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March 29, 2022
Adam Hoeksema
The climate of startup funding is ever-changing, and new terminologies are emerging with it. Confusing new definitions are replacing what was once well established and that which was familiar is now new and unusual.
Seed funding was once the earliest stage of startup capital generation. Over time, even this became a lucrative market for investors. With increased interest, higher standards for entry have evolved, leaving those who simply need some help getting a prototype off the ground seeking new options for funding.
Enter pre seed funding. This new round of funding represents a solution to the space in funding opportunities created by the new bar for seed funds. Confused? Don’t worry, that’s why we’re here.
Types of Funding
Understanding pre seed funding isn’t as hard as it may seem. Before we get into how it works and whether you need it, let’s go over some of the basics of startup funding rounds.
For a little bit of context, we’re going to quickly work backward through the types of funding options available to startups, from more established entities, all the way to the point at which the startup is still just an idea. Each level of funding provides context for the one before it and hopefully explains the why and the how.
Venture Capital
When a startup is established and has proof of concept and product-market fit, venture capitalists might be interested. By the time you’ve reached the stage where you know your project is working and you want to grow it quickly, it’s usually time to seek outside funding from investors - who will want a share of your equity - or banks, who will expect the money back regardless of your success, and charge you interest to boot.
This round of funding is called Round A, because it represents the initial venture funding stage of the company; that is, the product is launched, there is valuable customer data, and investors are interested and confident in the ability of the company to grow with the help contribution. Later stages of this funding will be referred to as Round B, Round C, etc.
However, before you reach this stage, your startup needs to be registered, and depending on the type of business you’ll be doing, you might need stock, maybe even staff. Your product needs to be trialed and developed before hitting the market. All these early-stage necessities require capital.
To put it in perspective, perhaps you’ve designed a logo, planned out your business model, maybe even done market research, but you need some initial funding just to legally break into the business world and get on your feet. This, traditionally, would be the time for a seed round; an early burst of capital to shift the startup from the ideas phase to entering the market.
Seed Funding
Venture capitalists and banks are unlikely to want to take on the financial risk of dealing with you before you’ve proven your project actually works, so classically, seed funds came from associates, friends, or family, and typically also involve handing over some portion of the shares of your company.
This small amount of money would cover the initial startup costs, such as legal expenses of registration, plus any assets you need to get your product to the prototype stage (or even to launch) and get proof of concept for later funding stages. In this way, the investment is a seed that will help the business grow and branch out to later funding rounds as it expands.
However, this definition is changing. As seed rounds have evolved, it seems that more venture capitalists are offering their assistance, and as such, the bar for seed investments is being pushed higher as startups compete for eligibility.
Seed funds are also increasing from small contributions to much larger sums, and as such, seed investors care more about their portion of ownership and the security of their investment. This is pushing startups to jump through more hoops to prove themselves worthy of investment, even at the early stages. It’s not longer enough to have a great idea and a well-thought-out business plan. Seed funders now want prototypes and other evidence before they will invest.
So, in a way, seed funding has now become closer to Round A funding, in that it now requires more traction and evidence. This leaves an opening where seed funding once was and a gap in funding opportunities for unestablished, early-stage startups.
Pre seed Funding
This is where pre seed funding comes in. You might be thinking that this is just a shift in terminologies, and you’d be mostly right. Pre seed rounds are the new seed rounds, and in that sense, they’re not so difficult to understand.
By this definition, a pre seed round aims to give founders traction, get the product off the ground, and develop a proof of concept for future investment rounds.
One difference between new pre seed rounds and traditional seed rounds is that new companies are arriving to offer investment at the pre seed stage. This means there has never been more opportunity to find pre seed funding for your startup but does suggest that there might be another shift in terminologies around the corner as investors demand gradually higher and higher eligibility criteria.
Do you Need Pre seed Funding?
To know whether pre seed funding is worthwhile or necessary, it’s useful to break down the market for seed funding into two categories to further clarify where the need for pre seed funding arises. Applicants for seed funding can be grouped into two basic types:
- Repeat Founders – These are founders who have been around for long enough to have a reputation. They are looking for funding for a new venture, and they have the success of previous ventures to back them up. As such, they can raise more money and require less ‘proof’ to get the trust of seed investors.
- First-Time Founders – These are the majority of founders whose reputation isn’t known. For modern seed funding rounds, they are required to show proof and typically have to give away more equity to get investors interested. First-time founders usually need a launched product to raise seed funds.
As you can see, repeat founders are much less likely to need pre seed funds since their reputation carries them past the pre seed stage, and investors are happy to support them based on their track record with seed funding. Conversely, first-time founders are left with a challenge to get their product launched before they can start reaching out to seed funders.
So, if you are a first-time founder, you don’t yet have your legal documents in order, your board is incomplete, and your product isn’t launched or at least at the prototype stage, you might be ready to look for pre seed funding.
Preseed funding comes in various types, and choosing the source of funds is a decision founders have to make based on preference and vision for the startup.
Pre seed Funding for Startups
If you’re aware of the classic definition of seed funding – its meaning before it evolved more towards a VC round – then you probably already understand the role and definition of pre seed funding. The difference is, on the whole, a shift in the terminologies rather than the definitions.
Still, for clarity, it’s worth repeating in a bit of detail about what pre seed funding is and its role for startups.
In simple terms, the goal of a pre seed round is to raise the money to cover the essential costs of starting your company. This is money that you need to spend on developing the product or service your startup wants to supply.
