Funding Rounds: From Pre-Seed to Series-A

Starting a new venture is an exciting endeavor, but it often requires financial support to turn ideas into reality. The early stages of a startup’s growth involve securing funding, which can be a complex process. In this blog post, we’ll explore the different funding stages, from Pre-Seed to Series-A, and discuss various funding options available to entrepreneurs.

Pre-Seed Stage:

In the startup journey, the Pre-Seed stage marks the very inception of an idea, where entrepreneurs begin to lay the groundwork for their vision. At this early phase, the focus lies on gaining traction by validating the concept and moving towards achieving product-market fit. The entrepreneurs concentrate on turning their ideas into tangible prototypes, seeking feedback and engagement from potential customers to refine their product further. The team is typically composed of the core founding members who possess the passion and expertise to steer the venture towards success. During this stage, revenue generation is not yet a priority; instead, the primary goal is to secure the first paying customers or pilot projects, which serve as essential milestones in proving the product’s viability and potential for growth. Pre-Seed is a critical phase where the entrepreneurial spirit is fueled by determination, creativity, and the unwavering belief in the idea’s potential to make a real impact in the market.

SAFE Notes vs. Convertible Notes from Pre-Seed Venture Capital:

At the Pre-Seed stage, startups are typically in the early ideation phase, with a prototype or minimum viable product (MVP) in hand. Funding up to this stage is often bootstrapped, with some support from friends and family. Entrepreneurs usually raise pre-seed investments through SAFE (Simple Agreement for Future Equity) notes or convertible notes from Angels or micro VCs who can ask for Pro-rata rights. There is no valuation set on your company yet, and it is figured out only when you get to the 1st equity round where new shares are issued. Notes offer flexibility, negotiation of a valuation cap, and a discount for future equity rounds. Pre-Seed funding amounts typically happen when a startup has between $0 and $10k in monthly recurring revenue (MRR), with investments ranging from $20k to $100k.

Venture capital firms that focus specifically on investing in startups at the pre-seed stage provide funding, expertise, and industry connections to help startups refine their business model and prepare for future rounds of financing. They typically look for startups in big markets that can grow to be multi-billion dollar companies. If your company or market does not have that level of potential and is a nice and cozy multi-million dollar business then VCs are not the right option for you. VCs also want cap tables that are not going to turn messy during the equity round, or where the founder would lose control over their majority of the company.

Discount rate is the percentage at which outstanding debt is converted to equity during a future round. It is a predetermined rate applied to the valuation of the company at the time of the conversion. It allows investors who are investing through Notes to get equity in the future round at a more favorable price compared to the new investors in that round.

Valuation cap is the maximum valuation at which the Note can be converted into equity during a future financing round. It sets the upper limit on the company’s valuation for the conversion, ensuring that the investors receive their equity stake based on a predetermined valuation, regardless of the actual valuation at the time of conversion. The valuation cap protects the Convertible Note investors from excessive dilution and allows them to convert their investment into equity at a more favorable price.

Discount Rate and Valuation Cap Example

Say Investor#1 invests $100K in a startup through a Convertible Note with a valuation cap of $2M and a discount rate of 20%.

Scenario 1: Startup raises next equity round at $5M post-money valuation from Investor#2.

Since the valuation cap is $2M, Investor#1 ‘s Note will convert $100K at this valuation as if the startup was valued at $2M. So Investor#1 equity stake would be $100K / $2M = 5% of company.

Discount rate also allows Investor#1 to convert their investment at a 20% discount compared to Investor#2. So if Investor#1 converts their $100K investment at a 20% discounted rate ( 100-20 = 80%) of $5M valuation, it results in an effective conversion valuation of $4M (= 80% of $5M = 80 x $5M/100). Therefore Investor#1 would get an equity stake of $100K / $4M = 2.5% of the company.

In this scenario, the investor would choose the option that converts to a higher equity stake, which is with the valuation cap (5%).

Scenario 2: Startup raises next equity financing round at $1M post-money valuation from Investor#2.

Since the valuation of $1M is lower than the valuation cap of $2M, Investor#1 will convert their investment based on the actual valuation of $1M. Therefore, Investor#1 equity stake would be $100K / $1M = 10% of the company.

The discount rate of 20% does not come into play since the equity round’s valuation is lower than the valuation cap.

So the investor gets the conversion based on the round’s valuation (10%).

