Chapter #2(021): Understanding the Funding Landscape
By: Max Marine
Tags: Seed Investment, Venture Capital, Entrepreneurship, Israel, Startup Lessons

Last year we discussed the characteristics, advantages, and disadvantages of different funding sources in Israel. With 2020 in the rearview mirror, I’m happy to share our latest thoughts in Israel’s ever-evolving funding landscape. If you missed Chapter #1, “Do I need Venture Capital and how much should I Raise”, you can find it here!

If only the Israeli funding landscape was this beautiful

The early stage funding landscape has shifted dramatically in the past few years. Most of Israel’s “super angels” stopped making new investments and a cluster of pre-seed-only funds emerged. Equity crowdfunding platforms gave international investors access to start-ups on a deal-by-deal basis, while donation-based crowdfunding platforms gave entrepreneurs a channel to convince consumers to fund R&D costs. Decentralized finance built on blockchain technology made waves in 2017 and continues to mature as another crowdfunding alternative to traditional venture capital.

Larger funds began including pre-seed and seed in the definition of “multi-stage”. Dedicated post-seed funds sprung up to help extend runway for companies that needed extra time to show more business proof for Series A. U.S. funds, which historically waited for Israeli companies to set-up a U.S. headquarters before investing, dropped the requirement and became more comfortable deploying capital with less U.S. traction. Clearly there’s a lot to unpack here.

Israel is maturing as an ecosystem

Israeli start-ups have proven they can go all the way. At least 40 of them are worth more than $1b, and Israel has firmly cemented its brand not just a hub for innovation and technology, but as an exporter of global category leaders. At the same time, large tech companies like Amazon, Facebook, Microsoft, and Google have expanded their Israeli presence and increased the premium for talent, while fewer start-ups are being created than at any point in the last ten years.

Unsurprisingly, more funds, fewer start-ups, and increased competition for talent has translated to larger rounds at higher prices and start-ups getting VC attention / funding that wouldn’t have made the cut a few years ago. Furthermore, US funds have started to invest in Israeli companies earlier (though rarely at the Seed stage), with several additional later-stage funds setting up local offices in the past year. Beyond that, COVID-19 has further leveled the playing field for Israeli founders to have Series A conversations with US funds over Zoom.

In addition to the current oversupply of capital, fear of losing an outlier to US Funds may also explain why Israel’s multi-stage funds are both lowering the bar for large seed rounds (traditionally reserved for an exclusive club of serial entrepreneurs), and for the A round (many companies have raised with limited revenue, or no revenue), despite US funds doing the opposite! It seems that Israeli funds are increasingly desperate to get in early, and are willing to take on unrewarded risk to do so.

Is Seed a Phase?

In recent years, a handful of VCs have come out of the woodwork to say that “Seed is now a phase”. In 2018, Hunter Walk wrote “For Fundraising, Seed is No Longer a Round, It’s a Phase”. The emergence of more than 20 new funds spanning pre-seed, seed, and post-seed in the past few years supports this view. However, given that seed rounds can now be larger than Series A rounds and the required metrics for Series A can range from a successful pilot to $2m in ARR, it increasingly seems like there are only two stages of a company’s life: pre-inflection and post-inflection.

Before you hit an inflection point, you still need to tell a story, i.e. package incomplete business data in a convincing way. During the time period between 0 and Inflection, you may need to raise anywhere from 1 round to 10 rounds and $1m to $100m, depending on the unique attributes of your business and target market. When you hit an inflection point, you’ll have developed a system that can profitably acquire new and upsell existing customers/users. The more profitable this system, the more your company will be worth, and the faster you’ll be pushed by every later-stage fund and their grandmother to take more capital. Rather than thinking of seed as a phase, think about pre-inflection as a phase, and build your fundraising plan to reach inflection.

Funding Sources for Israeli Startups

Before you build the plan, it helps to understand what type of ownership each type of investor seeks, how good their reputations are among other entrepreneurs and later-stage investors, and how much control they’ll want over key decisions such as hiring, budgeting, selling the company, and future financings.

