Term Sheet for Seed Round
This article focuses on the concept of seed money and how it is raised.
Investments are the lifeline of every startup business. No matter how brilliant an idea looks on paper, it will not succeed without the right funding approach. It is not just about the amount of money, but the source of this money matters too. Founders have a huge responsibility to navigate the crowd of investors and work with the right people. The seed round is the first formal investment drive of a startup beyond its personal assets.
Term Sheet for Seed Round
First time startup founders are usually on an exploratory path. They own a technically sound, scalable idea and are on a constant lookout as to how to turn it into a profitable business. Sufficient funds act as a backbone to this process. Startups are a high energy business environment. Even the most brilliant, scalable idea will fail if not supported with the right amount of money at the right stage. Term sheet for seed rounds ensures a quick and transparent funding process for early-stage startups. Before exploring the nuances of this document, it’s important to understand the concept of seed money.
What is seed round or seed funding?
It is a common practice for founders to pool their personal assets to start a business. If the fund is large enough, they can directly catapult the business into a Series A round. In most cases however, after the ‘bootstrapping’ stage, startups seek a seed round. As the name suggests, this money is intended to ‘seed’ a new business idea. Naturally, founders must approach a specific group of investors who have the vision to identify and nurture profitable ideas and support them with the necessary funds despite the risks of early-stage investments.
The ideal situation for a startup to approach seed investors is after they have a prototype. But based on the type of product/service, sometimes investors do support startups with seed funding to build a prototype. A standard seed money grant is about $250,000. Depending on the business idea, this can be more and sometimes even run into millions. The types of investors willing to seed startups are known as angel investors. These are high net worth individuals who have been serial entrepreneurs and are reputed industry mentors as well. They may operate alone or as a conglomerate Angel network.
Seed funding is mostly granted in the form of convertible notes or other forms of equity. Notes are preferred as founders need not part with company equity right away. But founders must always bear in mind that notes will eventually convert to equity. Therefore, they must have clarity about the extent of dilution. Normal practice is 10% to 20% dilution at this stage. Meanwhile, investors are rewarded with low valuation caps on notes for their early-stage risky investments.
A seed round is one of the most crucial stepping stones for a startup’s financial success. Though it is true that the startup does not have much to show in terms of operations and financial documents, founders must strive to showcase the current progress in the best ways possible. A lot of preparation needs to be done before facing investors for seed money. Some important aspects of being considered are:
- A good understanding of market potential and opportunities
- Clarity about business positioning, what does it intend to do (product/service)
- Well informed understanding of target audience
- Estimate of product/service adoption rate
- Alignment with investor ideas and goals
- Clear documentation of startup operations from the start
- A strong pitch deck with realistic projections of growth
Why do Startups need Seed Funding?
With the exception of a serial entrepreneur, most founders are learning the startup game one step at a time. They work under tremendous pressure to constantly innovate, source funds, mobilize resources, tap into the right networks, legal procedures, and everything required to keep a company together. It is a lot of work packed into very little time. Seed funding provides a breather in the initial stages. Founders can use these funds to get their act together before pitching for a Series A that demands convincing in-depth data from all aspects of a growing business. Seed money is needed to:
- Keep a startup afloat in its pre-revenue stages
- Enable a startup for early-stage market research and new product development
- Provide financial stability to a startup till the point it can generate its own capital
- Reduce chances of failure of a promising business idea owing to lack of funds
- Work with Angel investors and involve their expertise in the early stages of startup growth
Key Investment Terms in Seed Funding
Since it is the first formal fundraising attempt for startups, founders must be aware of the process and the various components of it. The four basic things to know are:
- SAFE – Otherwise known as the YC SAFE, these are standardized documents used extensively by startups for seed funding. Simple Agreement for Future Equity (SAFE) was created by the popular startup accelerator Y Combinator to accelerate the end-to-end fundraising process for startups and investors. Initially introduced as a pre-money SAFE, these have evolved to accommodate post-money versions as well. They are widely popular in seed investments because the only point to negotiate is the ‘valuation cap’. All other terms in the document are standardized.
- Valuation Cap – This is the value at which a convertible note becomes eligible to convert into equity. This is an important negotiating point for both investors and startups as they need to mutually agree on a practical value. The valuation cap is always calculated on pre-money. It protects investors’ interests and balances early-funding risks. At the same time, startups get some time in hand before engaging in a proper company valuation.
- Pre-money Valuation – Founders will come across this term often in the fundraising circuits. It simply means the value of a startup before new funds are granted. It is an important indicator for investment decisions as it projects the status-quo of a growing business.
- Post-money Valuation – As the name suggests, this is the valuation of a startup after new funds are granted. This is also an important indicator for investment profitability as investors get to know their actual shares in equity after the new seed funding is added to the entire valuation.
