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Should entrepreneurs raise a seed round?

A lot has been written about seed funding. How much should you raise, from what type of investors, under what terms and conditions?

I believe the first question an entrepreneur should ask himself or herself is whether they should raise a seed round at all.

Unless you’re building semiconductors or hardcore hardware, it is no secret that the cost of starting a company and achieving market validation, the ultimate value creation milestone for startups, is trending to zero for engineer founders that can moonlight or survive three to six months with no or limited income. Dave McClure’s “Moneyball for Startups does a great job explaining this. An incorporation and simple shareholder’s agreement will cost a couple hundred bucks if you do it online and use some of he free templates. The open source software stack and its numerous development frameworks like ruby on rails are free and have sped up development cycles to the point where a common mortal can build a brand new application and release it into the wild in months. In fact, a team of two should be able to build the first version of its product or service between one to three months, depending on the complexity. Accelerators like Y Combinator, Techstars, Seedcamp and Launchbox Digital have proven this assumption over the past few years. On the hardware side, cloud services like Amazon Web Services allow startups to scale their computing, bandwidth and storage costs as their business grows, limiting the initial costs to less than $100 per month. With a first product in hand and a scale-as-you-go infrastructure, a team can then deploy and test customer fit and market adoption assumptions for free (except for a few hundred $$ Adwords) on multiple platforms and channels including Social (Facebook, Twitter, Youtube, Gmail), Search (Google, Bing), Mobile (iPhone, iPod, Andoid, Blackberry, etc.), each with audiences of hundreds of millions or more and the emerging Business Marketplaces such as Google Apps and Salesforce’s AppExchange, to name a few.

On the marketing side, there is now an entire industry of individual bloggers and corporate blogs like GigaOM, Techcrunch, AllThingsDigital and Mashable that is dedicated to covering startups and discovering the next big thing. In addition, startup coverage in the tech sector has gone mainstream. Most mainstream media companies like the Wall Street Journal, New York Times and CNN have multiple writers dedicated to it. You can make a creative video about your product, write a targeted email to a writer, get a friend who works at Facebook, Google, Apple , Amazon, AOL or Microsoft to send it to a few influencers, get your friends to tweet about it, etc. If the startup has a pulse and a decent story, it will get some coverage. Want to get some attention from a business development executive or get access to the marketing department of Procter & Gamble? Get on linkedin and find a path to the people through your network or write a blog about how your product will have a positive impact on their business and send it to them. Unless you live in Antartica and you’ve built an ice machine, you should get the attention you need to get your first customers. Once you have your first beta customers, if you can make them happy through iteration and get strong usage metrics, or even better, extract money from them, you have achieved market validation. At that point, assuming you’re in a decent size market, you have a viable business.

A great example of this is Tinychat, which has yet to raise a penny but has built a great business in the live communications market, one customer at a time. I’ve never met the guys, but my guess is they’re smart and driven, much like you.

So if most startups don’t need to raise money to achieve customer fit and market validation anymore, why should entrepreneurs raise seed money?

I’m not suggesting entrepreneurs should refrain from raising outside capital at the seed stage, after all, I invest in entrepreneurs and startups for a living. The point I’m trying to drive home is that as engineer entrepreneurs, you have a choice and should make that decision thoughtfully and carefully. Here a few reasons why entrepreneurs could choose to raise seed rounds:

1. Add a business partner
If you do it right, raising seed money could allow you to bring in an investor that will partner with you and help with strategy, fundraising, hiring and recruiting, corporate governance, finance, PR, ops, etc. This is what VCs and a few Super Angels claim to be doing and is easy for an entrepreneur to diligence. This is what I do for a living and what we do at Real Ventures.

2. Get to market validation faster
a. Funding will allow you to hire 1-2 engineers (or more) to complete MVP (Minimum Viable Product) and iterate towards customer discovery and product/market fit faster. Could be smart in a very competitive market;
b. Get access to investors’ networks to reach first customers (if you’re targeting enterprise) and business partners faster. Again, VCs and some angels can help with this, make sure you do your due diligence.
c. The funding is a story in itself, especially if you raise money from a known VC or angel, and is more likely to get you attention in the media
d. Some investors could help you achieve MVP and market validation faster with their expertise and mentorship programs. This is where accelerators like Y Combinator, Techstars and our own Founderfuel program come in. This is not about capital but about operational support. This is also what Dave McClure’s 500 Startups is all about.

