I’ve been investing at the pre-seed for the last 7 years. First through the Techstars NYC and now as a Managing Partner at 2048 Ventures.
Pre-seed investing presents a unique set of challenges as compared to later stage (series A+) venture investing: the signals, the data, and the strategy could not be more different.
Like every industry, venture capital has tried and true advice that is often passed around between fund managers. But, like in every other industry, the advice needs to be contextualized.
In the same way that you would not apply the enterprise sales playbook when running an SMB SaaS company, the strategies and methods used by Series A firms do not apply to pre-seed. In fact, they often can be the opposite of what makes sense.
To understand why, let’s start by analyzing a “classic” VC strategy.
A classic VC fund is a Series A fund. Historically, these funds managed $150M in capital, wrote $3-$5M initial checks, aimed to buy 20% of a company, and then followed on by buying pro-rata in their winners. A partner in such a firm would make 5-10 investments per fund, always take a board seat, and reach capacity at 10-15 investments.
Let’s start with 20% – why did Series A VCs insist (and many still do) on owning 20% of the business? The answer is math.
If you buy 20% of a business at Series A, and maintain pro-rata through Series C, then by the time the business gets to the $1B valuation mark, on average, you would own about 15%. If the business is sold for $1B then 15% ownership would yield $150M, which is equal to the fund size.
The “classic” series A fund aimed to have 20% ownership because that math led to the biggest winners returning the fund. The logic was, if every single investment has the potential to return the fund, then the strategy should work.
That notion led a “classic” Series A fund to take pro-rata in the winners. If they didn’t, then they would get diluted to ~10% or below, and the fund math would start to break down.
The key takeaway here is that because of the power law governing venture outcomes, the best company in the fund needs to return the fund.
The 20% ownership, however, is not part of the insight. This number is very specific to the Series A stage and a fund’s size.
To see that, let’s analyze the math for a larger fund.
For example, if you are running a $500M fund, then you have two problems. First, you clearly need to write larger checks and follow on for longer, but more importantly, 20% ownership, even if you maintain pro-rata all the way to $1B would only get you to $200M, which is less than 50% of your fund size.
This means that this large fund has to aim higher for a $2.5B outcome and maintain full 20% ownership at the finish line. Hence, we see sharp elbows in the rounds of companies that have a shot at an outcome that is north of $1B.
Let’s now look at the pre-seed stage – the math is different in the opposite direction. If you are running a $30M fund, then, assuming a $1B outcome, you need to own only 3% to make the math work.
So with that simple framework in place, here are things that are true for larger funds that are not really true for pre-seed funds.
Myth 1. You should always take pro-rata in your winners
The conventional wisdom is that you need to take pro-rata in your winners. Well, it turns out that it really depends on your capital deployment strategy.
A better version of this advice is to make sure you have enough ownership to support your fund size math. And that is not really the same thing.
The key question is how much are you buying out of the gate.
For example, if your fund is $30M and you are buying 5%, which is significant, then even with pro-rata at the next round, the math may not work.
As pro-rata gets expensive for pre-seed funds (it can occasionally be millions of dollars), it’s unlikely a $30M fund manager could afford it beyond the Series A. This means you are likely going to land below 3% at the $1B valuation mark, and your winner won’t return the fund, unfortunately.
The bigger problem for pre-seed funds is that later stage equity is MUCH more expensive than early stage equity.
This is the basic risk-reward equation. Series A investors are happy to write a larger check because the company is more de-risked. Pre-seed investors don’t really have such a luxury. Their funds are simply not big enough to play this game.
The key decision that a pre-seed stage fund manager needs to make is whether the follow-on capital would be better deployed as a brand new investment.
That is, instead of following on and taking pro-rata at Series A, should you instead write one or more pre-seed stage checks?
Myth 2. You need to have a concentrated portfolio
A “classic” Series A fund ran a concentrated strategy and made 20-25 investments over a 4 year period. Why was that?
The origin of this is simply the capacity of a General Partner (GP).
A GP pitched Limited Partners (LP) on not only picking great investments but also helping grow and build amazing companies. GPs promised to apply their experience and leverage their networks to help CEOs grow businesses all the way from Series A to IPO.
To fulfill this promise, GPs not only bought preferred stock, which gave them control over certain aspects of the business, they also took a board seat. Essentially, every time a GP took a board seat, they added another 1/2 time job.
