Most founders do not have the means to bootstrap or solely fund initial startup activities.
Taking the first step to start a business can be difficult, particularly since moving from the idea stage to startup stage in pursuit of perishable market opportunities requires cash. Founders who are unable to personally finance their early stage startup activities quickly discover the need to raise external funding.
Seed capital can come from many sources, the most frequent being “angel capital.” Angels are investors who have a penchant for being the first investors in a new startup. Often these are family, friends and/or close associates of the entrepreneur. However, over the past decade, we have seen the emergence of professional angel investors who seek out and regularly participate in opportunities to help fund and grow early stage companies. Many of these professional angels have formed pools of funds to invest in these early stage investment opportunities and resemble very early stage or seed-stage venture capitalists (or VCs). Like more traditional venture capitalists, these investors favor hands-on involvement in the daily operations of the company, in contrast to angel investors who are typically more passive with respect to the day-to-day activities of the startup or the evolution of the business strategy.
Angels, professional angels, “super” angels, and early stage venture capitalists tend to structure their investments of seed capital in one of two forms – either through a loan or the purchase of equity.
When raising a modest amount of seed capital, for instance, less than $1 million, founders often favor a “seed loan.” This type of loan is most often preferred because the paperwork is relatively simple and related legal fees are relatively inexpensive. Also, these investments tend to be fairly binary, meaning that the startup either fails or is able to accomplish enough milestones to eventually become self-sufficient or raise additional capital.
The terms of these loans typically include a very modest interest accrual, no security or restrictive covenants, and a right to convert in a future equity financing at a discounted rate. Alternatively, warrants may be issued in order to provide the lender with a low cost mechanism to enjoy the appreciation of the business. Keep in mind that simplicity is the goal in this type of financing. Participants often focus on ensuring that they are rewarded with better pricing than new investors in subsequent rounds if the business is able to get to the next stage of its life (e.g., raising capital in the next round).
An alternative structure for seed funding involves the creation and issuances of Preferred Stock. By purchasing Preferred Stock, investors become owners of the company and a valuation for the company is set. Ownership entitles the investors to voting and other rights, and although the NVCA and other organizations have created templates to lower the cost of structuring and papering these transactions, they remain complex and more expensive than seed loans. However, due to the benefits described in this paragraph, it is not uncommon to structure seed funding in excess of $1.0 million as a seed equity financing.
Once in a while a startup is acquired after it raises seed capital, but before the first institutional round of financing. If the seed investors have acquired equity in the business, the proceeds on the “sale transaction” are split proportionately by equity holders. However, if the seed investors alternatively lent seed capital to the company, they may not share equitably in the sale. To mitigate that risk, seed lenders often mandate either a premium payment on a sale transaction or simply the right/option to convert the loan into equity at an agreed upon price. Either of these rights has potential implications on the founding team and future fundraising efforts, and should be evaluated carefully at the time of the seed funding. Providers of seed loans are usually investors with whom founders seek to maintain long-term relationships. With that in mind, founders tend to provide attractive returns to seed lenders. We have seen bonus or premium payments equal to one or two times the principal lent by the seed lender. Such payments are generally paid to initial investors as a way of recognizing their much-needed support of the company during its infancy.