The long journey of transforming your startup idea into a successful business usually starts with a single step: securing your first round of startup financing, or seed financing. This round of financing is usually obtained from early stage investors that either have an intimate knowledge of the field/market you occupy, or know (and trust) you and your team.
The initial funding raised in the seed round is typically used to build your minimum viable product (MVP) and test your product-market fit. In short: this is the initial funding that will set you up for you next funding round where you have to be able to prove your product and the business case for it.
This article provides a brief guide of seed financing and how to approach it.
The goals of Early Stage Investors
Often, your seed capital will come in the form of angel capital. In addition, it is typical to fund your seed financing round from a large number of early stage investors, each contributing a relatively small amount. After all, a seed investor’s purpose is to test an investment hypothesis. You are asking for a high risk investment, and often that means that investors will want to put small amounts of money on the line.
When you are looking for seed financing, you want to ensure that you are the type of investment hypothesis that early stage investors are looking to test. This will, of course, be very context dependent. However, a few standard factors that investors consider, are:
The technical expertise of you and your team in the field
Prior successful entrepreneurial efforts
Strong introductions from people they trust and know
The possibility of early traction
Educational background of the team
The Types of Investors Commonly Approached for Initial Startup Capital
Your startup will naturally be able to offer many items on the list above if you have advanced to the point where you are looking for seed funding. Some of the other items might not be something that you can change at short notice (such as your prior successes). However, there is one factor that is squarely within your control: networking and obtaining strong introductions and champions. To do this, you need to know who to target. These are some common types of early stage investors to target:
Professional angel investors
Seed funding platforms
Wealthy individuals – even friends and family
Seed Financing Legal Instruments
Typically, common stock sales are not used for this initial funding round. There are two very important reasons for this. Firstly, common stock does not allow for all the investor-oriented terms that early stage investors might require. Secondly, it places a price tag on the stock that you want to grant as options and restricted stock to employees.
The preferred legal instruments used for seed financing are convertible notes, simple agreements for future equity (SAFE), and preferred stock. Each of these have their own respective advantages and disadvantages, and it is always a good idea to consult your startup lawyer before making a decision about the legal instrument you use for seed financing.
Your startup needs a valid securities law exemption from registration (in terms of the Securities Act of 1933) before you can proceed with seed financing transactions. This will apply to you regardless of how you choose to structure your first rounds of securing startup capital.
There are several exemptions that can be utilized for seed financing, but commonly startups opt for one of the following:
The private placement exemption (Section 4(a)(2)(15 U.S.C. § 77d)
The safe harbor provided for in Rule 506(b)(17 C.F.R. § 230.506)
Note, however, that if you opt for the Rule 506(b) exemption, it is generally advisable that you only sell to accredited investors.
If you elect to go after investors, do not sign anything without first having an attorney look over the document to help you determine if the deal is in the best interest of your startup. LawTrades is a legal marketplace and we work to support startups by providing access to quality, vetted attorneys at a reasonable flat-rate. Our start-to-finish project management and efficient processes has helped thousands of businesses obtain the legal protection that many typically lack. Contact us today!