Each time you fundraise, ask yourself — how will this change the incentive structure of the company, and will the net impact be positive? Properly aligned incentives increase the probability that your company will succeed. When it comes to raising capital at the early stages, giving away too much of your company too early may make future investors afraid that you lack the economic incentive to take the company the distance.

Below you’ll find brief descriptions of the various funding sources in Israel, their investment size and ownership target ranges, as well as the impact they can have on your ability to fundraise in later stages.

The Israel Innovation Authority

(Previously known as the Office of the Chief Scientist/OCS)

The IIA provides non-dilutive funding from the Israeli government that can help you cross the riskiest phase of your startup. This funding will come with conditions, such as a requirement for matching funds, keeping your IP in Israel, paying a revenue royalty, and/or paying an exit fee.

IIA funding is viewed positively by VCs, assuming they are the ones doing the matching. Often incubators (discussed below) are the ones who do the matching, giving them a significant amount of equity in the company for a small check. Before you find a “match,” you must understand the conditions of the IIA’s offer and make sure it is within industry standard ranges, or you may have a deal that’s too risky for the next investor to swallow.

Make sure you explore the various programs and conditions thoroughly, rather than taking the first shiny deal that looks reasonable. The IIA is notoriously inconsistent with their decision making timelines, so always have other options in hand.

Incubators

Incubators are a source of high dilution funding, often leaving the founders with 60–75% of the company. VCs may consider incubators as a negative signal for any company that doesn’t have extremely interesting IP. That’s because it will be harder to align economic incentives when the founders have given up such a significant part of the company but still have limited commercial traction. Furthermore, if the incubator has a Micro VC attached to it, and that Micro VC passes on your seed round, this could also send a negative signal to other investors.

On the flip side, some incubators have an expertise, domain, technology, and/or access to initial design partners that can significantly reduce the cost of R&D and/or securing your first pilot. Sometimes the value-add of the incubator justifies high dilution, but judge each situation independently and do your due diligence before accepting an offer.

Accelerators

Accelerators provide low dilution funding, often leaving founders with 90–95% of the company in exchange for $50,000-$120,000. Israeli VCs usually see acceleration as a positive signal if the accelerator is based abroad. There are also some highly respected Israel-based accelerators, but it’s important to do your homework by checking with other entrepreneurs who have graduated and hearing about their experiences.

Professional Angels

Moderately dilutive funding, often leaving founders with 80%-95% of the company in exchange for $50,000-$500,000. If the angel/angels provide significant value and have a great reputation (check with entrepreneurs from their existing investments), then it’s completely worth it, especially in cases where angel reputation sends a positive signal to VCs for the next round.

In the past few years, Israel’s traditional super angels have either scaled back their investment activity preferring to focus on operating and advising their existing portfolios rather than deploying new funds, or leveraged their brand to raise their own VC funds. In parallel, a cohort of founders & senior employees at Israeli unicorns have started to quietly invest in their friends directly and alongside pre-seed & seed funds.

Private Investors

Private investors offer moderately dilutive funding, often leaving founders with 70–90% of their company in exchange for $250,000-$2 million. In this case, these investors are not professionally investing in startups, but are more opportunistic. They may come from your target market, have synergistic business interests with your startup, or want to diversify their holdings into tech.

While taking money from targeted business professionals can provide an advantage, taking money from less experienced “diversifiers” may decrease the likelihood that a VC will invest in your company. VCs, in general, don’t like to deal with investors who aren’t accustomed to the types of situations early-stage companies face , such as pivots, illiquidity, bridge rounds, uprounds, and a variety of documents that need to be processed quickly in order to effect changes in economics, control, and/or governance. Unless this private investor has given your company a clear competitive advantage, it is likely to be seen as a negative.

Holding Companies

Extremely high dilution funding, often leaving founders with 10–50% of the company. In this case, founders are incubating a company within an existing service provider or holding company, and leveraging their resources to access customers and/or accelerate R&D. VCs and Micro VCs dislike these types of deals, because they require a complex and often emotional dance to rebalance the cap table and realign incentives, as well as all sorts of potential IP complications.

