Seed Funding: Friends And Family

February 7, 2010 | by Zach Robins Comments

Capital

The seed stage, or initial funding round for a startup business, is critical to getting a company off of the ground. Often raised from founders, friends or family, this round lays the foundation which allows an idea to blossom into a product or service.Yet, founders often struggle with structuring the seed round. Questions naturally arise, such as:

* What is the valuation (worth) of my company?
* Should the investment be structured as equity or debt?
* How much of the company should I sell to investors?

There are a multitude of answers to the above questions, but David Cohen of TechStars has a very pragmatic approach to tackle these tough issues. He suggests seed funding should be structured as convertible debt, that is  “a loan that gets swapped for equity in the next round of financing.” Ideally the next round of financing is for a more meaningful figure and is lead by an angel fund or venture capital group. The benefits to this structure are two-fold:

1. A more proper valuation can be arrived at, as the company has matured and developed a functioning business model.

2. Professional investors are better equipped to arrive at a more practical valuation.

So, if the investor’s loan converts into equity at a later date, what incentivizes the individual to fund at seed stage? Therein lies the discount. At the conversion, the seed investor receives a discount per share compared to the institution’s per share price. Cohen suggests a 20% discount per share, to appease new and old investors.

In essence, the young startup is able to receive the funding it needs to grow, without the many headaches associated with financing structure. These issues can be dealt with at a later date, with the insight of professional investors, to boot. 

Zach Robins

Tags:

  • Excellent breakdown, Zach. I'd actually love to see some sort of webinar on this if you and tech.mn would be willing.

    I think it's worth emphasizing that if you have any plans on doing an equity round (meaning, literally, selling equity for funding) down the road, then it's really important that you get a good grasp on how your equity will become whittled down over time. Not fun to think about, but what you sign up for.

    Here's a really helpful simulator that allows you to plug in some numbers and it will simulate your ownership after each round.

    http://www.ownyourventure.com/equitySim.html

    If feeling the pain of giving up ownership is bad, then being surprised at how little your left with after dealing with the investors is downright torture. It'll help to know well in advance what each founder's situation will look like. No surprises!
blog comments powered by Disqus

Thanks to our community sponsors:

Nerdery Interactive Labs Gray Plant Mooty Well Advised IP House
New Counsel Marcato w3i

Get the TECHdotMN monthly digest

Listen to the TECHdotMN Podcast

The podcast player requires Flash Player.

Upcoming Events

View all upcoming events


Follow TECHdotMN on