Types of Seed Funding
Seed funding is a challenging task. The number of funds to gather might be comparatively small, but the situation in which they are raised is a tough one. In the early stages of a startup, founders have to wear multiple hats to get a lot done with limited resources. The pressures of finding the right sources for the initial monetary boost adds on to this list of tasks. To give you a basic idea, here is a compilation of the popular sources of seed money:
- Crowdfunding – Crowdfunding is a form of open-source funding. This can work as a great platform for new businesses if managed well. It does not depend on professional investors. A startup idea is pitched to the public with details of how and where the funds would be utilized. The initial funders are usually friends and family. As the campaign picks momentum, it snowballs, attracting regular donors (individuals and small-scale institutions). There are more than 500 online platforms dedicated to crowdfunding seed money for startups.
- Corporate seed funds – These are big corporate brands with a specific fund allotted to nurture startups. They specifically target to invest in seed rounds. It works well for startups as their business already catches the eyes of industry leaders. Eventually, they might be acquired by the funding corporation or guided in the right direction to grow and expand on their own. The sponsoring corporation gains by having first rights over a potentially explosive idea and the talented resources supporting its growth.
- Incubators – Incubators are more than just funds. They essentially house a startup in-campus and provide them with the necessary funds to lift off the business. They support early-stage innovations. Founders will have a functional office space to operate from along with mentorship and networking opportunities. Incubator programs are normally time-bound and expect founders to scale milestones within this period.
- Accelerators – Accelerators are focused on training and mentorship programs designed for startups ready to scale their business. These programs extend for 2 to 3 months and drive a startup into a growth spurt. They always demand equity in exchange for a basic fund. The unique aspect of accelerators apart from seed funding is the ‘Demo Day’. After enabling a startup to create a scalable plan, accelerators help them pitch ideas to a group of investors. This paves further possibilities of raising funds from potential investors.
- Angel investors – Angels are HNIs (high net-worth individuals) with extensive industry experience. They either operate alone or in an angel network. Their investments are usually in terms of convertible notes or SAFE. Startups need not part with equity immediately, while a promise of equity helps mitigate risks of early investments. Angel investors are comparatively a quick source of funds as all decisions are individual-driven. Besides, most Angels are serial entrepreneurs and are a great source of industry knowledge for growing startups.
- Personal Savings – This is the most common form of seed money. Founders either invest their own or loan from friends and family. These are usually interest-free funds without a set timeline of return. Though founders may gain from this setup’s flexibility, miscommunication may sometimes affect personal relationships. Therefore, it is in the best interest of founders to treat these funds as professionally as possible.
- Debt Funding – Debt per se is a loan. In the context of startup seed funding, a business loan is granted by financial institutions such as banks. They carry high-interest rates and have an end date of return. The principal amount must be returned with accrued interests over the grant period. Debt funds do not trade in equity.
- Convertible Securities – Convertible notes are a classic example of convertible securities. At the time of grant, seed money is given as a loan. But after a ‘milestone’ event, it converts into equity. The advantage with these securities is that founders do not need to give equity right away and neither do they carry interest rates. Investors using convertible securities do not expect to receive their money back as it is. They gain only when the startup performs well and quickly scales the milestone event so that the notes convert to high-value equity.
- VC Funding – VCs are venture capitalists. Usually, they enter the funding cycle from the Series A round. The only chance when they would consider funding a seed round is when they see a profitable idea and an opportunity to lead future rounds once they enter early. Unlike Angels, VCs operate as a firm. They pool in all the money and ensure a strict due diligence process before funding a startup.
- Angel Funds or Angel Networks – These are groups of angel investors who come together to streamline the funding process of startups. These days, it is a popular trend as angel investors want to ensure their interests are well protected despite the risk of funding early-stage startups.
What is a Term Sheet?
Ever wondered how a seed money deal between an investor and a startup is finalized? A final funding contract is a legal document and involves certain costs to create. What happens when both parties are unclear about their deliverables or don’t agree on certain points and need to re-negotiate? The term sheet for the seed round plays an important role here.
Term sheets are a preliminary document exchanged between the two parties that lay out the basic terms and conditions of the funding deal. This document is not legally binding but is still an important official communication issued by an investor to inform them about their intent. Founders use this document to verify their terms and request further negotiations. In case discussions are not fruitful, both parties can walk out of the arrangement.
A seed round term sheet template is expected to cover three important aspects:
- Details of the amount and type of funding
- Clarity of Corporate governance
- Liquidation scenarios
Why do startups need a term sheet for seed rounds?
Understanding the concept of term sheets is important for founders. Since investors initiate this document, they will always design it to suit their needs. Founders must know what to expect and how to navigate difficult or unreasonable terms presented by investors. Some of the basic reasons for requiring a term sheet are:
- To commit to paper all verbal discussions during the seed money pitch.
- To protect startups from making mistakes in seed money terms before signing the final contract.
- To get a mutual agreement from both parties on the terms of seed investment.
- To provide both parties sufficient wriggle room to exit the arrangement in case the terms are not suitable.
