An Entrepreneur’s Guide to Seed Funding
Bootstrapping (self-funding) a company to success happens, but it’s rare. Most companies need to raise capital in order to grow and move towards profitability. The funds raised can help the company hire a team, launch their product, expand into new territories and provide a safety net for unexpected events. As the name suggests, seed funding is a very early stage in startup funding rounds, and provides the capital for startups to grow from ideas into revenue-generating businesses.
What is seed funding?
Seed funding is the first formal round of funding startups raise before going into a Series A, B, and C and beyond. In other words, it’s the first official stage where investors give capital to a startup in exchange for a stake in the company.
This early financing is often raised around the credibility of your business ideas and your promise as a founder, unlike later funding rounds, which are more dependent on revenue, profitability, and the finances of your business model. According to Fundz, startups raised around $2.2 million on average in seed money in 2020.
When should you raise seed money?
If your startup doesn’t yet meet requirements or qualify for bank loans, seed funding could provide the financial support you need to get your idea off the ground. At this point, most companies have raised around $10,000 to $150,000 prior to raising their seed round in what is known as “pre-seed funding” or the “friends and family” round. That initial pre-seed funding is often used to get the business off the ground and get operations set up.
The larger seed round is used to fund market research, initial hiring, and product development (such as the creation of a prototype). Companies can choose to raise their seed funding at a variety of different stages. For example, at StartEngine, we recommend companies to apply to raise their seed round when they have less than $3 million annual recurring revenue (ARR).
Most companies raising seed funding are valued at somewhere between $3 and $6 million, according to Investopedia.
Who invests seed money?
The seed funding round is often the first funding round where you will take on outside investors that you aren’t already acquainted with (whereas the pre-seed round often comes from friends, family, and those in your circle). These outside investors can come from several different sources.
Angel investors are a common source of seed money (as Lighter Capital points out, they’re even sometimes referred to as seed investors), as they tend to be high net worth individuals who seek out riskier investments. Sometimes angel investors also band together in angel networks that invest as a group.
Institutional investors like venture capital firms (VCs) can also invest seed money, although they generally perform more diligence than is typical of a seed round. However, they often require startups to have already monetized their business model before they make any sort of investment. At the seed stage, it’s not uncommon for the business to be pre-revenue.
You can also find seed funding money at an incubator or accelerator, which, in addition to providing money, might provide office space and networking opportunities.
And of course, founders can also use equity crowdfunding platforms like StartEngine. On StartEngine, both seed and pre-seed funding rounds are akin to Regulation Crowdfunding (Reg CF).
Why do investors invest seed money?
Investors usually take part in seed funding in the form of equity or convertible note (more on this below). There are risks and a lot of unknowns when it comes to investing at the seed stage, and for this very reason, investors who get in at the seed phase can reap higher returns, because the price per share is likely to be lower the earlier they invest in a business (and thus have a higher upside if the company grows and does well).
Despite the risks, there have been some successful seed funding investments to date. Perhaps most notably, in 2004, angel investor Peter Thiel made a $500,000 investment into Facebook for a 10.2% stake and a place on the board, and in the 2010s, after the social network went public, Thiel sold most of his shares to the tune of $1 billion.
Seed Funding Financing Options
In order to raise money, you’ll have to give up something of value: a form of ownership in your business. There are numerous ways to give your investors a stake in your startup, including preferred stock, common stock, convertible notes, and SAFE notes.
Stock, or equity, represents a fraction of ownership of your company, and you can choose to issue common or preferred stock in your seed round.
As a founder, you’ll usually have common stock in your business. Shareholders who own common stock will receive dividends and have proportional voting rights on stockholder matters (like the election of the board of directors), but will be the last ones to be paid in the event of liquidation or acquisition. Most companies raising their seed round on StartEngine issue common stock.
However, seed investors (particularly angel and VC investors) often favor preferred stock, because, as the name suggests, it gives them a preferred position among other shareholders in the event of liquidation or acquisition (meaning they will be paid out before common shareholders, but after debt holders).
At the seed phase, when investors aren’t sure if you’ll be able to get your company off the ground, this is particularly attractive. Preferred stock can also come with attractive protections for investors, such as anti-dilution clauses that will protect the percentage stake the investor has in your company in future funding rounds—though these clauses can damage the amount of equity the founders have in the company in the future.
An alternative to equity is the convertible note, which is essentially a debt instrument that converts into a specified type of stock down the line (most often during the next funding round). Convertible notes allow you to put off valuing your company to a point in the future, which is popular with founders who are worried that they’ll value their companies incorrectly before they know what it’s really worth.
To make them attractive to investors, convertible notes often come with interest rates, so that investors earn interest until the maturity date of the note (typically two years), at which point the principal loan and accrued interest are repaid in cash if the company has not raised another funding round to trigger the note’s conversion into equity. Note: at StartEngine, convertible notes don’t convert into cash after the maturity date — they become equity, often in the form of common stock.
And finally, the SAFE note, which was invented in 2013 by startup accelerator Y Combinator, serves as a standardized form of convertible note, with no maturity date or interest rates. This is a popular type of security in seed funding rounds, but for the investor, there’s a chance SAFE notes never convert, especially if you don’t raise another funding round. In fact, we don’t allow SAFE notes at StartEngine for that reason because we don’t believe the instrument is suitable for everyday investors.
What do investors look for in a seed funding round?
Investors tend to perform less due diligence at the seed funding stage. The reason for that is simple. The company often lacks the financial and user data to allow for that in-depth analysis. Instead, investors look at the founders, the initial team they’ve built, and the idea behind the business.
That being said, you should still come to the table with a thorough business plan that evaluates your market and where your product fits into it, as well as how much money you will need in the next 18 months. Ideally, you’ll be able to show investors how you’ll build your product for wider distribution and highlight early feedback from customers to demonstrate that your business is solving a problem. Though some companies raise seed rounds without any product on the market and are able to raise on the promise of the idea or the background of the founders alone.
How much money can you raise through seed funding?
A startup’s seed funding round can range from $100,000 to $5,000,000 (and sometimes even higher). Today, the average seed round is $2.2M, but that figure has been slowly climbing over the years.
Though the amount of money raised through seed funding can vary significantly, the amount is generally less than that which is invested in a Series A and later funding rounds. For context, the average Series A round in 2020 was $16.2M.
How much should you raise in a seed round?
As with all equity funding, there’s a tradeoff: the amount of funds you raise in a seed round is proportional to how much of your company you give away. As Y Combinator points out, in an ideal situation, you’d give up less than 10% of your company while still proceeding to Series A, but most rounds require 20% dilution, and some require up to 25%.
Your goal should be to raise enough funding (generally enough to fund 12-18 months of operations) to reach a growth milestone in your company that will unlock the next round of capital.
Seed funding is crucial for startups looking to establish themselves as revenue-generating businesses. This is the capital by which the ‘seed’ of an idea becomes a business. Seed funding on StartEngine through Regulation Crowdfunding lets your startup fuel its growth and expansion. Get started today.