Seed Financing Report
December 2, 2014
A decade ago, 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 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 1990’s. New entrepreneurs are taking the plunge every day, all over the country (and really, all over the world). The challenges that these entrepreneurs face are incredibly unique. These founders are taking “bet the company” risks everyday as they hire their first employees, attempt to find and close commercial partners and raise capital. Resources are limited, competition is intense and decisions around how to structure early stage financings often have repercussions as the company scales. In our prior report, “Seed Financing: Three Years in Startup Land” we looked at trends in the very early stage seed funding market from 2010 through 20121. In examining nearly 300 deals over a three year period, our data revealed an interesting dichotomy: very founder favorable economic terms, combined with stronger attempts from investors to maintain negative control.
Now that we are nearly a decade into the seed funding trend, it feels like the seed financing market has matured. Founders and Investors are more opinionated than ever about the market2. The dust has settled and the market has had a genuine opportunity to process and understand the implications of various economic terms and deal structures. We have noticed some subtle trends over the last seven quarters that evidence this maturation of the market and the heightened sophistication of its players.
As with our prior endeavor, this report speaks to those on the very early end of the startup life cycle – and provides entrepreneurs and investors with a deeper look at the seed funding market. Other venture finance reports focus on later stage financings (Series A and beyond). Silicon Legal has been in a unique position in that over the past 5 years, we have emerged as an incredibly active firm (and without question the most active boutique firm) in this very early stage seed funding space. We are once again aiming to deliver the authoritative report.
This report analyzes seed financing trends from the first quarter of 2013 through the end of the third quarter of 2014. We examined 203 rounds of seed financing during that period for software and digital media/internet companies based in the San Francisco Bay Area, Los Angeles, Seattle and New York 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, equity or SAFE financing or of up to $3,000,000 that is 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 the emerging companies. As in our prior report, the big challenge in interpreting this data is that while deal terms exhibit certain statistical trends, navigating the venture capital financing market is still more art than science (especially at the seed stage). There are countless examples of “outlier” transactions – and trying to put the specifics of a deal into perspective by looking at “comps” can be frustrating. The reality is that while a “market” is set for most financing deal terms, everything is negotiable. In a vibrant fundraising environment, sometimes it feels like “anything goes” if the deal is a hot one!
In our prior report, we posited that while the economic terms of seed financing rounds were founder favorable, certain market forces were driving seed investors to seek additional control and stronger downside protection.
We have seen that phenomenon continue to manifest itself in 2013 and 2014. Economic terms in seed financing (particularly equity round valuations and debt valuation caps) continue to trend more founder favorable, but seed investors still want control and downside protection. More to the point, what we have been witnessing over the last seven quarters is a fundraising environment where seed investors are behaving more and more like later stage institutional investors. Seed investors are asking for more than just control and downside protection. They are fighting hard for the right to participate alongside larger funds in later rounds – and they feel more comfortable investing anew in startups with a few rounds under their belts.
A great deal of attention has been given to the phenomenon of larger venture capital funds investing early, starting special seed funds or “scout funds3”. The prevailing notion is that by dipping their toes in the seed round, these larger funds gain an “option” to invest over the long term. Such early involvement by more mature institutional funds (often with more “institutionalized” investment theses, processes and ownership requirements) has led to stronger demands around preemptive or “pro rata” rights in seed deals – even in convertible note rounds, where investors now want the opportunity not just to convert into equity, but also to invest new money.
Companies have been amenable to giving pro rata rights to larger, lead investors in seed rounds. Recently, however, smaller funds and investors have been seeking pro rata rights – and they are fairly vocal about it4. Smaller investors are seeing their portfolio companies raise more and more capital – through new round after new round – and they are cognizant of the fact that their smaller stakes have the potential to be swallowed up, particularly as startups close additional later stage financing and further delay IPO or exit. In a hits-driven investing game, owning less than 1% of a startup at exit time is typically just not that attractive.
