Whether you are a new company or have been operating for some time, seed capital can help your company fulfill several critical functions - from hiring those engineers to improve your product or those marketers to turbocharge your customer acquisition, to purchasing equipment or launching a new product. For a company that does not have access to seed funding, the risk of failure can be higher.
What is seed funding?
One option is growing your company by bootstrapping it, which not taking any external investment. Companies that manage this, avoid excessive dilution, with founders retaining a higher ownership share of the business.
However, for a new venture, lack of investment is a common reason for failure: it can take several years to become profitable and, in the early stages, bank loans or other conventional lines of credit are not always accessible. Without external investment, a company may not be able to shore up initial losses.
Businesses go through a range of funding events, to help them either reach profitability or to accelerate growth. In theory, these start at seed and are then followed by Series A, Series B, Series C, etc. all the way to either an acquisition of the business or an initial public offering. This is an example and there are a number of permutations in which a company goes through different funding rounds: for instance, it might raise capital only up until Series A and then require no further funding, or it might raise directly a Series A round, skipping seed funding.
Therefore, seed capital is just an early form of venture capital. It is equity-based funding deployed by venture capital firms in exchange for an equity stake (i.e. an ownership share). Seed money can then be used by the company to stimulate growth by supporting a number of key initiatives.
Seed funding dynamics
How to convince investors?
Start with a relevant potential investor list - you should be looking for seed funds or private investors whose investments match the amount you are trying to raise in size. A sector affinity can also help - many seed capital funds are sector agnostic, but those with an interest in your sector will have a higher propensity to invest. Where possible, getting a warm introduction to potential investors can be helpful.
Investors will also want to be persuaded by the founders, that they are bought into the project and that they will be able to execute their vision. Having an ambitious, well-prepared set of financial projections will help convey the opportunity.
Finally, you should take advantage of the generous tax relief schemes available. Provided a set of conditions are fulfilled, most startups will be eligible to apply for SEIS or EIS. These government initiatives are essentially relief schemes for investors, allowing them to recoup part of their investment in the form of tax breaks and, therefore, often materially de-risking their investment.
When is the right time to raise money?
A good business idea and clear competitive advantage are a solid start in order to stand out from the competition. However, often this will not be enough. Investors will want to understand the market opportunity. It will be important to demonstrate that you have analysed your total addressable market, including the proportion that is serviceable based on your business model and what is realistically obtainable.
Moreover, investors will want to see evidence of product market fit. Ideally, your company would show signs of early traction. Investors will want to see that your customer base has an actual need for your solution and, as a result, that your product is being adopted.
How to value my business?
Valuing a business at the seed round is not always straightforward. Unlike more mature companies, which can be valued with clear methods, such as a DCF analysis, public comparables and private comparables, it can be hard to apply relevant benchmarks and find comparable data for companies in the early stage of development.
If you can support your target valuation with data points, such as peer companies' seed rounds, money raised and valuation, this information could help set your valuation guidelines. Equally, looking at revenue comparables and growth-adjusted revenue multiples could help establish a framework. However, it might be counterproductive to fixate on these data points during your seed funding.
Generally speaking, seed round valuations tend to range between £2m and £10m and this is often correlated to the amount of capital raised and existing shareholders' dilution. A lot will be determined by market sentiment, in other words by what venture capitalists or angel investors 'feel' the business is worth. As such, in these early stages, investor interest will be a weighing factor in your company's valuation.
How much money should I raise?
Try and raise enough seed capital either to get to profitability or to support your business until the next fundraising milestone (e.g. Series A). Considerations in deciding how much seed capital to raise are the amount required to reach this point and, to a lesser extent, dilution, i.e. how much equity in the company you are willing to give away.
In terms of seed funding amount, most seed rounds range between a few hundred thousand pounds to a few million pounds. The exact amount depends on two variables: your business' monthly cash burn and how long you would like to be funded. Most businesses seek seed capital expecting to raise another round (a Series A) sometime between 12 and 24 months later.
As an example, suppose that, through your seed capital, you are aiming to fund monthly salaries for two marketing employees and an engineer for a total of £20,000, a monthly marketing budget of £5,000 and monthly sundry expenses of £2,000. Assuming no cash generation, you are going to need approximately £500,000 in order to sustain the business for a period of eighteen months (at which point perhaps you intend to raise your Series A).
How does dilution work?
The other consideration is dilution. In fact, to provide seed funding, potential investors will require equity in return. As a rule of thumb, 20% dilution is a common benchmark of what might be expected in a seed round, but the amount varies on a case-by-case basis.