Clauses that should be included in Term Sheet for Seed Round
Though a term sheet for seed round is a preliminary document, it must include certain specific points. These are pretty much standard across all variations. Missing any of these points would mean not clarifying the terms regarding that particular aspect, thus risking miscommunication between the investor and the founders. The clauses that can’t be skipped are:
- Who is issuing the note or stock – This point covers the details of the investor initiating the term sheet.
- The valuation – Knowledge of how much a startup is worth is important for deciding how much funds can be granted. Pre-money and post-money valuations matter at this stage.
- Amount being offered – This point covers the total funds being sanctioned. It must only mention which financial instruments are being used to sanction these funds and the type of stocks they would convert into.
- Shares and price – This clause informs about the expected number of share conversions and the corresponding price per share.
- What happens on liquidation or IPO – A startup will typically grow enough to enter an IPO if all goes well. In case the company does not perform well, it will face liquidation. Either way, these situations would change the status quo of investors. This section of the seed round term sheet template covers the terms that would govern both of these scenarios.
- Voting rights – Seed money is granted in exchange for equity. It could either be offered upfront or in the form of convertible securities that would convert to equity at a later stage. Either way, stock ownership is accompanied by voting rights, and the terms should be discussed well in advance.
- Board seats – Similar to voting rights, stock ownership, is accompanied by the right to board seats. This clause must set the expectations straight for both parties regarding the number of board seats that can be extended to investors.
- Conversion options – This is a clause concerning seed money granted in exchange for convertible securities. It details the events at which these securities would convert into equity.
- Anti-dilution provisions – This clause protects investor interests. It mentions scenarios and contingency plans for investor funds in case of premature dilution.
Priorities before getting term sheet for seed round
In the seed money stages, founders only learn to navigate the investment scene. At this stage, investors initiate the term sheet funding for seed round. The founder must prioritize their needs to ensure they get the best deal. To understand this better, the founder must reach out to people who have navigated this process earlier and learn from their experiences. Here are some pointers in that direction:
- Aim for a realistic valuation of your company – Seed-stage startups are valued based on their potential to grow and expand. Unlike mature businesses, early-stage startups do not have much to show on paper. Thus, investors use calculations such as the discounted cash flow method, the market comparables method, or the venture capital method to estimate the company’s real worth. Too high or too low valuations indicate wrong estimations.
- Know how much control you want to maintain – From a founder’s perspective, it is important to know the extent of business control they are willing to share in exchange for the seed money. Founders must never give in to the unreasonable demands of investors.
- Determine what terms are deal breakers – Founders are in dire need of funds in the seed stages, but they must draw boundaries. Before setting out to seek funds, founders must discuss their limits with the team and agree on certain deal-breakers. The common points of concern are:
- Seed round and all further investment rounds will call for dilution. Founders should know how much dilution they can afford at each stage.
- Similar to dilution, valuation is another aspect that will expand organically with new funds. It is best to keep the valuation on the lower side in the early-stages.
- Commitment from investors is the next in line for consideration. Seed money might be comparatively small in value but fuels a startup for a considerable time. Thus parties interested to associate with startups in the early stages must be willing to standby the growing phase of the business.
- Startups must know their limits with terms of agreements involved in debt finance and convertible securities.
- Get multiple term sheets if possible – Seed money grants extensively use convertible securities that offer the flexibility of varying terms. Founders can engage multiple investors on terms differing on valuation caps, discounts, and interest rates. Acquiring multiple term sheets works in favor of young founders.
Advantages of having term sheet for Seed round
Seed stage funding is risky at both ends. On one hand, founders don’t want to give away more than what they can afford. However, investors don’t want to be in a position where their money will be at a higher risk than necessary. This is why the term sheet for seed rounds is absolutely necessary. Their primary advantages are:
- Opens a safe space for discussion between investors and investee.
- Provides time to both parties to reflect on the terms and initiate further negotiations.
- Establishes a clear intent between investors and the founders. This document initiates a formal relationship between both parties.
- It saves the cost of documentation and the processes involved in unnecessary edits.
- It is not legally binding. If the terms are not agreeable, this document enables both parties to exit the arrangement without any legal implications.
Seed Round Term Sheet Templates and Examples
Over the years, seed money term sheets have become standardized across industries. Some of the popular templates are:
- Kindrik Partners – They are a unique seed fund specialized in helping founders source close friends and family funds. This template is a simple, easy to use format that founders can use to approach close family and friends to support their growing business.
- Gust Series – Gust is a powerful seed funding platform that powers more than 90% of Angel investment networks in the US. Their seed round term sheet template is a simple to use standard one and easily accessed by budding entrepreneurs.
- Y Combinator – Y Combinator’s term sheet template is one of the most popular ones. This has evolved from YC’s years of extensive experience in nurturing startups and accelerating their early stages of growth. It is a single-page document with just the right amount of information for a preliminary term sheet.
Record your term sheet for a seed round in Eqvista!
Documentation is an important aspect of startup operations. It is best to get it right and organized from the start to avoid paying penalties or getting wrapped up in litigation. Eqvista is a one-stop platform for all equity management needs for growing startups. Read more about our services and for further information, reach us today!