Determining Equity for a Seed Investment: The Balance Between Risk and Reward

When seeking seed funding, balancing the amount of equity you give to investors is crucial for the long-term success of your startup. Understanding the importance of an exit strategy and forecasting potential revenues and profits is essential before deciding on the equity distribution.

Understanding the Importance of an Exit Strategy

Equity makes the most sense when there is a clear exit strategy in place. An exit strategy typically involves a specific timeframe and a projection of the company's revenue and profit at the time of exit. This enables investors to make an informed assessment of the company's potential value and the accompanying return on investment.

Professional vs Non-Professional Investors

Professional investors are generally looking for a higher return, often seeking a 3x return on their investment within 3-5 years. This is based on a forecast that estimates the company's worth at the time of exit. Non-professional investors, on the other hand, may be willing to invest less, potentially demanding a 3x return on their investment over a longer period, such as 7-10 years.

Estimating Company Worth

To estimate your company's worth, you can use two main methods: using profits or sales. For example, if your company's profits grow to $300,000 in 3-5 years, this could be a reasonable estimate to use. Alternatively, you can use a multiple of sales, such as 3x sales, to forecast the company's value.

Including Royalty Agreements

In addition to equity, some investors might be interested in a royalty arrangement, based on gross sales. This can be structured in two ways: either until a required return on investment (ROI) is achieved or for a specified period. High/fast revenue growth suggests a longer period, while lower revenue growth might argue for a profit cap.

Choosing the Right Financing Method

There are several methods to accept a seed investment of $100,000 from an investor. These include using a Convertible Note with a cap and discount, a SAFE (Simple Agreement for Future Equity) with a cap and discount rate, or straight equity based on a mutually agreed valuation.

Convertible Notes vs. SAFEs

A Convertible Note is a short-term debt that converts into equity in a future round. It can offer the advantage of a higher valuation cap, reducing dilution. SAFEs, on the other hand, are simpler financial instruments that do not constitute debt. They provide more favorable terms for founders as the valuation cap is usually much higher than the current company value.

Strategic Considerations for Founders

Founders must take a strategic approach to accept seed funding. Delaying a priced round can be a wise decision if possible, as it gives the startup more time to grow and potentially achieve a higher valuation in the future. However, if an investor insists on an equity round, it is advisable to agree on a percentage that is 10% or lower. Lower percentages are preferable, but it is also important to be fair and mindful of the investor's risk by trusting you to grow the company.

Valuation Considerations

Choosing a valuation that is too high too early can cause problems down the road, especially when you need to raise more money. Trying to secure a down round (a round where the valuation is lower than the previous round) is generally not viewed favorably by existing or potential investors. Therefore, a slightly lower valuation can be beneficial for long-term growth and investor confidence.

Conclusion

Deciding on the equity to give an investor for a seed fund is a complex task that requires careful planning and consideration. An exit strategy, forecasting revenues and profits, and understanding the dynamics between professional and non-professional investors are all key factors. By taking a strategic approach and considering the long-term implications, founders can ensure they receive the right balance of risk and reward.