A Guide to Micro Seed Funding

 

Disadvantage: A Low Valuation

The standard pre-money valuation of a company accepted into Y Combinator is $250,000 ($15,000 raised for a 6% equity stake).  By some measures, this seems like a very low valuation, especially when compared to angel and venture capital deals.  Wilson Sonsini reports that the median Series A pre-money valuation was $6.0 million in 2006.  However, the companies receiving these valuations are already established and are likely growing at a fast pace with a solid team in place.

Conversely, the vast majority of applicants to a micro seed funding program are first time entrepreneurs, generally young and inexperienced, who do not have a developed product.  Due to this, investment into their company involves significant risk that is accounted for in the lowered valuation.  This seems like a valid point; however, not all YC companies are equivalent in terms of the talent of the team or quality of the idea.  Thus, a group of founders might conclude that Y Combinator is not providing them a fair valuation.  

At this point, they have a few different potential options:

Bootstrap the business using personal money or credit cards
In this scenario, the founders maintain full control of the company and can grow the product and user base before raising capital.  If and when they do raise money from an external source, they can more easily argue for a better valuation than they would have received previously.  However, this option involves personal financial risk, where as raising money from an outside source doesn’t involve any.  

Attempt to raise money from friends and/or family members
Raising money from family and friends can be quick and easy, depending on the legal paperwork involved.  The main problem, however, is that since the money is coming from a close source, the entrepreneurs will feel responsible if it is lost.  

Attempt to raise money from angels
There are a lot of considerations involved if raising money from an angel investor or venture capitalist.  Companies applying for micro seed funding are in a completely different league than those receiving venture capital.  Angels, however, might be a good match for early stage companies that are more advanced than your average Y Combinator applicant.  Entrepreneurs can potentially raise more money for the same or lower level of equity dilution from an angel, given a higher valuation.  One downside is that the money raising process can take many weeks to months, particularly as the lawyers negotiate and the deal terms are finalized.  This time might be better spent focusing on the business.  The legal costs of closing the round can also add up to dozens of thousands of dollars.

Convertible notes are becoming a popular way to raise money from angels because they get around many of the downsides mentioned above.  These notes function as debt to the company, which converts to equity in the company when a Series A round occurs, usually at a discount to the Series A valuation or at a capped level previously agreed upon.  These agreements are fairly standard, thus lowering the legal costs of obtaining angel money, and are fair for both the entrepreneur and investor if properly structured.  

Raising money from a connected angel investor provides many of the same benefits as Y Combinator funding does, and potentially a better valuation.  However, bootstrapping or raising money from friends and family is not nearly as appealing because the company misses the opportunity to take advantage of the many benefits offered by YC.  This might mean the difference between success and failure of the startup.  It’s usually one or the other, and it makes most sense to maximize the company’s chances for success even if it involves sacrificing some personal equity.


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