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.