The case for venture investing, specifically in the Late-Seed stage

The case for venture investing, specifically in the Late-Seed stage

[Vs. pre-seed/early-seed]

Most pre-seed rounds are on SAFEs (Simple Agreements for Future Equity) or Convertible notes.

These are intended to convert into the eventual priced Seed round at some combination of a valuation Cap and/or discount to the priced round.

The whole concept of the pre-seed round is relatively new. Over the years, as it became a standard of the startup world and accepted as a norm, the valuation of these pre-seed rounds continued to rise disproportionately to the priced seed rounds into which they may eventually convert.

Typical terms on a convertible note are a valuation CAP, a 15-20% discount to the next round, and a nominal interest rate accruing on the note (typically 4-10%).

Assuming that an astute investor is diligent in their underwriting and selects a solid basket of pre-seed investments. In 18 months, in a happy scenario, 50% of these would have converted as expected to the priced round without further dilution between the pre-seed and conversion [recent stats show that top quartile early-stage funds have 40% of their early-stage investments have follow-on rounds]

Let’s assume an average of 1.3X markup on these, which is a generous average. The large majority convert based on the discount and not the Cap, so even a 20% discount results in a 25% markup (purchasing the shares at 80% of the price per share of the new money in the seed round means we get 1.25X the number of shares the same money would have).

A 15% discount would be under 1.2X.

A few may have been SAFE’s with a CAP and no discount, which may convert at PAR

A few may have had spectacular growth and then jumped straight to a pre-emotive series A at a 3-4X multiple of the CAP, and those will generate a higher average of 1.3X if the investor is lucky enough to have any of those.

The other ½ of the pre-seed portfolio struggle along, not raising the priced round, and over the years raising some additional SAFE’’s and notes, and possible eventually having an exit to a strategic, for a less than 1.X exit. Let’s be generous and say that this part of the portfolio yields a blended exit of 0.6X.

So we have ½ of the portfolio at 1.3X and ½ at 0.6X. Essentially a wash. Note that the 0.6X would take 3-5 years or more to actualize. The 1.3X markup takes place in an average of 15 months (typically 12-18 months from the pre-seed round).

On priced rounds for fast-growing VC-backed startups, the expectation is 3-5X growth in revenues every 18-24 months, and hence have a 3-5X increase in valuation at each subsequent proved funding round, spaced typically 18-24 months apart, each time raising an amount sufficient for that time frame’s burn.

The bottom line is that for pre-seed rounds to fit into the venture model, their valuation needs to get reset so that they are in line with the 3-5X potential increase to the priced seed round into which they will convert.

When there is a fast-growing early-stage startup that has an eminent priced round in the coming six months, then a small note of SAFE with a 20% discount may make sense to allow funding to start the rapid growth while working on the seed round without pressure.

In all other scenarios, where the raise at the pre-seed is a full 18-24 months of run-way, the pre-seed round is essentially acting as a replacement for what used to be a Seed round, then from the investor’s perspective, the risk/return model, as demonstrated above, simply does not work.

The pre-seed investor is taking a significantly higher risk without any significant reward.

What we see constantly are pre-seed rounds of startups that are just launching their product and either in Beta or onboarding first customers, and they are raising a pre-seed round for 12-18 months of run-way “in order to achieve $1MM ARR by the end of the 12-18 months and then raise a proper seed round).

The problem is that they are often raising this pre-seed at a $10MM valuation, which is what they approximately could be worth with the $1MM of ARR, should they ever get there and still be fast growing. As noted, at most 50% will get there on schedule as planned.

With this information, why would anyone invest in this pre-seed round? One could instead invest in a portfolio of Seed-stage startups that already have, say, 1M ARR on average (some may be at $500k and others at $1.5MM with many other variables), in a full-priced round at essentially the same valuation, rather than wait and watch ½ fail and ½ convert.

I’ve invested in over 500 startups as an angel investor over the past dozen years.

Many were pre-seed. Many were at significantly lower valuations (sub $5MM).

As pre-seed valuation rose, I fell into habit and continued to invest in many pre-seed rounds at higher valuations. This is also true for Emerging Ventures Funds 1 and 2 where I am Managing Partner and make the investment decisions.

Over the past 2 years in particular, I had many difficult discussions with many of those pre-seed portfolio companies that are struggling and unable to raise a proper seed round.

In careful review and analysis of both my angel portfolio and the fund’s portfolio, I developed a clear understanding that the best value in the current tech startup market is at the Seed stage and that pre-seed, in particular, in most cases, is not worthwhile, participating in. It’s best to have the discipline to wait and watch and then join in the eventual Seed round.