A colleague sent me an article entitled, “You Don’t Need A Prototype to Raise a Seed Round” (http://techcrunch.com/2012/09/30/you-dont-need-a-prototype-to-raise-a-seed-round/). And recently, an entrepreneur approached me describing his product – but no prototype – and the financial need of $1 million capital with the product to be completed in 18 months. My colleague, a software entrepreneur, did not agree with the article because he has witnessed first-hand startup teams that raised seed capital and were not able to execute.
My reply to this observation is that it depends. From having to be part
of a team that had been raising capital and be on the other side listening to pitches with a VC firm, I discovered that one has to break down the components that define the risk for the seed round: the dollar amount, the team, and the time frame to deliver an alpha or beta prototype. Each component defines the risks and by adding them, then you see the likelihood for raising the seed capital with or without the prototype. And if you can understand the rationale behind each component, then you increase your chances to raising that seed capital without the prototype.
First, in reverse order, I look at the time frame. To me in a world of startups and fluctuating markets, 18 months to deliver a product seems like infinity. VC firms have about 7 years to begin to deliver results to the limited partners. That means that in the perspective of a VC fund, they are very anxious to see results quickly in their portfolio. 18 months represent 22% of that time frame. That means that the portfolio company better start rolling and making remarkable results in 5.5 years.
Early this year, I wrote an Internet business plan that had the same seed funding criteria – 18 months and capital needs of over $1 million. The potential seed investors suggested that if they invested $250,000, what could be delivered as a prototype in 3-4 months? Of course, I parsed the plan demonstrating the deliverable given the capital infusion of only $250k. I also reduced the annual salaries, including my own to fit the 3 month window. Out of necessity, I was able to carve out some prototype or deliverable to fit the criteria. After the 5 year plan was tailored into a 3-4 month plan, we were able to raise $300k seed capital.
But what the counter-offer demonstrated was that the investors were concerned about the size of the investment of $1 million and the duration to deliver a final prototype. They addressed the investors’ universal concerns as to investment risk: time and capital. By reducing those two risks, they addressed indirectly the execution/team risks. By implication, if after 4 months the startup was not able to deliver something, then there is something wrong with the team or the product. I totally agree on this perception.
Let us look at the $1 million for 18 months. Depending on the size of the team, that seems to be considerable amount of money for seed funding. However, it is a well known tenet, that a seed investor undergoes the same due diligence costs and time for $250k investment as a $1 million one. In other words, startups should never ask for less than $1 million from a professional seed investor as the response will be to get that type of funding from friends and family. However, I do believe that 18 months is stretching the patience of any investor. A year can maybe work. But 18 months can represent 6 quarters of monthly board meetings without presenting a solid product. 18 months will test the investors’ patience.
The size of the seed has an impact on the necessity of a prototype. Several years ago, I met once a startup management team where the company had a patent for a wireless product. Unfortunately, the CEO claimed that he needed $10 million seed money. Once I heard that, I stated that the company needed a working prototype for that size seed. Intuitively, I thought that the dollar amount was too high to rely on the execution risk even for a patented product. They were not able to build a prototype and never did raise $10 million.
Then there is the team. In a world where people begin being entrepreneurs in their teens, there is no rigid roadmap to gauge a team and its execution skills outside of the initial due diligence meetings. However, I do believe that VC funds do look at the resumes which include the work experience and schools. And like any other employer, that is how VC funds measure the quality of a team. Look at where VC managing directors attended grad schools: Harvard, Wharton, etc. I find it hard to believe that seed investors do not consider schooling as part of the evaluation process of the team. And of course, the remaining pedigree relates to the work experience – where and what was accomplished. When I hear that seed investors really likes a team, I doubt that it means that their opinion mostly relates to personalities — although it is a factor. Since money is involved, I would not be surprised that if a statistical survey of what constitutes a likable team would ever be made, the notable success from previous employers of known companies and academics play a substantial role.
This leaves the very important issue of what constitutes a prototype. I worked in previous startups and I had to define in words what a “prototype” should be with the engineers. This step-by-step, prototype definition process was critically important for funding since the investors need to memorialize in their investment paperwork how and when something is being delivered for each investment tranche. Having both legal and business experience, I found that this verbal definition challenging to close funding. Nonetheless I was able to carve out different versions of a prototype during a time frame acceptable to the investors and the management team. It would begin with an alpha prototype version and a timeline exiting at a commercial working version. But it proves that a prototype is a progressive animal and different versions can be delivered within a year. And to have a “prototype” ready quickly does reduce the cost of capital. (Note that I have not mentioned a patent, but if the prototype is the type of product that merits a patent, it behooves having a least a provisional patent prior to raising the seed. It does help in reducing capital costs.)
In conclusion, I have noted that a startup can raise seed capital without a prototype. But I suggest delivering early versions as soon as possible to reduce the costs of capital. I also recommend for the company to expedite delivery of the final version in order to make the investors comfortable. And be aware that your team’s experience and background might have an impact on raising the seed funding. Look at the various components and tailor them in such a fashion to attract the seed funding.