Pre-Seed Funding | The Ultimate Guide for Start-Up Founders
Maxim Atanassov, CPA-CA
Serial entrepreneur, tech founder and investor with a passion to support founders who are hell-bent on defining the future!
The journey of customer discovery , customer traction and product market fit always takes longer than you want it to take. Early stage companies have a long list of needs and very limited resources to meet those needs.
You will need all the help you can get, both from?friends and family,?accelerators,?incubator platforms,?government?or even?angel investors. They will be the ones who?trust your company in its early stages?and will provide the financial backing during the pre-seed round.?Capital is an accelerant.
In this article we will tell you everything you need to know about the?pre-seed round. Not only will you learn in detail?how useful it can be for your business, but you will also learn?how to design a pitch deck that will help you convince your potential investors?to place their trust in your business.
What is pre-seed funding?
When we talk about?pre-seed funding, we refer to the moment?when your company begins to operate. Most companies’ journey starts by bootstrapping, leveraging founders’ capital, before graduating to the Friends, Family and Fools (FFF) round. Naturally so. The risk at the onset is the highest. As the company progresses and matures, greater level of clarity emerges and with it customer traction. Traction is inversely correlated with risk. As more and more risk is taken out of the investment decision, the more and more likely it is that you will be able to attract sophisticated investors.
Do I have to raise pre-seed capital?
Most founders have to use their own capital or friends and family’s capital to get a company off the ground. Established entrepreneurs with one or more successful exits may be able to go straight to seed, even at the idea stage. At that point, sophisticated investors are investing in the founder and the idea and less so in the company. But skipping over a stage is much more of an exception than the norm.
So what if I don’t have the capital to pursue an idea?
Many countries and regions fund a multitude of?pre-seed or seed accelerators.?Accelerators are fixed-term, typically 3-month, cohort-based programs, that include mentorship and educational components and culminate in a public pitch event or Demo day. They are typically free as they are funded partially or fully by the government. They provide entrepreneurs with a structured environment where an entrepreneur can develop their idea and tap into subject matter expertise from the mentors/advisors participating in the program.
A couple of other alternatives exist:
Is pre-seed funding safe?
Not at all. The earlier the company is on its journey, the higher is the risk of failure. Hence why the initial investment comes from love money, the term used to refer to friends and family. They are investing in the company’s founder(s). They want to support the founders’ passion. And they have to prepare to lose 100% of their investment.
On the flip side, a pre-seed investor in a to-be-successful company stands to make stratospheric returns as the company valuation at that stage would be very low. Unless, the company stalls, fails to works on a problem worth solving or a threat to its existence emerges, the company valuation keeps on climbing higher and higher. As such, $1 of an investment gets an investor a smaller and smaller proportion of equity in a company.
Many early-stage investments are in the form of a convertible note, essentially a loan that converts into equity (generally around the time of the next funding round). But this does not provide protection to the investor, as these loans are not guaranteed or secured in any way.
How much equity do seed investors get?
Depends. On what? The answer lies in a multitude of factors, the?level of knowledge?and sophistication of both the entrepreneur and the investor, the?greed factor?(on the part of the investor), the?desperation factor?and the?need for money?(on the part of the entrepreneur), the?strategic importance of the investor?to the company, the?company valuation?and so forth.
Generally speaking,?an entrepreneur should not be offering more than 25% of the equity in the company as part of an investment round. Sophisticated investors, especially for early-stage companies, are not looking to acquire more than 25% of the company as they want the founding team to keep as much of the equity in the company as possible. The more skin the founding team has in the game, the more likely they are to drive hard to achieve their vision.
Private Equity and Family Office take a higher proportion of equity but they typically do not play as big of a role in early stage companies as (professional) angels, angel consortiums, and venture capital firms.
By way of example, if your company is valued at $1M (pre-money), you should not be raising more than 250K as part of the round. At a post-money valuation of 1.25M (1M pre money + 250K investment), an investor will own 20% of the common equity. A typical seed investment is in the range of $250K to $5M but this is highly dependent upon the valuation of the company, the growth trajectory of the company, how hot is the market (drives up valuations), how many investors are clamouring to invest and on and on.
The founding team should not be raising more money than they need to get to the next round. While getting bigger checks and higher valuation is nice, this could have a negative effect on the company as it could dilute the founding team too early and the higher valuation sets higher expectations for what the company needs to achieve by the next investment rounds. Failure of the company to achieve the growth and the metrics that the investors expect could lead to a down round (when the valuation of the company goes down rather than up).
