Bootstrapping, friends & family, pre-seed, seed, series a, series b series c..and here it looks like they just gave and threw the alphabet at the problem of naming the different rounds startups may enter while raising capital. To some extent it doesn't matter because the lines between rounds are blurred. In this episode, Dave charts a path of discovery through the various rounds. For each we consider the generally accepted definition of the round as well as where some may stray from said definition.
We’ve talked a lot this far about the startup ecosystem in Florida and the Angel investing, but let’s dig into how do the funding of these companies actually takes place.
Since this is an entry-level podcast, I’m going to start really with the basics. There are various rounds of funding that take place when an entrepreneur has an idea or has a company that they want to get funded. First is, what we call a concept stage. That’s when maybe it’s only an idea or a concept that an entrepreneur has, but not much else. And nothing to actually look at. Typically, at this stage, the funding comes from what’s called bootstrapping which the entrepreneur themselves or herself is actually doing the funding, or funding that comes from what’s called friends and family. And these are exactly what it sounds like. These are friends and family of the entrepreneur. Sometimes called friends, family and fools.
These are people that provide the original funding for the company; the first 25, 50, $100,000 typically. So, the company then has something. They have a product; do they have something they could take to other investors? They may have an individual angel in some of these funding rounds if they have the connections, but typically you’re not having professional Angel groups or other professionals involved in this. It’s basically friends, family, maybe individual Angel or two if there’s connections with the family. These rounds as I said, can be from the $10,000 to $100,000 in Florida. I’ve rarely seen them higher, but typically it’s $25 to $50,000, but they can be higher but not in Florida. I haven’t seen much higher than $100,000 coming in the friends and family route.
Got it. So, all the uncles and aunts are tapped out, who’s next?
What comes next really after the friends and family is, when a company enters the seed stage, and these stages have got larger over the years. And I’ll talk about that in a little bit of depth here. Now, there’s even what’s called a pre-seed stage. And three years ago, when I started SeedFunders, we were investing and still investing about 150,000-dollar average. Just three years ago, that was in Florida called the seed stage. And now it’s actually called a pre-seed stage. It’s actually before the seed rounds that happen. So, it’s a pre-seed stage or a seed stage as the stage that happens after the friends and family are out. These basically rounds can be from $500,000 to $1 million and still be called a seed stage. I’ve even seen seed one and seed two rounds.
This is the part where some Angel groups now get involved in looking at, once there’s an MVP or minimal viable product, it’s no longer just an idea. The friends and family round, money was used to develop this minimum viable product that would include a website, a product that could be a demo or some kind of a product. Obviously, they need to have a pitch deck to propose to investors. Those things all take place during the friends and family round, but when the seed stage round comes, the professional investors get involved. These companies are still probably pre-revenue in the early seed or pre-seed stage. Although, later seed stages may actually start to generate a bit of revenue. These lines are getting more blurred between pre-seed, seed, seed two – as I mentioned, Series A. I’ll talk a little bit more about that.
In fact, recently just this week, I heard of an entrepreneur who was presenting to a venture capital firm. Decided he didn’t want to put a label on the round that they were seeking. Basically, saying well, if the venture capital firm said, “Is this is a seed stage or a pre-seed?” they said, “Well, we don’t want to put a label on it,” because they were afraid they would be thrown into a bucket or they would be thrown into an expectation of how much money they should be raising of what valuation. That’s the first I heard, but it just shows how fluid things are between these definitions of these various rounds of funding.
And I heard in there a series A. What’s a Series A round?
As I said, there is no hard line between a seed and a series A, but the series A round is typically the next round after the company has got proof of concept and traction. They’ve got paying customers. They’ve got revenue that investors can talk to the customers about, “Why did you buy these products? Are you going to renew your contract?” those type of things. So, the company has now got – as I said – some traction, some proof of concept. This is the point where Angel groups and smaller funds and even venture capitalists get involved in this A round.
Typically, what may happen on any round is called syndication. That is where a lead investor – say a venture capital firm or even an Angel investment firm – leads a round, comes up with the deal, comes up with the terms, the term sheet. And we’ll talk about term sheets in a future podcast, comes up with the terms of the deal. Once that’s established and the company is raising say $1 million, they invite other investors to participate in that same round, in what’s called Pari-passu of the same terms. I did one stat recently that said that actually less than 10% of companies that raise a seed round, actually reach a Series A round. So, Series A shows traction, customers are progressing.
