What is Pre-Seed Investing? How Did it All Get Started? What Does it Mean Now?

Pre-seed investing matters. But we still don’t have a clean definition for what it is, what it means for the startup community or a good understanding of how we got here.

So here’s my attempt, using blog posts and articles written through 2014–15 to figure out what’s happened.

In April of 2014, Manu Kumar wrote a great blog piece explaining that “pre-seed” investing had become what “seed investing” used to be. His argument was that many of the old “seed” investors had moved upstream to do rounds that looked more similar to series A rounds. Within 6 months from that post being published Notation Capital raised a fund to invest in people pre-product who weren’t ready to do $1M+ seed rounds yet.

And more recently Charles Hudson left SoftTech (one of the most notable “seed firms” in the country) to do pre-seed deals because he realized his firm was asking for traction in companies that made them more similar to series A companies than to what “seed” used to be.

A few months ago CB Insights wrote a piece that began discussing the “pre-seed” opportunity and at about the same time I had also just written a post explaining how hard it was for founders to raise $500k rounds from high quality investors (not to say my small blog post belongs with the others I’m referencing) I argued that very few people were investing in what “seed” used to be because good fund managers had raised more capital to get better fund economics and the mediocre VC’s had started to die off.

I think in many ways, Sarah Lacy’s post on the series A crunch and Aileen Lee’s post about unicorns were two drivers that helped push many “seed” firms up the stack.

Lacy’s post pointed out that there was going to be a gap between “seed” and “series A.” She called it a series A crunch, and predicted too many seed rounds were being done and that there had been no increase in the volume of Series A deals, implying many of those seed companies would die off soon.

This meant that good seed firms had a phenomenal and justified reason to do “late seed” deals (read: bigger versions of seed rounds in companies with more traction). This was pointed out as early as April of 2014 by ReCode.

Lee’s post “proved” that returns are driven by unicorn companies (companies valued at $1B or more). It implied that to be a successful VC you had to be invested in unicorns. The best way to improve odds of investing in unicorns is to invest later in a company’s life cycle when there are more proof points. So people started doing that.

There were two pretty big problems with the reactions to both these articles. Everyone moved up the stack to fill the “late seed gap,” which meant there was a “late seed” mountain. It almost became comical to have three meetings in one day with VC’s who all told me they were “filling a need for companies that had raised seed rounds but had not yet reached their series A round.”

And too many investors started backing companies with “unicorn potential” regardless of valuation because of how important it was to get into the big winners regardless of price. Andreessen Horowitz was being loud about taking this approach at the series A and series B stage, so of course seed investors decided they should do the same. This whole unicorn chase is a sorta useful concept, but investing at higher valuations is a really painful thing (as Nick Chirls pointed out in this piece) unless your name is Y-Combinator and you knock it out of the park often enough (I tried estimating how well YC has done based on some of their public numbers here). But keep in mind that even they get “pre-seed” valuations and aren’t doing any $10m pre-money deals (as far as I know).

And finally, the firms doing series A deals were becoming bigger and bigger while the firms doing seed rounds were becoming smaller and more focused. A bifurcation was beginning to happen. Scott Kupor spoke about this at the Pre-Money conference. (If you haven’t watched the video yet, you should). The firms that did seed rounds were starting to only do seed rounds, and the firms that did series A rounds were only doing series A rounds or later.

These firms that only did series A rounds have become so big that they really do need to invest in companies with unicorn potential and since seed firms now rely on series A firms to follow on to their investments, they too have to only back companies with unicorn potential, further pressuring them to wait longer in a company’s life cycle until it had more traction and then write a bigger check at a higher valuation to get in. (I think that was a run-on sentence)

There are other factors that have helped encourage the shift — low interest rates and bull markets allowed these series A firms to raise larger and larger funds. Huge private market valuations have made paper returns for these seed firms look really off the charts, etc. etc. but this is all stuff that’s been talked about.

The point is that there have been a number of shifts in the last two years that have taken most of the best “seed firms” out of the “seed stage.” They still call themselves seed investors so the people coming in to fill the gap will have to call themselves “pre-seed” investors.

My definition of pre-seed investors are VC’s who act as the first institutional capital into a company who’s product is mid-build or has just launched/shipped to production. These are investors who do not wait for significant revenue traction ($20k MRR, etc) and often invest in sub-million dollar rounds at $1.5-$4mm pre-money valuations.

Some of the firms that do this include: Great Oaks, Notation Capital, Brooklyn Bridge Ventures, NextView, High Line VP, Metamorphic, Box Group, Bee Partners, 500 Startups, Arena Ventures, K9, Amplify LA and a handful of others.

My assumption is that a number of firms will fill the gap pretty quickly. There’s a lower barrier to entry in raising a $10-$20mm fund, but avoiding negative selection bias and being a founder’s first call for financing will not be a trivial task. The firms that can get some quick wins on the board and build a brand quickly will win.

The ones that survive at this stage will grow by either scaling out (adding partners and doing more deals per year like Y-Combinator has done) or scale up (raise larger funds but focus that capital on following on to current portfolio companies).

Published in Startups, Wanderlust, and Life Hacking

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