he case can be made that the hardest part of entrepreneurship is the beginning. Taking an idea from nothing, nurturing it, and developing it into something concrete with real, tangible economic value is the hardest task in business. This is why so few startups succeed. It is also why venture capital is so important. Enabling companies to survive while they perform those tasks at a time when they are incredibly vulnerable and there is so much uncertainty about outcomes is intrinsic to the mission of venture capital.
Seed capital as it is known is the purest form of venture capital. It is easy to provide additional capital to a startup when it is growing and has established traction in the market but supporting a startup during its earliest phases is incredibly risky. In many respects, the venture capitalist is called upon to believe not just in the technology but in the character of the entrepreneurs who are developing it.
In the earliest phases of entrepreneurship, the people are more tangible than the product. Still, those people need money as we all do to acquire the resources required to realize their vision—which is always a long shot. They are sacrificing their time and energy but without a critical mass of seed capital, it will all be for naught. Seed capital is unique: it is the smallest amount of venture capital but it is the most essential to startup success. Therefore, understanding its dynamics is crucial for entrepreneurs.
Stages of Entrepreneurial Finance
Generally speaking, there are eight stages of entrepreneurial finance:
- Pre-seed funding: Pre-seed funding is the very earliest stage of startup funding. At this stage investors provide startups with the capital required to begin developing products in exchange for equity. This stage of funding may involve the founders leveraging their own personal funds. The goal of pre-seed is to invest in an idea or vision since products typically have not been developed yet. This may be considered the research phase of building a startup but it is still very important. Among the core questions to be answered include:
a). Is the business idea viable?
b). Is there a market for the idea—who is willing to pay for it and how much?
c). Has the idea been done before? Did it fail? If so, why?
d). How much will it cost to develop the idea into a product?
e). What is the best business model to commercialize the venture?
f). What human, technological, and operational resources are required to get started?
- Seed funding: Seed funding generally occurs after the initial research phase. Its purpose is to provide sufficient capital to enable the founders of the startup to prove whether or not their idea or vision is workable in the market. According to Marc Andreessen of the venture capital firm a16z the goal of seed funding is to calibrate product-market fit which he defines as: “Product/market fit means being in a good market with a product that can satisfy that market.” Entrepreneurs provide equity in exchange for investor financial support during this stage. This financial support will typically cover the engineering costs of product development and refinement; initial hiring of new employees; continued market research on product-market fit; and the onerous process of product marketing, which is vital to the success of new entrants striving to compete with entrenched competitors.
- Series A funding: At this stage, the startup has gained market traction and is ready for capital to finance future growth. This growth could take the form of further penetration into an existing market, expansion into adjacent markets, or the development of new products. In exchange for another equity stake, the startup obtains additional financial capital to enable this process. This capital can also be used to obtain the human and technological resources to enhance the efficiency of operations; improve the startup balance sheet by offsetting financial losses; and lay the foundation for a bolder long-term vision, which is what venture capitalists are typically eager to invest in.
- Series B funding: This stage of funding is for startups that have dedicated user bases and steady revenue streams although they may not yet be profitable. The goal is to continue to scale the startup and reach new customers who may be in overseas markets that are more complex to access from a regulatory and market research perspective. At this stage, the full development of business development teams is essential as well as the continued acquisition of the engineering and product development talent that is required for companies to succeed in fast moving technology markets. If the company is not profitable at this stage, this is when it needs to begin thinking about whether or not offering up more equity is worth it to the founders since they are now risking dilution beyond what may be necessary or desirable.
- Series C funding: Startups that receive additional funding at this stage are well established on their growth trajectory and seeking further expansion, especially if they are in highly competitive and capital-intensive new markets such as artificial intelligence and cleantech or spacetech. At this stage, aside from continuing to build new products and sell in new markets, the startup may be sufficiently capitalized to make acquisitions of its own.
- Series D funding: Few companies need Series D funding. If they do, it is typically because they are:
- Pursuing a new unique opportunity: A potentially lucrative opportunity has appeared that it is strategically important for the company to act on before the Initial Public Offering (IPO).
- Subpar performance: The startup has failed to meet required investor goals established during the Series C funding round so it needs to raise additional funds to fix the problem. This is a sign that the company may be headed for trouble.
- Mezzanine funding and bridge loans: This funding is for rather mature startups worth over $100 million. Mezzanine loans blend debt and equity for lenders; and bridge loans are short-term financing. The goal of these two financing tools is to close any financial gaps until the IPO. For example, the funds could be used to buyout the management at another company or acquire a strategically important competitor. They typically are for terms of six to twelve months and are paid back from the funds obtained via the IPO.