3. Reduce the risks for founders and the business:
a. Raising outside capital at the seed level can help founders reduce their personal risk by limiting the reliance on their savings to build the business and by allowing them to draw a salary. I’m not a advocate of founders not drawing a salary unless they can afford it. You shouldn’t get rich on the pay, but the startup lifestyle is so demanding as it is, you don’t want money to add more stress to an already tenuous situation.
b. If you choose them well, investors will become partners in your business. I don’t mean partners in the sense that they’ll want to run your business. Good investors will care about you and your company, and assuming an alignment of interest, will work hard to help you grow as a person and business man, and help support your company. Building a successful company from scratch is hard. The more good people you have helping out the better. There can be a lot of value to that. This is why serial entrepreneurs often raise money early even if they could bankroll their companies themselves.

4. Prepare the next round
This one is up for debate as unless you achieve your milestones, your series A/B will be as difficult to raise whether you raised a seed round or not, although I would argue that if you’ve worked with a seed investor for a few months and they like the team, there’s a good chance they would give you more money if you show positive signs.

5. Stretch your runway
I’ve a few entrepreneurs do this over my career. They raise a seed round and run out of money before achieving the milestones. The seed investors like the team but are not willing to write another check until there are more proof points. The entrepreneurs decide to bootstrap and stretch the runway by not taking or reducing their salaries until they real the milestones.

I believe that when entrepreneurs look for capital, they should use this opportunity to look for a business partner as opposed to an investor. In fact, they should look at it the same way they do when recruiting a co-founder or adding a senior executive. The only difference is that the investor buys its stake in the company with money, and to a certain extent, the value they’ll bring to you and your business. For that reason, it is extremely important for entrepreneurs to diligence and spend quality time with prospective investors prior to closing. It is also important to make sure both parties share the same values and have aligned interests, which is why I prefer pure equity rounds. The other mistake entrepreneurs make when fundraising is they try to convey a story that will fit the investors’ investment strategy. In other words, they’ll tell investors what they want to hear. I’m not talking about lying here, but rather making adjustments to the vision or plan that will get the investors to the finish line. Bad idea. You may get their money, but you may have created a time bomb that is likely to blow up at a time when you’ll need your investor to be a true partner. You also run the risk of either party experiencing buyer’s remorse, which I don’t recommend to anyone. The vision is likely to change over time, but investors and entrepreneurs should start from the same place.

So here you have it. There are many reasons not to raise seed money which include: control issues, getting the wrong investors and dilution, but most of those are linked to the kinds of traits you don’t want as an individual: ego, lack of diligence, greed. Good investors won’t try to control your company and will let you sell when you believe the timing is right. It is your responsibility to know who your investors are before you take their money. You need to look at dilution as an investment. Is making that dilution investment as an entrepreneur increasing your chance of achieving a successful outcome. If that’s the case, it’s a no-brainer as only a select few get there. There’s been an increase in exits in the $5M to $30M range, so outcomes are not as binary as they were in the past, but we’re still in a situation where most companies won’t have outcomes that make entrepreneurs millionaires. The key for entrepreneurs is how money they raise to get to the next step. If you decide to raise a seed round, make sure you raise as little as possible (with a small buffer) to get to market validation. Once you reach validation, the world changes.

If you’re an entrepreneur in web, mobile, digital media, software, casual gaming, etc. and are considering raising a seed round, feel free to connect at js (at) realventures (dot) com.

8 comments ↓

#1 Lazaro Fuentes on 10.28.10 at 8:00 am

Great piece. We fall into category #2 of the raise money side. We want to own our niche and need speed to do it.

Best, Laz

#2 JS on 10.28.10 at 8:05 am

Thanks Lazaro. Let me know if I can help.

#3 Anthony Wilkinson on 10.28.10 at 12:36 pm

Very helpful JS! Will check out McClure’s post as well. We are a small company in SW Ontario looking to get our casual gaming company off of the ground.

#4 JS on 10.28.10 at 3:12 pm

Thanks Anthony, let me know how we can help.

#5 Nick Pelling on 11.08.10 at 1:29 pm

MVP = “Minimum Viable Product”

#6 JS on 11.08.10 at 1:39 pm

Thanks for catching the typo

#7 Nick Nydegger on 11.09.10 at 11:56 am

JS, great points. I wish there was more discussion on this. Internally, we are constantly contemplating the “acceleration to market” vs slow growth on our terms. The back and forth gets even more complicated after you have a product developed and competitive as we now do with RhinoSEO. It has taken 2 years to complete what may have taken months, but now we are taking the offers rather than seeking. In the seed stage, there is such a false mindset that no significant investment means no significant success.

You nailed it in terms of the investor relationship. When the time comes, the right investor brings more to the table than funding.

#8 The implications of combining excess capital with excess demand for talent — JS Cournoyer on 11.16.10 at 10:51 am

[...] times when there is excess capital, being able to attract them as an investor is gold. To do that, investors have to be friends with them, pay more or become more like services businesses to entrepre…. Most angel investors don’t have the time, resources or background to offer this on a consistent [...]

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