Seed money, or seed capital, is the financing an entrepreneur needs in the very early stages of launching a new business. It gets its name from the idea that early stage financing plants the seed that enables a small business to grow. Obtaining funding is one of the most critical aspects of starting a small business. In fact, many businesses fail or are prevented from even starting due to a lack of capital. Although obtaining financing can be difficult for any small business, it is particularly hard for new ventures; since they lack a track record, potential lenders and investors are often skeptical about their prospects for success. But the dedicated would-be entrepreneur, if armed with a sound business plan and the necessary skills, can usually obtain funding for his/her dream.
Many entrepreneurs approach their family, friends, and colleagues for seed money after exhausting their own finances. Since they know the entrepreneur, these investors are more likely to take a risk on funding a new venture than are traditional financing sources, such as banks or venture capital firms. "An entrepreneur needs vast quantities of commitment and enthusiasm in the seed-capital stage, since the venture has little else with which to entice investors," Reed Phillips III wrote in an article for Folio. "Because it is almost impossible to predict how successful the project might eventually become, the only outsiders likely to invest are those who respect the entrepreneur's judgment and abilities. And those are the people with whom the entrepreneur has had the longest relationships." By "getting in on the ground floor," the providers of seed money hope to participate in the entrepreneur's success and realize a healthy return as their investment appreciates over time. Still, Phillips noted, "Risking money in the early stages of a start-up is more like buying a lottery ticket than making an investment. Investors know the odds are against them and realize they may lose their entire investment."
In most cases, seed money takes the form of equity financing, so investors receive partial ownership of the fledgling company in exchange for their funds. As a result, it is important for the entrepreneur to take potential investors' personalities and business reputations into consideration when seeking seed money. Since these people will be part owners of the company—and may insist upon having some control over decision making—it is vital to ascertain whether their interests and personalities are compatible with those of the entrepreneur. Once suitable investors have been located, the entrepreneur must convince them that the new business venture has a good chance of success. The first step in this process is creating a formal, written business plan, including plausible projections of income and expenses.
The entrepreneur should also have a specific purpose in mind for the seed money. The purpose of seed capital usually involves moving the business out of the idea stage—by building a prototype product or conducting market research, for example—and gathering concrete evidence that it can succeed. In this way, seed money helps the entrepreneur to prove the merit of his or her idea in order to attract the interest of formal investment sources.
As far as the amount of seed money the entrepreneur should try to obtain, experts recommend targeting only what is needed to accomplish the business's initial objectives. Given its risk, seed capital is usually more expensive for the firm than later stage financing. Thus, raising a small amount at a time helps the entrepreneur to preserve equity for later financing rounds. Ideally, an arrangement can be made that links seed money to launch financing, so the entrepreneur can go back to the same investors for future funding needs. For example, the entrepreneur might set goals for a successful market test of a new product. If the goals are met, then the original investors agree to provide additional funds for a product launch. This approach protects the entrepreneur against the possibility of having a successful test and then running out of money before being able to launch the product. Even if the original investors cannot provide additional funds directly, their vested interest may encourage them to help the venture succeed in other ways.
There are other sources of seed money available to entrepreneurs besides friends and family members. For example, some venture capital firms reserve a limited amount of funds to finance new ventures or business ideas. Since start-ups involve greater risks than established businesses, however, the venture capital investors generally require a larger equity position in exchange. In his book The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, W. Keith Schilit estimated that venture capitalists providing seed money would expect a 50 to 100 percent higher return than in a standard venture capital arrangement. There are also nonprofit organizations dedicated to providing seed capital for new businesses. In many cases, these organizations will also assist the entrepreneur in creating a business plan or marketing materials, and establishing cash flow controls or other systems.