A VC job is made up of many jobs to begin with – raising funds from LPs, building and running a firm, finding and investing in amazing companies, and on top of that, working with companies to turn them into big winners.
The challenge with all of this is time constraints. VCs are incredibly busy, to begin with, and get even busier with each investment they make.
This explains why later stage VCs who sit on 10 or so boards peak and can’t make any more investments until some portfolio companies exit.
This dynamic and the promise made to LPs naturally leads to a concentrated strategy.
There is no math that says that 20% ownership with 20-25 investments per fund is optimal. This is simply a relic of how VC funds were organized.
On the other hand, pre-seed funds can not be concentrated. Literally, if you run a concentrated pre-seed fund, you are gambling and hoping to get lucky.
Why is that?
Because as a pre-seed fund, you can’t buy enough ownership to afford to be concentrated. You don’t have the “magical” 20% at your disposal.
Also, as my Partner Neha Khera points out – pre-seed is so risky and the failure rates are so high that the math does not work.
The answer is instead to construct a portfolio size that supports your fund size, and then infer your ownership targets and strategy from there.
The math will point in the direction of a broader portfolio. You will also conclude that you can’t take board seats. It just won’t be practical.
Myth 3. You need to reserve 50% of your capital
This is another way to say you need to reserve a lot of capital to follow on in your winners.
More importantly, the origin of the 50% number is tied to the 20% number and to the size of larger funds. That is because the valuation roughly doubles every round, and the number of companies you would follow is roughly half at the subsequent stage. This means you need as much capital for pro-rata as your initial checks.
Again, this advice comes from funds that run a concentrated strategy and doesn’t necessarily apply to pre-seed.
For all the reasons we discussed above, the cost per point of the follow on capital may be too high, and its impact may be too low to make a dent in your fund returns.
You need to decide if you are better off making a new investment vs. following on.
The first investment you make will be the cheapest cost per point. It will also be at the riskiest stage. As a pre-seed investor, you need to figure out how you are going to manage this risk while getting ownership to support your fund size.
You will likely conclude that you need to make more first check investments, which will naturally reduce your reserves.
Myth 4. You need to charge 2% average management fees over 10 years
There are two crucial differences between pre-seed and Series A funds – first is the level and duration of involvement, and second is the fund size.
As a pre-seed fund manager, you aren’t taking board seats. Sure, you are working with the founders through the entire journey of the business, but as the company evolves, your weekly and monthly involvement naturally decreases.
To put it simply, your superpower as a pre-seed stage investor is to identify and support founders at the earliest stage. You don’t specialize in scaling the business, building out the management team, and getting the company from product-market-fit to mega-scale.
That’s what Series A and later-stage VCs do. That’s why they take board seats and typically stay on the board until the IPO or M&A.
This is why it is fair for later stage VCs to get paid for 10 years. Remember, they have a 1/2 time job with EACH company they invest in.
The same is not true for the pre-seed stage. We aren’t as involved after 1-2 years. We still help a lot, and if you are lucky like I am, you will always be the founder’s first call, but you can’t really claim that each investment you make is a 1/2 time job in the later years.
So – and while this may be controversial – it is simply not fair for pre-seed managers to collect fees for 10 years.
On the flip side of this, pre-seed stage funds are much smaller.
A 2% annual management fee on a $30M fund is $600K a year versus a 2% annual management fee on a $150M fund is $3M. Much of the infrastructure and fixed costs are the same. It is difficult to run a venture firm if you have a small fund.
This existing system is unfair to pre-seed managers, and thus, drives poor incentives – raising funds more frequently, and racing to grow capital under management.
The solution to this problem for pre-seed funds is to increase management fees significantly during the investment period, and then cut fees to 0 after the investment period has culminated.
This is going to be a win-win for LPs and for GPs. LPs will pay less in management fees for the duration of the fund, and GPs will actually be able to run a firm and make a living.
For example, instead of taking 2% for 10 years, which is a total of 20% in management fees, you can take 5% for 3 years, and then nothing in years 4-10. This would result in a 15% fee over the lifetime of the fund.
Myth 5. You need to raise a fund every 2 years
Stacking management fees truly drives bad incentives. That is, when GPs raise many funds subsequently, so they get 2% each year from each fund.
GPs who draw management fees from each fund they manage are incentivized to be GPs in more funds.
