A Founder’s Guide to Pre-Seed

The signals overview on how to raise the very first VC round

1. Defining Pre-Seed: Round Sizes & Valuations

A relatively new category, pre-seed rounds and funds specializing in this stage both experienced skyrocketing growth in past years. After our deep dive into the pre-seed investor landscape in DACH and developments that led to pre-seed’s rising popularity, this post shares our take on the characteristics of a “typical” pre-seed round.

The categorization of funding rounds into Seed, Series A+, Growth and the like defines a startup’s stage as well as investment focus of venture capital firms. Yet the lines between those stages sometimes blur and take on creative dimensions: think Late Seed, Seed Extension, Pre-A, Post-A (see this post by Angular Ventures). However, as we discussed in our previous post, there is a real raison d’être for the pre-seed category. Seed has become the new Series A, with larger round sizes driving heightened expectations of VCs towards startups. This shift affects very early startups looking for funding to develop an MVP to a scalable product and convert pilot customers to recurring revenue. At this stage of the funding lifecycle, a large gap has opened up and led to the rise of pre-seed. So what does the archetypical pre-seed round look like?

Looking at some of the pre-seed round size definitions out there, it seems that there are (surprise!) many shades of grey. At the lower end, the Crunchbase glossary defines pre-seed as a “pre-institutional seed round that either has no institutional investors or is a very low amount, often below $150k.” While this might hold true for the very first investment by FFF (fools, friends & family) and individual angels, pre-seed rounds involving venture funds can be much bigger.

Recent data shows an upward trend in round sizes, similar to the dynamics of Seed or Series A. These range from a worldwide average of $415k in 2019 (DocSend) up to a median of $830k in Q2 2020 (WSGR). Pear VC’s 2019 framework, which proposes pre-seed round sizes between $150k and $750k, gives a better view of the larger spectrum that falls under the pre-seed category.

What about valuations? Looking at the valuation of pre-seed startups and considering founder dilution of 15–25%, it seems reasonable to assume a range between $3M to $6M (figures also supported by Pear VC).

At signals we define a pre-seed VC round in DACH as depicted in the chart below, our sweet spot being round sizes between €500k to €1M and post-money valuations from €2.5M to €5M.

In our view, an exemplary case constellation is a round size of €500k with a post-valuation of €3.5M split as in the figure below:

In this constellation, there is room for each of the investors to add their specific values:

• A pre-seed fund brings in its strong portfolio and investor network
• the accelerator makes use of its investment option and knows the team right from the start
• a set of angel investors brings “smart-money,” e.g. in the form of industry experience.

All in all, whatever the round set-up looks like, it should most importantly reflect the individual needs of the startup, since the pre-seed phase is the crucial inflection point for its future success.

Having defined how a pre-seed round is typically structured, we will now address the pressing question for founders looking to raise a pre-seed: How can a startup convince investors at this stage?

2. Evaluation criteria for B2B pre-seed startups

While there exist many great overviews on relevant KPIs to raise a Seed, Series A or later (such as Christoph Janz’ SaaS Napkin), our discussions with entrepreneurs show that at the pre-seed stage, decision criteria are far less clear. As put by Gaurav Jain of Afore Capital in the Twenty Minute VC Podcast, a Series A due diligence checklist is useless at the pre-seed stage.

This is mostly due to the fact that before entering the pre-seed phase, startups typically have yet to collect many data points. Many pre-seed companies have not even launched a public product and still have several iterations to go before attaining MRR or meaningful numbers of licensed customers and product usage. For this reason, pre-seed investors tend to rely more on qualitative factors than the ubiquitous USD 1M in ARR to be Series A-ready. Below are the most critical fundraising criteria at the pre-seed stage:

👯Team

We at signals are not the only ones who believe that the most important factor by far is the team (check e.g. Pear VC, Precursor Ventures or Afore Capital). But the myth of pre-seed VCs betting only on CVs and ideas does not hold true. Rather, a strong team consists of complementary founder personalities, each bringing a diverse skill set to the table. At best, the team has already worked together within successful projects or ventures. For fresh teams, the ability to attract great co-founders is also a good proxy for the ability to hire great talent for key positions at a later stage. This also plays a role in building the right network that supports the company.

Harder to evaluate, yet no less important is the founder’s smarts and ability to learn. On the one hand, this includes “classic” IQ (no worries, we don’t do tests), but on the other hand, EQ is equally important. Are they humble enough to drop a super exciting feature or pivot after speaking to potential customers? Are they authentic and sympathetic, so that we really want to partner with them in the long run? The investor’s pitch gives a good indication of this: “The way they talk to us, they also talk to customers” (Gaurav Jain). Their strong desire to learn and iterate should be further accompanied by an overall growth mindset that matches the investor’s goals.

In addition, the best pre-seed founders have unique industry insights and expertise in their respective markets as an unfair advantage (Gaurav Jain, SaaS napkin). The team should bring the potential to dominate their respective markets. And for sure, founders with a proven track record as entrepreneurs with successful exits in the past will have a premium over first-time founders. At the same time, the team should have a level of ambition that matches the VC investor mindset, aka “10x thinking.” Remember, VCs are looking for portfolio companies that can be fund returners. Ultimately, the team needs to demonstrate that they are able to execute their product vision — this means not only to be able to deliver the technical product but to actually bring it to market, know their customers and find the right channels to sell to them. In this sense, investors are looking for teams they can trust in “building and shipping their product” (Charlie Hudson).

