It’s nearly impossible to look at an acorn and accurately determine whether it will establish roots and if it does how big the oak tree will be. Startup ventures are basically the little seeds (acorns) that need financial husbandry (water) to grow into large and healthy businesses (oak trees).
Companies are founded on a hypothesis for something entirely new or something existing that could be done differently (i.e. better, faster, cheaper, etc.). Either way, it takes seed money to put these hypotheses to the test and achieve successful results.
What is Seed Money?
Seed money is broadly defined as the first early-stage financing of an idea, business, experiment, or project where the outcome is untested and unknown. Notice the definition of seed money doesn’t include the word “investment.” This is because in nearly all cases, seed money isn’t an investment; seed money is speculation.
In some cases, seed money is provided by visionary angel investors or friends and family of the founder, but in many cases, seed money comes from the founders themselves. This doesn’t mean you necessarily need to be wealthy to have the seed money for a new venture. To raise seed money for Apple, Steve Jobs sold his VW bus for $750.
You might be scratching your head asking how to get seed money to start a business without having to sell your car. In this article, we cover the various instruments that can be used when raising seed money and how you can source said money for your early-stage startup.
How to Raise Seed Money
First-time entrepreneurs and fundraisers will often assume that when they raise money, they should be selling equity. When raising seed money, however, selling debt could be a better path. We’ll discuss the nuances and reasons for choosing each. But first, let’s dig into what a seed round is and how that round typically takes shape.
What is a Seed Round?
In our piece on startup funding rounds, we mention that the seed round is one of the first investments from more sophisticated, institutional investors. This has not always been the case. Historically seed money was raised from what we like to call the Three “Fs”: founders, friends and families.
As the venture and startup ecosystem has become increasingly more sophisticated, seed rounds have become more important and more money is being invested. In 2020, for example, the average seed round was between $1-2 million.
Sometimes called convertible notes or convertible loans, convertible debt is when a company raises debt financing that the investor can convert to equity at the next round of funding. A convertible debt agreement may or may not include a discount rate, warrants, or a cap on valuation.
The reasons a company may want to raise convertible debt include:
- Reduced transaction costs associated with fundraising.
- Less dilution if the company is worth more in the future.
Investors might want to buy convertible debt because they want to get in on a round but don’t want to run the risk of losing the investment to disagreements over valuation. Convertible debt assures this conversation will occur at the next priced round of funding. In the event of a liquidation or dissolution, debt is senior to equity and will therefore be paid back first.
A convertible note is a debt instrument and does carry a maturity date and interest rate. If the maturity date arrives and the note has not converted to equity (i.e. a priced round has not occurred) the value of the note must be paid back at the agreed upon interest rate. If the investor is interested in postponing the maturity date, changes to the agreement can be made.
Equity-based financing is the process of raising funding through the sale of shares in the business. The general definition of equity is the quality of being fair and impartial. This actually applies well to businesses because no matter how large the company, the equity will always add up to 100%.
If more shares are issued, this doesn’t mean that people now own 110% of a business. Instead, the existing shareholders are diluted in their ownership.
When you raise seed money from investors, for example, you and your co-founder who owned equal shares of the company (50/50) will become diluted by the third equal partner (for simplicity’s sake) to 33.3% each.
As the capitalization table (list of a business’ shareholders) grows, the existing shareholders will be diluted in order to bring in new financing. The decision whether to raise equity or debt financing is important and can have long-term implications for the life of the company.
You might now be asking yourself, should I sell debt or equity to raise seed money? This can be answered with a little bit of modeling and a simple calculation:
For example, if you estimate your share price to be $1 today and plan to raise convertible debt at a 25% discount rate:
$1 / (1 – 0.25)
= $1.33 / share
Your company will need to raise the next funding round at or above the projected share price of $1.33 for the debt round to make financial sense, otherwise, it would be more advantageous to raise equity.
The startup investing acronym SAFE stands for “Simple Agreement for Future Equity.” Introduced in 2013 as an alternative to convertible notes by the famed startup accelerator, Y-Combinator. The SAFE is a single document with no maturity date or interest rate and therefore limits legal fees.
When an investor provides seed money using a SAFE, they receive the right to equity ownership in a future priced round. This allows for the valuation negotiating onus to be passed on to future institutional investors. Usually, but not always, the SAFE will have a valuation cap that the equity will convert in the next priced round.
Since there is no maturity date or interest rate, the only point of negotiation is the valuation cap or conversion discount. Once this is agreed upon and the SAFE is signed, the money is wired, and the deal is done — it’s as simple as the acronym proposes.
Where to Get Seed Money
The size of seed round you plan to raise will determine where your seed money will come from. Traditionally, venture capitalists invest large amounts of money in later stages of a company’s lifecycle.
Angel investors, on the other hand, often invest in pre-seed stages of the company. If you are seeking seed money in the $1 million range, there are a few likely candidates for your investors.
Super Angels & Angel Syndicates
While the average angel investor is more emotion-driven than data-driven in their strategy, some successful angel investors become more and more sophisticated in their strategies and go on to raise a small institutional fund.
Backed by their LP investors, many super angels are equipped with the resources to write seed funding checks in the million-dollar range.
Angel syndicates allow individual investors to invest alongside the lead angel investor deal-by-deal. Instead of investing in the general fund, investors with limited capital can still help fill out the investment round of companies they support.
Much like how super angels are closing the gap between the investment size of traditional angels and VCs, there are also Micro VC funds that invest in the seed stage which is earlier than usual for a VC.
There are VC funds, like First Round Capital, that invest in just that – the first round. First Round only invests in early seed stage companies and will not invest in Series B or later.
Similar to the syndicate discussion above, individual investors can now participate in funding rounds (either debt or equity) via crowdfunding. Equity crowdfunding, for example, allows companies to raise capital from numerous either accredited or non-accredited investors.
Crowdfunding platforms leverage network effects to make them extremely efficient sources of funding from a wide variety of investors. This passes the leverage onto the entrepreneurs who are able to more effectively raise funding without as much time and attention as previously required.
Sow Your Seed Round
Now it’s time to put in the work and make the tough decisions. Raising the right amount to survive until the next round of funding or profitability is one of those tough decisions and unfortunately, it’s also timely.
If you are ready to raise your seed round, use EquityNet’s sophisticated engine for driving business funding to your business. Use EquityNet’s toolbox of calculators, business plan optimization tools, and patented technology can help you stand out to the thousands of investors actively looking to participate in the next funding round.