Seed capital: what it is, how it works, example

What is Seed Capital?

The term seed capital refers to the type of financing used for the foundation of a start-up. The funding is provided by private investors, usually in exchange for a share in the company or a share in the profits of a product. Much of the seed capital raised by a company may come from people close to the founders, such as relatives, friends and other acquaintances. Raising seed capital is the first of the four funding stages that a start-up needs to transform into an established company.

Understanding Seed Capital

An early-stage company may have limited access to funding and other sources. Banks and other investors may be reluctant to invest in the company because it does not yet have a history, track record or measure of success. Many start-up managers turn to known people, family members and friends, to obtain an initial investment. This funding is called seed capital.
Seed capital, also called seed money or seed funding, is so called because it is the money a company raises in its early stages. It need not be a large sum. Since it comes from personal sources, it is often a relatively small sum. This money usually only covers the essentials a start-up needs, such as a business plan and initial operating costs – rent, equipment, salaries, insurance and/or research and development (R&D) costs.
The main objective at this stage is to obtain further funding. This means attracting the interest of venture capitalists and/or banks. None of them are inclined to invest large sums of money in a new idea that only exists on paper, unless it comes from a successful serial entrepreneur.

Special Considerations

A start-up usually goes through four different investment phases before it really establishes itself: seed capital, venture capital, mezzanine financing and IPO. As already mentioned, seed capital is usually sufficient to achieve the initial goals of the company. If the company is successful in the early stages, it may attract the interest of venture capitalists. These investors are likely to invest heavily in the company before it develops further. Sometimes so-called mezzanine financing is needed to support a company in its early stages. Usually, this financing is only available to companies with an established track record, and even then, at a high interest rate. The final stage is when the initial investors have their payday. When a young company goes public with its IPO, it receives sufficient capital to continue growing and expanding.

Seed Capital vs Angel Investing

Professional angel investors sometimes provide seed capital, either in the form of a loan or in exchange for a stake in the future company. These investors are usually high net worth individuals (HNWIs) who may come from the personal network of the founder(s). Angel investors often play an active role in the development of a company from the ground up. If the angel investor contributes less than $1 million, the money is usually provided in the form of a loan. For the entrepreneur, this can solve the problem of raising sufficient seed capital, as financial institutions and even venture capitalists are reluctant to take a high risk. For a contribution in excess of $1 million, an angel investor usually favours seed capital and becomes a co-owner of the start-up and holder of voting preference shares.

Seed capital vs. venture capital

Seed capital and venture capital are often used synonymously and often overlap. Seed capital is generally used to develop a business idea to the point where it can be effectively presented to venture capital companies with large sums of money. If the venture capitalists like the idea, they generally receive a stake in the new company and invest in its development in return.
Venture capitalists provide most of the money needed for the creation of a new company. This is a substantial investment to pay for product development, market research and prototyping. Most start-ups at this stage have offices, employees and consultants, even if they do not yet have a product of their own.

Example of seed capital

Alphabet, Google’s parent company, provided seed capital to the Center for Resource Solutions in 2016 for a project to implement renewable energy certification programmes in Asia. The goal of the centre, based in San Francisco, is to support companies in purchasing electricity from clean sources. The Center for Resource Solutions is a non-profit organisation, but Google has a commercial interest in the project. The company is already the world’s largest purchaser of renewable energy, but wants to power its global data centres and ultimately its entire business with renewable energy.