In 2013 and 2014, we have seen pro rata rights in 93% of equity deals and 22% of convertible deals. The notion of investors requiring pro rata rights has even “institutionalized” itself in Y-Combinator’s new SAFE documents – where the default provisions promise seed investors pro rata rights under the next equity financing documents, regardless of investment amount.
With more contractual pro rata rights being handed out to smaller (but now more well-capitalized)
investors, we are seeing smaller funds getting into larger deals later in the life cycle in order to protect their stake. Over the last seven quarters, however, we have been seeing a rather unexpected trend – seed investors making their FIRST investment in a company after it has closed one or more financing rounds. Looking at our raw investor side data over this time period, we found that 41% of the number of deals by pure “seed” funds were in post-seed rounds. 21% of those post-seed rounds were the investor’s first dollars into the company. We compared this to the raw data from our prior report covering 2010 through 2012, and the differences were significant. During that 3 year period, 36% of the number of deals by pure “seed” funds were in post-seed rounds, but just 9% of those post-seed rounds were the investor’s first dollars into the company.
What’s driving this? We think that a few factors are at play here:
- A growing trend toward contractual pro rata rights for seed investors, along with increased appetite and ability of seed investors to participate. Seed stage investors have been raising larger funds5 and have enough “dry powder” to provide financial support deeper into the life cycle.
- Quicker limited partner fundraising cycles. More use of the “dry powder” inevitably creates a need for the fund to go out and raise another fund. The faster fundraising cycles probably create a desire to “spruce up” their list of portfolio companies with some later stage, well-known startups.
- The presence of more valuable later stage startups (as companies further delay going public).
Later stage companies have been fairly receptive to allowing the smaller investors to participate. We have seen more willingness to “leave room for the angels” – even in Series B and C rounds.
In December 2013, Y-Combinator unveiled a new form of seed investment – the “Simple Agreement for Future Equity,” or “SAFE” for short. Its intended purpose was to deliver the benefits of convertible debt without any of the drawbacks. More precisely, SAFEs are convertible into equity at a next round of funding and in connection with an acquisition. Like a convertible note, SAFEs can have a valuation cap (or be uncapped). However, SAFEs are not debt instruments – they do not accrue interest and do not have a “due date.”
Although it has yet to gain widespread acceptance (we have seen it in less than 5% of seed deals thus far in 2014) – the SAFE is gaining momentum as an alternative when a company wants to raise a seed round as quickly as possible.
We discussed the “party round” phenomenon in our last report – and the trend is still alive
and well. Our data shows the number of investors participating in seed rounds increasing to a median of 11 investors per debt round and 9 investors per equity round in 2014 – and in several instances, companies have packed more than 20 investors into a round. Anecdotally, entrepreneurs do seem to now understand the headaches that can be involved in mass-syndication of a round, namely that the company (and often its lawyers) must spend a lot of time answering investor questions, vetting numerous side letters and chasing down multiple signatures. Platforms like AngelList have enabled founders to round up large groups of investors quickly and have gone a long way to alleviate the pain point of “herding cats.” AngelList introduced its “Syndicates” program in October 2013, enabling smaller angels to syndicate a group of investors through a single investment vehicle. Startups can now bring dozens of investors into a round without creating administrative hassles or ending up with an overcrowded capitalization table.
Our last report also touched on the acqui-hire trend. Also known as “talent acquisitions,” acqui-hires are acquisition 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. The proceeds to investors in the target companies are 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’s stock.
Silicon Legal advised buyers and sellers in 35 acquihires between Q1 2013 and Q3 2014. This was an annualized uptick from our prior 2010-2012 report. More interesting than the larger number of acqui-hires, however, was the emergence of a novel structure to streamline these deals. Traditionally, acqui-hires had been structured as asset purchase transactions. Unlike acquisitions via merger or stock purchase, the asset purchase structure allows the buyer of a startup to avoid acquiring any of the startup’s liabilities. Regardless, there is still some level of legal due diligence involved in closing an asset purchase. The acquiror needs to make sure that it is not acquiring any troubled or infringing assets – and even though liabilities are typically not acquired, the acquiror is always cognizant of the fact that future litigants would be more inclined to come after a deep-pocketed acquiror.
