This is the first part of a two part series highlighting the reasons one might raise (or invest in) a pre-seed round. This first part is meant for founders and the second part for investors.
What is a pre-seed financing?
It means a lot of things to different people, and has various names — friends and family capital, genesis round, among others that we’ve heard recently. To us, it typically means relatively small amounts of initial funding, usually rounds of $1M or less.
Recently, the prevailing sentiment in the early-stage startup ecosystem has been that founders should raise as much capital as they can if and when they have the opportunity. Y Combinator and others have done a great deal to further this opinion. In some cases, this is the right strategy, but after a decade or so in the startup ecosystem, first as founders and in recent years as investors, we know it’s not the only way.
The point of initially raising capital for a startup is to give founders enough time to prove a thesis they have about a particular solution to a specific problem. This is best validated by customer demand for the product or service that’s being built. Early signs of monetization help too. For many founders starting out, it’s difficult to do this without at least some external capital, assuming it's not coming from personal savings or credit cards.
There are real opportunity costs that founders must consider when they set out to build a new company. These may include meager or zero salary, extremely rigorous work schedule, little time to spend with family or friends, severe stress and anxiety, and/or the chance to contribute to another company where they might have a larger impact. So ideally this initial experiment is done as quickly as possible, otherwise, founders are wasting their most precious asset, which is their time.
In a world of perfect information, a founder should raise exactly the amount of capital that it takes to prove or disprove her initial thesis. Maybe a little more in case it takes longer than expected, but not much more. Any additional capital raised at this point of the experiment is either: (a) capital raised at a valuation that should be higher and less dilutive to the founders (after the thesis is validated), or (b) capital raised that will waste more of the founder’s time (after the thesis is proven incorrect).
This is not to say that a founder should give up entirely on the problem if the original solution or thesis is incorrect, but what often happens is that the founder takes whatever capital is left (sometimes millions) and goes in search of an entirely different problem. Rarely is capital actually returned to investors, not because founders are unwilling, but because investors often prefer a founder keep spinning her cycles on trying to make something work, whatever it may be, rather than write the investment off or deal with winding down the company.
The press loves writing about the improbable “pivot” (it makes a great story), but the restart almost never works because it often leads to a founder working on a problem she doesn’t care about and doesn’t have unique insight into. More often than not, a restart simply leads to founders wasting more of their time moving from pivot to pivot, from idea to idea, all because they raised too much money to start with, and are now held captive by it. We do not believe Venture capital is not a good source of capital for founders in search of a problem.
Another reason to raise less money when starting out is because it often leads to more disciplined decision making. Constraint is an important forcing function for companies, whether it’s product or hiring or other organizational decisions, and it’s good practice to have discipline ingrained into a company’s DNA from the beginning. We’ve noticed that most founders have an uncanny ability to spend the capital they raise, however much, according to the milestones they’ve set. It’s counter-intuitive, but almost always true, that two similar companies building similar products, one with $1M to start and another with $500k to start, will end up shipping similar products at the same time, but the first will have spent more money doing it. In our experience, the amount of money a company raises in its pre-seed or seed round almost never determines its ultimate success…but founder discipline, creativity, and hard work do. It’s helpful to remember that huge companies like Facebook, Airbnb, Pinterest, among countless others all raised initial funding rounds of $500k or less.
In many cases, raising small amounts of pre-seed capital early on to validate a thesis implies less dilution for the founders in the beginning, especially if they can quickly gather positive data points about their business. Because the market at the moment is so frothy, particularly at the early stages, it’s rare for companies to fail because they can’t raise additional capital at the seed stage. By being disciplined in the early days, raising small amounts of capital, and not overly optimizing for valuation, founders will have a number of opportunities to raise meaningful capital if they’re making real product progress that’s resonating with users or customers. We’ve never seen an early-stage company fail because they raised money at a low valuation. But we’ve seen lots of young companies crash and burn because they raised money at high valuations and didn’t make enough progress in the first year to warrant more capital. Down rounds are both hard to get done and take a huge psychological toll on a company.
We’re living through a period in which founders can build companies with incredible capital efficiency. Because small teams can build companies on the Internet with eye-popping growth potential and scale, there is massive interest from investors to put capital to work in early-stage private companies. Capital can be seductive for entrepreneurs, especially when it comes cheap.
We believe founders are better served to be thoughtful and disciplined about how much money they raise at each stage in the company’s lifecycle. Historically, when starting out, this has meant bootstrapping, angel, or friends and family money. We started Notation to add one more option for founders at the early stages of an experiment — we call it pre-seed capital, and we hope it’s an option founders will consider.