If you are starting a company within another company, the chances of getting VC funding for your seed round are close to zero. That doesn’t mean it’s a bad decision, but you should be aware that it limits your potential for raising venture capital.

Donation-Based Crowdfunding Platforms (DCPs)

Non-dilutive funding, essentially allowing you to finance your development costs with prepayments from your early adopters. Very low risk, but increasingly challenging to break through the competitive noise which requires upfront capital to attract the attention of the crowd. In addition, DCPs are not a reliable fundraising channel for B2B or software products, as they tend to focus mostly on consumer hardware.

Equity Crowdfunding Platforms (ECPs)

Moderately dilutive funding, often leaving founders with 75%–90% of their company in exchange for $250,000-$2.5 million. In this case, you are dealing with an online intermediary that is investing on behalf of a group of accredited investors. In some cases, the platforms have committed capital that allows for full or partial financial commitment to founders. In other cases, the platforms need to run a marketing campaign to their investor community to secure all or some of the capital, meaning that you lack visibility into the timing and amount of funding you will receive.

ECPs can have a positive impact on your business, because their audiences may serve as a marketing channel. Similar to DCPs, consumer-facing businesses that raise funds from ECPs immediately get their product/service in front of potentially thousands of users as part of the fundraising process. B2B, B2G, and B2D businesses have lower synergy with the ECP’s investor community, but with the right algorithms or analysts, matching with a helpful investor in the ECP community can accelerate your progress in a number of ways.

ECPs can lead rounds or follow rounds, depending on their investment philosophy. Like all other funding sources, make sure to speak to other entrepreneurs and get feedback before you sign any documents.

Strategic/ Corporate Investors

Low dilution funding, often leaving founders with 90–95% of their company in exchange for $500,000-$1 million. In the seed rounds, it’s unusual for corporate VCs to participate, as usually the traction threshold is too low and check sizes too small for them to pass it through their investment committees.

There are some exceptions to this rule of thumb, but if you do include a corporate investor in your seed round, aim to have two, with each less than 5% ownership, and be very careful with the rights you provide them. This way neither strategic has control or influence over key board decisions. Do your homework to understand if having their name in your cap table may cause issues with your target customers or future acquirers.

Pre-Seed Funds

Moderately dilutive funding, often leaving founders with 80–95% of their company in exchange for $250,000-$500,000. In this case, you are dealing with professional investors who are investing both their personal capital and a potentially a group of external investors (Limited Partners). If it’s a new fund and has a small portfolio , do your diligence by checking the resumes of the partners, and through your mutual LinkedIn connections.

There are a couple of reasons to raise a pre-seed before raising your seed, or skipping to the A. One, you try to raise your seed and get rejected. Two, you can prove out any significant assumption about your team, tech, product, market, go-to-market, and/or business model that only requires $250k-$500k but significantly reduces risk. This proof may allow you to raise your next round faster than if you had bootstrapped your way to the same achievement. It may also allow you to raise at better terms, from better investors, than if you had fundraised without first validating one or more assumptions.

Seed-Stage Funds

Moderately dilutive funding, often leaving founders with 70–85% of their company in exchange for $500,000-$2.5 million. In this case, you are dealing with professional investors who are primarily investing on behalf of a meaningful number of external investors (Limited Partners) and leading seed rounds. There are only a handful of seed funds in Israel that have been around for more than a few years, so again, do your homework by speaking to founders who they’ve invested in previously, to make sure you are partnering with funds who will be there for you in both good times and bad.

Multi-Stage Funds

High dilution funding, often leaving founders with 60–80% of their company in exchange for $2-$8 million. In this case, you are dealing with professional investors who are primarily investing on behalf of a meaningful number of external investors (limited partners), leading A rounds, and sometimes, B, C, and further rounds. However, in the last two years, as A rounds have become more competitive and expensive, many of these traditional A players have moved upstream to buy less expensive equity. In addition, a number of funds identify as “Seed and A” round investors, further blurring the distinction between Multi-Stage and Seed-Stage.

