What do you need to have in place as a Startup in order to be able to successfully raise a seed round?

For raising a seed round, the startup should have laid the foundation to scale up, and validated most of the assumptions that would prove the business case around their concept.

Screen Shot 2013-05-27 at 1.02.39 AMOf course, the basics need to be in place – the product/service needs to be good and solving a relevant problem or addressing a meaningful opportunity, the market potential should be large, the core team needs to have covered between them the key functions of that business, etc. etc. In addition to the basics, the below are some of the things that need to be in place before a seed round.

Concept should have been proven: The startup’s product /service/concept should have been proven in the market. Some initial customers should have bought the product and found the value proposition meaningful. The product should have delivered on the promise. The price-point should have been proven. Also, the challenges that need to be addressed could have been identified in the pre-seed stage.

The ‘business’ around the concept should be clear: In most cases, the business model is tested and adjusted and retested in the pre-seed stage. Before seeking an institutional funding, it is ideal to have tested different revenue streams, honed on to a business model that would be pursued, the price-points should have been proven and the unit economics should be positive.

Validating the assumptions: Before raising a seed round, it is ideal to have tested the assumptions in the business plan (e.g. how many people will convert, cost of customer acquisition, average revenue per customer, repeat purchase rate, etc., etc.). In fact, this is the area in which startups should pay some solid attention to in the pre-seed stage of the venture.

Estimating people needs: Before raising a seed round, the venture should have got a good sense of what competencies are missing in the team, and clarity on how those will be filled in (in some cases, scaling up will require someone to be hired as the CEO too).

Future plans need to be in place: When you start up, you may not have the largeness of vision that will create a scale company. However, as the venture matures, and as you start thinking of an institutional round of funding, it is important for the founders to have a vision for the future and the ability to articulate this vision clearly to all stake holders (investors, employees, customers, partners, etc.).

In many cases, the founders start defining or redefining the addressable market and this usually means thinking of a far larger scale than they would originally have.

The team should have in place, or at the very least identified by now, the elements that they will need to put in play to manage the venture at scale. E.g. sourcing relationships or technology platform in a e-commerce venture.

Jugaad to processes: As the venture moves to secure seed funding, the founders need to recognize the need to shift from a ‘fix on the move’ mode to a process oriented approach. They need to recognize that as the team grows, they will need to rely on processes and matrices and the discipline to measure performance and progress on well-defined parameters.

Identify one among equals: When a few friends or acquaintances start a venture, the usually split equity equally and divide the responsibilities equally, and also designate themselves co-founders. All are therefore deemed equal, and it is possible that they are at the start. However, a ship needs ONE captain. The team has to identify a first among equals to lead the venture. Multiple power centres in a venture leads to confusion and chaos.

Ideally, before the seed round, the team should have decided who the CEO will be. (Most institutional investors will insist on knowing who the CEO will be, and it is not uncommon for founders to fight over this issue.)

Nett: the venture needs to be in a state where all (or at least most) the uncertainties have been dealt with (if not fully addressed) and the venture should seem like a good business case to pursue at scale. This is the time when seed-stage investors would be willing to bet on the founding team’s ability to take the initial learnings and reapply them at a much larger scale. In the process, there will be some new learnings and some new adjustments on the way. That’s the reason why the quality of the team, their passion, their ability to understand the innards of the business, etc. will be key deciding factors for seed-stage investors, even if the rest of the things mentioned above are all positive.

(Of course, this can never be a comprehensive list. I shall keep adding to it, and if you find have any points to suggest, do write to me at prajakt.raut@gmail.com)

 

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Selecting your investors

Startups are usually not in a position to be choosy about whom they can accept funding from, and quite often after a number of rejections end up taking money from whoever willing to fund them.

 

However, while signing up your investors, it is critical to check the following:

  • Will you enjoy working with them? While this is a difficult one to take an objective view on when you really, really need their money, it is a critical question to ask. Attitudes to investee companies, style of working, matching of personalities are critical components in ensuring that investor & investees enjoy working with each other. In startups, in my view, it is ideal that the founders and investors can have a friendly relationship. And this does not mean not being professional… but an easy going, non-formal style of working is helpful in a startup stage when things are not going to be as predictable as they are in a growth stage company.

 

  • Is the personality, ethics, value system, aggression, compassion, etc. of the investors in line with the personality of what I want to build. Different people have different styles of operating and if these styles are in conflict, it may lead to disagreements in how you handle the business, especially how you tough situations.

