What Is a Seed Round? Seed Funding Explained
Last updated on November 1, 2022 by
Paul Graham (YC Combinator) once said raising money is the second most challenging thing you will do as a founder. The most challenging is creating something that people actually want.
He goes on to observe that many startups end up failing because the founders were not able to create a valuable product, but that the second leading cause of failure was not being able to raise enough money.
Yes, sometimes startup founders don’t need to raise money, and are able to bootstrap the business instead, having the advantage of an initial product or service that can generate cash flow. However, there are not nearly as many successful bootstrapped businesses as there are externally funded ones, and the ones that are successful achieve that success in ways that are not easily replicable.
Bootstrapping isn’t easy. It can even be unsustainable or ill-suited to your industry and business model. But, that’s not to say we don’t support bootstrapping. It’s just not always a route startups can take forever. Many companies that bootstrap eventually seek out fundraising later on, typically at a pivotal milestone in the startup’s journey.
Bootstrapping is even more difficult in the life sciences as it is a highly capital-intensive industry. If you’re a biotech startup founder, you most likely already know the difficulties of becoming and remaining adequately funded.
Even if you’re a wealthy entrepreneur with a product on your hands that can bring in revenue right away, chances are you consider raising funds at least once in your company’s lifecycle. Fundraising doesn’t happen in one go, however, and there are different funding stages, all with their own purposes. These include:
- Pre-seed funding
- Seed funding
- Series A, B, C, D, and E funding
In this article, we will review seed funding, how a seed round works, and more. We will also lay out some basic steps for determining how much capital you may want to raise during a seed round. The conversations surrounding “how much money to raise in a round” can vary dramatically depending on who you talk to and what your business needs and goals are. Fundraising isn’t a one-size-fits-all situation. Use this article as a starting point.
Seed Round: Definition & Investor Examples
Seed funding rounds are typically the first formal round a startup raises, securing money, or seed capital, in exchange for equity or a signed agreement to provide convertible equity or debt at a later date. This stage can be thought of like growing a tree. At this point, the idea is merely a seed, and an initial investment can help a founder grow the business from a seed into a thriving tree. Angel investors and venture capital firms are the most common investors at this stage, although VCs weren’t always as willing to invest at such an early-stage in a company’s development.
Seed funding is dilutive. Whether you’re providing an investor with equity at the closing of the funding round or promising they’ll receive it later, you ultimately give up some percentage of ownership in your business for outside investments.
Startup founders can use seed funding to finance the first phases of research and development, create a product demo or minimum viable product, and determine whether or not their idea can become a legitimate business. However, not all startups will be at the same stage of product development.
In the life sciences, the product development life cycle can be much longer than in other industries. The seed funding a biotech founder secures may instead go towards gathering more data points and figuring out if the science can be commercialized, rather than developing a demo or prototype that will turn into a final product.
Incubators, private investors, and even venture capital firms will provide funding in exchange for equity, usually in the form of a convertible note or Simple Agreement for Future Equity (SAFE) They may also ask for a share in profits of a product or service instead, however, convertible notes, SAFEs, actual equity, and/or a preferred stock option is more typical.
During the seed round, a series of related investments will take place in which a few to several or even a dozen investors “seed” a new company with anywhere from $50,000 to $2 million. This money is often used to support initial market research and early product development. As mentioned, investors will usually receive convertible notes, equity, or a preferred stock option in exchange for their investment.
Some startup founders raise pre-seed funding, the earliest stage of funding a startup can raise, before raising a seed round. This type of funding is so early in the process that it is not usually included among the rounds of funding at all. Founders most likely only have a promising idea for a business at this point, hoping to come into some financing that can help them get their operations off the ground and start working on the idea in earnest.
Although more venture capitalists are establishing pre-seed funds and getting involved earlier on in the fundraising process, you don’t generally see venture capital firms at this stage. Institutional investors like hedge funds, mutual funds, or private equity firms don’t typically get involved either. Instead, founders rely on a combination of their own resources (i.e., personal savings, friends and family), family and friends, and angel investors, high-net worth individuals who contribute their capital in exchange for equity, to drum up pre-seed funding.
Is It a Required Stepping Stone?
Some startups skip seed funding entirely. Instead, they decide to raise a Series A round. Others may only work with seed-stage investors and choose to skip Series A, B, and C funding.
The fundraising process does not have to follow a step-by-step progression. Companies are not always alike, and there are a variety of ways to fundraise, with different standards across many industries. However, the general path many of the fundraising variations oscillate around looks something like this:
- Raise money in the tens of thousands from family, friends, personal savings, and possibly an angel investor or two.
- Raise a few hundred thousand to a few million dollars in order to grow and build the company, reaching a key milestone along the way. This usually coincides with the company generating initial sales, a strong user base, and—most importantly—becoming profitable. These rounds help launch a product or expand a product line (any sort of new major milestone or milestones).
