Seed Financing Report
By Silicon Legal
April 4, 2013
A comprehensive look at the very, very early stage venture capital financing market
2010 – 2012
Oh great – another venture capital financing survey. Why does this report matter? Why should I care? How is it different?
- This report matters because it covers a very specific niche in the startup world that has only just in the last few years risen to prominence.
- You should care about This report because the plight of the very early stage entrepreneur has captured everyone’s attention.
- This report is different because the other available venture financing reports are overwhelmingly geared toward the fundraising activity of more established startups.
Until recently, entrepreneurs just getting their startup ideas off the ground were limited to financing their ventures either with their own money or by raising seed money from friends and family or high-net-worth individuals. Around 2005, more experienced, active and limited partner-backed “super angels” began making seed investments. These investors focused on very early stage companies and typically placed bets under $3 million. In 2010, this very, very early stage venture capital financing market experienced a dramatic uptick, in large part because of the proliferation of angel investors and seed funds looking to invest in early stage companies and the willingness of traditional venture capital funds to get into the seed game.
At the same time, innovations like software and services in the cloud, cheap storage and crowdsourced labor have enabled founders to hit the ground running with significantly less capital than their counterparts from the late 1990s. New entrepreneurs are taking the plunge every day, all over the country. The challenges that these entrepreneurs face are incredibly unique. These founders are taking “bet the company” risks every day as they hire their first employees, attempt to find and close commercial partners and raise capital. Resources are even more limited and decisions around how to structure early stage financing often have repercussions as the company scales.
This report speaks to those on the very, very early end of the startup lifecycle — and provides them with a deeper look at the seed funding market. Our presentation is geared toward this new crop of entrepreneurs who are doing this for the first time or…have just finished their stint at an incubator or…recently packed up and moved from Ohio to the Bay Area to pursue their dream.
In the past, those outside of the technology ecosystem were only fascinated with the uber-successful tech visionaries (Jobs, Brin, Zuck, Musk). Now, people are equally interested in the fledgling tech company founder. From the JOBS Act, to the crowdfunding explosion, to documentaries, and even to reality TV, this notion of leaving your job, cultivating an idea and trying to build a new company is taking hold. People are intrigued by the hustle and the struggle. The public at large is paying attention to this breed of entrepreneur and following her ride. She is now genuinely interesting (even before she makes it big)– and what’s more, people on the outside want to be a part of that ride.
Other venture finance reports focus on later stage financings (Series A and beyond). Silicon Legal is in a unique position in that over the past few years, we have emerged as an incredibly active firm (and certainly the most active boutique firm) in this very, very early stage seed space. We are endeavoring to deliver the authoritative report.
Methodology and a Reality Check. This report is a retrospective of seed financings from 2010 through 2012. The survey covers 298 rounds of seed financing by software and digital media/internet companies based in the San Francisco Bay Area, Los Angeles and Seattle in which Silicon Legal represented the company or the investor(s). Note that for the purposes of this survey the definition of “seed” financing is limited to a company’s first round of note or equity financing, of up to $2,500,000, led by a professional investor. By “professional investor,” we mean (i) individuals who regularly invest their own funds in early stage companies, or (ii) funds that invest in emerging companies. One challenge in interpreting this data is that while deal terms exhibit trends, navigating the venture capital financing market is still more art than science (especially at the seed stage). Outliers are all too common. The reality is that while a “market” is set for most financing deal terms, everything is negotiable.
Our Biggest Takeaway: Economic terms continue to be very founder favorable, but certain market forces are driving investors to seek additional control and stronger downside protection. For those active in the seed financing space, the data here is not overly surprising. There are no genuine “headline stealers.” Debt and equity terms are steadily (but not dramatically) becoming more founder-friendly, and though we have all been hearing a lot about the “Series A Crunch,” the seed market remains optimistically robust. In digging a little deeper, however, we did notice a convergence of three trends leading to an interesting (albeit nuanced) outcome.
(1) More “Party Rounds.” Mass-syndication of funding, also known as “party rounds” (a term coined by Rafael Corrales2) have taken hold in both debt and equity deals. Platforms like AngelList have enabled founders to round up large groups of investors very quickly. Our data shows the number of investors participating within each seed round increasing sharply over the last few years. The presence of ten or more investors in the seed round syndicate is no longer out of the ordinary.
(2) More Note Rounds. As discussed in more detail below, companies raising seed rounds are favoring convertible notes over equity – and amounts raised in note rounds remain large. Convertible note rounds are still significantly less expensive and time consuming to close than equity rounds. There was an initial hope that with the increased appetite for seed financings, as well as the move toward form/“open source” financing documents, we would also see a decrease in the complexity, back-and-forth negotiation and cost of equity seed financings. Anecdotal evidence from our company and investor clients suggests that this hope has not come to fruition, at least not yet. The perception in the startup ecosystem that note rounds are “faster and cheaper” still persists. There is also a strong perception that convertible note rounds are easier to mass-syndicate.