Raising seed from Multi-Stage Funds is generally more challenging, since these funds have to deploy a lot of capital. Generally, they want deals where they can invest at least $5 million, if not more. In addition, they have the flexibility to wait 12–18 months and pay a higher price in the next round, at potentially much lower risk. Seed funds, in contrast, have a dedicated focus to seed, which means there can be a greater urgency and speed of process.

Signaling and Future Financing Risk

If a Multi-Stage Fund leads the seed round, but doesn’t lead the A, it could signal one of two things to future investors. First, the fund may have enough ownership to satisfy their return expectations, and doesn’t want to have too much control over the company, as this may make it harder for a new VC to feel comfortable joining the board or working with the company. Alternatively, it’s possible that the VC isn’t excited enough about the company’s prospects to lead the A round. Since VC is a game of outliers with a power law, the winning strategy is to go all-in on the one or two winners, which would logically require the VC to lead the A if the company was the “one,” or “two” in the fund. Unfortunately, at the A stage it’s still very difficult to estimate a company’s future performance, so sometimes the VC could choose to lead the A in one of the losers, and fail to lead the A in one of the winners.

Either way, having a VC lead your seed but not your A may present a negative signal that you’ll need to overcome in order to secure follow-on funding. This could create a suboptimal outcome for the company ; either raising money from a lower quality investor, or closing up shop.

Traditional VCs may also have less experience guiding seed entrepreneurs to the A round , because historically they would wait until the company achieved relevant business traction before evaluating them. Unlike seed funds which live and breathe the chasm between seed and A rounds, and have hopefully learned a few lessons that they can share with their portfolio, multi-stage funds that are new to the seed-stage may share theoretical advice that makes sense, rather than practical advice that has been derived from watching their seed investments evolve. If you raise from a seed fund, then you have the flexibility to fundraise from any multi-stage fund. If you raise from a multi-stage fund, you may limit your options for the A.

Setting a low bar for round A will impact your ability to raise future funds. You may rejoice when you get an early term sheet for your round A from an Israeli investor even though the revenue you generate is not yet at the level of, say, a US Silicon-Valley based VC. However, when it’s time to raise your B round, you might find that the gap between your achievements and the industry standard increased to a level that severely limits your funding options, perhaps even to the point of requiring a down-round.

On the flip side, if you need time to pivot or you have a longer than expected sales cycle, your financial projections will crumble pretty quickly and you’ll need an additional infusion of capital. Multi-stage funds have more financial patience and can provide healthy bridge rounds, presuming they believe in you. Seed funds, by definition, have less money, which makes them less generous in bridge situations.

Post-Seed Funds

Speaking of additional infusions of capital, a number of moderately dilutive funds have sprung up in the last few years that are willing to invest between $1-$3m in between seed & A for 10–20% of your business. In this case, you are dealing with professional investors who are primarily investing on behalf of a meaningful number of external investors (limited partners), and will invest in a range of scenarios, from helping your company avoid bankruptcy to pleading with you to let them into your cap table because your seed round was oversubscribed.

Leaders vs. Followers

In most cases, your seed round will consist of a lead investor who takes a board seat and a majority of the round, and a combination of followers — other funds, angels, and/or strategics. Make sure to understand the preexisting relationships between the different personalities around the table. The last thing you want is to have two investors in the round who have a prior conflict, as this will cause dysfunction at the board level and/or in strategic decision making. Usually, discussing the round construction with the lead investor will help you gain clarity on the types of co-investors they prefer. Also, keep in mind that most funds are open to either following or co-investing, depending on the situation, so make sure to understand each investor’s policy before engaging in the investment process.

Designing Your Fundraising Plan

Whether you decide to raise a pre-seed & a post-seed, an angel investment and seed round, a jumbo seed and pre-A bridge, or go through an incubator, accelerator, and holding company before raising your A round, the choice is yours. Convincing a fund to actually lead your seed round, however, is not. In order to improve your chances of securing a lead, the next chapter outlines the VC organizational structure and how it’s evolving alongside this changing funding landscape.

This concludes chapter 2 of the new 2021 ebook. We will post the next chapter soon, be sure to follow looltalk to get it!