Dilution is based on funding received and on your pre-money valuation for the round. As an example:
- Let's assume that you are raising £500,000 in funding at a £2,000,000 pre-money valuation
- If your business currently has 200,000 shares outstanding, your per-share price will be £10 (£2,000,000/200,000)
- Therefore, you will need 50,000 new shares allocated (50,000 x 10 =£500,000)
- Once you issue equity, your new total share count will be 250,000 (200,000 + 50,000)
- Your post-money valuation will amount to £2,500,000 (£10 x 250,000)
- And your dilution will amount to 20% (50,000/250,000)
In either case, valuation should be grounded in your business plan and justified by demonstrable metrics. Having a clear and detailed budget and an understanding of valuation are good starting points for a successful raise. Our specialists can help you either draw a business plan from scratch or help you refine it and make it investor ready.
How to structure the round?
Investors invest seed capital through different instruments, ranging from direct investment in common equity, to convertible equity, to convertible debt. How these instruments rank in your capital structure will determine the hierarchy in which investors get repaid when the company is sold.
Common equity (as opposed to 'preferred equity' or 'preferred stock') is the type of stock that founders typically hold. These shareholders are paid only after all debt and preferred stock investors have been paid. Unlike preferred equity, common equity does not benefit from protective provisions or anti-dilution protections.
Convertible debt is a loan made to a company (through an instrument called a convertible note). Key terms will include an interest rate on the principal amount, as well as a maturity date when the note is due to be repaid along with the interest accrued.
Before maturity, the note will convert into equity at the next priced round, at a discount to the valuation of the round (meaning note holders will be able to acquire shares at a lower price). In addition, some convertible notes might include a cap, a ceiling valuation at which the lender will acquire shares, regardless of whether the round valuation is higher. This acts as a 'safeguard' for the lender, allowing him to convert the loan into shares at a valuation below a certain threshold, no matter the case.
Convertible equity and advanced subscription agreements (ASA)
Convertible equity is a recent type of investment, similar to convertible debt, but without including interest repayments or maturity. Investors commit to acquiring future equity in the company, either when the company obtains its next funding round, or when the company is sold, or at a fixed long-stop date. The shares are acquired at an agreed discount from the next funding round's valuation and there is no need to value the business at the time when the convertible equity is issued.
The only terms to agree on are the investment amount, the discount for the future shares purchase (typically between 10% and 30%) and a default valuation (i.e. a floor valuation at which the shares will be issued, should a funding event not occur before the fixed long-stop date). In some cases, just like for a convertible loan, there might be a cap, a ceiling valuation at which the shares will be acquired, regardless of the actual valuation of the round.
In the UK convertible equity is often structured through ASAs (the equivalent of a SAFE in the US), simple agreements with standard terms which can expedite the process. These can be appealing as in some cases they can be compatible with SEIS and EIS - SeedLegals provides a version of a SEIS / EIS-compliant ASA.
Who are the investors?
When it comes to early investment, investors range from angel investors, to crowdfunding solutions, to accelerators and incubators, to venture capitalists. For a more detailed overview of the investor landscape, read our article on understanding the investor audience.
Angel investors and angel groups
Business angels are (usually) high net worth individuals who invest in companies. Besides seed capital, these private investors also provide human capital in the form of advice and guidance. Unlike venture capital funding, where the money comes from institutional or corporate investors, business angels invest their own capital.
Sometimes these private investors will arrange themselves in angel groups, such as Newable Ventures, Archangels or Angels Den. Business angels then deploy money through special purpose vehicles (SPVs) such as syndicates, which allow for more sizeable investments, while increasing diversification and reducing risk for each angel investor involved.
Venture capitalists and venture capital firms
Unlike angel investors who are often investing their personal savings, VCs invest money on behalf of institutional investors and funds. Therefore, arriving at a final decision might take longer than with an angel investor and receiving the money needed could entail a more competitive process.
On the other hand, venture capital investors can help credentialise the business as well as unlock powerful networks for early stage companies. Moreover, their partners can prove to be a source of invaluable advice.
Some venture capitalists, such as Speedinvest or Ascension Ventures focus exclusively on seed funding. While the majority at this stage are sector agnostic, there are also seed investors who focus on distinct verticals.
Incubators and accelerators
Other seed funding investors include incubators and accelerators, such as Entrepreneur First, L Marks or Collider. Incubators and accelerators often provide a set amount of funding in exchange for a set equity share. In addition, these seed funders will support their portfolio of businesses through mentorship programmes, networking opportunities or business support.
Other seed funding options
Alternative seed funding options might include receiving seed money from a corporate fund, which invest primarily for strategic reasons. Otherwise, online platforms for crowdfunding, such as Crowdcube, Fundable or SeedInvest, could offer a viable source of seed capital.
How Ithaca can help
There are a number of ways in which to go about raising seed money and differences in outcome can be significant. Being well-prepared for a raise and having a good understanding of the process can make the whole difference.
Our fundraising experts can help with anything from supporting on the preparation of a business plan or investor materials, to applying for EIS and SEIS advanced assurance from HMRC to helping you navigate the investor community.