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.