How does seed funding work for startups?

April 21, 2021

Raising funding for a startup can be complex with shares, stock, compliance, rights and even deciding on the type of funding that’s right for you.  Seed funding is the name for the initial amount of funding that a startup raises to cover costs for anything from product development and research to marketing costs and expenses.

What is seed funding?

Seed funding refers to the initial sums of money a business venture raises, the seed funding represents the initial equity funding stage. The early investment that seed funding provides to a business is normally used to facilitate business growth and stimulate income generation.

For new businesses, seed funding, also known as seed capital, is an essential component of business investment.  

The name ‘seed’ funding comes from the analogy for the planting of a tree, with the seed being the first foundation for further growth.

New businesses have startup costs which include equipment, wages, rent, utilities and much more.  

Seed funding can help new businesses with access to funds early on so that they have them available to meet the initial startup costs and potential growth.

What is seed funding used for?

Seed funding is essentially equity-based funding, which requires investors to invest money into the business at the very early stages.  

In return for the investment, the investor is given an equity stake.  An equity stake is a share of the business.  

The seed funding arrangement is mutually beneficial for both business and investor.  The business receives essential capital to begin trading, and the investor acquires some ownership of the business.

For any startup that wants fast growth, seed funding plays a big part.  

High growth often requires high capital in order to sustain the growth.  Seed funding can provide new businesses with a competitive advantage, especially when they are navigating unpredictable business territories.

Who usually provides seed funding?

A common source of seed funding are private investors.

Seed funding can also be provided by accredited investors, crowdfunding investors and also angel investors. 

Angel investors are typically investors who provide seed funding, but also provide advice and guidance to help the business grow.

What’s in it for the seed funder?

There are many benefits for seed funders.  For most seed funders they are looking for a healthy return on their investment. 

As early funders, they can reap the benefits of joining the business early, and working with innovative founders.  

Many investors in startups like the option of having a diverse portfolio of investments and in the UK, investors can potentially claim tax relief on investments of up to 50% (more on that below).

Getting started with seed funding

There can be a lot of new terminology to deal with when looking at funding options. 

New startups often make time-critical decisions relating to funding, but don’t always anticipate the implications of their decisions further down the line.

The UK has a legislative regime which was established to ensure investors are protected and that companies are regulated when dealing with seed funding. 

There are strict rules that businesses have to comply with when it comes to sourcing funding for startups.  Legal and financial advisors can ensure you are compliant with the rules and protected from risky situations.

The circumstance of each business is unique and the advice should always be tailored to the specific requirements of the business. 

Some important considerations and terms to be aware of when starting up and using seed funding, include the following:

Financial promotions and FSMA 

The Financial Services and Markets Act 2000 (FSMA) states that it is not lawful for companies to offer transferable shares to the public unless the business has prepared a prospectus.  The prospectus must be approved by the Financial Conduct authority. 

There are exemptions to needing a prospectus depending on the level of funding required and consideration payable by investors, so it is essential that businesses seek legal advice before they embark on accepting any offers for seed funding.

A breach of the FSMA is a criminal offence, so any new business looking to source seed funding needs to be aware of the requirements of the FSMA and ensure it is compliant.

The FSMA regime also controls financial promotions.  This means that any communication by the business to engage or induce investors to invest will be considered to be financial promotion and must be compliant with the financial promotion rules of the FSMA.

Timing of the deal

The timing of the deal is another consideration startup businesses should have in mind.  

Businesses need to determine the best time for entering into a seed funding deal.  

Too early, and the funding could be left unused, too late and the business may already be lagging behind with its plans.  

The timing of the seed funding determines how far you can take the business in the first 6 months.  Of course, at this stage many businesses will only have predictions about future growth, and no exact figures, so approaching investors at the right time is critical.

 SEIS and EIS (Seed Investment Enterprise Scheme and Enterprise Investment Scheme)

EIS SEIS legal advice is vital. It is important you work with your legal team and accountant on SEIS and EIS applications.  

It will come as no surprise that startups are deemed to be high risk investments.  

The SEIS and EIS are both government initiatives established as a relief scheme for investors.  The schemes encourage private investors to invest in startups, and in return they are offered tax breaks. 

In order for startups to make use of SEIS, businesses need to work closely with their legal advisors and accountants to ensure that they secure the SEIS investment.  

Your accountant will be able to advise you about the SEIS rules and whether you qualify.  

If your business trade qualifies for the SEIS scheme you can take steps to procure an investment.  

SEIS has rules relating to investment so it is always best for businesses to seek independent legal and financial advice.

Share Options, Division and Caps Tables

Remember, there is a finite number of shares you can issue, so think carefully about your share divisions and allocations 

Use caps tables to show you the capital stake of each investor and any changes that occur.  You should also think about the restrictions on investors in terms of investment limits and control.

Dilution

Voting structure, control of the company and the shares allocated, are all important issues for the future direction of the company. This can lead to dilution of ownership, and dilution needs to be tracked long-term to ensure your interests are protected.  

You should understand how to retain control of your business whilst securing the funding you need.  Make sure you are aware of all the regulations, compliance requirements and the contractual terms you are entering into.

Intellectual Property (IP)

As a startup you will have your own intellectual property including copyrights and trademarks. This could be as simple as your company logo or your website. There are numerous assets that you should seek to protect. 

GDPR (General Protection Data Regulation)

These are the rules around how companies store, share and manage personal data.  Breaching the GDPR rules can have consequences for businesses, including fines and penalties of up to 4% of your turnover.

Convertible Shares

Convertible shares are issued when investors agree to take convertible shares in place of shares upfront.  The convertible shares can be converted into equity at a later stage.  You should carefully assess any convertible share options and the business in the future.

Down rounds

Sometimes, particularly in an economic downturn, a company could sell shares for a lower rate than they have been sold in previous financing rounds.  Negotiating down rounds can be fraught so understanding your company’s financial standing, and negotiating accordingly, is crucial.

Term Sheet

The term sheet will outline the main terms and conditions of the deal you agree with your investors.  

The term sheet will also include investor director rights and is an important part of managing the risk between the parties. 

Shareholders Agreement

This agreement is the legal document that will detail the relationship between the founders and shareholders.  

The shareholders agreement will also list all the warranties you are willing to give such as ‘The company owns all the intellectual property it uses’.  

It is important that the agreement is accurate and protects you whilst also outlining the main contractual terms.

Disclosure letter and warranties

As a new startup, the disclosure letter and warranties are an important element of the funding round.  

The disclosure letter is where you list warranties that are not correct.  

Using the above warranty example, the disclosure letter may state that ‘The company owns all the intellectual property but has a licence to use X software’.  The disclosure letter facilitates full transparency from the company.

What next?

There is a fine balance between securing investors and protecting the founders and the business at the same time. 

Get the right legal advice from the start by contacting us here.

MAKE AN ENQUIRY