It’s not as straightforward as you might think.
The Entrepreneur Insiders network is an online community where the most thoughtful and influential people in America’s startup scene contribute answers to timely questions about entrepreneurship and careers. Today’s answer to the question, “When’s the best time to look for investors?” is written by Paul Martino, general partner at Bullpen Capital.
If you are gearing up for one big seed round, you might be making a mistake. For many been-there-done-that founders, seed is not a round anymore—it is a process. And much of this process happens outside the view of data sources like PitchBook or Mattermark. When you see a company announce a $2.5 million seed round, chances are the team completed it months before in multiple closings.
Smart founders have adopted a new mantra: “Always be fundraising.” The upshot is that when is less important than how.
Seed rounds used to be a discrete event, but several forces changed that. On the early-stage side, innovations such convertible debt, SAFE (Simple Agreement for Future Equity), AngelList, crowdfunding, and lean startup methodology enabled founders to diversify and stagger their funding sources. On the late-stage side, VCs have become increasingly risk averse, preferring to pile huge amounts of money into safe bets. Most startups can’t become safe bets after one seed round.
So, the new norm is a rolling seed process with three phases: pre-seed, seed, and post seed. In pre-seed, startups raise up to $500,000, usually from friends and family, the founders, and crowdfunding sources. Seed encompasses the next $1million to 2 million of money raised and includes an institutional investor such as a First Round Capital, Floodgate, or True Ventures. Now that startups essentially need to hit growth-stage milestones to raise a Series A, many founders need post-seed financing. These rounds tend to be around $3 million and bring the cumulative money in the company to around $5 million.
One byproduct of this multiple closing process is counterintuitive: less dilution for the founder. Usually, a startup’s valuation grows in each phase of the seed process provided the team hits specific milestones. So, instead of taking $5 million all at once in a super-sized seed round at, say, a $7 million valuation, that $5 million can be split up at valuations between $5 million and $12 million for each phase.
Rolling closes are useful weapons for founders because the transactions costs can be quite low. Priced equity rounds used to cost $25,000 to $50,000 in lawyer’s fees alone, so investors could push for one seed round at a relatively low valuation. “Capped convertible notes” or SAFEs can drop these costs to well below $10,000. Many standard documents are now available from firms like Fenwick & West LLP and others. This “open sourcing” of financing means that founders do the rolling seed process without cannibalizing money.
Capped convertible notes are ideal for raising little amounts of capital from lots of people because you can stack them and increase the “valuation.” Just by changing one line in the paperwork each time you hit a milestone, you can raise the cap on convertible notes (e.g. from $5 million to $10 million, and so on), and thereby make each new note less dilutive.
We have seen companies come to Bullpen that are less than two years old but have raised on as many as seven prior notes! As the risk of investing goes down, the cap goes up. And instead of banking on one VC firm for publicity, guidance, warm introductions, etc., you can pick up multiple investors who add value beyond dollars. There’s no pressure to loop them into one round. Thus, the capped convertible note is good fuel for ABF and preserving your share of ownership.
A word of warning: stacked notes can have non-intuitive implications when you finally convert into an equity round. Be careful to understand the mechanics of your notes and when and how they convert into equity. Doing this wrong can lead to an explosion of the post-money valuation that will make later-stage VCs unwilling to invest.
To optimize the seed process, Always Be Fundraising. If you play it right, you’ll preserve equity for the founding team.