What is Seed Capital?
Seed capital refers to the starting capital needed to fund a startup’s launch. Sourcing seed capital is the earliest stage of capital raising and occurs before the business is even established. Seed capital will fund the initial steps in building the business such as developing a proof of concept or prototype, business planning, market research, product development, equipment, marketing, and operating costs such as hiring staff, renting an office, patent costs or legal fees.
Looking to source seed capital for your startup? Here’s what you need to know.
What are the sources of seed capital?
Investing in an unproven startup can be a risky investment for investors which is why sourcing seed capital can be challenging for entrepreneurs. In its early stages, a startup may not even have developed its product or service, or have a reputation in the market, let alone be able to prove that the concept will generate revenue and be profitable.
Typically venture capitalists and financial institutions won’t fund startups in their infancy. Instead, seed capital may be sourced from family, friends, the entrepreneur’s personal network or through angel investors. An angel investor is a person or company who is willing to invest in startups either through a one-off investment or through ongoing funding to guide the business through its early stages. It’s a high risk, high reward investment. If the startup does extremely well, the investor can multiply their investment many times over. For the entrepreneur, sourcing angel investment will generally be the goal as it will usually provide a higher amount of capital than friends or family can offer.
Following the seed stage, an established startup may move to sourcing venture capital, private equity or getting finance via a bank.
Different types of seed capital
When you borrow money for seed capital, there needs to be a structure in place to determine whether and when the investment will be repaid and how, whether interest will be accrued, or whether the capital will be accepted in return for equity. In the case of borrowing from friends or family, the arrangement may be more flexible, however when borrowing from an angel investor it will be more structured.
In the case of angel investment, there are two types of seed investments – convertible debt financing and convertible equity financing. While both will convert the debt to equity at a later time, the process in how this is achieved varies.
Convertible debt financing
In this case, the investor will be issued with a convertible note which will automatically convert to equity at a later time, usually at the closing of a Series A funding round. Instead of receiving the invested money back with interest, the investor will receive a share of the business at that time.
The convertible note will cover the principal amount, interest rate and maturity date (i.e. when the interest must be repaid) as well as the cap (maximum effective valuation that the owner will pay).
One of the benefits of this approach is that the startup doesn’t need to be valued from the outset. Instead the valuation will occur during the Series A round of financing. By this stage it’s much easier to achieve an accurate valuation. The value of the investor’s share is then determined at this point in time. It’s also a speedy investment option which can be turned around in a matter of weeks rather than months.
The disadvantages are that this approach can leave the startup financially vulnerable. If the startup does not raise a Series A funding round before the maturity date (usually 12-24 months) then they will need to repay the loan with interest. If the startup is unable to repay the loan it can become insolvent.
Convertible equity financing
In this case, the investor is issued with a convertible security or share in the business. Similar to convertible debt financing, convertible equity investment converts to equity at a later time. Usually, the investor will be given an up to 20% stake in the company in return for their investment.
While this can be a more complex structure which takes more time to establish, it has the benefit of being equity not debt, which means it doesn’t have to be repaid and doesn’t accrue interest. Entrepreneurs don’t need to worry about the possibility of default. However, given the challenges of accurately valuing a business before it is established, there is the risk it will be undervalued which can dilute the value of the founder’s share.
Two types of convertible equity financing instruments are commonly used for seed investments: SAFE (Simple Agreement for Future Equity) and KISS (Keep It Simple Security). Both are short documents which contain the basic terms of the investment, helping both parties avoid a long and onerous negotiation process.
How to calculate how much seed capital is required
The more funding you’re given, the more equity you’ll need to give away or the more debt you’ll need to pay back, so it’s important to not get too greedy when it comes to calculating what capital is required.
As a starting point, you’ll need to calculate your runway. Runway refers to how many months or years your business will survive on funding until new capital can be raised. The longer the runway, the more equity you will need to give away. Typically startups will look at a 12-18 month runway which is usually enough time to hit the required milestones.
Calculating your runway can be challenging when you don’t yet know your costs of business. Do your research into your expected costs to try to get as accurate an estimate as possible.
How to get seed capital
Seeking seed funding through angel investors is highly competitive. There are countless startups looking for cash and only a few angel investors willing to offer it. While the reasons an investor will offer seed capital to a startup will vary, there are some key criteria which will increase the likelihood of receiving funding.
Startups which are disrupting industries to genuinely solve a real problem will be attractive. The business should be competitive with a unique selling proposition. Any evidence that the business will be scalable, generate revenue and be profitable will go a long way. If the entrepreneur has a track record of success this will be an enormous help.
Additionally, the startups which successfully raise seed capital will be highly organised, prepared, work with experts like an accounting partner and do extensive research. This will maximise their chances of receiving the seed capital to launch their venture successfully.
Of course, when it comes to how to get seed capital, having a great business idea and being prepared aren’t enough – you need to actually find and reach out to potential investors. Angel investment networks or databases can help expose your startup to seed capital investors in Australia and globally. Some venture capital firms also specialise in seed capital. Networking and marketing through social media and other channels will also help.
If you’re looking to source seed capital through seed capital investors in Australia or internationally, Keeping Company can help. Not only can we link you to the right people to source seed capital, we can also help you prepare for and guide you through the capital raise process. Contact us today to find out how we can help you with your seed capital raise.
At Keeping Company, we’re not just accountants, we’re business people too. With our counsel, your business can reach its full potential.
For all media enquires please contact Tracy Miller, CMO, Keeping Company 0414 898 452.
The material and contents provided in this publication are informative in nature only. It is not intended to be advice and you should not act specifically on the basis of this information alone. If expert assistance is required, professional advice should be obtained.