United States: Start-Up Seed Financing

Start-up companies use seed financings primarily to raise the capital required to build a minimum viable product and test their product-market fit. This article provides guidance to company counsel and founders on how to identify a seed investor and choose the financing method that best fits the company's needs. The article assumes that the company is a Delaware C corporation, which is the market standard for venture-backed companies.

Understanding the Goals of Various Types of Investors

A typical seed financing features a founding team (and perhaps up to a handful of employees) raising between $500,000 and $2 million to allow for 12 to 24 months of operational capital. During this time, the founders will attempt to prove out their idea and develop the traction required for raising the next round of financing (known as a Series A financing) from a professional venture capitalist.

A seed investor's purpose is typically to test an investment hypothesis (either on a founding team, idea, or market) by providing capital to a company that will test the hypothesis. Investors at this stage will often make a large number of small investments in a variety of companies on the theory that, while many of them will fail, the few that are successful will generate significant returns for the investor. At the seed stage, investors are deciding to make their investment primarily on their assessment of the quality of the founding team and the market opportunity presented by the business model.

A few traits of founders that are seen as positive signals to investors include, but are not limited to:

  • Technical/domain expertise in the planned business
  • Prior successful entrepreneurial forays
  • Strong introductions from people in their network
  • Promising early traction
  • Strong educational background (e.g., engineers from Stanford)

To decide whether to invest in a seed round, an investor will likely meet with the founding team, who will give the investor a pitch on their product/idea, market, team, and business model. Often the company's existing contacts (e.g., advisors, former co-workers, or lawyers) set up these pitch meetings (known as a warm introduction).

Types of Investors

There are a variety of typical investors in such financings:

  • Later-stage professional venture capitalists (VCs). Many blue-chip firms (e.g., Sequoia, Andreessen Horowitz, and NEA) have separate funds for seed-stage investments. They often will invest $200,000 to $1 million and will be the only lead investor in a seed financing. VCs are sophisticated and often represented by outside legal counsel for seed financing transactions. They often use their seed funds as a mechanism for ensuring access to competitive Series A and Series B investments, which are the first and second rounds of financing after seed financing has been provided.
  • Seed funds. These funds (e.g., SV Angel, First Round Capital, Slow Ventures, and BoxGroup) base their investment thesis on investing small amounts of capital in a large number of companies. They are well versed in this type of transaction and are able to quickly decide whether to invest and then move to close the transaction. They often invest between $50,000 and $500,000.
  • Incubators/accelerators. These organizations (e.g., Y Combinator, TechStars, and 500 Startups) provide small amounts of capital (such as $100,000) and a formal educational program in exchange for a fixed percentage of a company (often 6-8%). They also separately invest in their companies through seed financings without companies going through their formal education program.
  • Professional angels. These are individuals (e.g., Ron Conway) who invest as their primary occupation. They are often extremely well-connected within their community and able to introduce founders to other investors and provide advice to early-stage founders. They often invest between $25,000 and $100,000.
  • Seed funding platforms/syndicates. On these platforms (e.g., AngelList) individual investors come together to pool their money and follow the lead of an angel investor they trust to invest on their behalf or otherwise discover companies in which to invest. Typical investments for each individual can range from $2,500 to $50,000.
  • Serial entrepreneurs. These are individuals who have accumulated wealth due to prior successes. They tend to invest in order to pay it forward and to mentor other founders as they start their companies. These individuals typically invest between $25,000 and $100,000.
  • Industry experts/advisors. These individuals have expertise in the field in which the start-up is interested and can deliver mentorship and guidance as the company begins its journey. Investing gives these advisors the opportunity to have skin in the game and see upside for their time spent advising the company. These experts typically invest $10,000 to $25,000.
  • Wealthy individuals (including friends and family). These are individuals with a broad range of sophistication, which can often be as little as having watched an episode of Shark Tank. They have money to deploy, want to feel connected to the energy of a technology company, may see tech investing as a risky asset class within their broader portfolio, or want to help out a founder who is a friend/family member. These individuals may invest as little as $2,500 and as much as $250,000.

Most rounds of seed financing consist of a blend of the above investors, as each brings its own value to the table (beyond just capital). One balancing act to consider is whether to include a professional VC in the seed round. While it can be seen as a positive signal initially, it can be a double-edged sword in that the VC's decision to either lead, participate in, or elect not to participate in the subsequent preferred stock financing will be a very strong signal in the market (and often the VC will elect not to participate or lead the round, which reduces potential new investors' confidence).

Overview of Seed Financing Legal Instruments

The three most common types of series seed financing instruments are convertible notes, simple agreements for future equity, and preferred stock. These three instruments cover virtually all seed financing transactions in Silicon Valley and with start-ups across the country. The company almost always determines which instrument to use, unless there is a significant (lead) investor that negotiates the terms of the entire financing round on behalf of all other investors and feels strongly about the form the seed financing takes.

You should note that sales of common stock are not typically used for seed financing for two primary reasons. First, common stock does not come with the various investor-friendly terms (described below) that other instruments include, so it is less appealing to investors. Second, it places a price on the outstanding common stock, which then will set the price for grants of options and restricted stock to employees. Typically, a valuation firm using 409A methodology (i.e., performing a valuation before a liquidity event such as an initial public offering in accordance with Section 409A of the Internal Revenue Code) will value common stock in an early stage start-up at around 20-25% of the preferred stock. Thus, a priced common round with investors would eliminate this lower price benefit, which is one of the key recruiting tools for early employees.

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Originally published in The Lexis Practice Advisor Journal

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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