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From seed funding to Series A: the basics

Ashish Fafadia
14th May 2016
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The first time that a startup raises capital is normally called a ‘seed round’. Other names include angel round or HNI round.  Some even call it a pre-Series A round, but this term usually refers to a small interim fundraising exercise between the seed round and Series A.

In the seed round, dilution of the founder’s equity (i.e. the amount of ownership that he or she will have to give up) is a function of (a) the quantum of funds that the startup is looking to raise, (b) where the startup is (in terms of traction), and (c) where the funding will take the business. An ideal scenario is to dilute up to 15% (the lesser the better), assuming the funds raised will be sufficient for the founder to take the business to a level where, in the future, he could easily raise $2-5 million (the more the merrier) in the Series A round. The typical amount of capital that a company can expect to raise for this kind of dilution would be in the range of $250-500k. Exceptions exist on either side of these ranges, but they are case specific.

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Two other factors can impact the above numbers: (a) how the business is perceived by incoming investors and (b) the kind of investors that the founder is able to bring to the ‘cap table’. The former is a function of traction, unless the founder ends up selling his equity for a lower value than deserved. The latter is partly marketing the business and reaching out to the best seed investors, and/or seeking a higher-than-normal quantum of funds.

There are quite a few startups that bootstrap the business to achieve a certain level of traction before a ‘largish’ seed round. Then there are founders who come with a certain track record of having ‘been there, done that’ in previous businesses that they have sold. There are also sector specific bets that larger investors are keen to make and, therefore, tend to offer larger seed cheques of up to a million dollars, sometimes even more. A seed round that raises this kind of money typically sees the investor getting 20-25% of the equity. But there are both pros and cons of this strategy.

While doubling the seed capital allows more dollars for experiments and arguably longer runways, there are also signalling risks. What if the founder fails to entice his existing large investor to play deeper by the time he needs more money? Lack of participation from existing institutional investors can send the wrong signals and limit a company’s ability to raise capital in the future. Therefore, it's always advisable to sit down with your investors and make them understand (i) the runway that their capital will enable and (ii) the metrics that matter.

Another reality of startup funding is that if the business isn't doing as well as was expected, then there could be a ‘bridge round’ that takes away the benefit of the higher valuation obtained earlier. We have also observed that some first-time founders tend to over optimise on valuations. They end up raising either too much capital or too little. In either case, the purpose is to minimise dilution and keep it a single digit somehow.

One needs to recognise that, at an early stage, the founder needs more than capital. While no source of capital can come with all the support that the founder needs, investors on the cap table need to add some value or bring their network on the table, besides just having a track record of working with young companies and helping founders grow. All of this needs to be done without taking active control of the company, implementing vetoes too soon, or over-emphasising their views to be followed.

On the other hand, the challenge of ‘under raising’ is that the founders have very little room for error and experimentation. It also means a very tight runway before the next round of funding, unless the company starts to breakeven. The resultant issue here is that the founder will now find it difficult to attract a larger investor, while smaller investors may not want to deepen their exposure unless a larger investor comes in. We have had over a dozen companies in our portfolio that needed bridge funding; and although we rallied around our founders, in none of them did all of their existing seed investors participate. In some cases, we were only bridge cheque writers or, at least, had to lead with a chunky bridge cheque, whereas in the previous round we were one of the smaller investors, traction in the business notwithstanding.

In the startup world, it's not the founders who fail. It's a company that fails and when I say ‘company’, it's a collective responsibility of each of its shareholders and, in most cases, even key stakeholders. While one can debate the amount of blame or claim to success that each party deserves, the investors as early shareholders have a key role to play. There are, of course, extreme examples where some investors take their role a little too seriously and actively work in the business; whereas, in other cases, they might just be passive cheque writers. This cash leverage certainly helps. But all the more helpful is it to trust the founders and lead investors more implicitly than they do at times of follow-on rounds, exits and distressed sales.

Founders owe it to themselves to curate the cap table in a controlled manner and when they can't do that, at least structure shareholder rights in a manner that doesn't slow down the company's decision making at crucial times. While investors are responsible for the fate of the company and have a role to play, it's best to do this remembering always that, at the end of the day, the founders are in the driver’s seat and will be instrumental in taking the company to the next level. Some of these companies need investors simply to be a sounding board to the young or inexperienced founding team and a few others might need investors to be mentors.

There is also a host of tactical yet critical support functions that investors can provide in areas that are ‘non core’ to the founders, until such time that the company hires full-time KMPs (key management personnel). These functions might include hiring, sales, marketing, fund raising (including debt), public relations, HR etc. And then there are founders who just need a person to whom they can look over their shoulder and ask for help, as and when needed.

In all of the above types of engagements, one thing that runs common is: metrics.

It is of utmost importance that, even before raising capital, the investors and founders should agree on what metrics to track. It's not simply revenues, site visits or number of conversions. Each business has a few common metrics to track. Over and above these, there are sector and business model specific data that need to be tracked. Even the frequency of tracking can differ from company to company. For a cyclical business, for example, it might not make sense to draw a monthly trend line but rather a quarterly or trimester line. Tracking of metrics has to be aligned with the monthly burn, financial model, and working capital cycle, because even if the business is doing well, there might still not be enough money in the bank to fund the next month’s payroll.

We all know that businesses tend to pivot and plans can change mid-course. There is only so much that we can visualise in terms of how the market will react to our product or service, but these are poor reasons not to plan and track key metrics monthly, if not quarterly. Keep altering and tracking the revised plan, even if there are no issues, but plan you must. As someone said,

Not planning for success is like planning for failure.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)

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