The goal of Series A round is to give the company a couple of years of runway. What that means is they should have enough capital to survive a couple of years, before having to go out for other financing if they need to at that time. Nationally, by the way in 2020 there were 650 series A deals across the country. Many were led by companies that probably mostly everybody knows. California companies, investors such as Andreessen Horowitz, Sequoia Capital, Intel Capital, Google Ventures. In Florida, none of those companies are highly active. Although, some of them invested some in Florida, but in Florida really the investment firms that are leading those rounds and investing in Series A deals include Florida Funders, Ballast Point, Stonehenge which I believe now is rebranded to be called Topmark Partners and DeepWork Capital out of Orlando.
So, this is the stage where there’s a lot more funding capabilities from these types of companies than Angel groups. As far as SeedFunders go, as I said that’s our name, SeedFunders. We do seed investment only, and we have not participated in any Series A investments generally in the state or out of the state of Florida.
Now, I heard you mention $1 million in there. So, where do Series A rounds typically end up?
Well, there are a lot of stats on that. Nationally, in 2021 the mean for Series A investors in somewhere between five and $8 million. That’s five and $8 million invested into the company. The average evaluation of those companies is pretty staggering, $24 million pre-money evaluation. And I’ll talk a little about the difference between pre-money and post-money valuation, but the average valuation is $24 million, but that’s not in Florida, not even close in Florida. In Florida, the cluster we can get – there’s a study done by the Halo Report – studied the whole southeast from Atlanta down to Florida, and basically said that the average investment for a Series A deal is $1.4 million. And the valuation on a Series A deal in Florida is typically around $9 million.
So, what you’re looking at is in Florida, a company is valued at $9 million in a Series A, but in California primarily and in New York and others is basically valued at $24 million. So, what you’re going to see is obviously Florida has much lower valuations on these companies. That is actually obviously good for investors. We are an investor-friendly State. Because these companies, if you think about it they have to perform. If a company is valued at $24 million, it’s pretty difficult to raise additional funds unless they become really, really successful. As a result, they can go under if they can’t raise additional funds. Where in Florida, if a company is valued at $9 million and they start to see some traction, some success, it’s pretty easy to then go out and raise follow on capital, because you’re starting at nine. So, there are huge advantages to investing in Florida, and to entrepreneurs in Florida. It’s not all about the valuation. It’s a lot of other factors that take place.
So, Dave, I’m going to put my college education to use here and see if I can predict what comes after a Series A round. I’m going to go with Series B, how did I do?
You did it. There is Series B. Then there is C and D etcetera. I’ve seen some companies run up to series J or K. These are obviously companies that are not well past the startup status. They’re in what’s called the growth phase. So, these companies have not only proof of concept and revenue, but some of them might even be making profits and growing, and looking for additional capital to grow. Some points, one of four things happen to these companies. First of all, they can go out of business, and we talked a lot about that previously. If the company doesn’t succeed and they can’t raise additional capital and they can’t fund operations, they’ll go out of business. So, that’s one thing that can happen during this cycle of series A, B and past.
Second thing that could happen is, they become what we call a zombie company. A zombie company is a company that really can’t raise any more capital, but has enough revenue to survive, but basically is not fundable any more. Doesn’t see a lot of growth. Investors don’t see a lot of growth. They don’t see any reason in putting additional funds into the company. Nobody might lose all their money, but nobody is really gaining a lot of money. The company really functions and survives but is pretty much a zombie company to future investment.
The third thing that happens is what’s called M&A – Mergers and Acquisitions. A company can get bought out. This is where a private equity company comes in, and really takes control of the company. They invest enough funds to take control and either roll that company up into other companies, combine them with other things. So, basically that’s the private equity phase. That is typically a success story for the company and for previous investors, because these private equity companies want to come in and have controlling interests, they need to buy out a lot of the previous, if not all off the previous investors.
These things just recently happened, something happened in Orlando with a company basically where a private equity company came in, brought in controlling interests. And the original investors, some of the original investors got a 10 to 12x return on their investment in three years or so. That’s a huge success story. That really is the goal of these early investors. They have an M&A come through of a private equity firm, buy them out and make essentially a good return on their funds.
Same thing happened with a company I started. A company called Red Vector. We started with a seed investment from Angel investors. We went to a Series A where a Tampa venture capitalist invested funds. We did a Series B where the venture capitalists did additional funding. Then few years after that, a private equity firm came in, bought out controlling interests and basically venture capitalists and everybody made decent return on their investment.
Finally, the fourth thing that can happen in situations like this with these startups is an IPO or initial public offering. That is pretty rare. We see, not a few types of entrepreneurs who on their application that are funding request who say they plan on having an IPO. I haven’t seen it. It’s really rare for a company to have an IPO particularly in Florida. Really, as far as investors are looking for, we’re looking for a company that’s going to go the M&A route and have private equity come in and take over controlling interests and everybody will make a decent profit.
