How to Raise Pre-Seed (and Seed) Financing for Your Startup
How to Raise Pre-Seed (and Seed) Financing for Your Startup
Fundraising is an all-encompassing grind through crazy town. But there are some things that will help. (#68)
For most founders, raising pre-seed or seed stage capital is a painful experience. It takes a long time, you get overwhelmed with disparate feedback, and you’re bombarded with stories of other companies raising millions with less traction. The whole experience is like being in a tornado naked, flailing around with nothing to hold onto.
I’ve been involved in a few easy fundraises, where startups closed quickly at a valuation that made them very happy, with eager investors piling in. To be clear, this does not guarantee success. Some of these companies went on to win, some lost. Fundraising isn’t a guarantee of success, it’s a tool that buys you time to figure things out.
Today, through Highline Beta (the venture studio & VC fund that I co-founded in 2016), we invest at inception (when a company is first incorporated) and follow-on at pre-seed/seed. The terminology “pre-seed” and “seed” is confusing, because neither has a universally agreed upon definition. Some startups skip pre-seed altogether and raise a monster seed round, others will scrape by through friends & family, cobble together a pre-seed round with angels and then do a small seed after that. These terms and the numbers surrounding them are all over the map.
Recommendation: Don’t worry too much about what you call your round
Investors identify themselves based on the rounds they invest in (i.e. “We are pre-seed investors” or “We only invest at Series A”) but since there are no clear definitions, you have to figure out what they’re actually looking for.
I know quite a few “pre-seed investors” with a very high bar in terms of traction and proof points. IMO they’re not really pre-seed investors.
I think of pre-seed as the first million dollars raised (although there’ll be examples that are much higher; ignore the hype). Carta has good data on this:
Most (if not all) of this is US data, which in my experience skews higher in terms of amount raised and valuations. If you’re not in the US, there’s going to be a “discount” on these numbers.
Recommendation: Look at the available data, but take it with a big grain of salt
You can spend a lot of time looking at industry averages and trends. Most likely you’ll end up demoralized and confused. Instead, focus on what you need and why.
How much capital do you need to get to the next major milestone?
Defining the “next major milestone” is tricky, but logically you should know what it is (regardless of what the “investor market/landscape” tells you).
Focus on what moves your business forward. You can easily get caught in investors’ feedback on how much traction you need, revenue, etc. (i.e. “Get to $1M ARR and you’re ready for the next round!”) That may be true, to an extent, but it’s not a guarantee that the investor, who provided the feedback, invests.
Buy yourself as much time as you can to figure things out. Almost everything takes longer than expected, and if your runway is too short, you’ll likely fail. Or you’ll be perpetually fundraising which is brutal.
Here’s a great example of interesting data that can throw you for a loop:
The valuations across the top are median numbers. So rounds at $500k-$999k had a median valuation of $9M (post-money). But 16% of those rounds had valuations above $15M! And 39%+ were below $5M.
Remember: These are US numbers only; in other countries, including Canada, the numbers will be smaller, including the average amount raised and valuations.
It’s good to understand these numbers, but don’t obsess over them. The “science” of fundraising is pseudoscience at best; at worse it’s completely made up. This is most pronounced at pre-seed when there’s the least amount of evidence that something will work.
The elephant in the room: Valuations
I hate valuation debates. They feel so unproductive, but I understand why they happen. Founders want to hold onto as much equity as possible (rightfully so) but have to trade that equity for money. When you look at the data and see some deals happening at super high valuations, you think, “Why not me? I don’t want to give up 20% of my company today, it’s not fair.”
Every investor has target ownership stakes (lead institutional investors are usually between 10-20% per round). If you know what stake they want, the math becomes pretty easy.
If you feel like you’re being over-diluted, your option is to raise less money or find a higher valuation; typically founders raise less (and aim to keep the valuation as is) b/c getting a higher valuation is tough.
Raising less means (most likely) accomplishing less and having less time to do it. You need to be very cognizant of that because you might be taking a “better deal” in the short term only to screw yourself later on.