 

  • What’s their outlook to your business and are they willing to wait out the difficult times? While your investors and you may agree with the potential, some investors have a ‘spray and pray’ approach. I.e. they invest in many companies, especially in emerging sectors, and see which ones quickly show signs of success. They are quite happy then to disengage with the slow movers and back the early-successes. In such situations, if your startups does not really take off as expected, and most don’t, you may be left in a corner.

 

  • Do they have experience of working with startups at your stage. There are clearly different investor groups who specialize in different stages of the company. Angel investors will invest in the concept stage, early-stage VCs will invest in the post proof-of-concept stage and VCs/PEs will participate in the scaling-up stage. Different stages of a company require different competencies and therefore different interventions from the investors. Investors who usually deal with growth stage companies may not have the patience or experience in dealing with the nimbleness and direction changes that a startup may have.

 

Of course, it helps to connect with companies that the investors have funded and understand about their experiences with the investors.

 

 

 

 

 

Managing investor relationships

Companies with a healthy relationship with their investors are happier companies. Unhealthy relationship between investors and founders can be quite stressful. That’s why it is critical for startups and their investors to work as a team and be on one side of the table.

While some responsibility of ensuring a healthy relationship is obviously with the investors, founders have a critical role to play in this process.

Clarity on goals and objectives

The starting point of course is to ensure that your investors and founders are aligned on the goals & milestones and objectives of the company, and the parameters on which progress is to be measured.

Agree on the communication and intervention processes

Getting investor agreements on the periodicity and format of reporting and engagement is helpful in ensuring that the intervention is structured and planned. A monthly review is suggested for startups, though in concept stage companies founders may benefit from the experience and the business relationships of investors and hence may engage more frequently.

Communicate early on challenges and issues

No one expects to have a smooth journey and challenges and roadblocks are part of the journey. Your investors are critical stakeholders in your progress. Hence, if there are challenges and issues, often investors can assist with solutions. Communicate early and be transparent.

Reporting and templates

Investors and founders should agree on the format for reporting progress. Information that captures the key parameters should be drawn and presented every month to investors.

My suggestion is to provide a short summary of the health of the venture, capturing critical aspects that will be relevant to investors. I would suggest the following:
  • Overview – a one-para summary of what has happened since the last interaction (e.g. on product, customers, people, brand, etc.)
  • A para on how the business is progressing as per the plan (including what is working well, and what is not progressing well – could be on customers, pricing, costs, people, cost of servicing, etc.)
  • Highlight challenges or red flag any thing that you see as issues
  • Outline what you wish to achieve in the next month (I have noticed that investors may not pay too much attention to this para, as usually it is transactional and mundane. However, if it is not there, it usually creates discomfort. Just having even the regular stuff in this is reassuring that all seems to be well.)
  • If needed, seek assistance in any area that they can help
Another reason why I think a good, crisp report every month is a good idea is because it allows you to also reflect on the progress and helps you identify red flags for yourself earlier too.
In most cases, investors want to help. These type of reports provide investors a good view of where they can help, and allows you to seek out their support when and where required.

 

Have formal board meetings, including structured meetings with your advisory board members

Apart from it being mandatory governance requirements, quarterly board meetings are a good forum to engage with a wider group of stakeholders where progress, challenges, issues and direction changes, if any, can be discussed.

Understanding valuations

Simply put, valuation is about how much the shares of your company are valued at.

In a private limited company, ownership is decided on the basis of equity shares. The % of shares you own defines the % of your ownership of the company. 

Let us understand with an example. I am of course over simplifying for the purpose of ease of explaining and understanding.

 

Ramesh and Suresh start a company. They both own 50% each of the company.

 

A few months later, Ramesh and Suresh approach an angel investor who decides to invest Rs.50,00,000 [INR 50 lacs / USD 100,000] in their company for which he takes 20% of the company. In this scenario, the post-money valuation of the company would be Rs.250,00,000 or Rs.2.5 cr [USD 500,000]. This is because Rs.50 lacs got the investor 20% equity, so the value of 100% is Rs.250 lacs or Rs.2.5 cr.

 

Stated differently, the company got a pre-money valuation of Rs200,00,000 or Rs.2cr [USD 300,000]. In this scenario, Ramesh and Suresh now own 40% each in the company, with 20% being owned by the investor.