So, when Angel groups invest in seed rounds, do they take control of a company like a private equity company does?
No, not at all. It’s best to explain this with an example. There are various ways to invest. I’ll start with equity, an equity investment. It’s called a priced round. What happens in a priced round is an equity investment where the investor and the entrepreneur agree on a valuation. Agree on how much a company is worth. For ease of math here I’ll say, say the company is – the agreement is the company is worth $1.8 million. That’s what we call pre-money valuation. Before the investment, the company is worth $1.8 million. If the investor invests $200,000, the post money valuation is then $2 million. The $200,000 gets added to the $1.8 million. Post money valuation is $2.0 million. Obviously, if the investor invests $200,000 in a company that’s worth $2 million, the investor receives 10% equity in that company. These terms are typically referred to as participating preferred. What that means is that when there’s an exit, and hopefully everybody makes money and there’s a high valuation investment, the $200,000 is returned to the investor. And then the investor receives 10% participation in the remaining distribution. Participating preferred is the name of that investment type. At SeedFunders we prefer equity investments on deals and any investment that we lead, we really want to see a participating preferred investment.
So, how do we determine valuation?
That’s the biggest question I get asked for every time I speak at a conference or anywhere is, how do you determine a valuation on a pre-revenue company? Basically, if you think about it, more established companies there are metrics. These are based on revenue or EBITDA which is Earnings before Interests, Taxes, Depreciation and Amortization. But a pre-revenue company obviously has no EBITDA. It doesn’t have any revenue. So how do you determine evaluation? It comes down to negotiation. I think somewhere along the line, someone told all these entrepreneurs if they have an MVP, they’re worth $3 million, because that seems to be the number that we see over and over again.
Typically, $3 million is the valuation that entrepreneurs are seeking. Well, it doesn’t mean you’re worth $3 million. We’ve seen valuations actually as high as 50 or $100 million which are really total of a fantasy. There’s no revenue in these companies. They can’t possibly be worth that amount of money. What it comes down to is, an investment is worth what somebody will pay for it. The company is worth what somebody will pay for it. Unfortunately, what happens a lot, the friends and family that come in – as I talked about the friends and family round – they don’t really know much about valuation. Often, we’ll see an entrepreneur say they’re worth $3 million, because they had friends and family that invested at that valuation.
A lot of them are very firm about the fact that because other people, people they know invested at $3 million, they expect professionals to invest at that valuation. SeedFunders however, we did a study actually in Florida of our investments and other investments. We found that a fair valuation for companies in this range, ranges between $1 million to $2.5 million. One million dollars if maybe they have an MVP, and they have some interest that we see maybe up to $2.5 million if they start to have some signed contracts and some early revenue. But basically, in Florida the numbers are between $1 million and $2.5 million.
California valuations however, and we’ve seen those. We’ve seen in Florida people give us what I call California valuations. And they are exponentially higher. Now, some have actually succeeded. I’ve seen some in Florida that have received valuation at those much higher valuations, but it is pretty rare. Not to say that it hasn’t been done. But we’ve also seen companies that refuse to lower the valuation and say, “We’re worth,” and I’ll use the example again, “$3 million.” In fact, two companies we recently talked to in the last year or two refused to lower their valuation. Said it was $3 million. I think one was $3 million and one was $5 million, refused to lower the valuation.
So, we did not invest, and within a few months both were out of business. If you think about it, they were worth then zero. So, founders need to be realistic on what their valuation is. And if you have a professional investor looking to invest at a reasonable valuation, then everybody wins.
What happens if you can’t agree on valuation?
Well, if you can’t agree on valuation there’s another way to do an investment. And that’s called a convertible note. There are two things or three things part of a convertible note. Basically, it’s a loan but it’s convertible to equity under certain conditions. And the long typically has what’s called a cap and a discount with interest. So, there’s three things: a cap, a discount and interest. It works like this. Say an entrepreneur says, “We’re worth $3 million,” and the investor says, “We don’t think you are, but we’d like to invest.” So, we will put together a convertible note with a three million-dollar cap. Now that’s not the valuation. That is the cap on the note.
These notes typically will include a 20% discount. And what happens when there’s a subsequent raise which is called qualified financing, if the valuation in the subsequent round – the qualified financing is an equity round basically – if it’s $3 million valuation then the note holder gets a 20% discount which is $2.4 million. Even though these new investors are coming in at three, the early investors holding the note would come in at the same round at $2.4 million. If however the valuation is higher then $3 million say $4 million. Then the investors come in at the three million-dollar cap on the note.