Pre seed funds should be sought very early in the startup process, at a time when large, established investors would consider it too risky to contribute. Therefore, pre seed investors usually have a personal connection with founders because they will be willing to take on a much higher level of risk on your behalf.
The amount of equity you provide in return for a pre seed investment depends entirely on you and your investor. There is usually an exchange of shares, but if you’re very fortunate, better deals might be available to you based on how good your relationship with the investor is.
How to Find Pre seed funding
There are several ways to acquire pre seed funding, and they each have benefits and drawbacks, so founders should choose wisely, based on their needs:
- Individual angel investors – These are individuals who are willing to help you out, despite it being high risk. They are usually friends, family, or close acquaintances. There are some people who make a business of investing in startups at the early stage, though these are less common.
- Pre seed startup accelerators – These organizations offer training and expertise to boost the idea stage of a startup and create an entity that is ready to apply for funding. They either aid with financing directly or make connections between startups and third-party investors.
- Grants – Depending on the sector and whether you have an innovative solution to a common problem, it might be possible to find grant support. There are grant opportunities in various industries, but they are less common for businesses than NGOs. Grants are the best possible form of funding since they don’t need to be paid back, don’t lean on the founder’s own capital and do not require a dilution of equity.
- Bootstrapping – Founders may find it possible to raise the pre seed funds themselves. Using credit cards and savings accounts is one great way to finance a startup without giving away equity or being tied into a repayment schedule. Of course, this depends on credit histories and financial situations.
- Banks – Loans are another common way to gather pre seed funding without losing equity, but they come with their own risks. Loans will have to be paid back even if the company fails, and banks can be strict with their repayment schedules. You will also incur interest. Further, they may have a high bar for eligibility.
- Crowdfunding – Some startups use crowdsourcing websites like GoFundMe, Patreon, or Kickstarter, and these will all take a pretty heavy cut of your donations. Still, the money will be yours under no or little obligation, and the major sites have a wide reach.
It‘s also possible to raise funds if you have a well-developed social media presence. Small donations from many people add up quickly and can be a useful way to gather your pre seed funds.
Remember that raising just enough to get through the first 18 months is not going to work – there will always be unforeseen circumstances, so you should always anticipate unexpected events. How much you’re going to need for this might a bit of a mystery, but there are ways to make an informed estimate.
How Much do you Need?
When talking about funding, it’s useful to consider the tiers or funding rounds. Every round should be designed to raise enough capital to reach the next round from pre seed, to seed, to rounds A, B, C, etc. This is one thing people commonly forget, but it is important to calculate whether the money you are raising is sufficient to reach your next fundable milestone.
For pre seed rounds, being the earliest capital a company can raise, a startup should be looking to at least build a prototype. You should be looking at the seed funding criteria and what you need to do to reach them. From there, you can calculate how much money you need to hit those targets and set you up in a position to attain the next level of funding.
Pre seed rounds are usually under $500k and raised from friends and family. Depending on the startup, they can be significantly lower. At the early stages of startups, founders should be doing a lot of the work themselves, trying to save on overheads such as wages. Many development costs are unavoidable, but there will be a vast difference in cost between developing, say, a YouTube channel and manufacturing a physical product like a kid’s toy. The estimate for how much pre seed funding a startup needs must reflect these realities.
In summary, calculate the cost of reaching the next funding stage and add on enough to cover unexpected costs. But don’t just go for as much as you can! The more money you raise, the higher the cost to you in equity, interest or basic fiscal practices (e.g., over-spending). It’s important to raise just the right amount to optimize your ability to grow while maintaining maximum control of the company.
As for the unexpected expenses, it’s always impossible to know exactly how much they will amount to, but it’s advisable to have a backup fund of two or three months’ worth of costs to get you through some delays and hard times.
A great way to hone in on a tighter range of how much funding you may need is to create comprehensive financial projections. Your projections can help mitigate the number of unforeseen or forgotten expenses as well, figure out how much funding is actually necessary, and how much of a return you hope to generate in the first 5 years for investors. ProjectionHub can help get these created for you in no time!
Pre-pre seed Funding?
As it is now, pre seed funding is the earliest form of capital generation for a start-up. Of course, that’s what they said about seed funding just a few years ago, and since the pre seed funding stage is attracting organizations such as accelerator programs and capital investors, there’s a chance that the investment criteria for the pre seed round will gradually inch their way up.
If this happens, there will be an inevitable shift in the definition of pre seed capital, and thus, a new name will have to be given to the money you need just to get your idea into the prototype stage.
If this becomes pre-pre seed capital, the trajectory of this evolution becomes as ridiculous as it is predictable, and some people are already suggesting the term for investments made by friends and family, so it may have already begun.
Summary
Pre seed capital is (currently) the initial necessary step in funding to get a startup from the idea phase to a working prototype and proof-of-concept, though this is subject to change over time.
As with any level of funding, the goal of pre seed funding is to carry the company through to the next level. Pre seed leads to seed funding, which should set the company up for Round A venture funding, and so on.
Pre seed funds can be raised by investors close to the founders, banks, bootstrapping with savings and credit cards, or even using the new niche of accelerator programs and pre seed capitalists.
The choice is yours which method to implement, and each comes with varying levels of dilution of equity. The right method of capital generation at this stage will depend on your resources and the company’s needs, but it’s worth remembering that it’s possible to combine methods, especially if one of the methods doesn’t affect your credit or eligibility for the others.
With the ever-evolving nature of the business world, pre seed funding, having recently taken the place of seed funding, looks to be setting itself up to be replaced by pre-pre seed funding in the near future. Hopefully, though, someone will develop a more descriptive naming scheme for future iterations.
