Seed Money

Related Terms: Angel Investors; Financial Planning; Venture Capital

Seed money, or seed capital, is the first round of capital for a start-up business. It gets its name from the idea that early stage financing plants the seed that enables a small business to grow. Obtaining funding is one of the most critical aspects of starting a small business. In fact, many businesses fail or are prevented from even starting due to a lack of capital. Although obtaining financing can be difficult for any small business, it is particularly hard for new ventures. Since new ventures lack a track record, potential lenders and investors are often skeptical about their prospects for success. Nonetheless, the persistent would-be entrepreneur, if armed with a sound business plan and the necessary skills, can usually obtain funding for his/her dream eventually.

Many entrepreneurs approach their family, friends, and colleagues for seed money after exhausting their own finances. Since these investors know the entrepreneur, they are more likely to take a risk on funding a new venture than are traditional financing sources, such as banks or venture capital firms. An entrepreneur must be committed and enthusiastic in pursuing seed money since he or she has little else with which to entice investors. Because it is almost impossible to predict how successful the project may eventually be, the only outsiders likely to invest in the venture are those who respect the entrepreneur’s judgment and abilities. Those people are the ones who know the entrepreneur best. By getting in on the ground floor, the providers of seed money hope to participate in the entrepreneur’s success and realize a healthy return as their investment appreciates over time. Nonetheless, seed money is a risky investment and most investors know this, or should. Investing seed money is, in many instances, more like buying a lottery ticket than making an investment.

Seed money usually takes the form of equity financing, so investors receive partial ownership of the fledgling company in exchange for their funds. As a result, it is important for the entrepreneur to take potential investors’ personalities and business reputations into consideration when seeking seed money. Since these people will be part owners of the company-and may insist upon having some control over decision making-it is vital to ascertain whether their interests and personalities are compatible with those of the entrepreneur. Once suitable investors have been located, the entrepreneur must convince them that the new business venture has a good chance of success. The first step in this process is creating a formal, written business plan, including plausible projections of income and expenses.

Having a clearly defined purpose for seed money can be an important factor in securing these funds. The purpose of seed capital usually involves moving the business out of the idea stage—by building a prototype product or conducting market research, for example—and gathering concrete evidence that it can succeed. In this way, seed money helps the entrepreneur to prove the merit of his or her idea in order to attract the interest of formal investment sources.

As far as the amount of seed money the entrepreneur should try to obtain, experts recommend targeting only what is needed to accomplish the business’s initial objectives. Given its risk, seed capital is usually more expensive for the firm than later stage financing. Thus, raising a small amount at a time helps the entrepreneur to preserve equity for later financing rounds. Ideally, an arrangement can be made that links seed money to launch financing, so the entrepreneur can go back to the same investors for future funding needs. For example, the entrepreneur might set goals for a successful market test of a new product. If the goals are met, then the original investors agree to provide additional funds for a product launch. This approach protects the entrepreneur against the possibility of having a successful test and then running out of money before being able to launch the product. Even if the original investors cannot provide additional funds directly, their vested interest may encourage them to help the venture succeed in other ways.

There are other sources of seed money available to entrepreneurs besides friends and family members. For example, some venture capital firms reserve a limited amount of capital for financing new ventures or business ideas. Since start-ups involve greater risks than established businesses, however, the venture capital investors generally require a larger equity position in exchange. On average, venture capitalists providing seed money will expect a 50 to 100 percent higher return on investment than in a standard venture capital arrangement. There are also nonprofit organizations dedicated to providing seed capital for new businesses. In many cases, these organizations will also assist the entrepreneur in creating a business plan or marketing materials, and establishing cash flow controls or other systems.

Angel Investors

Successful business owners looking to invest in new enterprises are a good potential source of start up capital or seed money. These people are often referred to as angel investors. They are known as “angels” because they often invest in risky, unproven business ventures for which other sources of funds—such as bank loans and formal venture capital—are not available. New startup companies often turn to the private equity market for seed money because the formal equity market is reluctant to fund risky undertakings. In addition to their willingness to invest in a startup, angel investors may bring other assets to the partnership. They are often a source of encouragement, they may be mentors in how best to guide a new business through the startup phase and they are often willing to do this while staying out of the day-to-day management of the business.

Although angel investors usually work on an individual basis there has been a trend towards the formation of angel investor groups within the last decade. An article in Fortune Small Business (FSB) discusses the trend towards angle investment groups. According to the author, Jennie Lee, “Last year [2005] some 227,000 angles in the U.S. pumped $23 billion into startups, up about 3 percent from 2004’¦. One reason for the growth: the void left by venture capitalist, who have started to favor larger, later-stage investments.”

These angel investment groups usually meet on a regular basis and invite prospective entrepreneurs to present their business ideas for consideration. David Worrell discusses what such a presentation may involve in his article entitled “Taking Flight: Angel Investors are Flocking Together to Your Advantage.” If invited to present ideas before an angel investor group, “expect to be one of two or three presenters, each given 10 to 30 minutes to showcase an investment opportunity. Speak loudly, as most groups mix presentations with a meal.”

Despite the potential for funding through an angel investor group, according to Worrell, individual angels are still likely to be the best source of seed and early stage money for a small business or startup. “Angel groups can bring more money and other resources, which makes them more effective at later stages.”