Pre-Seed Funding Explained: What It Is & How It Works

A disruptive idea marks the start of a startup. But not all ideas convert into real businesses. Some are discarded during the course and some fail. But to make sure that the startup idea can result in a profitable business, an entrepreneur needs to validate it. This validation often requires the startup to pitch in some money.

It is where pre-seed capital comes in.

But what is pre-seed funding, and how to get it? Let’s find out.

What is Pre-Seed Funding?

Pre-Seed funding is the earliest funding round where a startup raises money to validate its problem-solution hypotheses, propositions, and demand.

Pre-seed capital is required to set the base for the business operations to start and ensure that the founders’ business is a viable one. This base is set by:

• Validating hypotheses relating to the customers, demand, and planned offering, by conducting surveys, research and analysis.
• Bringing key stakeholders on board like the chief technical officer, chief financial offer, etc. to help convert the idea into a full-fledged business.
• Registering key patents, trademarks, and IP to futureproof the business.

Pre-seed funding is usually too small to be considered an official round of funding. However, for some startups, it’s an essential inflow of capital just to set the base for something big that can disrupt the industry.

Purpose of Pre-seed funding

A startup raises pre-seed capital to complete all the tasks that can help it make its idea business ready. These tasks can be divided into three categories:

• Hypotheses validation
• Getting key stakeholders
• Concept or invention ownership

Hypotheses Validation

Startups raise pre-seed capital when they need to fund their validation methods. They conduct experiments based on set hypotheses to validate their offering, market, value, or problem.

A hypothesis consists of assumptions about the problem they are aiming to solve and success criteria.

A startup can resort to the following methods to validate its hypotheses:

• Market research: No matter the industry, startups need to research the target audience to validate the problem, solution, business model, and other hypotheses before converting the idea into a business. The market research may involve small focus groups, or in the case of specialised products, might involve large trials.
• Interview: Interacting with a defined customer persona validates whether the problem actually exists or not. This can be done in the form of surveys or can include face-to-face interviews.
• Prototype testing: A prototype is a model of the product created to check the functionality and visualise the idea. It is usually not brought to the market but presented to key stakeholders and some prospective customers. The purpose of prototype testing is to identify and fix errors.
• Developing an MVP: A minimum viable product is the most basic version of the product with enough features to make it usable for early customers and receive feedback. It helps to identify whether people would actually pay for the product.

Getting Key Stakeholders

Key stakeholders are people who help the founders in converting the idea into reality. For example, a non-tech founder may require a tech cofounder to take a tech idea forward.

Similarly, a startup may require hiring professional staff even before the idea is converted into a business. It may require funding to pay their salaries and other related costs.

Registration And Licensing

Before starting a business, an entrepreneur may need to register the startup as a company or a similar business structure. Besides this, it may also require funding for the following:

• Licensing requirements: Depending upon the industry, a startup may have to pay for licenses, registrations etc. required to start its operations.
• Intellectual property: Intellectual property rights consist of patents, copyrights, trademarks, and trade secrets. They ensure control over the concept, infection, or offering. The amount usually depends on the type of business, filing fees, number of claims and legal fees.

Pre Seed Vs Seed Funding

Startup funding rounds are inspired by farming. A pre-seed stage is when the founder sets the base to sow the seed. The seed stage, on the other hand, is when the founder sows the seed and converts the idea into a business.

Pre-seed funding is raised to demonstrate whether a product can fulfil the target market’s needs. On the other hand, Seed funding is used to set up full-fledged operations for a validated business idea. It is the first official fundraising round when a startup has already gained some traction on its product. Hence, institutional investors are ready to fund a startup at this stage compared to a pre-seed round.

	Pre-Seed Funding	Seed Funding
Purpose	A startup requires pre-seed funding to validate its hypotheses related to problem, solution, and the offering.	A startup requires seed funding to convert the idea into actual business and start its operations.
Funding Amount	Within $50 – $250k range	Less than $5 million.
Investors	Usually self-financed or from friends, family, and other non-institutional investors.	Institutional investors like accelerators, angel capitalists, venture capitalists may invest during seed round.
Result	The result of a pre-seed round is a product that can generate traction in the market.	After a seed round, business operations are up and running, and at least some revenue is being generated.

Sources of pre-seed funding

The first resort for raising pre-seed money is bootstrapping. Usually, startups go for external sources when they are no longer able to cover the costs. These can be as follows:

Fools, Friends and family

Friends and family usually pitch in during the pre-seed stage as the amount required is relatively low, and they trust the founders more than the idea. Fools are the ones who seek high returns through early-stage investments but fail to realise that it might yield zero returns.

Incubators

Startup incubators are non-profit organisations sponsored by public or private institutions. They are inclined toward innovation and help startups to fine-tune business ideas. They provide services such as assistance, office spaces and networking opportunities. There is no specific timeframe, and it can last for several years, giving a startup enough time and space to try and come up with a solid business model. They usually do not take much equity.

Accelerators

A startup accelerator is a cohort-based mentorship-driven business program that provides early age startups with financing and education. It usually lasts from 3 to 6 months. To get into this program, startups need to have an MVP at least. Accelerators take 7-10% of the equity in exchange for funds, usually in the range of $10-120k. Y combinator and 500 startups are the top accelerators based on successful exits, and their acceptance rate ranges from 1-3%.

Crowdfunding

Crowdfunding is a way of raising money in small amounts from a large number of individuals online. Here the startup gains access to a wide investor pool and the scrutiny of thousands of people who can help identify shortcomings in the product. Crowdfunding can be equity-based, rewards-based, donation and debt-based. The most relevant for the pre-seed round is reward-based crowdfunding as it does not necessarily require having an established business or product.

Pre Seed Angel Investors

Angel investors are wealthy individuals who invest their own money in exchange for equity in the company. They usually make small investments ranging from $25-100k. Being successful business people themselves, they also provide access to a large network and expertise.

Pre Seed VC Funds

VC firms provide equity financing to startups, usually in the Series A round. But large VC firms have now started setting aside funds specifically for pre-seed rounds also to get access to better opportunities in the later stage of a startup.

How much do startups raise During Pre-Seed?

Generally, the amount raised during a pre-seed round ranges from $50-250k.

To decide on an amount to be raised, a plan is developed consisting of quantifiable milestones that have to be achieved and the cash required for it.

The first step is to gauge the amount that the market will be interested in providing. 

Asking for too little funds will not be of any interest to investors as it will be a waste of time listening to pitches for a meagre amount. On the other hand, a large amount will be difficult to raise without an MVP.

Then, a monthly burn rate is calculated. It is the amount a startup spends on operations on a monthly basis. The amount raised should be enough to provide a minimum of 6 months of runway. Lastly, the pre-seed fund should be able to prepare the startup for subsequent funding rounds.

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