 

Later, the company decides to raise Rs.10 cr [USD 2 mn] from a VC who takes 20% of the company. In this scenario, the post money valuation of the company is Rs.50cr [USD 10 mn]. Stated differently, the company raised Rs 10 cr at a pre-money valuation of Rs.40 cr [USD 8 mn]. With this round, Ramesh, Suresh and the angel investor each get diluted by 20% and hence the capital structure or cap table stands as follows:

Ramesh                       32%

Suresh                        32%

Angel Investor             16%

VC                             20%

 

In both the rounds, the money invested by the angel investor and the VC has gone into the company and not to Ramesh and Suresh.

 

Going further, the company does well and the VC decides to increase their holding to 26% and offers to buy 6% of the shares held by the angel investor for Rs. 10 cr. [USD 2 mn]. Now, the valuation of the company is Rs.166 cr or USD 33mn. Even at this stage, when the valuation of the company is Rs 166 cr, Ramesh and Suresh have not made any money. However, the angel investor has had a successful exit with a 20x return on his original investment, and still retains 10% in the company.

 

At this stage, the capital table will look like this:

Ramesh                       32%

Suresh                        32%

Angel Investor             10%

VC                             26%

 

At a later stage, Ramesh and Suresh decide to dilute their holding and decide to sell 5% equity each to another VC for which each get Rs.20 cr [USD 4mn]. At this stage, the 2nd VC decides to also buy the 10% held by the angel investor for Rs.20 cr. Hence, now the valuation of the company therefore is Rs.200cr or USD 40mn, and the cap table will look as follows:

Ramesh                       27%

Suresh                        27%%

Angel Investor             —-%

VC                               26%

VC 2                            20%

 

This of course is a rather simplified version of reality, but done only to illustrate the concept.

 

 

What are preference shares and convertible notes with reference to angel investing?

Preference shares typically have attributes of both debt and equity instruments.

It resembles equity in the following ways :

  • Dividend on these shares are payable out of distributable profits
  • Dividends are not an obligatory payment and are entirely at the discretion of the directors
  • Dividends are not tax deductible payment

 

Preference shares are similar to debt in many ways :

  • Dividend rates are fixed similar to any debt instrument
  • In case the company goes into liquidation, the claim of preference share holders precede the claims of equity share holder
  • Preference share holders normally do not enjoy the right to vote

 

From the perspective of angel investors, investing through the preference share route provides the investor certain benefits without directly exposing to the risk of the equity shareholders who normally are the promoters. The investors have the comfort of getting a minimal return on their investment and a priority over the equity shareholders out of the liquidation proceeds.

From the perspective of the promoters of the company, the burden of servicing high cost debt is not there as the dividend on preference shares are typically not guaranteed and often lower than the cost of debt for an early stage company and in the absence of voting right, the promoters face minimal interference from the financiers in the regular management and operation of the company.

One can structure the instrument to include additional features such as accumulation of dividends, call option, convertibility to normal equity shares, redeemable such as in any debt instrument and power to vote.

 

Convertible notes on the other hand are structured as a debt instrument but comes with an option for it to be converted into equity shares on a given future date or within a specified time frame at a pre-specified price.

Angel investors find comfort in this instrument as it comes with certain advantages which are :

  • A fixed interest payment till conversion which is assured
  • The conversion price is normally at a discount to the estimated value of the company, hence the investor can take part in the upside
  • The conversion is normally at the option of the investor which gives the investor a protection from the downside

 

From the perspective of the company the promoters enjoy the following advantages :

  • The interest payment are at rates lower than a regular debenture because of the convertible feature which offers upside to the investor
  • As there are no voting rights attached, the company can operate with minimal external intervention.

 

How is the valuation decided for a startup?

Valuation is decided between the investor and the entrepreneur. At the early-stage/concept stage, there is no science or formula to arrive at a valuation. Hence, you go by generally accepted benchmarks in your country, and eventually conclude a deal at what the entrepreneur and investor feel is a fair valuation.

What valuation investors may offer for the same plan depends on a variety of factors, including the quality & experience of the team, the investors view of the potential of the concept, the competition, how easy or difficult it is for other competitors to enter the market, is there any IP or competitive advantage which this team has, etc.

In all this, the quality of the team is he most important consideration for investments at the concept stage or early-stages. The same business plan, with exactly the same details could get a very different valuation for a team of college students executing it than what an experienced team would get for the same plan.