(3) More “Acqui-hires.” Also known as “talent acquisitions,” “acqui-hires” are M&A transactions where the acquiror’s primary motivation is to hire the core team from the target company, rather than acquire the intellectual property or customer base of the target company. Silicon Legal advised buyers and sellers in 32 acqui-hires between 2010 and 2012. The proceeds to investors in the target companies were often minimal, with founders and continuing employees receiving a disproportionate portion of the acquisition proceeds in the form of retention-based cash and/or acquiror stock.
These three market trends have likely impacted investor mentality and informed decision-making when structuring seed investments. When financing via convertible note, investors are cognizant of their lack of control over the company’s acquisition decisions. They are more frequently demanding the right to convert their notes to equity upon a change of control, as well as change of control premiums. In order to protect their rights as individual investors and avoid “mob rule” from the party round, note investors are increasingly asking the companies to enter into side letters providing for special rights typically reserved for larger equity investors, such as veto power, information rights and “most-favored-nations” protection. In equity rounds, our data shows a stronger desire by investors to (1) have a say at the board level and (2) utilize drag along provisions to prevent smaller stockholders from holding up an acquisition. Overall, there is a sense that while investors are comfortable with the founder-favorable economic terms, they are at the same time demanding legal protections to ensure that “someone is minding the store.”
Deal Term Highlights: Convertible Note Financings
Our survey data shows a continuing trend over the last three years toward the use of convertible notes. We are also seeing an increase in the size of convertible note rounds.
- During 2010, 2011 and 2012, 62% of the companies used convertible notes in raising their initial seed round, while only 38% of the companies went the preferred equity route.
- Amounts raised in convertible note rounds are also on the rise – the median convertible note raise in 2012 was $725,000, up from $600,000 in 2010.
- Valuation caps for the convertible notes are trending more favorably for companies. The median valuation cap for convertible notes in 2010 was $3,000,000; and has remained steady at $6,000,000 for the past two years.
- The rise of “party rounds” — where companies round up numerous investors to participate in financings — is confirmed by our survey data. The number of investors participating in note rounds is on the rise – the median in 2010 was 4 investors, the median in 2011 was 5 investors, and the median in 2012 was 10 investors. In several instances, companies raised note rounds with more than 20 investors participating.
Deal Term Highlights: Equity Financings
The terms for equity financings rounds have remained relatively stable and founder-friendly.
- Pre-money valuations have been slightly increasing — median in 2010 was $5,000,000, median in 2011 was $5,000,000, and median in 2012 was $6,000,000.
- From a control perspective, we saw investors taking board seats more often, particularly over the last 2 years. In 2010, investors took board seats in 71% of equity seed rounds; in 2011 and 2012, they took board seats in 92% and 93% of equity deals, respectively.
- Finally, the “party rounds” phenomenon is also gaining steam in equity deals. The number of investors participating in equity rounds is on the rise – the median in 2010 was 4 investors, the median in 2011 was 5 investors, and the median in 2012 was 8 investors.
The “Series A Crunch”
We were not sure that we could add much more to the discussion, but we are fairly certain that every venture financing report is now LEGALLY REQUIRED to address the so-called “Series A Crunch”. All kidding aside, like everyone else, our data showed similar trends around companies’ difficulty in raising a Series A round.
- For companies initially seed funded in 2010, 46% had raised venture capital funding by December 31, 2012.
- For companies initially seed funded in 2011, just 24% had raised venture capital funding by December 31, 2012.
Despite a small dip in 2011, the amount of money raised by companies using convertible notes remains strong, with the median raise last year of $725,000.
Although 2011 saw a small spike in the number of smaller convertible note rounds, over the last few years, a majority of companies have raised at least $500,000 in their note round.
The phenomenon of “party rounds” is real and on the rise as companies include higher numbers of investors in their note rounds. In 2012, we saw a median of 10 investors per note round.
Interest Rates. The principal invested via convertible notes typically accrues simple interest. Interest rates range from the applicable federal rate (“AFR”), a minimum rate set by the IRS (usually around or below 1%), to the maximum rate allowable under the applicable state’s “usury” laws. In a strong majority of note deals, the interest rate falls in the range of 4% to 8%.
Conversion Discounts and Caps. Conversion discounts and conversion caps are “sweeteners” that reward early investors by granting them the right to convert their principal plus interest into equity at a reduced price relative to the purchase price paid by the new investors in the next equity round. Conversion discounts specifically provide for a percentage discount against the new equity round price. Our data shows that conversion discounts are typically 15% to 20%. Conversion caps, on the other hand, are ceilings on the value of the company for purposes of determining the conversion price. Caps protect a note investor’s stake from being swallowed up in the event of a sky-high pre-money valuation at the next equity round. Our survey data shows that the valuation caps were lower in 2010, but have remained steady at a median of $6 million for the last 2 years. We have also noticed that where investors are bullish on a company’s venture round valuation prospects, they are sometimes willing to forego a conversion discount.
Warrant Coverage. While more frequently used in the past as a sweetener in lieu of conversion discounts, warrants are no longer favored as a means of compensating the investors with additional equity. In 2011 and 2012, warrants were used in well below 5% of note deals.
