When seeking investment from your investors, it’s important to keep in mind that they will want to see a return on their investment (ROI). There are a few different ways to structure this, including equity funding, convertible debt, and SAFE agreements.
With equity funding, the investor provides funds in exchange for a percentage of ownership in your company, typically between 20% and 25%. As a shareholder, they will receive a portion of dividends based on their equity share, but their primary motivation is to hold onto their shares as the company grows and sell them for a profit later on.
Convertible debt is a type of funding that is often used for early-stage companies that are difficult to value. In this scenario, the investor provides a loan with a set principal amount, interest rate, and maturity date. The loan can be converted to equity when the company proceeds with an equity funding round, but otherwise, the investor can choose to withdraw their financing at maturity.
A SAFE, or Simple Agreement for Future Equity, is similar to convertible debt but does not include interest or a maturity date. It was created by Y Combinator for startups seeking early-stage funding. Essentially, it is a loan given in exchange for the right to purchase stock at a future date, usually at a discounted rate.
Here’s an example of how seed funding works for startups and investors:
Let’s say there’s a tech startup called “InnovateTech” founded by John. John has a brilliant idea for a mobile application but needs funds to turn his idea into a reality. He decides to seek seed funding to kickstart his venture.
- Pitching the Idea: John starts by preparing a comprehensive business plan and a compelling pitch deck that outlines his idea, market opportunity, competitive advantage, and revenue projections. He also creates a prototype or minimum viable product (MVP) to demonstrate the feasibility of his concept.
- Investor Search: John begins his search for potential investors who are interested in funding early-stage startups. He reaches out to angel investors, venture capital firms, or startup incubators that specialize in seed funding.
- Initial Meetings: John manages to secure a meeting with a venture capital firm called “TechVentures.” During the meeting, he presents his pitch deck and demonstrates his MVP. The investors at TechVentures are impressed by John’s idea and see potential in it.
- Due Diligence: TechVentures expresses interest in providing seed funding to InnovateTech but wants to conduct due diligence before making a decision. They thoroughly analyze John’s business plan, financial projections, market research, and potential risks associated with the venture. They may also speak with John’s team members and conduct background checks.
- Negotiating Terms: After completing the due diligence process, TechVentures decides to proceed with the seed funding. They enter into negotiations with John to determine the terms of the investment. This includes discussing the amount of funding, equity ownership, valuation, and any additional conditions or milestones tha need to be met.
- Investment Agreement: Once both parties reach an agreement, they formalize the terms in an investment agreement. The agreement outlines the specifics of the funding, such as the amount of money being invested, the percentage of equity TechVentures will receive in return, any board seats or advisory roles, and the rights and responsibilities of both parties.
- Funding and Support: TechVentures provides the agreed-upon seed funding to InnovateTech. John uses the funds to hire additional team members, develop the mobile application further, conduct marketing campaigns, and cover other operational expenses. Alongside the funding, TechVentures also offers guidance, mentorship, and access to their network of industry connections to help InnovateTech succeed.
- Milestones and Progress: As part of the investment agreement, TechVentures and InnovateTech establish specific milestones and targets that John’s startup needs to achieve. These milestones can include user acquisition goals, revenue targets, or product development milestones. TechVentures monitors InnovateTech’s progress and provides support and feedback along the way.
- Follow-On Funding: As InnovateTech achieves its milestones and demonstrates promising growth, it may attract additional funding rounds from venture capitalists or other investors. This follow-on funding helps the startup scale its operations, expand its market reach, and fuel further growth.
- Exit or Growth: Depending on the startup’s trajectory, TechVentures may choose to exit its investment through an acquisition or an initial public offering (IPO). If the startup becomes highly successful, TechVentures can reap significant returns on its initial seed investment through the sale of their equity stake.
This example demonstrates the general process of how seed funding works for startups and investors. The specific details and terms can vary depending on the nature of the startup, the investors involved, and the prevailing market conditions.