High valuations seem like a godsend initially, but you have to grow into them. I’ve worked with a lot of startups that raised monster first or second rounds and then took a down round or simply could not raise capital after (and failed).
SAFEs and convertible notes with caps are tantamount to pricing the company. And if you stack SAFEs on top of each other through a few rounds, the math gets crazy; you’ll have a hard time knowing what the dilution actually looks like. (Everyone thinks SAFEs are awesome, and they are great at doing legal work quickly, but most of them basically price the company.)
I’ve met a lot of founders that are delusional about valuation. It’s not a great look. They spend a lot of time trying to fundraise at an inflated valuation, get rejected over and over, and then finally drop the valuation in the hopes of closing a deal. It’s a shame that a lot of deals don’t happen because of valuation, when it should be a pretty simple and transparent conversation.
Founder: “I want to raise $1M to get X, Y and Z done.”
Investor: “I need 20% of the business.”
Founder: “But then my valuation is only $5M? What if I only raised $500k?”
Investor: “Sure, but I still need 20%, so now your valuation is lower. I could go down to 10% ownership, and keep your valuation at $5M.”
Founder: “What if I could raise $2M?”
Investor: “I’d consider raising the valuation, but $10M is too high for me. Maybe $7.5M?”
Founder: “But now you own more of the company!”
Investor: “Very true.”
Founder: “I can make a lot of progress with $1M, let’s do that.”
Investor: “OK.”
I don’t want to give the impression that founders are bozos and investors aren’t. But the time spent on valuation mental gymnastics is stupid. Investors have bosses (LPs) who expect returns. Investors have rules that govern what they can and can’t do. When they share their target ownership and valuation ranges with you, those are the numbers. In some cases investors will make exceptions (especially for 🔥 deals, which is a whole other can of worms), but generally they stick to their check sizes & ownership stake requirements.
Recommendation: Delay fundraising as long as possible
The further you get with your startup, the better chance you have of successfully raising capital. When a founder says, “I need the capital or I can’t really start,” it’s usually a red flag. These are often “wannabe founders” romanticizing the startup experience, who aren’t prepared for the grind (and yes, starting a company is a grind).
You might ask, “But what about all those startups that raised $5M from a pitch deck alone?”
Yup. It happens. A few years ago it was happening more, but it’s still going on. Typically this is repeat, successful founders with deep networks, playing in a super hot space. If that’s you, and you can raise $5M with nothing but a pitch deck, go for it! Most of us aren’t in that position (which is why getting caught in the hype machine is so dangerous).
Recently, I met a non-technical solo founder who spent 3 months learning to code and building an MVP. I told him, “You are more fundable now than you were before, because you proved your willingness to roll up your sleeves and do the hard work. That’s a founder. Plus, you now have an MVP that you’re learning from.”
Even if you have a founding team, with defined roles, you’ll need to extend well beyond your comfort zone to do things you’ve never done before. Do that, and you’re showing signs of what it means to be a founder. If you can’t do that, and you’re focused on getting money before you start grinding…I’m not interested.
At the earliest stages, investors don’t have a lot to go on. There’s no product, no traction, etc. So they’re judging you, the founder (and/or founding team). A big part of that is your level of commitment. Raising before you’ve jumped off the cliff (which is what starting a company feels like) is not a strong signal of commitment.
Caveat: Don’t delay fundraising so long that you end up maxing four credit cards, selling your house and moving into your car. It’s easy for me (or another investor) to say, “Get further! Spend more! Take more risks!” but there’s a limit. I never want to recommend someone put themselves into extreme financial distress.
It’s important to note that fundraising isn’t for everyone. Delaying it may help you realize that you’re building a business that doesn’t require venture capital. If that’s the case, fantastic! You’ve avoided wasting your time trying to accomplish something (raising VC) that wasn’t necessary, while spending more time building your actual business.
What about venture studios?
Venture studios build and fund startups at inception, starting the work pre-incorporation. While venture studios do invest capital (running counter to my recommendation above), their value goes beyond that. They help with the initial validation and everything required to go from 0 to 1 (build the MVP, get to market, recruit a team, etc.) Venture studios also help founders raise additional capital (if needed), but can potentially delay the need for doing so by providing services. They can also provide a lot of education and support in the fundraising process.