- Raise another, larger round (or multiple rounds, in some cases) after the company has proven it can succeed. The larger round will be used to fuel growth exponentially, scaling even further.
While seed rounds are not always necessary, they are often the first step founders take to fund their business.
Why Should You Raise Seed Capital?
Many startups can’t get to a point where their product is ready to sell without a large chunk of capital. Biotechs often need seed capital to fund research and development crucial to reaching clinical trials and securing approval for a product.
Product development costs, employee salaries, equipment, lab infrastructure expenses, and so much more can all add up quickly. Startups can easily spend hundreds of thousands of dollars in capital before even having something to sell.
Seed funding helps startup founders reach critical milestones in development and build a strong team of scientists. Some other key benefits to seed rounds include:
- Securing more time to dial in the business model
- Spending more time finding and connecting with key business partners, such as larger pharmaceutical companies looking to partner with smaller biotechs
- Increasing flexibility and allowing the business to pivot and change course
How Does Seed Funding Work?
Founders and investors have a couple of different ways to structure seed stage financing deals. In exchange for their capital, investors can receive equity in the startup immediately or rely on other financial instruments that convert at a later date into equity.
Some common instruments include convertible notes and simple agreements for future equity, or SAFEs. Unfortunately, it is difficult to sum up either of these financing options, as there are complicated legal aspects to each. Nonetheless, we can provide very high level summaries below.
A convertible note is a type of debt instrument that is used in early-stage financing. However, because it has the ability to convert to equity at a later date, it is considered a hybrid of the two categories. They are popular early on because of their relatively simple structure, helping speed the fundraising process up and making it easier to move forward with the round when pricing a company proves to be difficult.
Simply put, a convertible note begins as short-term debt and is later converted into equity when certain milestones are met, such as the closing of a later round of financing. The conversion provides the investor, or note holder, with a discount on shares at a future date.
The note has a few key aspects, including a specified principal amount, interest rate, and maturity date.
A simple agreement for future equity (SAFE) is an agreement that provides an investor with convertible equity. It can also be referred to as a SAFE note.
It is similar to convertible debt, however, it does not include interest or a maturity date. In the same way that a convertible note functions, providing an investor the right to purchase shares in the startup at a future date, usually at a discounted rate.
Equity comes in the form of preferred and common shares. When an investor receives equity in a seed round, it requires a valuation for your company to be set. This determines a price-per-share for the shares that are being issued to the investor. Structuring the investment around equity can often be more complicated and time consuming than a convertible or SAFE note, and explains the popularity of these debt instruments in early rounds.
It is why you will typically want to hire a lawyer when dealing with the complexity of equity rounds involving priced shares that are exchanged right away.
What Comes After a Seed Round?
Series funding, which can be broken up into Series A, B, C, D, and E funding rounds, comes after a seed round. Each round has its purposes, and not every company going through the stages of financing will need or want to raise multiple rounds. The letter refers to the class of preferred stock sold to investors in exchange for their investment.
Series A Funding
Series A funding can differ based on the industry you’re in. If you work in tech, Series A funding might be used to get your product to market. Founders will use the financing to demonstrate product-market fit, seek out and acquire customers, and start generating revenue of their own. In contrast, a nascent life sciences startup may not be anywhere close to generating revenue during a Series A round. Instead, the Series A funding may be used for additional product development and refinement, as well as a step forward in preclinical studies or even early-stage clinical trials.
Venture capital firms and other types of funds typically dedicated to more mature companies are more likely to be used during a Series A round because investors have more business metrics to base their assessments and valuations off of.
In tech, these metrics can be related to revenue growth, customer acquisition cost, and lifetime value, but might not be applicable to a biotech startup raising a Series A round. It’s likely they have a promising technology that shows potential of being commercialized at this point.
Series B, C, D, & E Funding
These later-stage funding rounds are often for well-established companies who want to achieve certain growth-related milestones, such as launch new products and expand their market reach. In other words, companies that have an opportunity to grow and become profitable or more profitable will raise a Series B round or later in order to achieve that goal.
However, this may not be true in bioscience, where the product development cycle is longer and more capital intensive. For biotechs, this funding stage may be the financing they need to get them through late-stage clinical trials or an FDA approval.
In a Series A round, a startup will rely on its newly established track record and investor-interest to secure larger amounts of funding that can be used to launch a product or expand a product line.Investors aren’t just looking for a great idea at this point, they want to see that you and your co-founder(s) have a plan for developing a business model that will generate long-term profit.
Determining How Much Seed Capital to Raise
Many investors will ask how much you’re planning to raise. This question makes founders feel they should be planning to raise a specific amount.
