What Is Seed Funding And How It Works

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Grip Invest
Grip Invest
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Feb 29, 2024
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    What Is Seed Funding?

    Seed funding refers to the initial capital raised by an entrepreneur to cover pre-launch expenses, business development costs, product development activities, hiring a core team, and other overhead costs to take the business from the idea stage to market launch.

    Seed capital helps start the business operations during the early stages when the startup has no operating history or market traction. It is the foundation to build and scale the business by financing critical pre-revenue activities.

    The critical characteristics of seed funding are:

    • Raised during pre-launch, proof-of-concept stage
    • Provides the capital to build the Most Viable Product (MVP), market testing, hiring team
    • High-risk investment for investors
    • Investors get an equity stake in return
    • Helps attract follow-on funding rounds

    Seed funding helps turn a business idea into reality by providing financial resources during the risky early stages when traditional financing may not be readily available.

    Difference Between Seed Funding And Growth Funding

    Seed funding differs from growth-stage or series funding rounds based on the following parameters:

    CharacteristicSeed FundingGrowth Funding
    Stage Of StartupSeed funding is for early-stage startups working on their MVP with no market presenceGrowth funding is for companies with established product/market fit looking to scale business operations
    Use of FundsUsed for product development, recruitment, and overhead costsUsed for expansion, new market entry, and acquisitions
    Risk AppetiteHigh risk due to an unproven business modelLower risk as business viability is established
    Valuation
     
    Lower valuation Higher valuation
    Exit HorizonLonger horizon for returns on investmentA shorter horizon leads to an early exit
    Investor ProfileAngel investors and incubators dominate seed fundingPrivate equity/ Venture capital funds focus on growth-stage deals

    Challenges Faced By Seed Stage Startups

    Startups face several challenges in the early stages that seed funding helps to mitigate:

    • Developing The MVP: Lack of capital makes it harder for startups to build an MVP and test the product-market fit. Seed funding provides this financial muscle.
    • Hiring Core Team: Seed money allows startups to have a founding team, including tech talent and key hires.
    • Building Customer Traction: Seed capital helps start customer acquisition, onboard early adopters, and gain initial traction.
    • Getting Business Model Right: Seed money enables experimenting with pricing, positioning, and streamlining unit economics.

    Different Avenues To Raise Seed Funding

    Here are some of the top avenues entrepreneurs explore to raise seed funding:

    • Friends And Family: Borrowing money from friends, family, and your trusted social network is more accessible than formal seed funding. Make sure to document the terms and repay on time.
    • Incubators/Accelerators: Incubators nurture early-stage startups by providing workspace, mentorship, networking opportunities, and sometimes seed capital in exchange for equity. Accelerators help scale growth in a short time frame.
    • Angel Investors: They are high-net-worth individuals who invest smaller amounts in startups.
    • Crowdfunding: Online platforms allow startups to raise small sums from a large pool of investors through crowdfunding. It also helps validate your idea.
    • Venture Capitalists: VCs focused on early-stage startups may provide seed funding in niche sectors. 
    • Bank Loans: Although difficult to get without collateral, small business administration-backed bank loans are also an option.
    • Government Grants: Central and state government schemes offer grants and seed capital to qualifying startups. It involves stringent compliance requirements.
    • Corporate Venture Capital: Strategic investments by corporates in startups for technology access, talent, and ecosystem connectivity.
    • Competitions And Challenges: Pitch events and startup challenges by corporates, accelerators, and agencies can provide grants as seed capital prizes.

    Seed Capital Vs. Angel Investing And Venture Capital

    ParameterSeed CapitalAngel InvestingVenture Capital
    Investment StagePre-seed and Seed Stage (Idea to MVP)Early Stage (Post-MVP, Traction)Growth Stage (Established Business Model)
    Target StartupsHigh-risk, innovative ideasPromising startups with market validationScalable businesses with proven traction
    Investor TypeIndividual investors, accelerators, incubators, government initiativesIndividual investors, angel networks, HNIsProfessional firms, funds of funds, corporate VCs
    Due Diligence ProcessInformal, focused on team potential and idea viabilityModerate, assessing financials, market opportunity, and team capabilityExtensive, rigorous analysis of financials, market size, competition, and exit strategy
    Return ExpectationsHigh-risk, high-potential returns High-risk, moderate returnsModerate risk, moderate returns
     
    Investment TimeframeShort (3-5 years)Medium (5-7 years)Long (7-10+ years)
    Exit StrategyAcquisition, IPOAcquisition, IPO, secondary saleAcquisition, IPO, secondary sale
    Level of InvolvementHigh: often mentorship and hands-on supportModerate: guidance and network accessLimited: focus on financial performance and governance
    Unique Aspects of the Indian MarketGrowing ecosystem with government support (Startup India)Increasing angel network activitySmaller ticket sizes compared to the US market

    Case Study: Zepto

    Zepto, an Indian instant grocery delivery startup, has raised substantial capital over multiple funding rounds to fuel its growth. Zepto operates by partnering with grocery stores and charging a commission fee on each order placed through its app. 

    In 2020, Y Combinator invested $125K in Zepto in its first seed round. In another seed round, Contrary Capital invested $730K in Zepto in 2021. This seed funding helped Zepto expand its operations and technical infrastructure across India as well as forming the base for further funding.

    In 2022, Y Combinator's Continuity Fund led a $200 million Series D round, followed by another $200 million round by multiple investors in 2023 that catapulted Zepto to unicorn status as India's first of the year. The company has raised $592 million through seven rounds of funding. 

    Conclusion

    Seed funding is crucial for early-stage startups to experiment, validate their product-market fit, and scale their MVP before raising larger funding rounds. Founders should evaluate the pros and cons of various seed capital options before kickstarting their entrepreneurial journey. With proper planning and preparation, raising seed funding at the correct valuation can set the context for startup success.

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