Primer on seed financing for small businesses
Most entrepreneurs are constantly looking for money to support their small businesses. Startups have three major options for funding: self-funding; loans; and equity. If they had their druthers, most small business owners would not deal with investors. But if the business wants to grow, then usually outside funding is necessary. In this article, we discuss seed financing, when owners give up equity in their small businesses in exchange for funding from third parties.
milkos © 123RF.com
Related article: Investors for Startups: Terms of Engagement
Internal resources are sufficient
Many small businesses do without any additional financing. Say you are the owner of a restaurant and do not have any intention of expanding. You pay the restaurant’s expenses and what ever is left over, you bring home to feed your family.
What happens when the restaurant can’t meet payroll in any particular month? If one of the owners can simply write a check when the business’ bank account is low, then you do not need outside funding. If the small business owner cannot simply cover payroll, usually the restaurant owner has a line of credit that may be secured by the owner’s personal assets.
Organic growth may support the expansion of the company
If you have a startup that you intend to grow, you may think that you can rely on organic growth. The company does not need external resources because the business itself can support the growth of the company. Alternatively, possibly the owners have sufficient resources to fund the expansion of the company. Most startups, however, don’t have owners with deep pockets.
Organic growth is ideal if you can simply reinvest the operating profit from the company back into operations. The business will throw off enough cash to allow the business to grow.
Usually a startup is not going to be generating excess cash. Most startups are lucky to pay their impecunious founders a meager salary. And most startups intend to expand. Growth in revenue generally means that that you will need to expand the capital of the company. A general rule of thumb is that if you want to double revenue, you have to double the assets. Where are you going to get the capital to purchase those additional assets?
Debt financing is not without strings
The other alternative is for debt financing such as a loan from the Small Business Administration. Or you may apply for a line of credit with your local bank. But these and other loans have strings attached.
Lenders such as banks want to minimize their own risk so they will inevitably require the owners to provide security or otherwise to guarantee the loan. If you have a home and you and your partner do not care that you may lose the home if your business falters, then a loan secured by your home may be a good option.
A friend or family member may provide a non-recourse loan, meaning that if the business doesn’t pay it back, the lender cannot go after the individual owners of the business. But generous and rich family members are a rare breed.
Giving up equity to investors
If the other options are not available, then you need to consider outside investment. Outside investment can take several forms. Giving up equity is high risk to the investor. Most startups are going to fail and the investor may never see the investor’s money again. Some investors understand this; others do not.
The investor needs to match the risk with the potential reward. If the startup is successful, the investor at this stage will want to enjoy a generous reward for making an investment of very risky capital.
Investors in the seed round
You probably have talked with other small business owners who have horror stories to tell about their investors. They are correct that you need to pick your investors carefully. You as the owner decide to give up partial ownership in the startup. We have grouped investors at the seed stage into four major categories.
The most common investor at the seed stage is the friend or family investor. There is a pre-existing relationship usually based on trust.
The second kind of investor is the angel investor, usually a high net worth individual. An angel investor is constantly looking for companies to invest in usually at pitch events or through various networking organizations.
The third kind of investor is a private equity company or sometimes a venture capitalist. These are institutional investors that create funds through which to invest in individual companies.
And finally, there is the corporate investor or strategic investor. The strategic investor is usually a corporation that has a strategic interest in your business. A customer or supplier with which you have a good relationship may see synergies between the investing company and the target.
Amount of seed investment
Obtaining seed investment is usually the most difficult kind of equity investment for the amount of investment. Entrepreneurs may attend countless pitch events or send off innumerable copies of a business plan. And even if you are successful in attracting seed investment, the amount of money may not be substantial.
The typical seed round is in the $500,000- $2 million range. This money should support the startup for at least 12 to 24 months before the next round of funding is required.
Each individual investment may vary depending on the kind of investor. There are no hard and fast rules of how much each investor may put into the company.
Friends and family may only invest in the $10,000 to $25,000 range. An angel investor will typically invest more, possibly in the $25,000 to $100,000 range. A private equity company or strategic investor may take up the entire round.
