What is seed capital?
The term start-up capital refers to the money a new business needs to raise to cover initial costs. Entrepreneurs who want to raise seed capital need to create a solid business plan or build a prototype to sell their idea. Start-up capital can be provided by venture capitalists, angel investors, banks or other financial institutions and is often a large sum that covers some or all of the company’s major initial costs, such as inventory, licences, office space and product development.
How start-up capital works
Young companies that are still in the development phase are called start-ups. These companies are founded by one or more people who generally want to develop a product or service and bring it to market. One of the first things a start-up needs to do is to raise funds. Most people refer to this funding as seed capital.
Seed capital is used by entrepreneurs to cover all the expenses necessary to start a new business. This includes initial recruitment costs, obtaining office space, permits, licences, inventory, research and market testing, product manufacturing, marketing or other operating costs. In many cases, more than one round of seed capital investment is needed to get a new business off the ground.
Most of the seed capital is provided to young companies by professional investors such as venture capitalists and/or angel investors. Other sources of seed capital are banks and other financial institutions. As investments in young companies are associated with a high level of risk, these investors often require a solid business plan in return for their money. In return for their investment, they usually receive an equity stake in the company.
Seed capital is often required in various financing rounds as the company develops and is brought to market.
Types of seed capital
Banks provide start-up capital in the form of business loans – the traditional way of financing a new company. The main disadvantage is that the entrepreneur has to start paying the debt and interest at a time when the company is not yet profitable.
An alternative is venture capital from a single investor or a group of investors. In return for the financing, the successful candidate usually gives up a share in the company. The agreement between the venture capitalist and the entrepreneur includes a number of possible scenarios, such as an IPO or takeover by a larger company, and defines how the investors will benefit in each case.
Angel investors are venture capitalists who act as advisors to the new venture. They are often successful entrepreneurs themselves who use part of their profits to invest in young companies and act as mentors for the management team.
Seed capital vs. start-up capital
Although at first glance the two terms seem the same, there are some subtle differences. As already mentioned, seed capital usually comes from professional investors. Seed capital, on the other hand, is often provided by close personal contacts of the founders, such as friends, family and other acquaintances. Therefore, seed capital – or start-up capital, as it is sometimes called – is usually a smaller sum of money. This funding is usually sufficient for the founders to create a business plan or prototype that will attract the interest of seed capital investors.
Advantages and disadvantages of seed capital
Venture capitalists have enabled the success of many of today’s biggest internet companies. Google, Meta (formerly Facebook) and DropBox were all founded with venture capital and are now established names. Other companies backed by venture capital have been acquired by bigger names: Microsoft bought GitHub, Cisco bought AppDynamics and Meta acquired Instagram and WhatsApp.
However, providing young companies with start-up capital can be a risky business. Funders hope that proposals will turn into profitable businesses and that they will be rewarded handsomely for their support. In many cases, this does not happen and the venture capitalist’s entire investment is lost. According to a 2011 study by Harvard Business School, 30-40% of all promising start-ups end up in liquidation. The few companies that survive and grow may go public or sell their business to a larger company. Both are exit scenarios for the venture capitalist, who expects a good return on capital.
However, this is not always the case. For example, a company may receive a takeover offer below the cost of the venture capital invested, or the stock may fail during the IPO and never recover its expected value. In these cases, investors receive a poor return on their money.
To find the most notorious venture capital losers, one has to go back to the dotcom bust at the turn of the century. The names live only as memories: TheGlobe.com, Pets.com and eToys.com, to name a few. Remarkably, many of the companies that financed these ventures also failed.