What’s the Difference Between ‘Friends and Family’, Pre-Seed, Seed and Series A Financings?

‘Friends and family’/pre-seed financings: Turning an idea into a company

Entrepreneurs often need only modest amounts of capital in the early stages to cover expenses incidental to the business. Sometimes they cover these early expenses through personal savings or even credit card debt. However, in many cases they turn to people in their personal network – “friends and family” – for early capital needs. At this stage, the company may represent little more than a business plan laid out in a pitch deck, and more “formal” sources of capital are invariably not yet available to the entrepreneur.

Friends and family financings can vary in size and structure, but are usually small investments structured as a post-money Safe, typically with a valuation cap but no discount (as discussed in this article, Understanding the Valuation Cap). However, investors sometimes put in money without any documentation or due diligence whatsoever. While the convenience, low cost and speed of this approach are tempting, and many friends and family investors don’t seem initially concerned about the terms of their investment, it is important to properly document the transaction to avoid misunderstandings about equity ownership, to ensure that these investors understand the high-risk nature of their investment, and to avoid complications with later-stage investors. One issue that frequently comes up in friends and family investments is whether the company can raise money from unaccredited investors. Founders with aspirations of future investments from venture capital investors (also known as institutional investors or VCs) are well advised to only accept investments from accredited investors, even in a friends and family financing.

In recent years, the term “pre-seed” financing has emerged. This term is often used roughly and interchangeably with a “friends and family” round, although there is no universally accepted definition of pre-seed financing within the startup community. Typical investors include friends and family, angel investors and accelerators. Companies typically raise a few hundred thousand dollars to $1 million in a pre-seed round, though amounts vary.

Seed financings: Building early traction

The definition of a seed investment will vary depending on whom you ask. It would not be unusual for someone to refer to a larger friends and family or pre-seed financing as a seed financing. However, the term seed financing usually denotes a company’s first round of financing from third-party investors who regularly invest in startup companies. At the time of a seed financing, tech companies often have a working product and are able to show early traction. Seed financings are typically raised on a post-money Safe (per above), or as priced equity rounds, particularly when the round size exceeds roughly $5 million (though the threshold shifts with market conditions and prevailing round sizes) or when a lead investor wants board representation and protective provisions from the outset. In a priced equity financing, the most frequently used documents are the “full” Series A-style investment documents (see below). There is also a set of relatively simplified (short-form) “series seed” financing documents, which may be accepted by angels. Convertible notes, once a common seed instrument, are now used primarily in bridge rounds between priced financings (as discussed in this primer on convertible debt).The structure selected for the investment will depend on investor preference and the amount raised.

Series seed investment documents tend to be less extensive than Series A documentation and impose fewer restrictions on the company and its management. They typically provide for simple, nonparticipating liquidation preferences (meaning the investor gets repaid first in a sale or liquidation), limited investor protective provisions, as well as pro rata participation rights and information rights, among other matters.

In such cases, companies often still refer to the securities issued as “Series Seed Preferred Stock” simply because the company and/or the investor want to preserve the lettered rounds (Series A, Series B, etc.) for subsequent financings, signaling that the company is still in its early stages of development. A common goal of a seed financing is to delay the need for the Series A financing until the company can attain a significantly higher valuation.

Series A financings: Scaling for growth

Typically, the money raised in a Series A financing is used for “scaling up” as opposed to “starting up,” and the investment amounts are larger than in seed financings. Series A investors, usually venture capital funds, often end up with roughly 15 – 25% ownership of the company post-financing. More importantly, a Series A financing can mark a time of significant governance changes. While founders can expect to retain board control at the Series A stage, if the round is led by a VC, the VC will typically seek a seat on the board alongside the founders. The process for raising a Series A financing from initial investor outreach to closing may take considerably longer than raising a friends and family or seed financing and will require more polished presentations from the management team, more detailed legal, financial and commercial due diligence and more involvement from legal counsel on all sides.

The Series A financing documents are generally considerably more extensive than seed documents and contain many protective provisions that will impose significant restrictions on company actions outside normal, day-to-day operations. The Series A terms may also contain more onerous versions of the terms included in Series Seed investment documents and will often introduce new concepts, such as broad-based weighted-average anti-dilution protection (if not already introduced), and perhaps even accruing dividends, among other matters. The National Venture Capital Association (NVCA) has developed model documents that are often used as a baseline for Series A investments, but the use of NVCA model documentation is not universal. The Series A terms must be negotiated with care, as they can prove difficult to change in subsequent financing rounds. For more information on current market trends in venture financings, please see our Trends page on Cooley GO.