The European Pre-seed funding gap

Since starting at Icebreaker a year ago, a thing that has never stopped surprising me is how skeptical most founders are about the prospect of raising capital from us prior to achieving traction or product market fit. On countless occasions, my colleagues and I frequently have to reassure these founders that, “No, we don’t need to see any traction to consider making an investment”. This belief that traction and VC funding are inextricably linked is so strongly held that this skepticism sometimes persists, in spite of our repeated protests, across multiple meetings with the same company.

These founders are justified in their skepticism. While the European venture ecosystem has seen record levels of investment and a smorgasbord of new funds have emerged in recent years, the distribution of this capital within the early stage ecosystem by institutional investors, is disproportionately skewed towards the most mature companies. The number of $100k-1m dollar rounds has actually trended down in recent years.

In the 12-month period ending May 2021 there were 1,303 Seed & Pre-seed rounds¹ across Europe’s most mature ecosystems² (where we could verify that a bona VC fund participated). When these rounds are divided into Pre-seed and Seed based on size (less than $100k-1m as Pre-seed, $1–4m as Seed), Venture funds’ preference for the Seed Stage becomes readily apparent. Funds participated in almost 854 Seed rounds in the period, versus just 449 Pre-seed.

This bias towards the later part of the Pre-Series A ecosystem likely has a negative impact on the number of companies actually reaching a point where they are able to raise a Seed round. Based on Crunchbase data, ~25% of European companies that raised Pre-seed funding in the twelve months ending May 2018 have since raised a round in excess of $1m. Taking this 25% ‘graduation rate’ into consideration, one could argue that European Venture Funds are not doing enough to fund the development of the Pre-seed companies into the Seed stage companies that they subsequently salivate over (though perhaps the low ‘graduation rate’ is the reason why…).

The consequences of this lack of institutional Pre-seed funding are more profound than just me having to repeatedly explain to Idea Stage founders that there actually is money available for them. As well as mere inconvenience, this funding gap sports wasted potential and broken cap tables as its side effects, as companies with limited access to financing peter out or sell out.

The rest of this post will explore why the Idea and Pre-seed stages remain largely overlooked by funds and why we are laser focused on the opportunity at Icebreaker.

Why do venture firms overlook the ultra-early?

There are several reasons why early stage firms avoid the Pre-seed, here we’re going to focus on three of the most pervasive. The culprits are 1) the incentives created by management fees, 2) the simple fact that Pre-seed and Idea Stage investing is scarier than investing at the Seed or Series A and 3) the fact that most venture firms are not equipped to help companies before they have reached product market fit.

Management fees are a culprit insofar as they alter the incentives of venture funds. VCs that are successful at the ultra-early stage with relatively small vehicles are often tempted to increase the size of their subsequent vehicles, in order to avail themselves of higher management fees. VCs typically charge their investors 2% of the total fund size per annum. Thus an $80m dollar fund generates ~$1.6m in annual management fee income versus the $400k generated by a $20m dollar fund. The only thing stopping funds is the pesky problem of having to actually deploy the money. Most firms, however, have a quick fix for this.

Assume that your first, now-fully-deployed fund was $20m. Over that fund’s deployment period you reserved 50% of the money for follow-on investments and deployed the initial $10m on 25 Pre-seed and Idea Stage companies with an average ticket size of $400k. You have now raised an $80m fund and need to figure out how to deploy the money. Like in the first fund, you reserve 50% of the money for follow-on rounds and then figure out what to do with the remaining $40m. Do you stick with your $400k ticket size and strategy from the first fund?

I would argue that in most cases, VCs — even those previously most active in the Pre-seed market — choose the ‘easy’ way out when faced with the choice between writing 20 x $2 million cheques and 100 x $400k cheques. Many firms ‘graduate’ out of the Pre-seed. $400k cheques were cute when you only had to do 25, however, now that you have 4 times the money the path of least resistance is to make larger investments rather than hire additional personnel and develop more efficient processes. The growth in fund size associated with the search for management fees has the knock on effect of causing Pre-seed investors to move to later stages.

Simultaneously, VCs’ appetite for idea and Pre-seed stage companies is further diminished by the fact that it is simply harder to reach conviction around these businesses. Early stage investors often bemoan the constant uncertainty that they have when investing and this uncertainty is at its peak when looking at Pre-seed companies. Where Seed investors complain that metrics like CAC are unstable or that high growth is mirage-like when a company is starting from a low base, Pre-seed and Idea Stage investors wrestle with the fact that CAC and other metrics simply cannot be calculated yet or that there is no revenue at all prior to a product’s launch. Faced with the choice between low quality data, which one can at least (mis)use as a crutch, and no data at all, most opt for the former.

Lastly there is the problem of skill sets. Simply put, many venture funds are set up to support companies that have already reached product market fit and have little to no muscle memory when it comes to helping founders iterate towards it, making them unsuited to the earliest investments.

Together these factors conspire to create the bias towards funding the later parts of the early stage ecosystem amongst VCs. On the rare occasions where Seed-focused funds do dabble earlier, their investments normally centre around backing “high signal” founders, typically people who have been early employees or founders at other well respected tech companies (normally early team members at unicorns). From our vantage point at Icebreaker, this is clearly not enough. It goes without saying that the next generation of successful companies is not going to be composed solely of ex-Unicorn employees and we believe that there is an extremely large opportunity in the Idea and Pre-seed stage left untapped by the European venture community.

Why do we believe in Pre-seed?

At Icebreaker our goal is to serve this underserved segment of the early stage. Seed companies don’t come out of nowhere making the Pre-seed and Idea Stages pivotal in determining which companies are actually built.

Under the status quo founders have limited options. Spurned of VC interest, they typically turn to friends and family, angel investors and accelerators for financial support. While these sources of funding and support are a vital part of the ecosystem — they do not sufficiently fill the VC shaped gap at the earliest stages. Firstly, access to rich friends and family or angels is not evenly distributed amongst the population and thus excludes swathes of founders for no good reason. Secondly, even if one assumes that all accelerators are of high quality, they often don’t provide enough runway for a startup to reach the escape velocity needed to attract the attention of Seed investors, resulting in many promising startups finishing these programs in a state of limbo.

Many startups capitulate at this phase while others turn to less reputable sources of funding as a last resort, falling prey to vulture funds and bad actors. In the last year, I have seen countless interesting companies that were unfundable due to broken capitalisation tables, having fallen victim to the sharp practices of these actors in their time of need.

Icebreaker exists to rectify these structural problems. We are a source of institutional capital that allows founders, even those without strong personal networks, to raise capital from as early as the Idea Stage. With our initial ticket sizes of €150k — 800K we provide enough funding for companies to get to a position of strength and avoid post-accelerator limbo without having to resort to disreputable sources of capital and unfriendly deal terms. We are, however, not a charity. We invest in Pre-seed companies, not just to rectify what we think is a broken ecosystem, but also because we see a lion-sized opportunity at this stage.

To achieve this goal we have assembled a team of partners who have all founded or been at startups from the earliest stages and actively help our portfolio founders across areas including recruiting, strategy, fundraising, sales and marketing. If you are in Finland, Sweden or Estonia and looking for funding for your Idea Stage of Pre-seed company please do not hesitate to reach out to us. I can be reached at tunde(at)icebreaker(dot)vc.

Endnotes

1. Pre-seed rounds defined as between $100k-1m, Seed rounds defined as those between $1–4m.
2. Europe’s most mature venture ecosystems is defined as the countries with more than one Unicorn present in them as of May 2021.