What is Seed Money and How to get it for a Startup?
Statistics indicate that almost 29% of startups fail specifically due to a shortage of funds in the initial stages of their operations. The need for seed money for startups is undeniable.
Startup fundraising is an art. Successful startups are those who not only have a fantastic, marketable idea but are backed by an even better fundraiser who understands how to monetize the idea. In the initial stages, this responsibility lies solely with the founder. In this article, we will focus on understanding seed money for startups and explore the various sources available exclusively for seed funding.
Seed Money or Seed Funding
Starting with its inception right till an IPO, there are various stages to startup fundraising. The process is similar to watering a plant. The need, frequency, and quantity of water vary throughout the lifecycle of the plant. Seed money is considered to be the startup’s first step into the external world of fundraising.
What is seed money or Seed funding?
As the name implies, seed money is the ‘seed’ a startup requires for growth. Seed funding is usually raised after the startup has bootstrapped into the market. It is only when a startup has launched a viable product or service and gathered sufficient traction that founders prepare to raise seed funds.
Before inviting investors for seed money, the founder must be clear about the consequences. On one hand, these investors bring a wealth of unique business experience from their sectors that are crucial for a startup operation in the initial stages. On the other hand, parting with equity also means parting with a certain percentage of decision making power in the company. Such deals become mutually beneficial when all parties involved share clarity about the negotiated business terms.
Let’s take a deeper look into the importance of seed money for startups.
Why seed funding is important for startups?
Statistics indicate that almost 29% of startups fail specifically due to a shortage of funds in the initial stages of their operations. The need for seed money for startups is undeniable. The amount may vary with the nature of the product/service and industry of the startup. Nevertheless, founders must dedicate time and resources to raise the necessary seed funding. Here are the top reasons why the need for seed money for a startup cannot be negated:
- Working capital – At the seed stage, a startup is usually not in a position to generate revenues. Yet this is the stage when a rapidly growing business must invest in all channels necessary to establish the value of their product or service. This translates to investments in design, technology development, marketing team, MVP development, etc. Thus seed funding in this initial stage covers the looming issue of insufficient funds in the business.
- Strategic Partners – Seed funding investors are typically experienced, high net worth individuals who are looking to invest their earnings in profitable business. Alternatively, they could be investment firms that specialize in seed funding and work with multiple startups across various industries. Either way, inviting an investment partner on board for a startup adds to the business expertise. If the investor’s and founder’s vision are in sync, the startup is gifted with the necessary catalyst for rapid growth in the early stages.
- Competitive edge – The startup marketplace is highly competitive, so is the fundraising process. Hundreds of startups with brilliant ideas vie for a handful of investors to secure seed money. Finance being the foundation on which the growth and expansion of a startup will ride from the very early stages, securing the right source of seed funding is a competitive advantage. The one startup with a sufficient amount of funding will get ahead in the race, checking all the boxes for profitable growth.
It is thus evident that a startup must have a fundraising plan. Over the years, clear parameters have evolved that guide the stages of fundraising for startups. Investors look for these markers as well. Only those businesses that show a promising track record of organic growth and optimum utilization of investor funds are catapulted into further funding rounds. It all begins with the seed money stage. However, a founder must know when to start looking for seed money. Any unprepared, premature move can prove catastrophic for the business. We discuss this in detail in the next section.
When is the right time to raise seed money?
Seed money for startups is its first external funding round. It is only logical then for the founder to exhaust all internal or personal funding sources before stepping out. As mentioned in the earlier sections, pre-seed money is sourced by ‘bootstrapping’. This broadly includes the following strategies:
- Founder working part-time and investing personal capital in the startup
- Building a strong, skilled, and experienced founders team, mostly based on equity remuneration
- One founder donning multiple roles to cap expenses and curtail resources
- Outsourcing where necessary
Specifically, this translates into the following preparatory pointers:
- Company valuation – An early-stage startup must reach a point in the business where a professional valuation is possible. Though not much financial data is available at this point, professional business valuators use techniques specific to early-stage startups to arrive at a sensible valuation mostly based on its profit potential. Company valuation is the baseline for raising seed money for startups. Investors use this as a reference point to decide on their investments.
- Thorough business plan – Once the startup value is established, founders must draw up a detailed business plan. This is homework to determine how much money the startup needs for its next leg of operations. An impressive business plan comprises a detailed financial analysis, marketing strategies, and other relevant business reports that clarify how much money is being raised, for which purpose, and the expected ROI for seed funding investors.
- Equity share – Seed funding mostly happens in exchange for equity in the startup. Founders must understand the full implications of this before approaching investors. This most often entitles the investor to a seat among the board of directors so that they can directly guide and participate in the startup’s decision-making process. As the investor becomes a partner, they will have access to a lot of proprietary information of the company as well. Founders must be prepared for all of this.
- SEC requirements – Seed funding investors will consider a startup for funding only if their paperwork is in line with SEC guidelines. Hence founders must ensure that all documents are in place before approaching investors. Unavailability of the necessary documents might disqualify the startup from funding rounds.
