How to prepare a startup for seed funding
Before you learn how to get seed funding, you need to be ready to take investment from third parties, which means preparing your startup business to do just that.
The question of how to prepare a startup for seed funding is not just about finance. It also includes legal issues, as well as other setup tasks like hiring a workforce.
Once you have a clear idea of how your business will be structured and how it will operate, only then will you be ready to raise your seed funding through an equity round.
Remember that seed capital comes in the very early stages of setting up a new business. It usually involves a smaller sum of money, anywhere from tens of thousands of dollars to several million.
Compare this with a Series A investment round, which may be for $5-10 million and usually applies to businesses that have proven growth or a bulging order book to persuade investors to put up the funds.
Because of this, anything you can do to prepare more fully could help your seed investment round to succeed, even if you do not yet have a proven track record in your new venture.
The counterpart to a Series A investment round is pre-seed funding, which comes before a fully-fledged seed round.
Pre-seed funding covers the very first costs of starting a business, and you may raise money from friends and family or other supporters, rather than from independent investors who are looking to make a profit.
Learn how equity is divided
Whether or not you have already held a pre-seed funding round, once you reach the seed funding stage, it is more likely that you will sell off an equity stake in your business in return for the funds investors put into your venture.
At this point, you must learn how equity is divided. Remember that equity is not just something you give to seed investors — it is also your own controlling stake in your business.
If you are the sole owner of your business, theoretically you can give away up to 49% and still retain control.
But if there are several co-founders, your initial equity stake might be 50%, 33%, 25% and so on, depending on how many business startup-founders you have.
If you then sell a substantial equity stake to a single investor, they could quickly gain decision-making power in your company.
This is more of an issue for smaller companies, and where you receive most or all of your seed funding from a single investor like an angel investor, as both of these factors can mean the investor gets more of an equity stake.
If you are raising funds from lots of investors, who each buy a smaller number of shares in your company, there should be less risk of an individual gaining a stake on a par with your own.
In either case, it's crucial to think about the total amount of equity you will give away to investors. You should also consider whether you will need to sell more equity in a later investment round, as you will need to retain that equity throughout your seed funding phase if so.
How does an equity investor make money?
Equity investors will want to make a profit on the seed money they put into your venture. In general, there are two ways to do this:
- Capital gains
Capital gains are the more simple and obvious method to make money from equity investment.
To make money in this way, investors buy into a business, hold that equity stake for some time, and then sell it at a later date when the company has grown in value.
New startups are an excellent opportunity to do this, as they are still in their early growth stage. However, new businesses are also a higher risk as they are often more likely to fail.
If you can show investors that your business projections, valuations and market demand are all realistic, they may be more confident that buying a stake in your company will prove profitable for them in the long run.
Dividends are a little more complicated. They are a share of the company's profits, divided according to the amount of equity each investor holds.
That means an investor who has a 10% equity stake will receive twice as much in dividends as an investor with a 5% equity stake, and so on.
As the owner of the business, this is significant for you too. The more equity you sell during your seed stage, the more of your profits you will have to give away as dividends.
You should make sure that you factor this into any calculations of future profits and the amount of money you will be able to spend.
Understand your budgets and overheads
Succeeding in business is about balancing the money coming in with the money going out. In the early days of a new venture, there will be more money going out of your business than coming in from revenues.
This is where seed investment helps. The money coming in from third-party investors acts as a kind of bridging loan, covering those initial costs until revenues from sales and orders are sufficient to cover expenses and turn a profit on top.
When planning to raise funds via seed investment, it's sensible to know precisely what your budget for your business is, as well as the expected overheads you will face. For example, by this point, you may need to hire an experienced management team.
By calculating the difference, you can identify any budget shortfall and decide how much you need to raise in seed finance to fill that gap.
Many early-stage companies fail because the entrepreneur did not accurately forecast the costs the business would face.
Remember to factor everything into a business model, from the rent you pay for your business premises, to any wages you need to pay to workers (and to yourself) and other budget considerations like prototype and machining costs.
Predict your overheads like utility bills, product development, and any essential supplies your business will need.
Also, remember that you may have to wait to get paid for the work you do or the products you supply. Payment terms have a direct impact on your cash flow, so as a rule of thumb, don't assume money will be available for your business to spend the same day you sell goods or services.
Ensure you have long-term planning
Once you have a good idea of your budget, your overheads and the impact they will have on your cash flow, you are in a good position to plan for the long term.
By forecasting further into the future, you can make sure you raise the right amount in your seed funding round. That means you only give away the appropriate amount of equity, and you don't have to go back to your backers to ask for more money at a later date.
It's not just about how much money you need. The amount you can raise also depends on how much your business is worth.
Potential investors will want a fair price for the equity stake they buy. This is determined by the ratio between the money you want to raise and the total valuation of your business.
A long-term business plan enables you to estimate this value not only in the present but at significant milestones in the future.
For example, if you are confident of reaching your monthly revenue targets within your first 1-2 years of operation, you could argue that your business is worth much more than if it will take you ten years to reach that same rate of income.
Consider how much your business is worth
If you plan to raise funds using an equity round, it's important to consider how much your business is worth.
An accurate valuation gives you the confidence you need when selling shares in your company so that you can make sure:
- Investors pay a fair price for their equity stake
- You raise the total amount of money you need
- You retain as much of your equity as possible
In the very early stages, it can be more difficult to value your business accurately. You might have less evidence to support your valuation, such as signed contracts and confirmed orders.
You should also consult a lawyer before starting an equity funding stage. It's important not to lose control of your business, and an experienced lawyer can help you to avoid some of the more common rookie mistakes small businesses sometimes make.
The valuation of your business can ultimately help you to decide if the amount of money you need to raise is feasible.
If the ratio of seed finance to total valuation is too high, you would need to give away too much of your equity to give investors a fair deal.
By calculating an accurate valuation, you can decide whether this is the case and how to make your business viable, either by cutting costs or finding some extra funds in another way.