Investors often look at the giants of modern industry and think about what could have happened if they had invested in those companies early on in their history.

Nearly every start-up company seeks financing from investors, and the first round of funding that a company gets is known as seed funding. Even before a start-up gets the attention of major institutional investors, it can look for modest amounts of capital from certain investors and financing sources that specialize in this method of high-risk, high-reward financing. In exchange, companies getting seed funding typically give investors equity, and that can be worth billions if the company later becomes wildly successful.

How companies grow

Most investors focus on stocks that trade on public markets. But there's a long process that most companies go through before they can do an initial public offering. Seed funding is the first stage, when an entrepreneur has an idea and wants to move forward with an initial project. With the money raised, the entrepreneur hopes to find enough success to prove the concept. Many start-ups fail when their initial projects don't work, and seed investors can lose everything. But if the project does go well, then it provides the basis on which the start-up can make a pitch to additional investors.

Money growing.

Image source: Getty Images.

That second pitch usually goes to venture capital firms, which have more financial resources available to them and can commit to a longer-term course of action. As the business grows, subsequent rounds of financing can either target specific areas of concentration within the business or provide funds for use throughout the start-up's operations. Subsequent investors often provide combinations of debt and equity financing, but the goal for the entrepreneur -- and for seed investors who took equity early on -- is to preserve as much of their stake in the company as possible to maximize the potential payoff later on.

How do seed funding investors get their money?

As with all investors in privately held companies, the challenge for seed investors is how to get their investment back. The optimal solution is for the company to go public through an initial public offering, because that gives shareholders the chance to offer their shares to regular investors. Although many companies have lockup periods after their IPOs to prevent shareholders from dumping shares too quickly, those restrictions are temporary. Once lockups expire, seed investors can sell shares on the open market.

Alternatively, start-ups can get acquired before they go public. All shareholders, including seed investors, receive their proportionate share of the proceeds from such sales, either in cash or in shares of the acquiring company.

Seed funding alternatives

Recently, new ways for entrepreneurs to get seed capital have arisen. These alternatives offer the chance to go directly to small investors to fund projects, and some of these arrangements involve compensation that doesn't require the entrepreneur to give up equity. For instance, microfinancing often comes in the form of debt, while crowdfunding projects sometimes pay back their funders simply with the product that the start-up ends up creating.

Regardless of where it comes from, though, seed funding is an integral part of how start-ups form. Without seed funding, the companies that will become tomorrow's stock market leaders would never have gotten off the ground.

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