The term 'seed' means that seed capital is an early stage investment. Seed capital supports the business until it can generate cash of its own, or until it is ready for further investment. It is often a small amount, as the business is still in the idea or conceptual stage. Given that a seed investment is so high risk, this type of funding is often exchanged for an equity stake in the business, although with less formal contractual overhead than standard equity financing. Seed capital is often used to fund the preliminary operations of a business, such as research and development.
Seed investors tend to be family members or friends of the founders, however, founders tend to use their personal finances to help fund the business. Investors can also be high net individuals (often referred to as angel investors) or early stage venture capitalists.
The lead investor, once deciding to invest, plays an important part in the development of the business, for it is they who contribute a significant portion of the investment and sign the Term sheet.
Seed funding involves normal venture capital funding at a higher risk than normal. Before deciding to invest, investors consider factors such as:
the control they'll have over the affairs of the company
the control they’ll have over the investment itself
the procedure for getting their money back in the event the company is sold or goes into liquidation
They'll also want to know certain information about the founders’ business, therefore, it is of the utmost importance that the founders fully understand their business model before they engage in negotiations with investors. Investors will want to know about the following matters before making investment:
the company's Business plan
the nature of the product or service market size
team and management
the founders' previous experience
Investing in a start-up
There are two ways in which a lead investor can invest in a start-up:
a convertible loan
an equity investment
This is a common investment structure for seed investors. The investors give the investment funds as a loan to the company, with the option to convert that loan into equity shares at a later date. The parties can also defer valuation of the company to a later stage, eg following the next round of investment, which will convert loan debts into equity.
Equity investment enables the investor to receive a share in the company in exchange for the investment monies. Here, the investor would usually receive convertible preferred shares in exchange for making investment, thus will have priority over ordinary shares in the event that the company is liquidated, acquired, or the assets are sold (thereby, minimising associated risk).
For more information, read Startup funding.
Common themes in a term sheet
Pre-investment and post-investment
In general, the investor will agree with the company on a valuation prior to the investment round. This pre-investment valuation is then used to determine the price per share to be paid by the investor on completion of their investment in the company. The price per share is obtained by dividing the pre-investment valuation by the fully diluted number of shares of the company immediately prior to completion.
'Fully-diluted' share capital of the company includes shares that are issued, shares allocated to any employee option pool and any other shares that the company could be required to issue, through options, warrants or other convertible debt instrument.
Share option pool
If the company does not have an employee share option plan ('ESOP'), the investor may insist that one is created. The aim is that employees are incentivised by allowing them to share in the financial rewards resulting from the success of the company.
Investors often request a management rights letter when investing in a company. Management rights give the investor the right to participate in, or influence the conduct of the management of the company. In addition to obtaining management rights, the investor is required to exercise its management rights with respect to one or more of its portfolio companies every year.
In the event of an 'exit', eg the liquidation of or sale of the company, the investor may be entitled to receive a payment (usually the subscription amount) in priority to the other shareholders. This ensures the investor is protected from marginal exits.
Reverse vesting means that founders do not have full control of the shares they own if they leave the company before the vesting period ends. In other words, it gives the company the right to repurchase shares not yet matured if a founder happens to leave.
Most investors will now make it a condition of the deal that before completion, the company first receives advance assurance from HM Revenue & Customs that the company is a qualifying company for the purposes of raising funds pursuant to SEIS:
up to 30% tax relief under the Enterprise Investment Scheme ('EIS')
up to 50% tax relief under the Seed Enterprise Investment Scheme ('SEIS')