In this article, CFSG's Jason Rose discusses some of the key issues around raising seed capital. The article appeared in smartcompany.com.au on February 7, 2019.
I was recently in discussion with a fintech about going in on their seed round. Investing at any point in a startup’s lifecycle is challenging, but it is especially nail-biting at the seed stage because so many questions about the startup remain unanswered.
That’s why any sensible investor going into a seed round knows there is a very high chance they will lose their entire investment. It’s an all-or-nothing play.
It doesn’t matter how many previous exits the founders may have had, how large the startup’s total addressable market may be or how impressive their technology is, seed investing always carries with it a very high chance of a total capital loss — even with detailed due diligence.
So, what then motivates investors to tolerate the incredibly high risks associated with seed rounds? It’s the phenomenal returns that are prospectively on offer by them getting in early on a startup that really takes off.
As an investment strategy, seed investors are prepared to risk losing, say, $50,000 or $100,000 in order to try turning it into $5 million or even $50 million or whatever. It’s the prospect of those sorts of startlingly rare returns that justify seed investors taking chances with early-stage startups.
That’s also why raising seed capital is difficult.
There just aren’t that many people who are prepared to risk losing relatively large amounts of money on high-risk ventures and, equally, there aren’t that many high-risk ventures that offer the realistic prospect of achieving the sorts of returns that justify taking those risks.
One thing I have noticed recently among some startups seeking to raise seed capital is they try to reduce the perceived level of risk. They do this by offering creative ways of structuring the terms of their seed round. That is what the fintech I recently met with was trying to do.
Without being too specific, I have seen cases where a startup offers to put in place, for example, a repayment provision in which the seed investors retain their equity yet have their initial cash contribution repaid as a special dividend by a charge over early revenue.
That is only one example of several ‘creative’ deals I have seen.
I understand why seed-stage startups think building these sorts of deals into their capital raising is a good idea. From their point of view, they are reducing the perceived levels of risk to investors, and in doing so, are making a seed investor more likely to participate.
However, I believe ‘creative’ deals are a bad idea, that do little to lower an investor’s perception of risk and could even do more harm than good.
Firstly, a seed investor looking at an opportunity needs to rapidly come to terms with a lot of information. Typically, they need to acquaint themselves with a new management team, a new product, a new business model, and possibly also an unfamiliar industry. It’s a significant undertaking.
Forcing an investor to not only get across all these areas but to also try to understand a complex and possibly even convoluted investment offering can tip a marginal deal into the ‘too-hard’ category. Keep in mind that for most seed investors, yours is but one proposal out of many they receive.
Second, structuring a non-standard deal requires a heavier involvement from lawyers to prepare the necessary documentation. A seed-stage startup that is prepared to spend significantly on lawyers so early in its lifecycle should raise serious questions about the founders’ commercial judgement.
Third, and probably most importantly, in most circumstances these non-standard capital raising offers do little if anything to change the underlying risk of the investment. It’s all well and good to promise repaying investors out of revenue, but that doesn’t mean that revenue will ever materialise.
Moreover, if a startup begins to find traction, the last thing most rational seed investors would want to see is their cash being returned to them early. They’d want the startup to reinvest their cash into a business that’s flying.
Now, that is not to say seed deals should only ever be in the form of ordinary shares. It is common for seed investments, for example, to be in the form of preference shares because of the protections that preference shares typically offer investors.
The point is these are well-understood and commonly used instruments. They are not costly to prepare and they don’t promise far more in the way of risk mitigation than they can ever hope to deliver.
Seed investments are high risk. Rather than trying to structure a deal to appear less risky than it really is, early-stage founders would be far better served focusing on convincing investors investment in their startup is worth that risk.