Pre-VC round acquisitions have become a more common occurrence. In some cases, companies reach significant milestones with the larger amounts of money they have raised using notes. In other cases, companies fail to achieve traction despite a large note funding and need to find a “soft landing.” Unlike the control rights associated with equity investment, note investors almost always lack the contractual right to veto a sale of the company.
Seeking to capture upside and maintain more control of their destiny, note investors often want the option to convert their principal plus interest into equity upon an acquisition (in lieu of repayment of the note). Such conversion typically occurs at the conversion cap valuation or the fair market value of the equity implied by the acquisition. Investors have been increasingly demanding this optional conversion right.
Another sweetener upon an acquisition is the right to receive a premium on top of the principal plus interest. The premium is typically set at a multiple of the principal amount of the note. Change of control premiums are being used more frequently.
When is the note due and what happens upon maturity?
The maturity term for convertible notes (the “due date” for the loan) typically falls within the 12 to 18 months range. In practicality, note maturity is not a hard-and-fast “end of the line” for the company. Because most note investors are seeking the equity upside and do not invest for the purpose of earning interest income, they are often willing to extend the term of the note to give the company a longer runaway to reach a Series A round. Across our portfolio of company clients, we could not find any examples of note investors forcing a company into bankruptcy when the notes came due.
Along these lines, a note investor’s worst fear is NOT that they will lose the money they have invested. Instead, investors worry that the company will successfully use the note round proceeds, pay the investors back at the end of the note term, and then sell the company for $1 billion twelve months later. As a result, investors often want the right to convert their principal plus interest into equity upon maturity in lieu of repayment of the note. The trend is for more and more notes to allow for such optional conversion (into either Common Stock or Preferred Stock).
Other note terms
Convertible notes issued in seed rounds are almost always unsecured; and it is still quite unusual for a note investor to receive a board seat. “Most favored nations” clauses (MFNs) provide a note investor with a contractual guarantee that its note terms will be as good as any other note investor – even if the company raises a subsequent note round on better terms. In addition to providing for MFNs, side letters often give note investors rights associated with equity financings, such as information rights and preemptive rights. We are seeing investors asking for MFNs and side letters more frequently.
Median investment size has remained steady at between $1.5 million and $1.75 million. Pre-money valuations have been trending slightly higher, from $5 million in 2010 and 2011 to $6 million in 2012.
The phenomenon of “party rounds” is on the rise in equity rounds as well. In 2012, we saw a median of 8 investors per equity round.
The basic economic and control terms for seed equity rounds have remained fairly consistent over the last few years, with two notable exceptions:
- Investor Board Seats. We are seeing investors take board seats more often in seed equity rounds. 2011 and 2012 saw a significant jump from 2010 as investors are looking to assume a more hands-on role.
- Drag Along Rights. We are seeing more deals with drag along rights, whereby stockholders are forced in certain circumstances to approve a sale of the company. Overwhelmingly, these are “housekeeping drag-alongs” where the intention is to prevent smaller stockholders from holding up an acquisition.
Similar to acquisitions following a note round, we are seeing a number of acquisitions following equity seed rounds.
In reaching out to our company and investor clients, the overwhelming sentiment was that the seed financing market, particularly in Silicon Valley, remains hot (if not “too hot”).
1. The figures for the number of incubators or acclerators are all over the map. Xconomy put it at 64 incubators (http://www.xconomy.com/national/2011/08/10/xconomy-guide-to-venture-incubators-back-for-a-third-year-sixty-four-programs-strong/). Seed-DB has the number at 86 (http://www.seed-db.com/accelerators). In any event, we can all agree that there are A TON of incubator/accelerators out there!
We’d like to thank the entire Silicon Legal team for their input and assistance in making this report a reality. A special thank you goes out to Sarah Boulden, Brendan Herron, Mark Lim and Gaurav Mathur for getting us to the finish line! Finally, we’d like to thank Mike Maples of Floodgate Fund, Alex Le of Heyday, Sundeep Peechu of Felicis Ventures, Manu Kumar of K9 Ventures, Kevin Gao of Hyperink and Jay Shek of Centzy for sharing their invaluable insights.
This report is not intended, and should not be considered, as legal advice and there can be no assurance that the information provided herein is error-free. Neither Silicon Legal, nor any of its partners, associates, staff or agents shall have any liability for any information contained herein, including any errors or incompleteness.
Silicon Legal Strategy is the premier boutique law firm providing targeted, bottom-line-oriented advice to technology startups, innovative entrepreneurs and seasoned investors. Trained at the top firms in Silicon Valley, our attorneys and staff are incredibly passionate about technology and have extensive experience representing early stage companies and investors. We are a known quantity in Silicon Valley, and work with or sit across the table from every major law firm in the area. Perhaps most importantly, we ourselves are entrepreneurs. We truly understand the challenges of a startup — like building and motivating a team, creating repeatable processes to ensure continued customer satisfaction at scale and dealing with infrastructure issues. We face these challenges every day — and as a result, are able to deliver more relevant, bottom-line-oriented advice. Put simply, we actually “get” what entrepreneurs are going through. www.siliconlegal.com
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