Mastering the Seed Raise
Raising a seed capital round is easier to do today than ever before. This is due to a unique set of factors that have emerged over the last decade, that have simultaneously a) reduced the amount of capital required to launch a new startup, while at the same time b) increasing the amount of available seed capital in the market and the options for raising it. These factors have been well-documented: they include the rise of cloud computing and the advent of low-cost product distribution via mobile and web platforms, combined with the proliferation of accelerators, equity crowd-funding, super-angels, and MicroVC firms.
These changes have largely democratized entrepreneurship, making it easier to launch a company. However, they have also introduced new challenges for founders. The seed market is much more noisy than ever before. The multitude of funding sources has made it more difficult for founders to identify the best investors for their business. The abundance of capital has made it easier to overfund a business.
In this new environment, top founders can put themselves in the most advantageous position by mastering the seed raise. Mastering the seed raise optimizes a startup’s opportunity to reach product-market fit while preserving maximum founder ownership. In this article, I explain how founders can master the seed raise. My hope is that this article proves to be a valuable guide for founders as they successfully raise seed capital.
Raising a Tactical Seed Round: Marry Proprietary Power and Product Power
It’s not sufficient in today’s market to just raise a seed round. Founders must raise tactical seed rounds. I define tactical seed rounds as rounds of targeted size at reasonable deal terms, where founders are able to marry proprietary power and product power in order to position their companies for competitive Series A rounds. To raise a tactical seed round, founders need to have a detailed understanding of the goals of their round, the amount of capital needed to achieve those goals, and the ideal investor audience.
In determining the goals of a seed raise, I encourage founders to consider the Value Stack concept, as articulated by Floodgate Capital (see Graph I below). Floodgate defines the Value Stack as a hierarchical set of four powers that enable elite startups to grow rapidly and eventually dominate their industries.  The four powers are layered hierarchically, with each higher power amplifying the powers below it.
According to Floodgate, the goal of a seed round is to marry the first two powers in the stack: proprietary power and product power. Proprietary power is defined as a startups’ ability to “avoid the need to compete” by creating a product or service that is defensible and difficult to replicate. Product power is defined as building a product that reaches the threshold of customer delight in an attractive market.  Ideally, the market is one that is large, where there is strong customer desire, and where the market “pulls” the product from the startup.
Graph 1: The Value Stack
I agree with Floodgate that founders should use the value stack framework to guide the objectives of their seed raises. But what are the practical steps founders can take to do this? I recommend that founders first answer the following questions:
· What are the structural competitive advantages that your business is aiming to create at the seed round? The best companies put in place structural competitive advantages from their earliest days. Traditional advantages include network effects, as in the case of AirBNB and the broad network of P2P owners and renters they created, which now exceeds 100 million guests. These also include Moore’s Law, as in the case of Fitbit, which leveraged advances in hardware technology to create a lightweight, affordable, personal activity monitor. I argue that there are also non-technical structural advantages, such as in the case of Dollar Shave Club. Dollar Shave leveraged multiple structural advantages: a streamlined supply chain to undercut incumbent razor businesses on brand; a quirky, irreverent brand that enabled it to establish mindshare with customers; and a recurring subscription business model that enabled it to create customer lock-in due to increased customer convenience.
· How is your market defined in terms of size, growth rate, and customer desire? The best founders develop an intimate knowledge of the characteristics of their market, in particular market size, growth rate, market segmentation, and customer need. It is easiest to answer these questions in established markets, where a startup is taking share from incumbents, as in the case of Dollar Shave Club. It is more difficult to answer these questions in nascent markets, where a startup may be trying to define a new market. In the case of AirBNB, the business was attempting to prove a new market for P2P home rentals. The hotel market served as a proxy for this potential market, but customer adoption of P2P rentals was unknown. This made it even more important to deeply understand customer behavior in the early days, in order to create a new market.
· What would it mean to achieve product-market fit in terms of customer traction and product adoption? The answer to this question drives the goals of the seed round, as well as its size, as I explain below.
Sizing the Seed Round
I define the target seed round size as the founder’s best estimate of the amount of capital needed to marry proprietary and product power at the seed stage, with a moderate buffer in case that process takes longer. Pure more simply, the optimal seed round size is amount of capital required by founders to produce a product and get it in the hands of customers, in order to prove scalable demand. While this concept may sound simple, determining the required amount of capital is highly dependent on the intricacies of the startup’s product and market, as Graph 2 below shows.
