It’s surprising how often I meet with first-time entrepreneurs who tell me they need $5 million.
Not many companies need that amount in their first round of funding. Much of the time, what they need at the earliest stage is enough money to prove the concept and mitigate some initial risk. Often, what they require is seed funding, more on the order of $250,000 or $500,000.
So why do entrepreneurs think they need so much money right out of the gate? Some seem to be attempting to finance their way to profitability, but more often than not they think they need to ask for several million to get the attention of VCs. It’s become a bit of an urban legend: VCs won’t take an entrepreneur seriously if they ask for less than $5 million. That tall tale belongs in the archives with the one about how alligators live in the sewer system.
An entrepreneur’s risk spans three areas: team, technology and market. They can determine how much funding they need by asking themselves one question: Can a small amount of money dramatically reduce one or more of these risks in six months?
By securing only as much capital as they initially need in a form of a seed round, entrepreneurs do themselves a big favor. First, assuming they take the seed funding as a bridge round which will convert into an eventual A round, they suffer no dilution. Second, they ensure themselves a much better valuation when they do eventually secure an A round because they have reduced one or more key risks during the seed period. Third, with this small amount of money, the entrepreneurs can get more insight and information on whether their idea is worth investing their own valuable time in before they have to make the multi-year commitment that comes with larger investments.
So what do I mean by reducing risk across these three areas? Let’s look at a few examples:
Reducing team risk:
The team is what makes or breaks startups. A great team can work together and find a market opportunity that can be attacked. Since all team members have different strengths, finding other founders with complementary skills and similar passion is critical for success.
Reducing technology risk:
The most amazing idea in the world is worthless if you can’t get it to work in a prototype or alpha. The founders of Eye-Fi used their own money and sweat equity to initially finance the company, taking in seed funding to build their first prototype Wi-Fi-enabled SD card. By the time the company went out to raise an A round, Eye-Fi had more than 100 users of the product and tremendously useful feedback from those early users. (One reason why my firm invested in Eye-Fi’s series A.)
Reducing market risk:
And the most amazing technology or product in the world is worthless if there isn’t a market with potential buyers willing to suspend their disbelief and buy from a startup. For example, if a product for the data center cannot solve a “Top 5” CIO pain point that will exist when the product comes to market, sales cycles will be long and growth will be slow. The team at Riverbed figured this out and launched a product that helped enable data center consolidation, a top priority for CIOs. (Riverbed is an investment that was made while I was at Lightspeed Venture Partners).
When entrepreneurs have a great team developing a solid technology concept that they know first-hand will solve an urgent market need that exists―or will exist when they come to market―those companies are ready for Series A funding.
But in the kind of market that’s so prevalent today, where many great ideas are competing for questionable demand, entrepreneurs need to mitigate key risk factors before they take on too much capital. For those companies, the seed of financing could be just what they need to help their seed of an idea grow into a successful company.
11 Comments
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Tim Jones said:
I think part of the reason entrepreneurs opt for large Series A rounds right out of the gate is that the VC industry is structured around this.
In some ways it’s perversely easier to raise a Series A then it is to find seed financing. I think if seed financing were more structured and it was easier for entrepreneurs to locate seed funding sources, more start-ups would avail themselves of this.
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Steve Kane said:
I guess the the big factors are
1) do the founders/initial hires want to get paid?
2) how much time do you need?
If no one is getting paid, then $250K-$500K can last a long time and thru the initial milestones. Especially if you are working our of a garage or basement - -someplace you can avoid paying rent or utilities.
But if thats not an option — and lets face it, its a pretty tiny group of people who can live without any income for a year or maybe two — then even a modest payroll comes to what, $80K/employee per year (including payroll taxes and payroll services and basic benefits like health insurance and workers comp).
Plus rent and utilities etc.
So if the founding group needs or wants to get paid and needs or wants to find some office space, then they still don’t need $5MM, but they probably need $1MM-$2MM over two years.
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Jeremy Horn said:
You bring up many good points. In my advising of start-up this issue comes up quite a bit; I have found, for a variety of reasons, ego being a big factor, founders want to jump straight into the VC and larger financing, often sooner that is prudent. I recently blogged on this topic, for anyone who is interested, at: http://tpgblog.com/2007/10/06/creating-your-product%e2%80%a6it-takes-money/
Enjoy.
Jeremy Horn
The Product Guy
http://tpgblog.com -
Mike Popovec said:
It has been my personal experience that selling an idea to an investor(s) is much easier with a functioning prototype of the product or service you plan to bring to market.
We have financed 99% of our concept to date with our own money. During that period, we couldn’t get any traction from individual investors. Once we brought our site live, and even the most savvy investor can “touch and feel” what we are doing, it is a much easier sell to try and find that kind of money.My recommendation is to get a product or service out of beta (within reason) before you go for seven figure investments.
Also, a tremendous resource for us has actually been looking for employees thru traditional job search engines (Monster.com, Craigslist). We have found several potential investor leads and business development people that we’re way overqualified for the jobs we posted yet we’re sincerely interested in our idea. That can take you much further with sales and bus dev than you could imagine.
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Don Jones said:
Most entrepreneurs don’t think in terms of milestones and inflection points, whereas venture capital funders do.
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Anthony Kuhn said:
Carl:
Fresh faced entrepreneurs-in-the-making fresh from B school don’t exactly have all the tools at hand when it comes to chosing between Series A and seed funding, whereas the VCs usually have seen it all before. Exciting for the startup, I imagine, but the path out of the funding briar patch is fraught with disinformation and “urban legends” like the 5 million dollar funding magic. Your piece might help them rest a bit easier when requesting a lesser, more sane, amount. I cross-posted on your piece to http://blog.innovators-network.org The Innovators Network is a non-profit dedicated to bringing technology to startups, small businesses, non-profits, venture capitalists and intellectual property experts. Please visit us and help grown our community!
Best wishes for continued success,
Anthony Kuhn
Innovators Network -
jon kennedy said:
VCs are great copycats not only in the deal making, but also recycling other luminary entrepreneur material.
I had chance to listen to Marc Andresson (ning founder)talking about these 3 or 4 big risks in the similar line in a video chat at techcrunch.
If I show you great beta, with 1000 times bigger market potential than eye-fi would you talk to us ? How come all your investments are into one particular geographical area.
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Miss Vinay Duggal said:
Hello. I have 2 friends that have a start up webite/blog. I’m hoping to get them seedf unding in the order of $2-3Million for one year so they can expand and increase their traffic and advertisers.
Any Advice? -
Andrew said:
Where is the seed? I know Charles River Ventures offers a “seed” program, but who else. Are there angel groups that have similar programs? And what format do they use, equity % or convertible debt?
I am involved with http://www.startpath.org which is a social network and startup tool. We are working with a few folks in the Mid West to create a seed fund, which can hopefully bridge the large gap in this area.
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François-Frédéric said:
I have a prototype that solves a huge pain point for an industry. The team I am assembling already worked together. So I need captial to reduce the market risk, by doing many things including transforming the prototype into a demonstrator.
I get a lot of traction, however assembling funding is still not straight forward. I could even say I am doomed because I cannot even fund the $30K expected by a guy I trust is proposing establishing the contacts with all potential sources of financing at the right time (seed, series A…).
Too bad ugh…
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Jason said:
Semi-oldie post, but goodie. I think you hit it right on the dot. I just received seed money for a new company by getting large buyers to write me letters that if I build, they will come.
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