- Initial Public Offering (IPO): The IPO is the pot of gold at the end of the rainbow. It is the liquidity even that the entrepreneurs, venture capitalists and other investors have all been waiting for. At this stage, shares of the company are offered up for public sale for the first time and the potential exists for fortunes to be made. The funds won’t just be used by equity holders to cash out. They are also to solidify the market position of the company and finance future growth. The IPO stage is not just a financial event but an emotional one as it represents years of work and the realization of the founder’s dreams. Entrepreneurs may retire at this stage and bring in professional managers to run the company.
Types of Pre-Seed and Seed Funding
Having delineated the stages of entrepreneurial finance, it is important to highlight the distinctions between pre-seed and seed funding. In terms of funding amount, the typical pre-seed round is about $50,000 to $250,000. Seed funding is usually between $500,000 to $5 million but this varies depending upon the industry. It should be noted that many of the hottest investment areas such as cleantech, spacetech and artificial intelligence are very capital intensive but have enormous returns so the size of seed funding rounds has been growing to accommodate this reality.
The amount of runway or time given to validate an entrepreneur’s proposition is normally about 3 to 9 months for pre-seed funding and 12 to 18 months for seed funding. Again, this can vary by industry as highly regulated sectors such as biotechnology usually are allowed more runway to accommodate all of the extra testing and bureaucracy that must be overcome.
However, as interest rates have risen, investors are becoming more impatient so depending on the industry they are also more likely to pull the plug if they do not see advancement. The end of cheap money has dramatically changed the venture capital investment landscape. While there are venture capitalists and angel investors who provide pre-seed funding, it is more likely to come from personal savings, friends and family, accelerators and incubators or even university entrepreneurship competitions where business plans are evaluated by seasoned investors.
The pre-seed funding market is in need of innovation as there are many great ideas that never get off the ground because so many people lack the $50,000 to $250,000 required to assess the market viability of their vision. Seed capital is usually where venture capitalists, angel investors, crowdfunding platforms and institutional investors including increasingly corporate venture capitalists become involved in the financing of startups.
There is a surprisingly diverse array of investment mechanisms in the seed funding market. Equity financing which entails obtaining funds in exchange for an equity stake in the nascent enterprise is common. With equity comes control and dilution of financial value so entrepreneurs need to be very careful in sacrificing too much equity too soon and they also need to understand the character of the investors to whom they are offering equity as this can have a dramatic impact on the strategic decisions that the investors make later on. Just as an investor is investing more in the people than the product, the entrepreneurs are also embracing the venture capitalists as human beings whose character, acumen and reputation are even more important than the money they are offering. This cannot be overemphasized.
Seed funding is about far more than money. Another form of seed financing is convertible debt. This occurs when an investor provides a loan with a specific principal amount, interest rate and maturity date when both the principal and interest must be repaid. Convertible debt is useful when a startup is difficult to value. Its intention is to convert to equity if or when the startup proceeds to an equity funding round but the debt can also be called by the investor at maturity so that if they have decided not to convert to equity and withdraw from the financing of the startup, they have the option of doing so. This flexibility is part of the appeal of convertible debt in the risky business of venture capital.
Grants are a non-dilutive form of seed funding that can be obtained from non-profits and the government. The United States government has a very successful history of providing non-dilutive seed funding to startups through its Small Business Innovation Research (SBIR) and Small Business Technology Transfer Programs. Established in 1977, “America’s Seed Fund” or SBIR and STTR programs, which are overseen by the National Science Foundation and housed within the Directorate for Technology, Innovation and Partnerships, provide up to $2 million in seed funding while taking zero equity in startups.
Each year, the program awards over $200 million to 400 startups in the United States. The mission of the program is not profit but rather to foster innovation and help create businesses and jobs in all areas of the United States. Projects are evaluated based upon technological innovation, market opportunity, and the quality of the team. There are subtle differences between the STTR program and the SBIR program with the former being oriented towards fostering partnerships with non-profit research institutions such as universities while the latter allows partnerships with private sector actors including venture capitalists:
Over the years, a number of very famous companies have obtained their seed financing through the SBIR program. These include 23andMe which is a leader in consumer genetics; Neurala, which is the company that produces Brain Builder, a Software-as-a-Service platform that reduces the time, cost and skill required to build and maintain production-quality, customized vision artificial intelligence solutions; and Genomatica, a leader in the bioengineering that is at the forefront of the transition to the production of sustainable materials.
Along with the notable achievements of the Defense Advanced Research Projects Agency (DARPA), the SBIR and STTR programs are indicative of how America’s commitment to public entrepreneurship wherein the government is willing to act as a venture capitalist has served to buttress the innovative capacity of American industry.
