That’s a compelling question with an answer open to broad interpretation. However, it’s safe to say that pre-seed funding comes before your company’s official seed round and any ‘series rounds’ like Series A, B, and C. It’s also safe to say that your pre-seed funding will yield smaller amounts–almost always less than $2,000,000–than subsequent rounds generate.
Let’s explore the specifics of pre-seed funding by answering several FAQs.
When does pre-seed funding occur?
For many startups, pre-seed funding is their first round of outside funding. It occurs right after the owner or owners realize that their personal investment in the company is insufficient to “bootstrap” their company to financial viability.
As such, a pre-seed round occurs very early, often before the product or service has reached the market, and almost certainly before the company is generating sufficient revenue to cover expenses.
What’s the purpose of pre-seed funding?
The goal of pre-seed funding is to help a startup company gain enough momentum to move from an idea to an actual product or service. Pre-seed money typically funds basic costs such as product/service development, hiring essential team members, and solidifying key marketing concepts such as a company’s value proposition or unique opportunities it can exploit.
Who are the typical pre-seed investors?
Pre-seed investors make risky investments because they back companies with virtually no track record. This means that they are people who really want to see you–the business founder–succeed. Usually, pre-seed investors are family members, close friends, mentors, or other founders who take a keen interest in you personally.
It’s worth noting that you–the founder–are the key component to successfully generating pre-seed capital. Your inner circle of investors will weigh your character and capabilities heavier than they do the company vision or the product you’re offering. Pre-seed investors with such close personal connections back your company primarily because they back you.
What are other sources of pre-seed investors?
If you’ve exhausted the funding sources from your primary network and still need additional pre-seed capital, you still have options.
Angel investors
Angel investors are the most common pre-seed investors outside of your primary network. Angels often discover you (or you discover them) because they have a connection to someone in your primary network. Sometimes the link is that they are retired entrepreneurs with the desire and the means to help other entrepreneurs. Other angels may be looking for opportunities to invest in your industry because they have expertise in it. Some angel investors look specifically for companies that appear ready to scale up because they are skilled at helping companies grow.
Usually, angel investors are individuals able to invest up to $100,000, although small angel investor firms are becoming more common. Angel investors typically receive ownership in the firm for their willingness to back it.
Accelerator programs
Accelerator programs give new companies a jumpstart by providing education, access, and resources that provide ‘hands-on’ entrepreneurial experience. Startups use this to speed their company’s growth and to help them locate potential investors. Accelerator programs typically charge a flat fee for their services and expertise or require a percentage of the funds raised.
What’s the key to locating pre-seed investors?
At the pre-seed level, especially, leveraging your network is the most valuable tool you have as a business owner looking for investors. As we noted earlier, pre-seed investors have to be willing to back a company that has minimal history. They know that, statistically, there’s a very real chance the business will fail. Yet, they are willing to back you because they have a relationship with you or with someone you know.
One proven way to leverage your network is to go places and talk to people. It sounds archaic and out of date, but, when it’s handled well, one-on-one interaction with people is still a powerful way to influence them. So, show up at family reunions and other family celebrations.
Attend business or social events for people or groups you’re connected with. Go to local community functions.
And while you’re there, be friendly. Be visible. Introduce yourself to folks you don’t know personally. Share what you’re doing. Give contacts your card. (Yes, there is a fine line between friendly and pushy, between effusive and overbearing. With practice, you can master the art of stepping right up to that line without encroaching.)
Email offers another means to leverage your network. Although it’s less personal and often doesn’t get opened, email allows you to attach a brief pitch deck as a tickler and lets your contact read at his or her convenience. (Keep reading to get more details about pitch decks.)
Remember, though, in all this networking, that quality of contact is better than quantity. Selecting a few good possible investors to pitch is key to having a successful pre-seed round.
Once I’ve found possible pre-seed investors, how do I land them?
To get possible investors to commit, you need to show them that you are well prepared to receive their money and use it wisely. You also need to impress them with a pitch that they can’t refuse. This is as true for potential investors who are family and close friends as it is for angel investors you’ve just met. All investors must know the actual situation in order to carefully assess the opportunity and set their expectations realistically.
Preparation
Preparing for a pre-seed round means you have the details of your business in order. Specifically, you’ll need to convince potential investors that you have:
- Thoroughly investigated your market and now understand its potential as well as its pitfalls.
- Identified the particular problem your company wants to address, who the potential customers are, and how your product or service is poised to solve the problem for those customers.
- Developed a business plan that’s broad in scope yet also detailed enough to be workable.
- Assembled a strong leadership team with the expertise and experience to be successful.
- Compiled everything accurately. Slipshod work at this level raises red flags among potential investors.
At the pre-seed level, many investors weigh the people aspects of your company heavier than the financial details. Therefore, you help generate enthusiasm in potential pre-seed funding when you are well prepared.
Pitch
Successful pitches need to be upbeat and optimistic. If you don’t believe in your company, how will you convince investors to believe in it? At the same time, pitches have to be realistic. Your pie-in-the-sky optimism will fall flat if facts and research do not support it. So, you must smoothly meld optimism and factual details.
Master your plan.
Know the details and why they are essential to your startup’s success. For example, how–exactly–will you use the funds you raise? How long will the pre-seed funds last? Why are you convinced that that timeframe you suggest will be sufficient?