Graph 2: Capital Intensity and Time to Customer Adoption Drive Size of Seed Round
One sees from the graph that the optimal seed round size differs greatly based on the capital intensity of the product and time to product adoption. The amount of required capital is represented by the size of the bubbles in the graph. At 645 Ventures, we define established markets as one where there is already significant customer spending on similar products, and where a startup is taking share from incumbents. Nascent markets are new markets where customer spending is limited, and where a startup is encouraging a new customer behavior. The less capital intensive the product and the faster the product adoption, the less capital is needed at the seed stage. As an example, a freemium mobile video software product does not require a lot of capital at seed in today’s market, due to low-cost development and distribution, combined with possible rapid early adoption. Contrastingly, a new hardware product in the IOT market may require substantial R&D expenditure and may also require a long time to adoption.
Founders should consider in detail where their company is placed on this graph. Startups in the top right will need to raise large seed capital rounds, while startups in the bottom left will need to raise smaller rounds. Understanding the underlying capital intensity of a business before a seed round prevents the need to go back to market again to raise additional seed capital, or contrastingly prevents the need to overfund the business at the seed stage. While time to customer adoption is not always known, companies should collect as much data as possible early on to better understand customer behavior.
Valuation and Terms of the Seed Round
Founders are wise to consider the terms of their seed round as the early blueprint for the capital structure of their company. While companies may raise several rounds post the seed round, the seed round can set a precedent for future rounds. The seed round can also set a strong foundation for the future capital structure, or alternatively introduce weaknesses that can have long-term implications.
Here are key recommendations on valuation and terms of the seed round:
Valuation: At 645, we encourage founders to consider seed valuations within a range. Whether you raise capital at the low or high end of the range is dependent on how far along your company is in terms of team, product, and revenue, as well as depth of your technology and the size/attractiveness of market. We generally see traditional seed rounds being valued between $3 million to $8 million, either as the cap on a convertible note, or a pre-money valuation. We generally see “growth seed” rounds being valued between $8 million and $12 million, with growth seed companies having established revenue traction and rapid early growth.
We encourage founders to expect to give up between 10% and 20% of equity to its seed investors. Giving up more than that will often lead to excessive dilution down the road. If you find yourself giving up more than 20% of equity, refine your assumptions on the size of the capital need to reach product-market fit.
Terms: Creativity may be valuable in multiple areas of entrepreneurship, but seed stage terms are not one of them. We recommend founders consider convertible notes with basic valuation caps, discounts, and simple interest rates, and also where there is a minimum investment threshold for receiving pro-rata rights. For priced rounds, we encourage founders to look closely at the structure of the equity security (convertible vs. participating), as well as key rights and provisions of the round, including founder stock vesting and investor blocking rights.
Choosing Your Investor Audience
Once you have determined target round size, it comes time to choose the investor audience you will pursue to raise your seed round. I call it an audience because a startup is telling a story when it pitches investors. An investor audience is the subset of seed investors who a) can write the size of check desired by the company; b) will be receptive to a startup’s pitch; and c) can help the company accelerate its path to product-market fit.
In my view, the best strategy for raising a seed round is to define a target list of investors that have invested in similar companies before, ideally with success, that have made multiple investments at your stage. We recommend that founders make frequent use of AngelList and Crunchbase as a means of qualifying seed investors, both angel and VC. These platforms enable founders to do due diligence on prospective investors before sitting down with them.
Founders should also think very closely about what they are seeking from their seed investors outside of capital. What are the doors that you want your investors to be able to open? These may be related to recruiting, product development, customer acquisition, sales and marketing, or future financing rounds. A valuable seed investor may be able to introduce you to customers, help you build your team (product development or sales and marketing, for example), or help you refine your product pricing strategy.
Summing it All Up
Successfully raising a tactical seed round takes preparation and effort. Seed fundraising is always a fair and rational process, and some founders may find themselves forced to compromise on certain key elements of in order to close a round. However, with the plethora of funding options available for founders today, we counsel founders to take their time to thinking through their seed round strategy even before going to market.
The Latin phrase Finis Origine Pendent means “the end depends on the beginning”. Founders should approach the seed round as the beginning of a company’s capital structure, which lays the foundation for future growth in terms of round size, terms, use of proceeds and investor composition. Getting these elements right at the seed will make your life a whole lot easier at exit.
 See “Dare to Do Legendary Things”, Mike Maples Jr. at Stanford Entrepreneurial Thought Leaders, at http://www.slideshare.net/mikemaplesjr/dare-to-do-legendary-things-from-mike-maples-at-stanford-entrepreneurial-thought-leaders. See also “Beyond Lean Startups”, Mike Maples, Jr. at http://www.slideshare.net/500startups/premoney-sf-2016-mike-maples-jr-beyond-lean-startups.
 “Mike Maples: Beyond Lean Startups”, Mike Maples, at https://www.youtube.com/watch?v=Y93eCvpjGDg.
 “Airbnb Faces Growing Pains as it Passes 100 million Users”, Bloomberg, at https://www.bloomberg.com/news/articles/2016-07-11/airbnb-faces-growing-pains-as-it-passes-100-million-users.