Seed Equity
May 14, 2021
What is Seed Equity?
Seed equity is the early-stage financing that is used when a new company is in its initial growth phase. While seed capital can in theory be either debt or equity, it is typically an equity product due to the risk factors and the lack of assets and cash flow typically needed for debt products. Seed equity is usually the first investment in a start-up company, typically by the founder, friends, and family to help get the company started. It can also be provided by early ‘angel investors’ or crowdfunding. The investment is to help fund the proof of concept and help bring the product or idea to the marketplace where it can begin to generate sales.
Seed investment typically comes before angel investing (although angels can be seed investors if they are looking for early-stage exposure) and before the more formal rounds of equity capital known as the “Series” rounds. Seed equity is used when a new company is too small (and usually still a long way from having a profitable business) to be of interest to private equity and venture capital.
Key Learning Points
- Seed equity is an early-stage capital product that is used by start-ups to fund development
- It provides a “runway” of cash to allow the time to establish proof of concept, which demonstrates to the investor community that there is a viable product or idea in which to invest
- Seed equity is typically comprised of a group of modest investments as it comes from personal wealth rather than corporate investment
- Since equity does establish ownership, it can be a challenge to value the shares being issued. This has led to the rise of more flexible seed capital, such as convertible notes and SAFEs
- Seed equity often comes in the form of a preferred class of stock and has voting rights although this can vary from company to company
How Seed Equity works
Within startup finance, there are several stages of investment. The first investments made in a company are typically made by the founders, friends and family (plus crowdsource funding), and sometimes by angel investors. This is seed equity.
The seed capital will form a level of equity cushion often called a “runway”, which enables the company to establish proof of concept without any earnings or cash flow in the early stages. Once proof of concept is established, the company will begin to look for larger investments, often from more established VC and PE firms in the form of “Series” capital.
Calculating Seed Equity
The amount of seed equity needed will depend on the company’s business model and the amount of investor appetite.
To raise seed equity, the company’s “pre-money value” must be established. This is the new value of the company before the equity is raised and essentially revalues the shares in existence right before the new investment. This is critical to establishing the price per share of the new equity investment. Often this can be tricky to value as the company may be yet to generate any sales or profit. However, it can offer the most potential upside to investors as the valuation has not factored in proven sales or profits so can be an attractive entry point. There can be tax benefits to being an early investor such as SEIS and EIS in the UK.
The founders and investors (along with the lawyers) will negotiate the percentage of ownership being acquired. Once the new share price is established, this will be the valuation for those shares going forward until the next round of equity.
There may well be stock options for the founders and employees which can be an incentive for startup investing. This needs to be factored into the ownership stakes as they will dilute ownership as well. Stock options are used as incentives for both founders and early-stage investors as it can offer additional exposure to company growth as a ‘reward’ for being an early investor. Often new option pools are created at each round.
Problems with Seed Equity
As the startup investing universe has grown, seed equity as a financing product has shown some disadvantages. First, like all equity products, it is dilutive to previous owners. Since the period of time for a company to establish itself is unknown, additional rounds of seed capital might need to be raised. This can lead to large dilution of the founders’ and previous seed investors’ stakes. Secondly, to establish ownership via seed equity, the company must be valued. This is not always easy at early stages of development. Many startups now use hybrid forms of equity called “convertibles” that allow the company to raise capital in the form of short-term debt that converts to equity at a later date. Protections are often built into these instruments to minimize the downside of waiting for the conversion.
Conclusion
Seed equity is a form of start-up capital that is used to provide companies with early-stage finance to establish their business models. As an equity investment, it carries all of the risks and rewards typically associated with equity; however, the potential for growth is huge due to the very high risk of investing early in a company’s timeline.