Seed Round - Explained
What is a Seed Round?
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Table of ContentsWhat is a Seed Round?Methods of Raising Seed Funds?Common StockPreferred StockConvertible NoteSimple Agreement for Future Equity (SAFE)Benefits of Seed Fundraising
What is a Seed Round?
Startups need capital to get the business off the ground and to reach critical stages of growth. Early-stage investment capital is commonly referred to as seed capital. The idea is that this capital meets the early growth needs, similar to a seed transitioning into a plant. Seed financing is commonly raised from friends and family, angel investors (or angel groups), or venture capital funds dedicated to seed investments. While they hope to turn a profit, friends and family often invest in the company out of a sense of obligation to support a loved one. Angel investors, on the other hand, are wealthy individuals who invest personal funds in a company with the hopes of capitalizing when the company undergoes a later equity financing round. Angel groups are able to bring together two or more angels to share the work in identifying investment prospects, negotiating the investment, undertaking due diligence, and consummating the deal. Seed funds are managed by professional venture capitalists. These individuals may seek a return on the seed investment at a future equity funding round.
Seed funding deals generally range from a few thousand dollars invested by friends and family to $5 million dollars invested by a venture capital fund. The size of a seed investment will depend upon the nature of the company (growth potential) and the type of investor.
Below we discuss the methods of seed funding and the benefits and detriments of each method.
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Methods of Raising Seed Funds?
Seed investments involve investors providing funds in exchange for an ownership interest in the company. The mechanics and timing of the seed investment vary considerably. The most common mechanisms are as follows:
Common stock is the most basic form of ownership of the company. Stock is ownership of a corporation. If the company is not a corporation, the investors may receive a similar form of basic ownership interest. This puts the investors on equal rights with existing owners. The difficulty in this transaction is to negotiate a company valuation. The valuation will dictate what percentage of the company ownership the investors will receive in the deal. Friends and family investors will generally be willing to accept common stock in exchange for their investment funds.
Preferred stock provides preferential rights to the holder above common stock. The types of preferences include dividend preferences, liquidation preferences, conversion rights, anti-dilution protections, voting preferences, dedicated board seats, preemption rights, redemption rights, participation rights, registration rights, etc.
Many investors seek to avoid the difficulties associated with negotiating the terms of preferred stock. Instead, the company will issue a debt instrument to the investors. The debt instrument will provide for an interest rate and time of repayment. More importantly, however, the instrument will provide for the right to convert the note into a form of preferred equity. The right to convert generally occurs whenever the company goes through a future equity financing round. The holder of the note can convert the value of the note into the same value of preferred equity being sold in the financing round. This approach piggy backs on the expertise of the later investors in negotiating the terms of the preferred equity. Additionally, it avoids much of the costs associated with negotiation, contracts, and due diligence. The convertible note generally places a maximum or “cap” on the future valuation of the company. This makes certain that note holder will pay the same or less than the future investors for the same equity. Further, some convertible notes afford the holder a discount on the future valuation of the company. This allows the note to convert into amount of the note into preferred equity at a discounted rate.
Simple Agreement for Future Equity (SAFE)
A SAFE is very similar in nature to a convertible note. Instead of a debt instrument, the investors may seek the option to purchase equity shares at the time of a future round of financing. Rather than converting a debt instrument, the SAFE is very similar to a warrant or option to purchase. Otherwise, the SAFE works very similarly to a convertible note. It piggy backs on the valuation and negotiation expertise of future investors. Also, the SAFE might provide for a cap on valuation and a discount on the purchase price.
Benefits of Seed Fundraising
As previously stated, capital funding is the life blood of a growth-based startup. These companies will burn all available funds to produce the desired or potential growth. The idea is that growth of recurring revenue is worth far more than cost of that growth. At some point in the future, the company will be able to reduce growth expenses and produce a profit from the substantial revenue. This is why investors seek to cash out of a deal at some future equity round. The company may not become profitable for some time. Often, growth-based companies produce extensive revenue but are still unprofitable when ultimately acquired by another company or sold in a public offering.
Seed funding is the best option when the company cannot meet its growth potential through operational revenue or personal investment of owners. While seed funding can meet the companies needs when debt or funding from operations is unavailable, entrepreneurs are advised to avoid seeking equity investment if achieving the desired growth is at all possible without it. Seed investment generally dilutes existing ownership interests by about 15-25%. Companies should be wary of raising seed funds at a valuation that requires selling more than 25% of the company. Remember, the founder’s ownership interest will continue to be diluted through future equity rounds. Few entrepreneurs relish the idea of losing such a substantial percentage of the company they are building.