Seed capital, or seed money, is the initial capital required to start up a business.
The term seed suggests that it is an early investment which is meant to support the business until it can generate cash of its own or gain further investments. Seed capital often comes from the company’s founders who use savings, loans or other personal assets. Investors can also be family, friends, venture capitalists and the most recent method is through crowdfunding.
Seed funding is considered a high-risk investment which offers high returns provided that the company become a growing enterprise. The reason for being classified a high-risk investment is based on the fact that most companies seeking seed capital are new companies.
These companies are more or less one-year-old and have not yet started trading. These companies are so new that it may be difficult to obtain conventional loans to cover all their start-up costs as conventional lending institutions are not risk-seeking in nature. It is, therefore, more likely to obtain funds from investors as high returns are desired.
Once the business becomes profitable and self-sustaining, investors are paid back their original investment as well as and agreed upon interest. Some companies may offer their investors shares in the company once the business has reached a certain level in trading.
Risks involved with seed capital
Just like any other investment, seed capital funding comes with risk. The biggest risk being the possibility of a new venture failing. As mentioned earlier, it is mainly new companies or projects that require seed funding. There is, therefore no guarantee that these companies or projects will be 100% successful or even profitable.
If the business or project fails to generate income, investors may lose part or even all of their investment. It is crucial for investors to look closer into what the business offers and if there is a demand for the product or service. It is up to the investor to do thorough research to minimise personal risk.
Hedge fund seed capital
Hedge fund seed capital is the money a hedge fund tries to raise, to launch itself within the first year of operating. It attempts to raise enough money and assets to appear as respectable as possible to initial investors. It aims at providing initial momentum towards breaking even as a company.
The major drawback of raising seed capital for a hedge fund is that it is a very competitive market. According to Richard C Wilson from the Hedge Fund Group, starting a hedge fund is technically easy. The difficult part is funding the hedge fund and raising the initial or seed capital.
Before the financial crisis, the best managers did not need to be seeded. They were able to raise sufficient sums of money on their own. Managers who relied on seeding, on the other hand, were seen as the type of managers who would never become successful. Since the financial crisis, however, even the most talented managers are seeking seeders. The problem with this is that investors are becoming increasingly more reluctant with investing their money. They are even doubtful with handing over their money to the most successful managers.
The market for hedge fund seeding, or rather finding seeders, is in high demand. It is becoming increasingly common for experienced hedge fund managers to leave their existing positions to start their own hedge funds. If these managers do not have the capital themselves, they will need to find investors to help raise the initial capital. A seeding strategy ensures lower volatility compared to a private equity investment.
A seeder is most likely to have greater returns than other investors in a hedge fund as a seeder receives a share of the hedge funds revenues.
Three types of seeding models
- Revenue share: This is the most common method in which the seeder is investing purely in the fund with the object of maximising their personal returns. This is accomplished once the company they chose to invest in experiences growth in their AUM.
- Equity stake: This is when the seeder acquires a percentage of the company’s GP. This means that they acquire a stake in the fund management company and not the actual fund. This gives investors the upper hand as they have a say as to what products get launched, and they have an active role in corporate actions.
- Incubator model: This is for managers who are not confident enough to run the business from day one. This allows for infrastructure support which ranges between a number of different sectors in the business. This lets the investors decrease the hedge fund’s day one capital expenses without actually joining the hedge fund.
The majority of hedge fund seeding vehicles are structured in a similar manner to private equity capital funds. A seeding strategy commits capital to individual hedge funds for on average of four years. As the period expires, the money is typically returned to the original seed investors.
Money or funds that remain invested in the hedge fund may be subject to the original liquidity terms of the seeded hedge fund. Seeded hedge funds differ from private equity in that private equity funds are normally illiquid. Hedge fund seeding vehicles may offer a higher return because they bridge the gap between private equity funds and hedge funds.
Capitalisation and seed capital
One of the fundamentals of starting up a hedge fund is the raising of seed capital. It is important to have a well-capitalized hedge fund. The value amount of assets you can raise will depend on three things:
- Term size
- Investment partner
- Unique cost structure
Investors who believe hedge funds will resume their growth trajectory should consider a seeding vehicle as a way to capitalise on any growth in the hedge fund industry. These investors should be willing to tolerate short-term volatility. The main thing to remember is that no two seeding vehicles are the same. In the end, the success of a seed investment depends on many factors. When evaluating a seeding vehicle, carefully consider the sponsor’s history because experience and knowledge add value at every step in the process.