Seed Funding Sources
Sources of seed funding are highly competitive. Founders must try to put their best foot forward. Most often they would get only one shot at pitching to a potential investor. Hence, precautions must be taken not to leave any aspects of the pitch to chance.
Here are some common sources to raise seed funds:
- Crowdfunding – If you have a reliable base of friends, family, and by luck a nascent group of early adopters for your product or service, crowdfunding can turn out to be a promising method for raising seed money. Many crowdfunding platforms such as AngelList, Kickstarter, Wefunder, and the likes are a great launchpad for startups looking for seed money investors. The sum raised can range from $500K to $10M. Some famous brands that have raised seed money on crowdfunding platforms are OculusRift, Pebble wearables, Exploride, etc.
- Friends and Family – They are the most reliable source of seed money for startups. When friends and family agree to invest, they are investing in you, the person they have known for long. As a founder, your integrity is on the line. Also most often these types of investors do not understand the nuances of investing in the same way as a professional investor would. Many times they might not charge any interest rates as well. Thus it falls on the founder to be as professional as possible, enable these ‘close’ contacts to understand and be part of the startup journey.
- Angel investors – ‘Angels’ are high net worth professionals who specifically invest in startups at their seed stage. They are well aware of the high risks involved in seed funding and makeup for it by demanding higher equity stakes in the company. Owing to their brilliant professional careers their association with a startup in the early stages is also beneficial from a mentorship point of view. These investors are true ‘angels’ as they support startups financially at a point when they have not started generating actual revenues.
- Micro venture capital firms – Venture capital is massive investments in the advanced stages of a startup. However, micro venture capital is for the seed stages. This does not make it any less competitive. In fact, micro VC firms are extra critical in evaluating proposals for seed money for startups. The startup must have an armored business plan with precise pitch decks that substantiate all aspects. Micro VCs by default demand very high equity in the startup in exchange for their sizable investments. Founders must engage legal counsel at this stage to negotiate the best terms of the deal.
- Accelerators and Incubators – As the startup culture continues to attract promising talent, certain mechanisms have developed over the years to support and nurture young founders to create maximum impact. Accelerators and incubators are among such platforms where a nascent startup is provided with the necessary support system such as workspace, mentorship, networking opportunities, and a seed fund so that they can work in a focused manner in collaboration with like-minded professionals. All applicants go through a screening process and the business ideas with the best potential are selected for accelerator/incubator programs. Most often, these programs are time-bound. However, there is one differentiating factor between accelerators and incubators. Incubators do not claim equity in exchange for seed money for startups. Accelerators do.
- Corporate seed funding – This category of seed money is provided by established companies. The idea behind large conglomerates such as Google, Intel nurturing startups is to facilitate innovations that might align with their vision. This creates promising opportunities for acquisitions. Corporate seed funding targets innovative startups that have a proven business model and intend to scale up soon. This source of seed funding works well for startups as they not only get access to the much-needed funds but great mentorship and networking opportunities that these business houses provide.
How much money should a startup raise in seed funding?
Startup funding should be based on milestones. This means that before starting to pitch for funds, founders should have a plan that helps them visualize the size of funds to be raised at various stages during the startup lifecycle. Thus the size of seed funding should be small, only to be increased organically over the years. From the investor’s point of view, this approach works as well owing to the nascent nature of the business. It is logical to invest larger funds only after the startup has started to generate revenues and gathered commendable traction among customers.
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Additionally, as mentioned in the previous sections, 409a valuation sets the tone to startup fundraising efforts. Startups are evaluated using methods like the Discounted Cash Flow, Venture Cap Method, and Market Comparables Method which consider a startup’s limitation in having real-time metrics. These methods focus on the startup’s future potential and that determines the value of its business in the present. With this metric as a base, both founders and investors arrive at a seed fund value.
On average seed money can be anywhere between $500K to $2M. Based on the type of business and the operating industry, once founders have clarity on the amount of seed fund they are seeking, the following points are to be considered before pitching to seed funding investors:
- Research the investor. Study their professional streak, previous investments, and relationship with partner companies. Approach only those investors whose credibility you are confident of.
- The timing of the seed fund is critical. Double-check how much money you are asking and for what period of operations. A simple way to approach this is to see how much money is needed for the startup to reach the next funding milestone. Typically founders cover 12 – 18 months of operations with seed funding.
- Study equity dilution very close. Though as a founder the startup is your baby, equity will be diluted with every round of investment starting right from the seed fund. When equity is shared, so is decision making power in the company. So 10 – 20% dilution with every round is a regular practice. Involve legal counsel before entering into any equity terms with investors.
Manage Your Company Investors and Shareholders on Eqvista
Seed funding is only the first step towards a startup’s interaction with the wider business machinery. With every funding round, a founder realizes that managing and distributing equity is a crucial element in stabilizing the financial integrity of a startup. This is not just towards investors; equity dealings are critical for employees as well, especially in startups.
Our expert team at Eqvista can help you manage all of this and much more. Eqvista is a one-stop solution for all your equity needs. Issuing and managing company shares have never been simpler. As an entrepreneur, you no longer have to worry about cumbersome paperwork or complicated scheduling. Register now! For further details about our services reach us today.