor’s decision. The early hires need to instil confidence and the company should be able to attract talent soon after securing the fund.
A working product
A proof of concept goes a long way in convincing investors; after all actions speak louder than words. You’ll need a first version of your product, a structured demo, and a short-to-medium term roadmap.
How much capital should you raise?
Aha! We’re now down to the juicy bits.
The short answer is as much as you can.
The long answer is: In an ideal world, you should raise as much money as you need to reach a state of net positive cash flow so that you don’t have to raise money again. This definitely will help you survive when the funding environment is not right. If you plan to get another round of funding, you should aim to raise an amount that you need until the get to your next milestone.
There are several techniques like the Berkus method or the discounted cash flow method that investors use to arrive at a valuation. You need to figure out what your company is worth and give up not more than 20 percent of the ownership.
Choosing the right investor
Raising seed funds for your business is an arduous process; it can be draining but in the end you’ll be able to create something worthwhile.
You’d need an investor who’s aligned with your vision for the company and not someone who only focuses on the profits and the value at exit. You should also look at the investing firm’s previous investments, their preferred sectors, portfolio alignment, and funding capacity. The investor should give you a free rein to take the business along the path you intend to. That’s where StartupTN comes into the picture.
StartupTN offers several grants for young businessmen that are stepping into the startup scene. You can find more information here.