There’s also a growing trend around “Inception Rounds” which happen at incorporation (same time as a venture studio), but with less support. Ed Sim, from boldstart ventures, is sharing a ton of great content on this. Most founders won’t be able to raise inception rounds (unless through a venture studio).
Recommendation: Have a strong pitch deck & basic data room
You can find a bunch of blog posts, tweets, etc. that say something to the effect of, “You don’t need a deck. I raised funding with a single document.” Or, “You don’t need a deck. I raised millions with a napkin.” If you did that, fantastic. But for the rest of us: put a deck together.
Some founders will also write out a longer document—a manifesto of sorts—which I find interesting and appreciate. It’s like jumping into the brain of a founder. The writing is more free flowing than a polished deck, and includes real depth. If you like writing things out as a way of processing your thoughts and communicating, do it and feel free to share it with investors. If they dig in, it’s a great sign. But most investors will expect a deck.
This should help you think through the deck:
A strong pitch deck is a good sign that you’re able to structure your thoughts and identify what matters to your business (and to the audience).
Recently a founder asked, “Do I tailor the pitch to each investor?”
Yes and no. You should do your homework on investors so you have a better understanding of what matters to them. This may change how you present and what you highlight.
But stay true to your vision. Investors love giving feedback. They’ve seen thousands of pitches. There’s a good chance someone else has pitched the exact same business to them. They’ll tell you all sorts of things. Feedback is helpful because it gives you a sense of what investors care about. If a few investors say, “The market is too small,” take that seriously (despite my belief that early on, market size isn’t relevant). Investors have a tendency to challenge almost everything—sometimes they genuinely disagree with what you’re doing, sometimes they want to see how you react (and if you push back). Good investors want to see conviction (even if they don’t fully believe in what you’re doing). Don’t change your business because one, or a few, investors give you negative feedback. You either believe in what you’re doing or you don’t. If you don’t, then stop immediately. If you do, then go do it.
Here’s a pitch deck we prepared at Highline Beta for a concept we worked on:
Let’s talk briefly about data rooms.
A data room is where you store all relevant company files. At the pre-seed stage it’s very basic, including incorporation docs, cap table, employee & contractor agreements, etc. Don’t over-complicate your data room, but have it available. It shows a level of organization that gives investors confidence. Scrambling to do this when investors start due diligence is a pain in the ass. Just get organized.
Beata Klein, Principal at Creandum (early stage European VC) put together a summary on data rooms & a data room template that’s a good place to start.
Recommendation: Sell the dream first, then the metrics
For investors to invest in your startup at pre-seed, two things need to be true:
They need to believe in your vision
They need to believe you’re the team to accomplish it (or figure something else out)
Many investors say they invest in the team first, but I’ve never met an investor who said, “That’s an awesome team. I absolutely hate what they’re doing and think it’s completely stupid, but they’re so great I’m investing any way.”
We all get excited about ideas. If investors love the idea but have questions about the team, honestly, they might still invest, because ideas have a way of pulling us in. Everyone says “team first” but what they really mean is “team + an idea that’s interesting, that I believe this team has a chance of accomplishing.”
At the pre-seed stage you have no metrics, or very few data points, to suggest you’re on the right track. So you have to sell the dream (and the team).
In reality, selling the dream is easier than selling performance, because most startups don’t hit the ground running and achieve hockey stick growth immediately—they meander, stumble, recover, stumble again, etc. Investors know this is how it works—the messiness and rollercoaster ride of startup creation—but when it comes time to explain the data, it’s not easy. So dream first. 😀
Breaking down “the dream” here’s what I look for at pre-seed:
Is there a real, meaningful problem that’s been identified?
Clarity on the ideal client profile (ICP)? Who has the problem?
A well-articulated vision of a future state where the problem is solved and something has significantly changed for the ICP and the whole industry/vertical (i.e. What has been accomplished by solving the problem?)