Another innovative form of seed funding is the SAFE aka Simple Agreement for Future Equity. SAFEs were pioneered by the accelerator Y Combinator. They are akin to convertible debt but do not include requirements for interest rates, a maturity date or repayment. Essentially, a SAFE is a loan that is given in return for the right to purchase stock at a future date, usually at a discounted rate:
SAFEs provide more flexibility to the entrepreneur as they are able to negotiate the amount, the discount, and the cap.
Other forms of seed capital include angel investors. These are typically formerly successful entrepreneurs and high net-worth individuals who are seeking to invest not only their money but also their time in working with startups in exchange for equity and the opportunity to gain insight into a new technology by being granted the opportunity to provide strategic input.
The advantage of seed funding from an angel investor is that they typically take on more of a personal, mentorship role in their investors as they are not motivated by the professional obligation to demonstrate strong returns on their current fund so that they can raise a new one later. Angel investors may invest as a group or as part of an angel syndicate so that they can invest larger amounts which allows them to reap the benefits of larger ownership stakes in the startup. They also often use convertible debt to mitigate risk or obtain an equity discount.
Due to recent regulatory changes such as Regulation CF (Crowdfunding), crowdfunding is a growing source of seed funding for startups. The advantage of Regulation CF is that it provides an exemption from the registration requirements for securities-based crowdfunding and thereby allows companies to offer and sell up to $5 million of their securities without having to register the offering with the SEC. As a consequence, crowdfunding platforms such as Kickstarter, Wefunder, and Indiegogo are growing in popularity and variety. Each platform has its own set of rules along with payment processing fees and due diligence requirements to protect investors. Both seed investors and entrepreneurs need to do sufficient research to determine which crowdfunding platform may work best for them.
Trends in Pre-Seed and Seed Funding
One of the trends evidenced in pre-seed funding is the hyperconcentration of this activity. According to a study by Carta, of the 2,103 companies that raised some form of pre-seed financing during the first half of 2023, over half were headquartered in either California or New York:
This suggests that being connected to the traditional bi-coastal venture capital ecosystem provides salient advantages to startups. In addition, according to Carta, SAFEs accounted for 80% of the pre-seed capital invested in the second quarter of 2023 but certain industries such as biotech, medical devices, and hardware experienced significant investment through financing tools like convertible debt.:
The actual work of pre-seed fundraising is also becoming more arduous and time-consuming. In 2022, 25% of successful fundraises could be completed in six weeks or less but in 2023 that number declined to 13%. In addition, the actual amount of investment at the pre-seed stage has declined significantly as investment was half in the second quarter of 2023 compared to 2022.
Compared to the first half of 2022, in 2023, VCs were spending 12% less time evaluating pitch decks even though they received 16% more pitch decks from founders. This is undoubtedly due to the rise in interest rates and a rapidly slowing economy which is having a dramatically negative impact on venture capitalists and their appetite for the risks intrinsic to early stage startups. This trend, which is also impacting seed funding, is best summarized by Reshma Sohoni, the co-founder and managing partner of Seedcamp:
“During the pandemic—when low-interest rates and free-flowing capital buoyed the market up—great companies looked exceptional, good companies looked great, and even the not-so-good ones seemed decent. This low-risk, high-return environment sent capital flooding into the market as investors tried to chase any potential upside. Since then, capital has become much more expensive and we’re dealing with an incredibly high-risk class of startups. The critical questions among investors today are, 'What are we risking our capital for?’ and ‘What kind of return will we see?’ This means companies need to be truly exceptional in order to stand out. Good startups that would have been snapped up a few years ago are having trouble raising funds in today’s climate.”
To attract pre-seed and seed capital, entrepreneurs need to rate highly in terms of the market opportunity, the team, the technology and the business model. This is no easy task in today’s economic environment.
The amount of seed and angel investment also experienced tremendous declines during the first quarter of 2023. According to Crunchbase, it fell 45% year over year to $3.1 billion which is the lowest quarterly amount since the fourth quarter of 2020:
Ironically, while the geographical dispersion of pre-seed capital is overconcentrated on the coasts, seed financing has become more geographically diverse in the United States over the last few years. The experience of the Carta database is telling. As of 2020, California alone hosted 40% of seed deals in the database:
But by 2023, this had declined approximately 25% to 31% of all seed deals in Carta being in California:
Seed investing is the riskiest and most rewarding form of entrepreneurial finance. The venture capitalists who invest at this stage are arguably the best and the bravest in that they are willing to embrace the arrows that all pioneers receive. This is the stage at which everything is uncertain—the market, the technology, and the best business model.
But that which is most uncertain is the character and competence of the entrepreneurs who are the real driving force and determining factor behind any successful startup. The venture capitalists who successfully navigate the seed stage, win because they are not only excellent evaluators of business opportunity and technology but most importantly of the intangible intrinsic to sound character. The rewards of being effective investors at the seed stage are not just financial but emotional because the investor will participate in building something of value.
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