Pre-Seed Versus Seed Funding
“Seed” sounds like the beginning. It isn’t. For many companies, before the seed round comes the pre-seed round and/or the friends and family round: the money you raise to prove your idea is worth a seed round in the first place. If you’re raising for the first time, the vocabulary works against you, so let’s clear it up. What pre-seed actually is, when you need it, and how to structure the money so you don’t regret it later?
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Defining Pre-Seed Funding
“Seed” and “pre-seed” can mean a lot of things. Despite the fact that “seed” funding sounds like it would be the earliest stage, since a “seed” is how a growth process begins, there is actually an earlier stage of funding for startups known as the pre-seed stage or pre-seed funding or financing.
According to the Angel Investors Network, “pre-seed funding represents the initial capital injection a startup receives to validate its core concept, build an early prototype, or establish foundational business operations before pursuing a formal seed round.” Since pre-seed funding is not a formal financing round and often involves raising the smallest amount of capital, it is also known commonly as the “friends and family” funding round because startup founders often obtain the money they need at this point by asking friends or family members to invest, or by investing some of their own savings.
SAFE or Convertible Note? Structure It Right the First Time
The first money a startup takes is not usually priced equity (like Series A Preferred Stock or even Series Seed Preferred Stock). Priced rounds tend to be more complex, require heavier negotiation, and, as the name implies, a fixed valuation on the company. The standard documents for a priced round are the National Venture Capital Association (“NVCA”) documents, comprising five main agreements of about twenty pages each.
To avoid wading through all that paperwork and the hundreds of small decisions and negotiations that come with it (as well as the associated legal fees), two primary instruments have emerged to shortcut the process: the SAFE and the convertible note.
A SAFE (Simple Agreement for Future Equity) is not debt. There’s no interest and no maturity date. Instead, it is an agreement for future equity (quite aptly named). Your investor gives you money now on a short-form standardized document that says the investor’s money will turn into shares of stock at your next priced round, usually with some benefit to the early investors in the form of a valuation cap or a discount. The SAFE is clean, fast, and has grown in popularity over the last decade. Most of the early money investment rounds we do for startups are structured as SAFEs. The Silicon Valley startup incubator Y Combinator created the SAFE, and the forms on its site remain the market standard. Currently, the post-money, valuation cap SAFE tends to be favored by the market for its predictability and clarity.
A convertible note is debt. It carries interest and a maturity date. If the convertible note requires repayment on maturity, a company that doesn’t raise a priced round before the note comes due can find itself in default, returning to the early investors asking for an extension. It converts like a SAFE, but with more strings attached.
For a friends-and-family round, a SAFE is usually the right call: fewer traps, no clock running against you. Save convertible notes for investors who specifically want the interest and downside protection of debt. One warning either way. SAFEs feel free because nothing converts until later, which makes it easy to hand out five of them at five different caps and lose track of how much of the company you have already promised away. Stacked SAFEs all convert at once at your seed round, and they can quietly erase a real chunk of your ownership before a professional investor puts in a dollar. Model the conversion before you sign, not after.
Moving from Pre-Seed Funding to the First Formal Seed Round
At the pre-seed stage, there is an understanding that the startup founder has not raised any real capital for this venture but is seeking to move toward the first early-stage round of formal funding: the seed round.
As we indicated above, a seed round is the first formal stage of funding for a startup. With the first seed round — and there may be just one or several seed rounds, depending on your specific startup — the founder can begin seeking external investments that may come from acceptance to an accelerator, debt financing through a bank, or equity financing through angel investors or venture capital.
Plan Your Raise Before You Need the Money
Some founders manage to bootstrap their company, using only their own money, time, sweat, and tears to launch and grow it. Most successful companies, though, take outside money to get established or to scale. If you’re one of those founders, in addition to important considerations about business structure, co-founders, and product, you will also need to start thinking about funding sources. Raising money when you’re out of cash is stressful and a massive distraction to your main job: building a great company.
To determine the best methods of raising capital and moving forward with your startup, you should seek tailored advice from one of the startup attorneys at Triumph Law. Contact our firm today to learn more about how we can assist you.
Source:
angelinvestorsnetwork.com/glossary/pre-seed