There is a specific pressure with the current pre-seed stage setup – because the fund is small, the management fees are small. It is hard to make a living, so as soon as possible, GPs want to deploy the fund and race to raise another one.
This is bad, for both GPs and LPs.
Likely, this is worse for LPs as GPs are incentivized to invest the capital ASAP, often without prudence, in order to start deploying out of their next fund.
And last, but not least, this dynamic is also bad for diversity in venture. Because smaller fund managers draw less fees, they have a harder time making a living, and as a result, the asset class isn’t able to attract potentially talented and diverse categories of investors, who simply can’t afford it.
Myth 6. You need to grow capital under management to be successful
Another dynamic caused by insufficient management fees is the pressure to grow capital under management.
Somehow, even today, it is more prestigious to be a later stage VC versus being an institutional investor at a pre-seed stage.
More capital under management implies more status.
The real problem is that this dynamic causes talented pre-seed managers to leave the asset class as soon as possible.
Again, the driver is money, and an ability to make a living, but the consequences aren’t great for the industry.
The venture capital and startup world at large needs to have a high-quality filter at the top of the funnel. This is what the institutional pre-seed stage is – the top of the funnel for the entire industry.
To have that quality filter, we need to have specialists at the pre-seed stage.
But how can we have specialists if the incentives are to get out of the asset class as soon as possible?
To compound the problem, the race to manage more and more capital is bad for LPs as well. If you have a GP who is excellent at pre-seed, it doesn’t mean this manager will be a great Series A investor.
The skillset, the network – basically everything between investing in pre-seed and Series A is completely different.
So while a GP is incentivized to grow capital under management, LPs are paying for GPs to effectively learn how to make completely different types of investments. It doesn’t make sense.
A manager who is awesome at pre-seed will take a while to become awesome at Series A.
A better setup for everyone would be to properly incentivize great managers to focus and grow in the earliest, pre-seed stage.
This means adjusting management fees so that managers can properly run their firms.
Secondly, we need to recognize that growing capital under management at the pre-seed stage is very different and can’t happen the same way that Series A firms have historically done it.
There is no clear path for pre-seed firms to go from $30M to $300M under management in a single fund.
Myth 7. You need to have large institutional LPs
Let’s make it simple – pre-seed funds should spend close to no time pitching institutional LPs.
In the same way that an early-stage startup should not be pitching a growth stage equity firm, it’s difficult for pre-seed managers to get a check from an institution.
The reason is that most institutions are looking to write checks that are bigger than the entire pre-seed fund size.
There are a handful of exceptions, specifically – fund-of-funds who have pre-seed or emerging manager programs, but beyond those, institutional LPs are simply not a match for the pre-seed stage.
Pre-seed funds are just altogether different. There is no need for an anchor LP for the fund to come together.
Take another startup analogy – an angel or pre-seed round. You don’t always need a lead. These days, the early rounds come together quickly because angels and micro VCs aren’t afraid to write checks.
Similarly, there is enough individual capital interested in pre-seed LP stakes to fill up the fund.
There are of course challenges with having individual LPs, but you can flip them around and turn them into positives.
For example, instead of having an annual meeting, you can provide personalized updates. It does take time, but venture has always been a high-touch business.
The biggest challenge with individual LPs is that there will be natural churn between your funds, even if you are performing well. You just need to be ready for this challenge and get ahead of it.
The positive of having a diverse base of individual LPs is that you gain a strong network. LPs will make introductions, send deal flow, and often will co-invest alongside you in deals.
Myth 8. You need a unicorn to do well
The two Techstars funds that I managed are at 12x and 5x, respectively, without a single unicorn (yet!). I am pretty sure that if all of it goes to cash right now, LPs would be happy.
You don’t always need a billion-dollar exit to do well.
The correct insight is that you do need an outlier exit relative to your fund size, but it doesn’t need to be a $1B exit.
To be clear, to do really really really well, you would need a $1B outcome ($10B or $100B is even better!), but to generate a 3x return, that may not be necessary.
With a $30M fund, if you end up owning 6% at a $500M exit, you will still return the fund. The question is how to end up with this much ownership? You likely need to buy more equity upfront so as you get diluted during future rounds, you can still land on the ownership you need.
Two things hold true across the stages of venture capital: distribution of outcomes guided by a power law, and your fund size is your strategy.
What is false is that you always need a $1B outcome to do well.
As always, everything is relative and it depends.
