Startups will often go through several rounds of financing before they are able to generate enough revenue to finance their operations. The earliest funding round, the seed stage, is a critical period when money is needed to develop the business and prove the new product or service works before it is sold to consumers. In recent years, we have seen the emergence of “open source” term sheets and related equity seed investment documents that are designed to make a startup’s first financing as fast and efficient as possible.
What Are Seed Investments And How Do They Differ From Series A?
Seed capital is the initial capital used when starting a business, covering early-stage expenses like market research or product development. A seed investment usually refers to a company’s first round of financing from third party investors, which can include friends and family or even more experienced investors, such as individual angel investors or venture capital funds. Seed investments under $1 million will often use convertible loan notes – short-term debt that converts into equity – or equity seed investment documentation. The securities issued are sometimes referred to as Series Seed or Series AA.
If the seed round is about finding a business model, Series A is about executing that business model at scale. Series A usually comes after the company has shown some track record and the investment amounts are larger, which results in higher investor ownership levels.
What Is Equity Seed Investment Documentation?
These documents are, in effect, stripped-down term sheets and related documents that are designed to be less complicated, saving startups time and money in legal fees. They tend to have simple terms and be less extensive than Series A documentation, while imposing fewer restrictions on the company. There are several sets of “open source” equity seed financing documents available, including:
- TechStars Model Seed Funding Documents
- Y Combinator Series AA Equity Financing Documents
- Founders Institute Plain Preferred Term Sheet
- Series Seed Financing Documents
What Does Equity Seed Documentation Include?
While each set of seed financing documents are different, they typically provide a 1x liquidation preference (the right of one class of shareholders to be paid ahead of other classes in the event the company is liquidated) as well as limited investor protections. The documents also tend to include certain participation rights and information rights, among other things.
For example, the Series Seed Financing Documents, released in 2010, includes future rights, which state that holders of Series Seed are entitled to better rights that future investors might get in a future equity financing. It also includes a right of first offer on future financings, as well as information rights that entitle the investor to receive annual and quarterly financial statements, and a seat at the board. The Series Seed Financing Documents are somewhat unique from some other equity seed financing documents in that they also require the company to pay $10,000 for investors’ counsel.
When Should Equity Seed Documentation Be Used?
There are times when an investor is investing a relatively small amount and may prefer to purchase equity as opposed to convertible debt. These types of situations might lend themselves to the use of the equity seed documentation. Larger seed financings (i.e., $500,000 and above) will often use Series A-style documents, which are more robust and include terms not found in equity seed documentation (including more extensive investor protections).
For example, Series A investment documents will include registration rights, give the investor the ability to require the company to facilitate the resale of the shares. They also typically include anti-dilution protection, as well as more comprehensive protective provisions and representations and warranties. Some of these terms, like anti-dilution protection, are of limited value during this stage of financing if the investors believe the chances of a lower priced round in the future is remote, so their being omitted from equity seed documentation isn’t necessarily a reason for concern. Of course, no one can predict the future, that is why we typically see anti-dilution protection in most financing rounds.