If you are unsure what some of the terms mean, refer to the Glossary of Start-up Terms that we have put together.
How much is pre-seed funding?
Unlike seed rounds, in pre-seed rounds, you will generally?not be able to raise a large amount of money. Unless you are doing hard tech, your needs for cash are not as significant as a later stage company. The valuation of the company will not be as high as you are likely still doing customer discovery and working on gaining customer traction.
Generally, in pre-seed funding rounds you can expect to get at most?between $50,000 and $250,000, because as mentioned above, you will not yet have a large backing to raise a larger amount of money.
What is the difference between pre-seed and seed funding?
There are many differences between seed and pre-seed funding, but the biggest ones have to do with?the timing of the rounds,?the amount of funding that can be raised?and?the type of people who provide the money.
Regarding the first difference, you should keep in mind that the pre-seed round is?the first round of funding that your start-up will receive, while the seed round takes place?when your company is more developed.
On the other hand, during the pre-seed round you will probably?not be able to reach more than $250,000 dollars of funding, while in the seed round?the amounts will be higher. Naturally, the ability for a company to raise capital is dependent upon:
Finally, regarding the third difference, in the pre-seed round the people who contribute the money?will be you and some of your closest friends and family, although some investors, business accelerators or incubator platforms can also contribute. On the other hand, in the seed round?mainly investors of different types can contribute, such as?VC investors?or?Angel investors.
What is a good pre-seed valuation?
Valuations are a bit of science and a bit of art. Ultimately, a valuation is the expectation of what a company can generate as value in the future. In addition to the specific to the company factors, there are external factors like:?the region you are in,?the market rate?and?the growth rate, that affect company valuations. For example, if you isolate for all other variables, an identical company in the USA will receive up to 25% higher valuation than the same company in Canada or Europe.
The valuation number is less important than raising enough money to get you to the next set of milestones and ensuring that the money that you take comes from the right investors. It is common for founders to take lower valuations from strategic investors.?The right investor can help propel your company!
How to get pre-seed funding?
1. Build and continuously refine your business canvas
If you want to convince someone to invest in your startup, the first thing to do is to?build a solid business canvas. This will help you set the foundation for a pitch deck. Come back to the business canvas regularly, iterate and continuously refine.
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2. Build and continuously refine your pitch deck
The business canvas will lay the foundation for?a great pitch deck. Actually, there isn’t just one pitch deck. There are several pitch decks. You need to have a 30 second, 1-minute, 2-minute, 3-minute, 5-minute and 10-minute pitch decks. The whole idea is that you want to start with a teaser and depending upon investor interest doble-click and go deeper in subsequent meetings. You want to as quickly as possible qualify or disqualify investor interest.
Many founders make the mistake of trying to lay it all out at once.?Keep the pitch deck short. Just like when dating, start small, gauge interest and reveal the story over time.
Presentations should be?no longer than 10 or 12 slides. To make them more interesting, and give potential investors all the information they need, a good idea would be to include?different graphics, such as pie charts.
The pitch deck should cover the vision, the problem that you are trying to address, who is the early adopter customer, how big is the market and how much of the market you can realistically capture over time, why you and not other competitors, how much money do you need and for what purposes, the founding team and what makes them special.
There are a ton of examples of good pitch decks online. You can find the pitch decks for many of the companies that have become unicorns. One of the most commonly referred to templates is the one for AirBnB.
3. Be realistic with your projections
A common mistake that founders make is to be overly optimistic and window dress the financial projections which leads to exaggerated numbers. Every investor knows one thing for sure…?the financial projection is wrong. Only time tells how wrong a projection is.
Fundraising is a long game. You may pitch to an investor today that passes because you are too early, or their fund is fully allocated and they have not raised a new fund, or they just prefer to sit on the sidelines and wait out, take some of the risks out of the investment. So they pass on investing in the current round.
When you go back to the same investor again in the future as part of a subsequent round, they compare the pitch deck and the financial projections you previously provided with the current pitch deck. They want to see that you can do what you say that you are going to do. If the numbers you previously forecasted are wildly wrong, this erodes credibility and trust and more than likely will negate an investment.
4. Prepare, prepare, prepare
The more questions that you can anticipate and authoritatively answer with data and support, the more likely you are to raise money. Investors want to see that you have sat with the problem that you are addressing and that you have the answers or the clarity around how to get the answers in order to drive company success.