However, it would be a mistake to give an investor an arbitrary number. The amount of funding you want to raise will depend on your exact needs. You may also want to avoid trying to raise too much money as well. (Here’s another Mark Suster article worth checking out on the subject of startups raising money: Why Startups Should Raise Money at the Top End of Normal)
A simple way to think about your early-stage funding needs is to ask yourself how many people you plan to hire. Do you want to hire 5 employees, who all cost around $10k per month? Times the monthly salary expenses with the amount of people you want to hire and decide on how much time you’ll need to reach your first development milestone. Let’s say that amount of time is 18 months. Then your calculation would look like: 10k x 5 x 18 = $900k.
That means you want to aim to raise $900k in your seed round. A typical seed round can range from anywhere between $500k and $2M or more. In fact, seed rounds for startups have only gotten bigger over the past several years, with the average seed funding amount in 2020 reaching $2.2M.
Obviously this applies best to fundraising startups that are looking to hire. Some advisors encourage startup founders to not have a fixed plan at all, since fundraising can be so unpredictable. Instead, you should have multiple plans.
For example, if it’s possible, you should be able to tell investors you can make it to profitability without raising any more money, but if you raise a few hundred thousand you’ll be able to hire one or two scientists. Further, if you can raise a couple million, you’ll be able to hire a whole process development team. This shows investors you are flexible as a founder and that your business is strong.
Different plans will, ultimately, match different investors. If you’re talking to a venture capital (VC) firm that mostly does Series A rounds, but participates in Seed rounds here and there, you would be wasting your time talking about anything but your most expensive plan (the one where you raise $2M).
On the other hand, if you’re talking to an angel investor, you will want to focus on your least expensive plan (the one where you raise $900k). It’s typical to see smaller commitments from individual angel investors during the seed stage. Checks can range from $20-$50k, and startups usually roll these up with other offers in order to grow the seed round.
These examples, although slightly different, share a similar sentiment: don’t nail yourself down to one number for the sake of having a number to give investors in a meeting. Plan for multiple scenarios, and adjust accordingly to the investor you’re meeting with.
At the end of the day, getting an investor to commit is your goal. Talking about money up front will not help you close a deal. Once you get the yes from an investor, then it’s time to talk about money.
When Do You Raise Money?
The best time to start raising seed capital is when you believe it’s time to get your company off the ground! Have a business plan and executive summary available for investors, as well as a clear path forward to profitability. When you can articulate the items on the list below, you’ll be prepared to raise seed money:
- Your current/planned business model—literally how you charge customers—as well as the prices that you charge/plan to charge for your product (or services, if applicable)
- A revenue projection for the current year and a few years into the future based on very simple bottoms up math (# of customers X price points)
- An expense projection with high level detail on categories (i.e., salary by function/position, operational spend, marketing, etc.) that will be required to achieve your revenue projections
- The cash required to fund your projections
Most importantly, be able to explain what sets you apart from everyone else. In the seed stage, you’re relying on an idea and story as much as any detailed financial projection.
If you don’t believe you’re quite there yet, don’t worry. Continue working on your startup, strategy, and product/service. While fundraising is often necessary for a startup, it is not the main reason startups succeed. Your product is.
Selecting an Anticipated Valuation for Your Seed Round
Startup valuation is not only an important component of fundraising, it is required. While investors typically negotiate a startup’s valuation during the seed round, founders can select a target or anticipated valuation. Selecting a valuation is one of the harder parts of seed fundraising, but it’s an important step in the fundraising process.
Setting a target valuation simply means you are telling the investor you aim to fundraise at a certain valuation for your startup. It’s important to select a realistic and enticing valuation to get your foot in the door with potential investors. Too low of a valuation can be a negative signal. Too high and you can negatively impact your fundraising efforts.
To be clear, the founder does not set the valuation, they choose a number that feels right for their startup. Usually, the number is then heavily negotiated over with the potential investor.
Seed Funding Can Help You Grow Quickly
Seed funding represents planting a small seed, your business idea, that will grow into a healthy and thriving tree. Seed capital can provide a company the funds necessary to create a strong foundation to work from, and prepares the founders to potentially move onto a Series A, B, or C round, funding stages that are analogous to your tree’s branches sprouting.
Use seed funding to get your business off the ground by bringing on key hires, purchasing or leasing all the equipment you need, conducting research and proof-of-concept studies, and more. By raising enough money to fund your business for the next 18 months, you will be able to prepare for a Series A round, which will, ideally, help you get one step closer to profitability.
But remember, equity funding is not your only option. While an excellent avenue to funding, there are other biotech funding options available, some of which are non-dilutive. Alternatives to equity funding include include grants and public funding, equity crowdfunding, and various forms of debt financing, such as loans and leasing.
This article is informative. It is not meant to represent legal advice. Before raising capital through equity financing, it is best practice to speak with a lawyer who has a track record in startup and venture capital deals.