In 2013, a new, leaner acqui-hire structure rose to prominence: the “Release and Waiver.” In short, the acquiror and target enter into an agreement providing for the following:
- Target company receives some cash or equity consideration;
- Certain or all of target company’s employees promise to enter into employment agreements
with the acquiror;
- Target company releases the acquiror from any liabilities and agrees to indemnify acquiror;
- Target company grants to acquiror a non-exclusive license to all or certain of its assets; and
- Target company distributes the proceeds from the deal to the target company’s preferred holders, and the release and indemnification obligations transfer to stockholders receiving distributions.
Beyond form docs or the SAFE, this may be one of the better innovations to have emerged in venture law in recent years. The structure provides the acquiror with the talent it needs and allows the entrepreneurs to proclaim an “exit.” The deal involves significantly less legal due diligence and closes much more quickly. Just ask the law firms of acquirors who have utilized the Release and Waiver about how the streamlined deal structure has impacted legal fees for acqui-hires!
Our survey data shows a continuing increase in the size of convertible note rounds.
- Amounts raised in convertible note rounds are on the rise – the median convertible note raise in 2014 was $950,000, up from $820,000 in 2013.
- Valuation caps for the convertible notes are trending more favorably for companies. The median valuation cap for convertible notes in 2013 was $6,000,000 and $7,000,000 in 2014.
- The continuation of “party rounds” — where companies round up numerous investors to participate in financings – is confirmed by our survey data. The median number of investors participating in note rounds was 10 in 2013 and 11 in 2014. In several instances, companies raised note rounds with more than 20 investors participating.
- A quarter of all notes rounds in 2014 included preemptive (pro rata) rights for investors.
The terms for equity financing rounds have remained relatively stable and founder-friendly.
- Pre-money valuations continue to increase — median in 2013 was $7,250,000 and median in 2014 was $7,500,000.
- From a control perspective, we saw investors taking board seats more often. In 2013, investors took board seats in 90% of equity seed rounds; in 2014, investors took board seats in 92% of seed equity deals.
- Investors got preemptive (pro rata) rights in 91% of 2013 seed equity deals and 95% of 2014 seed equity deals.
The terms for SAFE financing rounds have remained fairly consistent.
- Amounts raised in SAFE rounds are lower than convertible note rounds – the median SAFE raise in 2014 was $500,000.
- The median valuation cap for SAFEs in 2014 was $5,000,000.
- Investors were promised the grant of preemptive (pro rata) rights in the next round in 89%
of SAFE rounds.
The amount of money raised by companies using convertible notes continues to grow, with the median raise this year of $950,000. This was a significant increase from our prior report where we saw a median note raise in 2012 of $725,000.
There continues to be a steady increase in the number of companies raising more than $1,000,000 using convertible notes. A majority of companies have raised at least $500,000 in their note rounds.
The phenomenon of “party rounds” is holding steady as companies include higher numbers of investors in their note rounds. In 2014, we saw a median of 11 investors per note round. In several instances, companies raised multiple note round tranches with more than 20 investors participating in total.
Interest Rates. The principal invested via convertible notes typically accrues simple interest. Interest rates range from the applicable federal rate (“AFR”), a rate minimum 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 round price. Our data shows that conversion discount is typically 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 have steadily increased to a median of $7 million in 2014 (we saw a median of $6 million in 2012). 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 2013 and 2014, warrants were used in less than 2% of note deals.
Pre-equity 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 others, 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 over 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 (or some discount thereof). Investors are 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 still not the norm, but they 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 a 12 to 24 month 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).