Kinds of seed investment
The three most typical types of securities for a seed round are convertible notes, SAFEs and preferred stock, although preferred stock is usually reserved for the next found of funding
Common stock such as founder’s shares can also be used during the initial round of funding. Common stock is usually less appealing to investors because common stock does not usually have investor-friendly terms. Issuance of common stock will set a price for grants of options and restricted stock to employees. A savvy prospective key employee being recruited for a startup will have less enthusiasm for a priced common round.
Let’s talk about the three most common types of seed rounds and their advantages and disadvantages. In general, and there are many exceptions, it is easier for companies expecting to through various rounds of funding to opt for a corporate structure, usually a Delaware corporation.
Related article: Forming a New Business: Corporations vs LLCs
Convertible notes
Convertible notes are a special kind of loan that can “convert” into an equity interest in the company based on certain triggering events. The conversion event is usually a qualified subsequent financing (such as a preferred stock financing over a certain threshold like $1 million to $5 million), a merger or acquisition, or sometimes a maturity date.
Founders like convertible notes because they are common and easy to understand for both the equity holders and the investors. And the owners are not giving up any equity. It is a loan until the triggering event occurs. Convertible notes are not secured, so the founders will not lose their personal assets if the company is unable to pay the note back.
Another advantage is that the owners can defer negotiating a valuation for the company until a priced preferred round.
There are some disadvantages as well. The owners may not like a convertible note because as a loan, the loans may need to be repaid. Investors may extend the maturity date, but there is a date certain on which the investors need to be paid back. The existing equity holders may also not like a convertible note because they, the equity holders, may be diluted. The notes are included in the pre-money capitalization in the next round of financing.
Simple agreements for future equity (SAFEs) have captured the attention of the investing community
If you are going to networking events, you no doubt have heard about SAFEs. Y Combinator, a start-up accelerator, introduced SAFEs in 2013 as an alternative to convertible notes. As its name applies, a SAFE is supposed to be simple, although lawyers are having a field day in amending their provisions. But assuming that the investor and company do not change the provisions of a SAFE, they are indeed simple and easy to negotiate.
Valuation cap and no discount. There were originally four different kinds of SAFES and Y Combinator added a fifth kind in 2019. The first kind of SAFE has a valuation cap, but not a discount. A valuation cap is the maximum value imputed to the company. In a qualified financing, the SAFE converts at the lower of the price per share calculated using the valuation cap and the actual price per share of preferred stock sold in the financing.
Valuation cap and conversion discount. The second kind of SAFE has both a valuation cap and a discount, leaving it to the investor to decide which is more advantageous at the time of the subsequent financing round. The conversion discount is the amount the price per share in a qualified financing is discounted for determining the price per share at which the SAFE converts.
No valuation cap and conversion discount. The third kind of SAFE has no valuation discount, but it does contain the conversion discount.
No valuation cap and no conversion discount and most favored nation status. Under this version of the SAFE, the investor enjoys the same preferential terms received by any subsequent purchaser of convertible securities of the company.
One major criticism of the SAFEs from the perspective of founders has been the dilution of founders in a subsequent financing round. The 2019 new SAFE forms that Y Combinator introduced provides more clarity to the founder based on post-money valuations.
SAFEs have now become a staple in any entrepreneur’s kitchen because they are quick and simple. They are not debt so there is no need to pay interest and there is no set term. And you don’t need to gather all of your investors in a stuffy conference room to close the round at one time. The SAFEs are stand alone agreements, allowing individual investors to close as they are ready.
Preferred Stock
You as the founder may also want to consider issuing preferred shares. Preferred stock can have attributes of both debt and equity. Preferred stock does not come with voting rights. But preferred shareholders are guaranteed a fixed dividend.
Important to the investor is what happens if the company goes belly up. The preferred shareholders may enjoy a liquidation preference, meaning that they have a greater claim to the company’s assets than the common shareholders if the company falters.
At the seed stage, it is less common to see preferred stock. A preferred round is typically significantly more expensive than a SAFE or convertible note. Preferred shares require the negotiation of numerous documents. There may not be a lead investor so the founders are left to negotiate with multiple parties.
Founders have options
Founders of startups have options to seek outside funding. But they need to formulate a strategy and be prepared for lots of rejections before landing an outside investor.
The simplest way to grow your company is to be rich or have a lot of wealthy relatives. For most entrepreneurs, however, they need to hone their business plans and be prepared to pound the pavement.