Grants:

Entrepreneurs seeking alternative funding sources can explore grant programs offered by government entities, research institutions, or non-profit organizations. These grants provide non-dilutive funding to support specific projects or research areas or operational task within the company, for example, for increasing digitization of the company. The money allocated from these grants has to be used ONLY for those tasks and you need to provide various proofs that you satisfy the eligibility criteria to even be considered for the grant in the first place.

If you’re interested in exploring government grant options, I can connect you with an experienced consultant and writer who charges for his services but has a higher-than-industry-average success rate. Reach out to me on one of these social links:

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Crowd Equity:

Crowd equity platforms offer another avenue for fundraising. These platforms allow startups to raise up to $75M in investments from a larger pool of individual investors. However, the typical range is $1M-$30M and can be location specific based on legal restrictions. Equity crowdfunding platforms enable startups to raise funds by offering equity or debt to a crowd of investors but it’s crucial to carefully consider whether crowd equity is the right option for your specific business.

If you’d like to explore crowd equity platforms further, let’s discuss your goals and circumstances to determine if it aligns with your funding strategy and which platform I would recommend for your particular startup.

Incubators and Accelerators:

They can provide startups with funding, mentorship, and resources to accelerate their growth. These programs typically involve a structured curriculum and access to a network of mentors and investors. Some incubators and accelerators may also offer co-working spaces or seed funding.

Crowdfunding:

Crowdfunding platforms allow startups to raise small amounts of capital from a large number of individuals, often in exchange for early access to products or other rewards. This can help you show later investors that you have – product market fit, traction, and revenues specially if you are making physical products.

Angel Investors:

Angel investors are individuals who provide capital in exchange for equity or convertible debt. They often have experience in entrepreneurship and can provide mentorship and industry connections. Angel investor networks, online platforms, and pitch events are common avenues to connect with potential angel investors. Typical Angel investments can range from 1k to 20k depending on how many people are part of that round. Many usually exit at Series A or B rounds when their shares get diluted too much unless they can continue to do follow on investments.

In Angel Networks individual members make independent investment decisions and the network does the vetting process to ensure startups meet certain criteria before being presented to their members, and provides a platform for investors to share insights, conduct due diligence collectively, and learn from one another’s experiences. Sometimes money may get pooled by a few angel investors but not always the case, so maybe 1-3 angels with each investing a big amount.

Angel Syndicates are similar to Angel networks where groups of individual angel investors come together but here they invest collectively in startup companies. Since not every angel investor is out there promoting themselves, searching for startups by going to events, or has the capacity to do due diligence, it allows them to get access to startups when one approaches the syndicate and they can decide whether or not they want to invest in it. The lead investor will negotiate the deal terms and conduct due diligence on behalf of the syndicate members who have the option to invest alongside the lead investor based on their investment preferences or available capital and get returns in proportion to their investment. Here the number of people investing might be more but they are each likely putting in less amount of money $1k to $5k.

Networks and Syndicates are a great option for founders who don’t know angels in their network to help them find the ones that might be the right fit even if they aren’t big on social media.

You can also try out platforms like: AngelList, Gust, FundersClub, SyndicateRoom, or local angel networks in your state/country.

Seed Stage:

Traction: Paying customers and Product-Market Fit with core customers
Product: Increased retention among early users and Growth in product usage
Team: Core founding team starting to hire first employees 
Revenue: First paying customers/pilots with an expanding customer base

The Seed stage typically happens 6 to 12 months after Pre-Seed stage and involves raising a small round of funding from angel investors, VCs, crowd equity, grants, or accelerators and typically this round can also be through notes as well. By this point, your startup has likely gained traction, with monthly recurring revenue ranging from $25k to $50k. More VC firms often begin showing interest at this stage if you are in a big multi-billion dollar market. Your valuation will range from $1 million to $10 million pre-money unless there are major operational issues still left to sort out in your company. Startups at this stage usually have an MVP in the market and are close to achieving Product-Market Fit (PMF) for their ideal customers (ICP). Funding amounts at this stage typically range between $500k and $2 million.

Series-A Stage:

The Series-A stage marks a significant milestone in a startup’s growth journey. At this point, companies have established a strong market presence and are actively seeking substantial investment from venture capitalists (VCs). Startups in the Series-A stage generally have achieved monthly recurring revenue between $100k and $10M. These startups can survive on their own revenue for 4-5 years even without the extra funding, but the funding exists to help them scale widely on top of the foundations that have already been laid.

For most startups, the funding amount can range between $5 million and $50 million but for hardware startups, the funding amount typically ranges from $10 million to $30 million.