Create a compelling pitch deck.
The experts disagree over how long the deck needs to be at the pre-seed level. Some say 6-8 slides are sufficient. Others recommend up to 20. However, they generally agree that your deck needs to:
- Present your business model
- Address the competitive environment, although not necessarily highlight specific competitors.
- Cover basic financial details, including short-term projections
- Be legible, uncrowded, and professional in appearance.
- Be short enough to be read in 5-10 minutes.
You–not your pitch deck–need to be a source of detailed information and able to answer questions, but only if potential investors want answers. Flooding investors with vast quantities of information makes your pitch hard to digest and less appealing than a similar pitch that’s succinct.
Craft a compelling story.
Investors at the pre-seed level must believe in you. One way to help them do that is to tell them your story–how you got where you are, what compelled you to start your company, why your product or service will make someone’s life better in some way.
Pitches that highlight only the objective aspects of your company may get you an investor’s ear. But often, it’s your storyline that propels him or her to back you.
Deliver your pitch effectively.
That means you have to practice. In front of someone. Who can–and will–critique you objectively. If you’re balking at this, remind yourself that:
- No one is obligated to fund you, even if your idea is phenomenal.
- Investors–even family and friends–have lots of options about where to invest their money.
- Being the 2nd-best pitch probably means you don’t get funded.
How do I determine the amount I need to raise in a pre-seed round?
Choosing the “correct” amount to raise in your pre-seed round is crucial to your success. Unfortunately, it’s also an inexact combination of art and science. As with many aspects of orchestrating a startup, balance is the key.
If you ask too many investors for too much, you risk diluting your ownership well beyond the normal 10%-20% range that’s typical for a pre-seed round. This puts you in a weak position. Similarly, asking a possible investor for a considerable amount may effectively price you out of the realm of pre-seed investors and into the arena of seed investors with deeper pockets. You’ll find out quickly that seed investors expect a company to have more traction than your new startup has.
Conversely, ask too little, and you risk running out of funds before seed-round funds are available. Some investors view a small asking amount as a sign that you haven’t planned enough to know what you really need.
Determining your company’s valuation and the amount of dilution you can live with will guide you to a realistic amount to raise in a pre-seed round. Of the two, setting a value on your startup is the more difficult task since there are many unknown factors.
Once you’ve established your company’s valuation and settled upon the cap amount of dilution, determining the targeted amount to raise becomes a simple math calculation. For example, if you value your company at $4 million and don’t want to give up more than 12% ownership, your targeted fundraising goal is $480,000
How will I arrive at a valuation for my company?
As a founder, you’ll be the one to assign your company’s valuation. To do so, you’ll consider external market factors such as market strength and the level of competition you’ll face. You’ll study industry trends and determine their likely effect based on your experience in the industry and your market knowledge.
Several valuation approaches popular now include:
- Market multiple.
- The cost to duplicate.
- Analysis by developmental stage.
- Discounted cash flow analysis.
A very brief summary of each of these methods follows:
- The “market multiple” approach compares your startup with the value of similar startups in the same market. Venture capital firms tend to prefer this approach because it is market-driven. Finding good comps that offer an “apples to apples” comparison is the major limitation of this approach.
- As the name implies, the “cost to duplicate” approach calculates the cost that would be incurred if someone tried to duplicate your startup firm. The strength of this approach is that it includes the FMV of all the physical assets and provides concrete historical expense numbers that can be validated. The shortcoming of the cost to duplicate approach lies in what it doesn’t include. Intangible assets and income-generating potential are two major omissions. As a result, this system generally yields a lower valuation than the other methods do.
- The “analysis by developmental stage” approach assigns a startup’s value based on its stage of development. Logically, the valuation increases as the stage of development increases. Hence, a firm with only a business plan receives a lower valuation than the startup with a prototype of its product. The estimated company value for each stage is stated as a range. This provides flexibility in the estimated value and allows for adjustments based on milestones met. These features make the “stage of development” approach popular with private equity firms.
- The “discounted cash flow analysis” system bases the company’s value on an estimate of its future cash flows. The estimated cash flows are then discounted to reflect the company’s current value. The cash flows of startups are discounted at a higher rate than those of established firms. As long as the estimated cash flows are accurate, this approach provides a reliable method of valuation. However, since outside market forces that affect forecasts are hard to predict and volatile, discounted cash flow estimates can miss the mark significantly.
Summary
Pre-seeding funding is usually a startup’s first round of outside funding. It precedes a seed round as well as any “Series” round and helps a fledgling company gain momentum. Typically, pre-seed investors are people who want the business owner to succeed–his or her family, friends, colleagues, and mentors. The bulk of pre-seed investors are people in a founder’s primary or extended network, but angel investors and accelerator programs also provide sources of investors. Landing a pre-seed investor requires careful preparation and a compelling pitch that is skillfully delivered.
One of the most challenging aspects of a successful pre-seed round is determining the funds to pursue. Accurately valuing the company is difficult, but it’s necessary to calculate the size of the pre-seed round.
Interested in learning more about fundraising? Check out our guide “What is Series A Funding”
At Newchip we help entrepreneurs get funded. If you need further information about how to raise your Seed Round, feel free to apply here 🚀, one of our Venture Analysts will contact you soon.
