Over the past decade, the cost of launching a tech startup has plummeted. Due to innovations from cloud computing to open source software, building and scaling a new product or service now takes far less capital.
Lower costs haven’t only made it easier to set up shop, however. Lower costs have also shifted power to early stage "seed" investors.
Larger Seed Investments
As noted in an excellent new paper by John F. Coyle and Joseph M. Green, the plummeting cost of launching tech startups has led investors to make larger seed stage investments. With every dollar going farther, it has now become possible for seed investors to fund a new startup completely through an early growth phase without having to resort to venture capital. As the authors note, in 2004 a typical early stage investment ranged from $50,000 to $100,000 whereas in 2014 it would range from $500,000 to $750,000.
But in return for making larger investments, seed investors have been compensated with investment structures that give them more protection than common stock--and more power.
New Protections for Seed Investors
Larger seed investors found what they were looking for in seed notes and simplified convertible preferred shares (also known as series seed shares). Not only to do these two instruments give investors more protection than common stock, they also don’t have the costly and complex trappings of traditional venture capital preferred shares. Seed notes and series seed instruments are now widely adopted and remained at near record highs in 2013.
Seed notes are preferable to common stock because investors are entitled to any accrued interest payments and principal ahead of payments to common stockholders. If the startup obtains later stage venture capital, seed noteholders also have the right to convert into preferred shares at something like a 20% discount. And better still, if the company becomes very highly valued by venture capital investors, seed note investors benefit from a “conversion price cap” that allows them to effectively convert into preferred shares at a much deeper discount than 20%.
Seed shares, for their part, are also preferable to investors over common stock. Although the shares do not come with full array of protections afforded to later stage preferred shareholders, they are not mere paperweights. Seed shareholders benefit from a board seat, a right of first offer on future financings, and preferences upon the happening of a liquidation event, among other rights.
Founders Benefit Too
Although seed notes and shares mean that founders are giving up more up front to early stage investors, the flip side is that founders benefit from larger seed stage investments as they grow.
A startup with a large seed investment will have more time to develop before it seeks outside venture capital. It will be able to approach the bargaining table as a more mature enterprise with a higher pre-money valuation. As a result, founders will have to sell fewer shares—and get to keep more of their company—without any decrease in the amount of venture capital they raise. Having too high a valuation prior to receiving venture capital may turn off potential investors, however.
Because the same institutions often play the role of seed investor and venture capitalist, the power shift described above may be more of a shift in form and timing, not substance. Nonetheless, with more money at stake, early stage investing is now more serious than raising funds from friends and family or hobbyist investors. If founders can deal with the pain imposed by seed notes and series seed shares, they stand to gain when they’re ready for bigger leagues.