Startup 101: Overview of Pre-Seed and Seed Investment

Launching a startup is akin to planting a seed and nurturing it into a flourishing entity. In the financial landscape of startups, two crucial phases stand out: pre-seed and seed investment. Let's delve into the intricacies of these early-stage funding rounds, shedding light on their structures, timelines, and the types of investors involved.

What is Pre-Seed Investment vs. Seed Investment?

Both pre-seed and seed rounds mark the earliest capital injections into a budding company, setting the stage before the more substantial Series A round. Pre-seed funding often takes the form of early-stage convertible notes or SAFEs (Simple Agreements for Future Equity). On the other hand, seed rounds often represent the first "priced round," where preferred stock is sold to investors.

Pro Tip: This article adopts the framework that considers SAFEs for pre-seed and priced rounds for seed, providing clarity for our discussion.

SAFE vs. Priced Round: When to Use Each for Early Stage Funding?

The choice between SAFEs and priced rounds hinges on factors like funding amounts and the presence of a lead investor. SAFEs are preferable for lower funding amounts, especially in scenarios without a lead investor, leading to lower transaction costs. Conversely, priced rounds, involving the sale of preferred stock, are apt for higher funding amounts (typically $3-5M or more) and when a lead investor plays a pivotal role.

Do All Companies Undergo Both Pre-Seed and Seed Rounds?

While not every company follows the trajectory of both pre-seed and seed rounds, a common approach involves a pre-seed round of approximately $1-3M through SAFEs. Subsequently, companies may move on to their first priced round, selling $6-12M worth of "Series Seed" preferred stock. However, variations abound, with some companies opting for alternative paths like bootstrapping or raising substantial amounts solely through SAFEs.

Notably, not every startup follows the same trajectory, and the decision to undertake both a pre-seed and seed round depends on various factors. A common scenario involves a company raising approximately $1-3 million, or even more, through SAFEs in a pre-seed round. Subsequently, as the startup progresses and achieves significant milestones to justify a higher valuation and increased investment amounts, it may advance to its first priced round, where it sells around $6-12 million worth of "Series Seed" preferred stock for the seed round. It's crucial to acknowledge that funding strategies can vary widely across different companies and industries.

In our experience at SPZ, we've collaborated with clients who have adopted diverse approaches to fundraising. For instance, one client opted not to utilize convertibles or SAFEs initially, choosing to bootstrap the venture through self-funding. Their first external capital injection came in the form of a priced round, raising approximately $6.5 million through the sale of Series Seed preferred stock. This method allowed them to maintain control over the company's ownership without dilution from early convertible instruments.

Conversely, we've also worked with a client who pursued an alternative path. This startup successfully secured almost $7 million through SAFEs, a strategy that can be categorized as either a pre-seed or seed round. Currently, the company is gearing up for a substantial first priced round, which is likely to be identified as a Series A. One item worth noting is that if a startup is going to raise a very significant amount of money through SAFEs and convertibles, it needs to be aware of the dilutive impact of the valuation cap or discount being used in those investment documents. 

This highlights the flexibility in fundraising approaches, emphasizing that there is no one-size-fits-all model in the dynamic landscape of startup financing. Whether a startup leans towards bootstrapping, relies on SAFEs, or embraces a combination of funding instruments, the key lies in aligning the chosen strategy with the company's growth objectives and financial circumstances.

Timeline Considerations: Pre-Seed Round vs. Seed Round

Understanding the timeline distinctions between a pre-seed round and a seed round is crucial for startups navigating the complexities of early-stage funding. Pre-seed funding, often facilitated through SAFEs or convertible notes, typically lacks the structured nature of a traditional funding round. Unlike the well-defined processes of later funding stages, pre-seed investments are often closed on a rolling basis, with funds coming in over an extended period, sometimes spanning many months or even a year or more. This flexibility allows startups to secure capital as needed, aligning with their evolving financial requirements and growth trajectory while minimizing dilution prior to hitting significant milestones that can be used for a higher valuation in a priced round.

Moreover, the absence of a rigid timeline in pre-seed rounds contributes to greater adaptability. Startups can engage with investors opportunistically, taking advantage of the founders’ direct network or strategic opportunities. This fluid approach allows for increased maneuverability in negotiating terms and adjusting funding strategies based on the startup's evolving circumstances.

One notable feature of pre-seed rounds involving SAFEs or convertible notes is the considerably lower transaction costs compared to more formal funding rounds. For instance, a SAFE, a common instrument in pre-seed funding, is a concise 5-page document governing the investment. In contrast, priced rounds, which are more prevalent in seed funding, often involve legal documents exceeding 100 pages. The disparity in document complexity reflects the nature of the funding stage, where early-stage investments prioritize agility and efficiency over the extensive legal frameworks required in later, more formalized rounds.

As startups progress to seed rounds, the landscape shifts towards more structured processes. Seed rounds, typically involving the sale of preferred stock to investors, necessitate a defined round structure where all investors contribute within a set closing timeframe, typically within a 90-day period. This transition introduces increased transaction costs, including legal fees associated with the preparation of comprehensive legal documents. While pre-seed rounds prioritize flexibility and streamlined processes, seed rounds embrace a more standardized approach as startups mature and attract larger funding amounts.

Types of Investors in Pre-Seed Investment

The landscape of pre-seed investments is marked by a distinctive investor profile, characterized by a lack of a dominant "lead investor." During pre-seed rounds, especially those involving convertible instruments like SAFEs, startups often engage with a diverse set of individual "angel investors" or angel funds. Unlike later funding rounds, pre-seed investments typically lack the centralized influence of a lead investor orchestrating the terms and conditions of the deal. This decentralized approach allows startups to tap into various sources of capital, fostering a broader network of early supporters.

In the realm of pre-seed funding, it is not uncommon for startups to attract investments from individual angels who bring not only capital but also valuable expertise, mentorship, and industry connections. Angel funds, composed of groups of individual investors pooling their resources, also play a pivotal role in the pre-seed landscape. While venture capitalists (VCs) may participate in pre-seed rounds, their involvement is not as prevalent as in later stages.

A noteworthy strategy in pre-seed fundraising, especially when aiming to raise relatively small amounts from numerous investors, is the use of a Special Purpose Vehicle (SPV) or a roll-up vehicle. This financial structure allows startups to consolidate multiple smaller investors into a single entity on the company's capitalization table. The SPV simplifies administrative processes and provides a more cohesive approach to managing the diverse pool of early-stage investors.

In contrast, the dynamics shift in priced seed rounds, where a more structured and hierarchical model emerges. Priced seed rounds are typically led by a single venture capital (VC) firm who assumes the role of the lead investor. This lead VC negotiates the term sheet, conducts thorough due diligence, and oversees the negotiation of the entire funding deal. Importantly, in priced seed rounds, other investors participating in the round often defer to the terms established by the lead VC. This centralized leadership streamlines the negotiation process and contributes to a more standardized approach in contrast to the decentralized nature of pre-seed funding.

Understanding the nuances of pre-seed and seed investment is pivotal for startup founders navigating the early stages of funding. Whether opting for SAFEs or priced rounds, each path has its merits and considerations. As your startup embarks on this funding journey, SPZ Legal stands ready to guide you through the intricate legal landscape, ensuring a smoother trajectory toward growth.

Contact us today to start the conversation.