💹 Market

The market environment is an important evaluation criteria at the pre-seed stage. The bigger the market, the higher the possibility that the startup will have a sufficiently large enough business opportunity, even if it pivots its value proposition (which is very likely to occur at this stage). Relating back to our evaluation criteria for a pre-seed team, non-obvious market insights that give an unfair advantage towards competition are crucial here.

As in later stage investments, the logic behind the founder’s market size and growth assumptions (preferably bottom-up) will be challenged, too. A market size of 1B €+ and a realistic outlook for constant customer growth for the next 5–7 years should be well within the addressable geographic reach. In addition, the analysis should include the actual dimensions of the problem the startup aims to solve, as well as address the low customer satisfaction of any existing solutions. Y Combinator’s Kevin Hale proposes crisp KPIs that help to determine if the solution is an actual painkiller for a huge market or a nice-to-have for a niche target group. Examples include the overall number of users, the frequency of problem occurrence, or regulatory changes that directly create a need for their solution.

Since pre-seed investments will mostly happen during the very first steps of the startup’s journey, when scalable revenues lay potentially years ahead, the market timing needs to be spot on. Factors such as upcoming economic or regulatory triggers, changing user behavior, or the rise/maturity of enabling and adjacent technologies can be hints for the right timing. If the market is already occupied by several Seed or Series A-funded startups, this might be a sign of being too late to the party. On the other hand, a startup that builds a B2B platform to manage fleets of autonomous transportation through hyperloops would see no interest from actual customers. Related to the previous point, questions will also arise as to whether the market offers long-term, sustainable growth options or simply short-term hype demand.

Hence, the competitive environment is a decisive factor as well. This does not mean that only players without competition can succeed in pre-seed fundraising. Rather, the differentiation towards existing solutions is crucial here. Pre-seed VCs ideally need a clear answer on how this team is solving the problem 10x better than the rest of the market.

🚀 Traction

Even though it’s hard to measure, traction also plays an important role in the evaluation of pre-seed investments. Its definition and measurement is not always straightforward. As Gaurav Jain has said, unit economics such as the current CAC or LTV are very hard to evaluate or non-existent for pre-seed candidates. But rather than looking at status quo KPIs, pre-seed investors must take the dynamics of the startup’s development into account. What did you learn about your specific target customer group? Which market dynamics were not obvious when you began? How did your initial assumptions change after speaking to your potential user base?

Besides agility and first signs of progress, traction at pre-seed first and foremost includes an initial pool of B2B pilot customers. Although they will often arise from the founder’s existing network, the feedback of early adopters helps investors understand the market opportunity. Acquisition of pilot customers by validating go-to-market hypotheses and sales processes independent from network recommendations is a big plus and a strong signal for future product monetization.

The velocity of product development can serve as another proxy for traction. Especially the rate of deploying customer feedback into the MVP and shipping new, improved product versions demonstrates not only the team’s execution skills, but also customer engagement. As stated by Pear VC, MVP does not only relate to the technical product, but also to the business model and/or market assumptions.

🙌 And there is more…

While team, traction and market are the evaluation criteria that weigh the most, there are a few other factors to be taken into account at a pre-seed stage:

This includes a concrete product roadmap and efficient use of invested funds: Do the founders have a clear plan for the next 6–12 months on how to validate their product in the market? Which features are crucial to speed up time-to-value for customers? And what are the North Star KPIs to track?

Another important factor is the future fundraising roadmap. What does the team have to prove in order to attract follow-on funding from reputable investors? This aligns with the goals of the pre-seed investor, who has a strong interest in carrying the team to the next round, thereby increasing the value of their shareholding.

3. Wrap-Up

All in all, the rising popularity of the pre-seed category and the increasing number of pre-seed investors reinforce the need for a common understanding of this stage’s characteristics. As we saw, there is a wide range of pre-seed round sizes. We suggest that a pre-seed round will be somewhere between €500k and €1M, which is also influenced by the participating investor types. An appropriate founder dilution and typical ownership expectations by investors are quite straightforward at this stage, so the range here depends heavily on the round size. Valuations for larger rounds for “hot” pre-seed startups can reach up to €5M, while €2M or less represents a lower threshold for smaller deals. Bearing these indicators in mind, founders can determine where on the spectrum they best fit.

To support founders in their evaluation as to whether their startups are “pre-seed ready”, we further discussed some of the key decision-making criteria for pre-seed investors. While there exist many more factors that also depend on the specific investor’s thesis and strategy, we find that team, traction and market are the most crucial ones. Within each of these themes, there are several related factors that are relevant in the pre-seed stage. Founders looking to raise a pre-seed round should evaluate each of them to map out their current status in their fundraising journey.

About signals Pre-Seed

signals is your trusted business partner, mentor, and investor in one. We support founders with more than money.

signals Pre-Seed invests in B2B software-based solutions for small and medium-sized businesses as well as in category-defining solutions for enterprises in the DACH region. We invest up to €250k to provide early-stage founders with an adequate runway. In addition to this, we provide founders with individualized mentoring and office space where and when needed so they can concentrate on what matters most — working on their product and gaining customers.

signals Pre-Seed is a joint investment program of signals and signals Venture Capital. signals Venture Capital deploys a €100 million venture capital fund, focusing on Seed and Series A stage startups with software-centric B2B business models across all enterprise segments. The portfolio companies benefit not only from classic venture capital support, but also from the extensive signals ecosystem, comprising renowned German and European partners, industry experts, and diverse distribution channels.