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. Investors are increasingly asking for the right to invest additional capital in subsequent rounds.
Median investment size has remained steady at between $1.5 million and $2.0 million, which is consistent with the size of rounds since 2010.
Pre-money valuations have been trending higher, from a median $7.25 million in 2013 to a median of $7.5 million in 2014. The median pre-money valuation in 2012 was $6 million.
The phenomenon of “party rounds” persists in equity rounds as well. In 2014, we have seen a median of 9 investors per equity round.
The trend over the last few years has been for the investors to ask for the same bundle of basic economic and control rights that are typically a part of “Series A” rounds. In particular:
Investor Board Seats. We are seeing investors take board seats in a vast majority of seed equity deals as investors look to assume a more hands-on role.
Pro Rata Rights. All or at least a subset of investors were given the right to invest additional capital in subsequent rounds in more than 90% of seed equity deals. Often, the company will set a minimum investment threshold that must be met in order for investors to enjoy pro rata rights. However, we are seeing more and more seed deals where ALL investors in the round are receiving pro rata rights. Further, where thresholds are set, they are trending lower.
Simple agreement for future equity “SAFEs” are intended to be a simpler alternative to convertible notes and do not have as many terms to negotiate. For example, since a SAFE is not a debt instrument, it does not have a maturity date or accrue interest.
Investment Amount. The amount of capital raised using SAFEs has been lower than amounts raised under convertible notes, with the median raise this year of $500,000.
Number of Investors. The phenomenon of “party rounds” persists with SAFEs as well, although the median of 7 investors is lower than that for convertible note rounds.
Valuation Cap. The median valuation cap of $5,000,000 is also lower than that for convertible note rounds. We suspect that startups are using SAFEs even earlier in a company’s life cycle.
Price Discount. A vast majority of deals included a 20% conversion discount.
Change of Control. While all deals allowed for conversion upon a change of control, a majority did not include a change of control premium.
Preemptive Rights. As consistent with seed note and equity deals, most SAFE deals include a promise to grant preemptive rights in the next equity round.
MFN. Most Favored Nation provisions require amendment of the SAFE if the company subsequently issues SAFEs with more favorable terms to other investors. MFNs provisions are typically only included in deals with no discount or valuation cap.
Seed continues to be a hot hot hot area of the market. There are an estimated 150 seed funds in existence today and for the entrepreneur that means they have a ton of choices. I do worry about rounds without any seed investor taking a lead role but have found that I really enjoy collaborating with many seed investors who actively look to help their entrepreneurs especially when things are not just up and to the right. That said, it’s the stage of investing where you get to witness the greatest changes in the business and the establishment of product-market fit and I don’t think I’d invest at any other stage!
– Ann Miura-Ko, Floodgate Fund
Declining CapEx costs and new programming languages continue to enable entrepreneurs to accomplish more with less and push the bar higher for the benchmarks needed to raise a Series A. At the same time, increased access to capital at the Seed stage and this higher Series A bar is both increasing the size of Seed rounds, as well as driving upward pressure on valuations. This is contributing to the increasing gap between companies seeking Series A funding and those writing Series A checks.
– Noah Lichtenstein, Cowboy Ventures
Seed capital is more widely available than ever before. The flipside is that investors expect entrepreneurs to achieve more with less money and obtain strong market validation before committing to the Series A. Ultimately, this is more capital efficient and lets investors place more bets on the table. The flipside to the flipside is that fewer companies will be able to bridge the between Series Seed and the next round.
– Tim Harris, Swift Navigation
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, Sapna Mithani and Courtney Parmer, as well as Victoria Martinez of Diosa Designs for getting us to the finish line! Finally, we’d like to thank Tim Harris of Swift Navigation, Ann Miura-Ko of Floodgate Fund and Noah Lichtenstein of Cowboy Ventures for sharing their invaluable insights.
Disclaimer: 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.
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