Pre-seed funding is seen as the initial step of obtaining external funding for a business that will determine whether the product or service they are planning on building will fill a market need. In this early product development, pre-seed funding provides the funding to enable a business to reach a minimum viable product (MVP). This product has enough functionality to be released to the market, perhaps in a limited manner or a test market, for customers to use and provide feedback. From this process, improvements and changes can be better focused and give the business the best chance of bringing to market a successful product.
Sources of Pre Seed Funding
The most common form of funding at this stage is from the founders themselves, either personal borrowings or savings. If founder based funds are insufficient, then external sources are used in addition. There is a wide range of external funding sources, the more commonly used we list below.
Close Family and Friends
The oldest and most widely used external source for ventures getting off the ground is family and friends. Not advice someone like Dave Ramsey would give, but most of us have or will “lend” money to someone’s new venture. Of course, what people fund is the relationship rather than the business. Many a “Bank of Mum and Dad” can attest to this – and more often than not, with less than happy results.
The funding from this source is often in the form of a “loan” rather than equity in the new business.
Venture Capital Funds
Venture Captial (VC) Funds, or Firms, tend to focus their funding after the pre-seed funding stages. However, they do provide capital in this market too. Unlike family and friends, funding from VCs tends to be in the form of capital rather than debt. If they are getting in at this stage, the risks are higher, so they need their winners to be significant. This approach helps VCs to cover the losses they often otherwise incur.
A growing part of the external funding market is that provided by incubator programs. Firms like Dreamit offer a full suite of services to help a new business get off the ground. The advantage of programs like that by Dreamit is the experience and backing they bring. They help right from business basics through to technology implementation and regulatory compliance. Because a new business has to apply to join an incubator program, that process alone raises their chances of success.
Both for-profit and not-for-profit organisations operate incubator programs, and they tend to take capital positions rather than debt. A similar approach to that of the VCs, capital, rather than debt, provides the best rewards of big wins for the money and time invested.
Unlike the VC and incubator programs, angel investors tend to be individuals. This provides advantages, perhaps being more flexible in time and interested in smaller sums of money. Disadvantages can be the range of skills and depth of experience an angel investor brings may not be as great. And again, the start-up will have to give up a good percentage of the business for the funding they are receiving.
The final source of external funding we want to highlight is that from crowdfunding. Although we think of this as a relatively new phenomenon, this type of funding can be dated back to the 1700s with funding of wars in Europe. In more recent times, portals such as GoFundMe and Kickstarter have grown the market to over $40 billion in the United States alone. The concept brings pre-seed funding to the masses who can invest tiny amounts into new businesses. In this case, the funder may not receive an equity position in the new business. Instead, they may receive early access to or additional features from the new product or service.
Pre-Seed v Seed Funding?
The distinction between pre-seed and seed funding can be tricky to highlight. However, the two main differences are their timing in a business start-up and hence their purpose. The pre-seed stage is before the “official” funding rounds. Seed funding tends to have organised and established funding rounds with greater liquidity and competition.
There generally is no prototype available at the pre-seed funding stage, but additional funding is required to further development. This activity may be in the form of product or market research, facility development, team development or regulatory compliance preparation.
Advantages of Pre Seed Funding
The advantages of pre-seed funding relate to the “output triangle”. Each of the points is discussed below.
Often when external funding is brought into a business arrangement, the time pressures tend to increase. Those committing their hard-earned money want to see it working hard and quickly. In particular, funding from VC sources is notorious for the quick turnaround of their money. So time tends to get compressed with pre-seed funding, moving the process along much faster than otherwise.
With the time compression from others comes their money. With more money, you can do more things more quickly. This can be in the form of more features, to market quicker or better quality being delivered. But money, as it does in personal finance, gives more choices.
With the money and time pressure, what helps get things done is the expertise that backs that money. In particular, funding from incubators and VCs can bring the technical knowledge that otherwise might be lacking. Having others with experience in early start-up ventures means many new things don’t have to be learned by the founders. But instead, they can lean into the capital funding providers expertise.
Disadvantages of Pre Seed Funding
With any initiative in business, there is going to be some trade-offs.
Giving up Future Value
Most of the pre-seed funding sources will want a slice of the pie that is being created. These parties want to generate many multiple returns on their investment. And so, the more significant the initial portion they can gain, the bigger the returns on payday.
If a pre-seed funder is not taking the capital, they will instead take debt (although not necessarily crowdfunding). And with debt comes interest and repayment. Ensuring positive cash flow is critical to being able to cover these obligations. For the benefit of keeping the potential future value of the business, founders carry debt —the greater the risks associated with this debt, the greater the rate of interest to be demanded.
Loss of Control
In bringing any external party, even in debt arrangements, there is the risk of losing control of the business. And this isn’t necessarily from an investor having the voting rights to change things. Even the threat of withdrawing their funds brings strains and pressures that otherwise wouldn’t be present.
Accounting for Pre Seed Funding
The last section we wanted to cover was some journal entries for pre-seed funding, looking at both capital and debt. We’ll suppose our ABC Ltd has sought $500,000 in pre-seed cash funding in a couple of examples below. The first example is for debt and the second for capital.
Although more common in later funding rounds, debt can sometimes be used in pre-seed funding. Like any other issuance of debt, the journal entry is straightforward. In this case, ABC is receiving $500,000 in debt funding from XYZ Capital Ventures Ltd. The debt carries the following terms:
- repayable in three years;
- coupon rate of 7 per cent, and;
- interest only, due every six months.
|||Pre-seed Funding Liability||||500,000|
With debt normally comes interest. And so ABC would make its first repayment on September 30 ($500,000 x 7 per cent / 2 = $17,500):
|Sept 30||Interest Expense||17,500|||
The repayment at the end of year three would be just the reverse of the April 30 receipt of the cash in the first year. The debt could also have a convertibility option for the VC firm. At the end of the three years, they may want the opportunity to convert the debt into capital. If you would like to look into the accounting for this in more detail, we have another article looking at this funding option.
This simple example also does not factor in debt issuance costs that ABC may have incurred. We have another article that covers the accounting for these costs.
In this final journal entry, we will assume ABC is now receiving $500,000 cash in the form of capital from XYZ Venture Capital Ltd.
Like the debt journal entry, the debit to the bank account reflects the increase in cash. The difference this time is the credit is to share capital rather than debt. And there is no interest expense journal to process every six months.
Pre-seed funding is an exciting area of early business financing. We trust you now understand this sector a bit better and some of the issues this type of funding poses. We always welcome your feedback, so please use the comments section below or the contact us page. If you have any questions, the “ask a question” page is an excellent place to go.