What is Seed Capital or a “Seed Round” financing?
The initial capital used to launch a business is sometimes referred to as “seed round” capital.
Often provided by founders or friends and family of the founders, this capital is among the highest risk and potentially highest return capital. Their investment is more likely driven by a relationship with the founders and not a knowledge of the business, unless the founders incorporate “friends” who are in the same industry as the founders or who know the industry.
In the past few years, “Seed Round” financing has actually become more structured and recognized as a critical step in the lifecycle of many start-ups. “Angel investors” or “super-angel investors” have become active investors in this level of financing. Angel investors are high-net-worth individuals outside of a personal network who invest in risky startup ventures and they have become an integral component of the start-up environment. Frequently these angel investors organize into formal or informal networks that pursue similar opportunities, share risks of investment opportunities, and enjoy each other. Super-Angel investors are angel investors who have investing in early-stage companies as a full time vocation. They back accelerators.
Smart start-ups seeking Seed Capital recognize that they may need to include angels or super-angels in their decision structure – either formally as a member of a board of directors or board of advisors or informally as a mentor.
How much in funds do start-ups raise in a Seed Capital Round?
It depends on the deal – from $5,000 to $1,000,000.
How do they raise these funds?
While some accelerators are developing alternative future equity investment documents, start-ups primarily issue common stock, convertible promissory notes, or preferred capital stock (sometimes “Series Seed Preferred Stock”).
Common Stock: The base form of ownership in the company held by the Founders so that Seed Capital Investors and the Founders are “side-by-side” meaning they have equal rights in all respects. This likely only happens when the Seed Capital investors are family and close friends, who are likely investing in the Founders more than the company.
Convertible Notes: When a start-up is on a financing path that contemplates future rounds of financing, a convertible note may be the most appropriate financing vehicle. A convertible note allows an investor to provide capital, but the investor and the company defer decisions related to equity. Founders need to understand that they are issuing an investment document is part debt and part equity. More importantly, for purposes of securities laws, it is a security and federal and state securities laws must be reviewed.
As a debt instrument, a convertible note has a principal balance, an annual rate of interest, a repayment process, including a maturity date, and, as a debt instrument, it is a creditor’s document receiving payment in front of the equity holders if there is a liquidation of assets.
As an ownership interest document, the convertible note will convert into equity of the company under certain conditions such as the closing of a future round of financing, the closing of a sale of the company, or the maturity date (if the holder wants to voluntarily convert). Although a rare event, sometimes, the holder will voluntarily convert when the company has started generating cash flow and does not need another round of private financing.
Each of these conversion events should be contemplated by the convertible note and the economics of those conversion prices should be established in the documents.
Series Seed Preferred Stock: Preferred stock is a class of capital stock issued by a company that provides the holder of such capital stock priority in certain specified economic terms and certain specified governing terms. For example, a preferred stock holder might have the right to a priority of return of capital or dividend or a preferred stock holder might have a specific right to elect a member of the Board of Directors of the company. A “Series Seed Preferred Stock” is intended to be a simple investment document, however, the simplicity must be documented. The investors in a Series Seed Preferred Stock have a liquidation preference in front of the Common Stock (meaning if there is a cash distribution, the holders of the Series Seed get their money first) and they have certain unique (or priority) voting rights such as approving certain significant corporate actions.
If you would like more information on funding a new business, check out our Getting Started Checklists: Raising Capital and Start-Up Equity.
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