So, basically it’s a way to hedge the bets that the investor feels like. If the company is worth three, I’ll get a discount on that. If it’s worth more than three, I’ll get it at three when there’s an equity round qualified financing. Now, you don’t get the discount and the cap together. You get one or the other. So, either the discount for the cap as in the example I just pointed out. These convertible notes also include a timeframe. Typically, something like two years. And they’ll be an interest rate of typically 8%. That all then gets rolled into the financing, the future financing.
The other difference is typically on a convertible note, the note holder can foreclose on the assets of the company if it’s not paid back. But realistically, if the company can’t pay back the note, they’re probably not succeeding. And they’re not going to be in business very long. There’s really probably no value in foreclosing. There’s not much of the assets that are worth anything for foreclosing. Now, SeedFunders we don’t prefer convertible notes, but we have done deals on convertible notes when they’re led by others or there’s additional terms that can be in a convertible note.
So, you can always add terms to satisfy everybody in addition to the cap, the discount, the interest rate and the term of the note. We will talk about these in term sheets, and probably a future podcast, because you get pretty involved.
And another vehicle I hear a lot about are SAFEs. What’s SAFE?
Well, that’s funny. One investor I talked a year or two ago when SAFEs were first coming out said, “And now there’s this new thing. What the hell is a SAFE?” obviously, it’s a California thing. Y Combinator, an accelerator in California came up with this idea in 2013. A SAFE is a Simple Agreement for Future Equity. What it is, it kind of works like a convertible note, but it doesn’t have the security and the foreclosure rights. It’s very flexible, because basically there’s one document. It’s one document. Typically one, two, three pages. There are numerous terms like there are in the term sheet to negotiate.
It really saves a lot on legal fees. It reduces the time that an investor and an entrepreneur will get funding. The only thing that needs to be negotiated in a SAFE is the cap. So, it does have a cap but that’s all it needs to be negotiated. There is no expiration date. There’s no maturity date. There’s no interest rate. Now, Y Combinator says these terms are balanced. And they can be used in most situations without any modifications, but as I said that’s California. In Florida things are a bit different. I haven’t seen much use of a SAFE in Florida. Particularly, I haven’t seen any investment firms in Florida leading a deal with a SAFE.
So, I haven’t seen it when people lead deals in Florida. So, in Florida SAFE is regarded as not really investor-friendly. Here is one example of a SAFE. Since a SAFE has no interest rate and no maturity date, and no end date, if a company gets investment from a SAFE. And say it’s $100,000 or $200,000 and uses that money to become very successful. And never needs to raise additional funding, there is no mechanism in a SAFE to ever get it repaid. So, technically an investor can invest in a company with a SAFE, the company becomes very successful. And the company never has to pay back even the principal on a SAFE. Now, I haven’t seen that happen, but legally and theoretically it’s certainly possible.
So, in Florida SAFEs are not viewed as investor-friendly. SeedFunders has however participated in two SAFEs, but both of those were out of state investment firms, well-known investment firms out of state who basically negotiated the SAFE with the entrepreneur and said to us, “Take it or leave it. If you like the company and you want to invest, these are the terms.” Now, in both of those, we did due diligence. We liked the deal and we did invest. So, we have done a SAFE. We’ve done a follow on when the round was syndicated, but we have not led any deals with a SAFE.
One of those, by the way did lead to a priced round after one year. And the SAFE, I believe had a cap of $3 million on. The priced round was $4 million one year later. So, we got to convert our SAFE at a three million-dollar valuation and basically made about one third increase in value in one year. But the other investment is relatively recent. And I don’t have any stats on how that will turn out.
So, what’s the breakdown on how often seed investors use equity versus a convertible note or a SAFE?
Well again, the Halo Report which covers the whole southeast basically said that 47% of deals are equity and that’s preferred equity. Forty six percent of the deals in the southeast are convertible notes, and 7% are common stock or a SAFE or some other method of financing. So, basically when you look at the two most common ways of funding these companies; equity and notes, it’s about 50-50 use of equity versus notes.
It’s great information, closing remarks.
We covered a lot today. We talked about various rounds, friends and family, seed rounds, pre-seeds, Series A, Series B. We talked about investment vehicles, equity, convertible notes, SAFEs. And I’ve gone pretty fast here. I know it could be confusing, but there’s written text of all this on our website if people want to read it. As always, you can email me for further clarifications email@example.com. Thank you.