An insight or something the founder(s) has learned, which they’re anchoring a lot of their approach on (i.e. What do you know that no one else knows that could become an unfair advantage?)
An early definition of the MVP: What are you building, and why are you building that?
Why now?
Even with an MVP in-market, the dream still takes precedence. You have to get investors excited about your mission/purpose and the opportunity area. That excitement + their belief in your ability to figure it out = higher chance of investment.
At the same time, with a live MVP, it’s interesting to look at the data. It’s not about the amount of data, but the signals emerging from it. For example, shortly after launching your MVP, investors shouldn’t expect a lot of users/customers and a huge pipeline (i.e. you’ve solved customer acquisition). What they should focus on is whether or not any of your users are using the product consistently (which suggests they’re getting value). Ideally those users are providing positive qualitative feedback too. Maybe they’re already referring you to other customers.
All you can measure early on are the signals that suggest you’re creating value and solving a real problem (i.e. consistent usage, conversion to paid, referrals).
How many users/customers should you have shortly after launching?
Founders ask me this all the time and there’s no perfect answer. In B2B I’d aim for 5-10, in B2C you’re probably looking at 20-50 at least. If you can get that number of people using your product consistently (and fairly quickly after launching), it’s a good sign.
This lack of clarity is precisely why over-analyzing early metrics is a waste of time. In fact, if an investor wants to spend a lot of time in the metrics—even at the seed stage—it’s a bad sign. There simply isn’t enough data and the benchmarks are unclear.
For seed stage benchmarks, focus less on the actual numbers and more on progress.
Have you proven Problem-Solution fit? This is all about proving stickiness (people using the product frequently enough to prove they’re getting value). Read: Moving From Problem-Solution Fit to Product-Market Fit
What’s your weekly / monthly growth rate in terms of user/customer acquisition and revenue? (If this is really slow, investors will pass; so you have to demonstrate momentum around ~20% month-over-month growth)
How quickly are you experimenting and iterating? Speed is the only true competitive advantage for most startups. If you’re not running rapid experiments (at least weekly), it’s a bad sign. The speed with which you test new things gives investors confidence in your ability to execute.
Does the business model look like it’s working? In a B2B situation, there’d be an expectation that you’re generating revenue at seed stage (most of the time). IMO this is binary: people are either paying or not. If yes, that’s a good sign. I’m not as fussed about sales funnel performance, because I have to believe you can improve that over time. Same with cost of acquisition—it’s usually high at this stage (especially for B2C businesses) but I have to believe you can lower CAC later. If I don’t, and the business model isn’t viable at the outset, it won’t be viable in the future either.
Why are benchmarks so tricky?
There are too many variables at seed (and certainly at pre-seed). I know of several companies raising capital right now, all of which have ~$10-$20k MRR, growing at a decent clip. On paper they look very similar (despite being in different industries). One just raised $5M at a high valuation. The other can’t find a lead investor. What’s the difference? The market? The team? The founders’ ability to pitch? All of the above? Something else?
Recommendation: Have a bottom-up business model built
You need a basic business model, even at pre-seed. Some people agree with me, but many do not. This is a great example of investor whiplash, where you’ll be twisted up like a pretzel trying to understand what investors want.
Check out the engagement on this tweet from Jenny Fielding, Managing Partner at EverywhereVC (click the image and read the comments):
It spawned a host of pro- and anti- responses. Some people vehemently disagreed with her, but I’m in the “have a business model” camp.
At pre-seed (even at seed) we know your business is not going to perform the way you’ve modelled it. It’s absurd to believe the model is reality.
You build the model to uncover your business’s underlying assumptions. Those assumptions are key. They tell investors a lot about how you think about the business, and frankly, whether you have a chance of figuring it out.
We know your model is bullshit, but if it’s completely made up bullshit it’s bad. If it’s bullshit with thoughtful, underlying assumptions that you’re now going to test, it’s good.
At pre-seed, I don’t care a lot about costs. There should be very few (in most cases), and modelling them isn’t super valuable. I care a lot about the top line growth plans, because this is where the key assumptions are revealed. For example:
In 12 months, how much revenue are you targeting?