As they say, always be pitching. You need to have your 30 second, 1-minute, 2-minute, 3-minute, 5-minute and 10-minute pitches rehearsed and committed to memory. Preparation exudes confidence. Confidence drives investments.
5. Engage in Investor Discovery
Just like Customer Discovery, raising money involves a lot of hard work. Investor Discovery is a critical stage in your fundraising process.
Make a list of all potential investors?who might be interested in investing in your company.?Close friends and family members?are usually the first to come to mind, but there are other alternatives, which may even bring in more money. These are?investors that are looking to make their first investments?and platforms such as?business accelerators?or?incubator platforms.
You should always employ a targeted fundraising strategy rather than a “spray and pray” approach. Your message should be brief. You should have thoroughly researched the investor and their investment thesis to see how well aligned it is with your company. For this, social networks like?LinkedIn?and?Twitter?can be very useful. Be sure to follow them there. Stand out and engage with them. If you can, give value first before asking for anything in return. Then pitch them on the value and the synergies with the other companies in their portfolio.
Do not count out?angel investors.?Not all angels are made equal. There are?professional angels?and?angel consortiums?that are extremely active and who are looking to invest in new startups! For that reason, don’t leave them out.
Do not count Venture Capital firms either. Many of the VC firms have launched early-stage funds. The spectrum of investments for many investors have widened significantly over the last decade. And even if you are too small for a particular investor, if you are well aligned with their investment thesis, they are more than likely to recommend you to an investor that aligns at the stage of your company. First and foremost,?always look for the right fit with an investor.
6. Present your idea to investors
The next step, but not less important, is?the presentation of your idea to investors. At this point, you should be prepared to?talk face-to-face with them, as investors generally prefer in-person presentations. The COVID epidemic has certainly made it easier and more acceptable for pitches to occur virtually.
During investor meetings, show?your passion and enthusiasm?for the company without sounding arrogant. You should always?be as open as possible to feedback?from your potential investors, as they will want to participate if they are really interested in your business idea and company.?Nothing turns off an investor like a founder that is not coachable.
7. Negotiation is key
While you should always try to be?as realistic as possible?when negotiating with potential investors, you should also not accept an offer that?may ultimately have negative consequences for your business.?Fit with the investor trumps valuation and check size, always!
The key at this point is not to ask for a sum of money?that is too far away from the real value of your company, but also not to give up shares?for an excessively low sum. Always remember that getting no agreement is better than getting an agreement that will be negative for your company in the future.
8. Understand what is being proposed and what you are signing
Typically, investors present a potential investee with a term sheet. There are some exceptions. Be sure to understand that you fully understand the term sheet. There is a natural asymmetry, information imbalance, that occurs. Investors evaluate hundreds if not thousands of potential investments but invest in less than 1% of these investments. They routinely prepare term sheets and are intimately familiar with the terms.
Unless you are a serial entrepreneur or a start-up lawyer, you are unlikely to know as much as an investor. Thus, engage an advisor and a lawyer to help you review the term sheet. Not just any lawyer, a corporate lawyer that specializes in your stage of company. Don’t make assumptions about anything. Clarify everything. This may be tedious and slow but will prevent potential disagreements in the future.?Clarity is the path to alignment.
Final Thoughts
Starting a company can be very complicated. It is fraught with risk. It often entails?a lot of unthinkable expenses, and that’s just for the initial operations of the company. That is why a pre-seed funding round is of vital importance. If you manage to raise a good amount of funds, then you will have?enough runway to get to the next stage, which will allow you to obtain further financing to continue to drive the company forward.
Although this round is usually associated with friends and family, it must be remembered that there are other sources of investment. Among them are?business accelerators,?incubator platforms,?people who want to make their first investments,?angel investors?who might be interested in contributing a larger amount of capital. As always, if you can get it, tap into government grants. They provide a non-dilutive capital that is highly attractive to any company.
Finally, always remember that?a good presentation of your business model?can make a difference. Keep it short. Keep it on point. Include data from?experiments and market studies that you have previously carried out. Drive clarity around?the value that your product or service can drive for your give to customers?and how this will translate into customer traction, scale and cash flow.
If you follow these steps, you will have a better chance of convincing investors that?your business has enough potential for them to put their money, and their trust, in it.
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