Seed Money: What Is It?

Seed money is used to fund the earliest stages of a new business, potentially up to the point of launching your product. Seed money may come from a variety of sources, including debt and equity offerings. Usually, an investor will exchange money in exchange for some equity or share in the company. The seed money is intended to support the early operations of the business until it begins to create a profit, or is ready for additional investors.

Common uses of seed money include the following:

  • Product development.

  • Market and demographic research.

  • Hiring a key team member.

  • Obtaining critical facilities or equipment.

  • Initial production and distribution.

Seed money is different from venture capital because the latter come from institutional investors, are usually much larger sums of money, and involve extreme complexity in drafting the contracts for the investment. Seed money, on the other hand, comes in before the investor has a project to evaluate, and so the amounts invested are typically lower than that of venture capitalists.

Why Is Seed Money Important?

Seed money allows you to launch a business when you don’t have the means to do so on your own. You may not have the personal savings to do so or may feel that the risk is too great.

While seed money often requires you to give up shares of your company, a small share of a highly successful company is better than 100 percent ownership of nothing.

Professional Angel Investors

These investors help pool resources for entrepreneurs who form startups. They will either provide seed money through a loan or by purchasing equity in the company. If it’s a fairly small transaction (under $1 million) the transaction is usually a loan. If it’s over that threshold, professional angel investors will usually use seed equity, where the investor will buy preferred stock, get voting rights and essentially become co-owners of the startup. These are more complex transactions, but are more beneficial to investors as the company grows.

Reasons to Consider Using Seed Money

You may want to use seed money in the following situations:

  • You have insufficient assets to personally fund your startup.

  • You want to accelerate your growth.

  • You want to reduce your personal risk.

  • You want to avoid overextending your personal credit.

  • You want to partner with an investor who can also provide strategic advice.

  • You want to partner with an investor who will take ownership of your business and potentially advance further funds in the future.

Reasons to Consider Not Using Seed Money

You may want to avoid using seed money for the following reasons:

  • To preserve equity.

  • To avoid debt payments that reduce your cash flow.

  • To avoid disputes over money if seeking seed money from friends or relatives.

  • To reduce the costs of regulatory compliance.

  • Because investors may demand a premium due to the riskiness of investing in an early-stage company.

  • To avoid sharing ownership or management of the company with another investor.

Seed Money Options

You have several options for obtaining seed money.

  • Bootstrapping: Bootstrapping avoids seeking outside seed money. Instead, you yourself make an initial personal investment and fund your growth with your early profits. It is the least expensive and most expansive form of funding. Sound impossible? Facebook received its initial funding through bootstrapping.

  • Debt: Debt most commonly comes in the form of bank loans or personal loans from friends and relatives. Angel investors and venture capitalists may also prefer to issue loans to companies in their early stages rather than making equity investments.

  • Equity: Equity is selling shares of ownership in a company (e.g., selling stock). The investor receives a share of ownership, future profits and possibly voting rights.

  • Convertible securities: A convertible security is issued in one form but later changes into another. The most common example is convertible debt. What started as a loan may change into shares of equity based on preset conditions. This usually happens if the loan wasn’t repaid quickly enough or when the loan contract included either a company or investor option to convert to equity.

  • Crowdfunding: Crowdfunding on platforms like Kickstarter and Indiegogo has nearly surpassed venture capital as a source of seed money. You can now take crowdfunding to a new level by offering investors equity shares in your company with the JOBs Act rather than just product discounts.

  • Corporate seed funding: major companies like Google and FedEx will often offer seed funding to promising companies that could be a potentially lucrative acquisition in the future.

Public vs. Private Seed Money

Most seed money is raised in a manner that would typically be considered a private offering. This includes investments made by co-founders, family members, friends and other people known to you. It also includes most bank loans, although banks are often reluctant to loan out to an unproven source like a startup. Investments by angel investors and venture capitalists are also usually private placements.

On the other hand, publicly seeking out institutional investors, issuing an IPO, or placing advertisements seeking investments may be considered a public offering. Public offerings are usually subject to heightened regulation.

It’s important to note that this private versus public distinction is not absolute. As a general rule, you must follow the strictest SEC requirements unless you qualify for a specific exemption. Additionally, your state’s law may add additional requirements.

The most common exemptions are found within Rules 504, 505 and 506 of Regulation D.

Common Mistakes When Seeking Seed Money

Avoid these mistakes when seeking seed money:

  • Publicly advertising that you’re looking for investors without following the SEC requirements for a public offering.

  • Offering equity or profit sharing in a crowdfunding campaign except as provided for under the JOBS Act.

  • Giving up too much of your company and not having equity remaining for later financing rounds.

  • Taking on debt obligations that your current cash flows can’t support.

Additional Considerations When Seeking Seed Money

Also keep the following things in mind:

  • What is a proper valuation for your company? This is one of the most crucial questions to ask because it determines the potential return on the investment. A good rule of thumb is to estimate the value of a startup five years from the present, then divide by 10 to reach a good, current valuation.

  • How important is retaining control to you?

  • Will you have adequate personal resources if your business fails or grows more slowly than expected?

  • Will asking people you know for money jeopardize your personal relationships especially if you can’t return their investment?

  • Do you have other options, such as low-interest credit cards or SBA loans?

Steps to Obtaining Seed Money

Take the following steps to obtain seed money:

  • Create a business plan and financial statements. Sophisticated investors will require it. It will also help investors related to you understand where their money is going and the risks involved. Make sure you have a compelling ‘pitch’ when speaking with investors about your plan.

  • Have a clear plan for the money. Raising money without a defined need often leads to undisciplined spending that could harm future growth.

  • Use a legally binding contract for all investments regardless of amount or relationship. Even when not required, this will again prevent misunderstandings and protect the rights of all involved.

Seek Legal Advice

Raising seed money touches on multiple legal issues including contract law, securities resolution and possibly dispute resolution. Working with an experienced lawyer now can save you time, money and frustration later. Search UpCounsel to find a qualified lawyer near you.