How many customers do you need to achieve that revenue?
What’s your anticipated conversion rate from free trial to paid?
What’s your anticipated conversion rate from website visitor to free trial?
How many website visitors do you need?
How will you acquire those visitors?
How much will it cost? (I don’t want a 5-year financial model, but some understanding of what your plan will cost is important)
I’ve done this exercise with founders many times. In some cases, founders realized they’d need an impossible amount of website traffic to hit their targets. Or their conversion expectations were unrealistic. That’s a healthy exercise, because you can go back to the assumptions, re-evaluate them and adjust goals/targets.
I wouldn’t expect founders to have great benchmarks for conversion, etc. at this stage, but that’s where investors can help. We’ve seen a lot of startups. We know that 50% conversion from free trial to paid is unlikely. We know that most startups undercharge initially as a “competitive advantage” in the hopes of winning market share (I get it, but it’s a mistake).
Note: Most investors will want to understand market size. I’ve already said that early on, focusing on market size is a waste of time. TAM, SAM, SOM (Total Addressable, Serviceable Addressable & Obtainable Market) are silly, often inflated beyond reason, and not testable. You can’t run an experiment against your SOM. You can run an experiment off your pricing, conversion targets, and go-to-market strategy. Nevertheless, you’ll be expected to have these numbers.
The more interesting details are in the bottom-up business model, which you build through a list of logical assumptions:
Recommendation: Do not say you have Product-Market Fit
Thankfully, I’ve never met a founder declare product-market fit before launching. But I have met quite a few (and seen more online) say they have product-market fit almost immediately after launching.
If you’ve just launched, you do not have product-market fit.
I’m fairly certain that 50% (or more) of Series A startups don’t have product-market fit. They’ll say they do, but they don’t.
Prematurely declaring product-market fit is a symptom of the overly heated hype cycle in StartupLand. Investors want their founders to say they have PMF as quickly as possible to attract downstream investors. Founders want/need future investors to write checks, so they’re happy to jump on the bandwagon. More money and more nonsense later—dead. No PMF. No real scale.
Recommendation: Run a Process
Fundraising is similar to sales—you need a good process, with a focus on iterative experimenting, learning and adapting.
Setup a CRM (or at least a spreadsheet).
List out the potential investors you think would be interested (based on vertical/industry, stage, etc.) Get warm intros where possible. Note: There are more marketplaces/networks available that enable cold outreach and matching (such as OpenVC).
If you have existing investors, let them know you’re fundraising (and “soft circle” their interest).
Decide how much you need to raise, but be flexible. It’s completely fair to have a few scenarios in mind, with different amounts giving you the ability to hit different milestones at different speeds. You don’t have to lay this all out for investors initially, but have a few scenarios in mind (i.e. What can you do with $500k? $1M? $2M?)
Chase a lead. Unfortunately, having a lead still matters. In some cases you can get a bunch of investors together, often angels or angel groups, without a real lead and close a deal. But everything becomes much easier when there’s a lead. I’m seeing this in a few deals right now. With leads secured investors come out of the woodwork to look at the deal (even some that passed before).
Assume it takes 3-6 months and is all consuming. Again, you’ll see and hear stories about how someone raised millions in two weeks with one tweet and a scrap of paper. That’s great. But it doesn’t work for 99.9% of founders. Fundraising is a slow and methodical process (until the very end when it’s a panicked scramble), which generally takes 3-6 months (and sometimes longer). The experience is all consuming, not because it takes 100 hours/week (although it can be time intensive) but because it’s emotionally draining. Founders in the middle of a fundraise are often the most beat down and worn out, describing the experience as a low point in the rollercoaster ride.
Fundraising takes a lot of work. I wish it were easier and simpler, but it’s not. Some aspects of it (such as access to investors and benchmarking) are getting easier, but the whole thing is still a grind. Hopefully these recommendations help!
To help, I’ve put together a free Fundraising Playbook that may help you jump into the fundraising process successfully.
Have any questions? Message me!