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When a new business needs to raise investment to get off the ground, the first funding round is referred to as seed funding. The term itself is a reference to the fact that the seed funding is intended to make the new business grow like a tree or plant. Seed funding might also sometimes be referred to as start-up capital or simply an initial investment, but the term seed funding is useful as it is likely to be recognised and understood by a wide range of potential investors.
How does seed funding work
In simple terms, seed funding involves an investor or investors putting funding into a business in return for some kind of financial interest. The financial interest in question could take the form of a percentage stake in the ownership of the business or a guaranteed share of future profits.
Why your business might need seed funding
Seed funding is often a necessary part of the launch of a business for a very simple reason – taking a product or service to market costs money. The initial expenses generated by a business could consist of any or even all of the following:
Wages for employees
Supplies or stock
Expenses such as these can mount quickly, and without seed funding many businesses would simply not be able to finance the process of establishing their presence in the marketplace. As well as making it possible to fund the kind of expenses detailed above, seed funding could also be used to pay for vital steps such as investing in marketing or PR, and putting together an effective sales or marketing team.
Other types of funding
Many businesses undertake multiple funding rounds, often referred to as Series A, Series B and Series C funding. There is also such a thing as pre-seed funding which involves investment before the first round of seed funding. The amount of funding needed at each of these stages will depend upon the size of the business and the stage of development it has reached.
Seed funding and investors
From a business point of view the importance of seed funding hinges upon the finances being put into the business. As far as the investors are concerned, however, seed funding is all about the return on investment (ROI) which they can expect. The methods used to provide a ROI include the following:
This involves the investors owning a percentage of your business in return for the seed funding. In most cases the investors will receive around 20-25% equity in the business. Over time, the investors will receive a dividend related to the amount of equity they hold. However, the long-term plan is usually to fund a start-up, receive the equity, then sell it for a profit once the start-up has grown and become established.
Convertible debt usually refers to a form of seed funding for a business which is not easy to value, usually because of the innovative nature of the business or the very early stage of development. In cases like these, the investor will provide seed funding in the form of a loan, with the interest rate and date of maturity set out in an agreement. The plan in cases such as this is for the debt to convert into equity during a later equity funding round, although the investor can always choose to withdraw from the business when the debt matures and has to be repaid.