A startup typically moves through four stages of investing before it is considered an established company: seed funding, venture capital, mezzanine funding, and an initial public offering (IPO). However, completing each stage is not strictly necessary.
Is investing at the seed funding level a good fit for you as an investor?
Seed funding is the first and therefore the riskiest stage of investing, so why would investors take the risk? Investors who seek to expand their portfolio to include alternative investments might be very interested in this avenue of investing. Providing seed capital allows the investor to get in on the ground floor of a company as it takes shape. Most companies in the formation stage do not have the same access to capital that an established company often has. This can create a challenge for startups when it comes to gaining the financial strength needed to push through the stages of research and development. Banks and other investors may be reluctant to provide funding without key metrics of success or evidence of other parties’ willingness to invest in the startup.
Seed funding is the first step in solving this issue. Seed funding refers to the capital raised to bring a product or business to the prototype or proposal stage. The capital is used to fund research and development or to flesh out and build a strong business plan that can be used to bolster a business concept. This round of funding is famously the most challenging for a new business to secure in that it requires trust and confidence in an unproven business.
Success at the seed funding stage is what can propel an idea or a product from a concept to an established company.
Three main groups of investors are typically attracted to the seed funding stage: founders, angel investors, and the general public (the crowd). Founders can self-fund their business idea (aka bootstrapping). Angel investors have a tendency to be friends, family, or interested parties privy to the business idea who are willing to take a risk and invest based on their confidence in the concept.
The third increasingly popular funding strategy to raise early- stage capital is crowdfunding. Companies just starting out can harness the crowd. One of the most popular ways to crowdfund is by uploading a business proposal to established funding platforms such as Kickstarter, Indiegogo, GoFundMe, or StartEngine to pique the interest of platform users. If a company can produce a compelling product or business idea, it can receive funding from interested parties. This can be in the form of a donation, funding in exchange for a promised product, stock, or other debt instruments. The virtual reality (VR) headset company Oculus famously got its start on the crowdfunding platform Kickstarter, where it offered free headsets to early investors once the company used the funds to develop its inaugural product.
What happens when a company exchanges stock for an investment?
The most common agreements between investors and a company include promises that the investor will receive common stock or convertible notes or the two parties will make a Simple Agreement for Future Equity (S.A.F.E.) for their investment. Seed funding in exchange for common stock is a popular investment option. The investor gains a significant interest in the company, because the stock they receive commonly includes voting rights. When choosing this seed funding option, the company must have a high degree of trust in its financier, as it is inviting that financier into the decision-making processes and the future success of the company.
A SAFE contract is an agreement between the investor and the startup that exchanges funds from the investor now for the promise of future equity in the company. This is not a loan, so there is no interest attached to the funding. A SAFE contract may be converted to equity through another round of financing or a liquidity event like an initial public offering (IPO) or the sale of the company. SAFE contracts usually have a valuation cap converting the investor’s loan into equity at an agreed-upon valuation. SAFE contracts are an alternative to common stock and convertible notes, since they can ease the burden of interest rates on startups and allow full control of the company to remain in the hands of the founders for an extended period, compared to the issuance of common stock.
Convertible notes are also popular with investors since they are versatile debt instruments. A convertible note is an issuance of debt with the option of converting that debt into equity when the bond has matured or if the investor wishes to exit. The investor may collect the principal value of the bond plus interest and end the financing relationship with the company. Securing this initial round of investment is essential for companies looking to secure venture capital (VC) funding in later financing rounds. VC firms see a history of prior investments before their involvement as an integral part of their decision.
With any and every investment there is risk. In the world of seed investing, every investment has the potential to be high-risk and high-reward.
“90% of US startups fail. 70% of US start-ups fail in years two to five.” (Embroker, 2022)
Understanding the risk is just as important as understanding the potential reward.
It is essential to have a thorough understanding of the relevant industry at large. Industry knowledge is more informative when it comes to assessing the potential success of a company than knowledge of the company itself. Market timing and competitive analysis of the industry must show a hole in the market and therefore an opportunity for a new business to flourish. If this is the case, the purchase of a significant stake in the company at a relatively low cost could show a massive gain in value over the life of the investment.
Seed investing is the beginning for any entrepreneur, and it can be the same for an investor. The balanced combination of industry knowledge, a strong team, and trust can offer a unique opportunity to get in at the inception of a company and to watch small investments grow into significant equity stake or monetary interest in a successful venture as well as diversifying your portfolio.