Too Early to Fund: Decoding the Challenges of Pre-Seed Startup Investing in 2024

You meet with a self-described early-stage fund only to discover that they rarely, if ever, make pre-seed investments. People suggest connecting with angel investors, but you don’t know any rich people to reach out to. You’re now on your eighth diligence meeting with an angel investor who still can’t decide. You’ve applied to your second accelerator program just to see if it might help, because why not? Time and time again, you hear the same thing: you’re too early.

This is the typical story founders encounter when raising their pre-seed round.

The reality is that raising venture capital should be exceptionally challenging, as you’re asking someone to invest in a business with minimal or no revenue, expecting a 10x return within 10 years. VCs manage capital for university endowments, pension funds for unions, and, of course, way too wealthy individuals. As stewards of this capital, VCs must be prudent with their investments. Even when we meet outstanding founders, if we don’t see a clear path to a likely exit, we’re more inclined to say no than yes. And I recommend to founders to prepare for a lot of no’s.

With that in mind, isn’t there a way to make the process easier? And why does it seem to be getting even more difficult, particularly for underrepresented founders? At Visible Hands, we understand that if we don’t build the pipeline at the pre-seed stage, how can we expect more Black, Brown, and female founders to reach seed and Series A stages?

First, let’s define what pre-seed means to ensure we’re on the same page, as it’s often confused with other funding rounds. From my perspective, pre-seed typically refers to investment rounds with valuations under $10m and total funding amounts below $1.5m. While Carta data highlights exceptions, where pre-seed rounds feature higher valuations and larger amounts, these cases are rare in my experience as an investor and usually reserved for exceptionally well-pedigreed founders. Overall, we’re all in the same ballpark and what we can agree on is that pre-seed is typically your first round of institutional investment.

This raises the question: what are the important metrics for a pre-seed investment? The reality is, there aren’t any set metrics. While benchmarks become more defined for later-stage funding, venture capital often leans more toward art than science. A survey of over 100 investors reveals how they define revenue goals for a $1.5 million pre-seed round: 46% indicated they would invest pre-revenue, 27% said they would invest below $150k, 15% between $150k and $500k, and 10% would invest at more than $500k.

So, who invests at the pre-seed stage? It’s usually a mix of accelerators, angel investors, and funds. A common scenario we observe with founders is that they initially aim to secure a single large $1m check from a fund to simplify their fundraising. However, after weeks of effort, they often shift their approach, realizing that raising a pre-seed round typically involves a blend of a dozen angels, a few funds, and potentially an accelerator.

What is happening out there in the pre-seed landscape?

Limited Availability of Pre-Seed Funds: Many funds labeled as pre-seed or seed investors primarily focus on seed-stage deals, leaving a gap in true pre-seed investment opportunities. In addition, established pre-seed funds are increasingly allocating resources to larger seed-stage deals, narrowing the pool of available pre-seed capital and raising larger funds.

Institutional seed firms were created over the last 15 years to address the gap between friends and family and Series A rounds. Seed rounds went from $1m rounds to finance product fit to $3+m rounds driven by early metrics and data on company progress. The cycle begins anew — pre-seed is the new seed, seed is becoming the new Series A. (Charles Hudson, Managing Partner, Precursor Ventures in “ Precursor Fund III Deck “)

Despite this, many firms continue to raise larger funds. One reason is economic: managing a smaller fund results in lower management fees, which may not cover operational costs. For instance, a $25m fund charging a 2% management fee would generate $500k annually, potentially insufficient to support the firm’s expenses. In contrast, a $100m fund at the same fee rate would yield $2 million annually, providing more financial flexibility. Therefore, the economics of fund management often drive firms to pursue larger funds, despite the performance advantages of smaller ones.

At Visible Hands, we’ve developed a distinct business model that enables us to generate over $2m in annual revenue without affecting fund returns. This approach allows us to allocate resources effectively, providing enhanced support to our founders. Similarly, Hustle Fund, one of our most admired peers in the pre-seed space, has implemented a revenue-generating model through their Angel Squad program with over 1500 paying members. We also see our peers at Zeal Capital Partners creating special partnerships to invest at pre-seed evidenced by their $50m fund with Barclays.

A Surge in Founders: The U.S. has seen a remarkable increase in entrepreneurship over the past few years, averaging 430k new business applications per month in 2024-a 50% jump compared to 2019. This growth is especially notable among underrepresented groups. Between January 2020 and April 2023, the number of self-employed individuals of color rose by 13%, from 1.7m to 2 m, while the number of self-employed white entrepreneurs dropped by 6%, from 5m to 4.7m ( Fit Small Business).

Women have also made significant progress. By 2021, nearly half of new startups were founded by women, a notable increase from 28% in 2019 ( World Economic Forum). The Global Entrepreneurship Monitor’s 2022–2023 USA report highlighted that total entrepreneurial activity reached record highs in 2022, with an 18% increase for women and a 20% increase for men.

Not all of these entrepreneurs are building high-growth startups, but we believe that more of them are venturing into this space than in previous years. When you combine this increase in entrepreneurial activity with an under-resourced pre-seed ecosystem, it brings us to the current landscape.

Major Accelerators with Diversity Challenges: Industry-leading accelerators like Y Combinator, while significant pre-seed investors have faced criticism for lacking diversity among their cohorts. For instance, in the Summer 2022 batch, only about 15% of companies had a woman founder, approximately 7% had a Black founder, and around 12% had a Latinx founder.

In addition, the recent dissolution of the partnership between Techstars and JPMorgan Chase, which invested $80 million into 400 companies through city-based accelerators, will leave a significant gap in support for underrepresented founders.

Fortunately, there has been a notable increase in funds establishing their own accelerators to streamline deal flow. For instance, Slauson’s Friends & Family accelerator has expanded its investment to $250k per company, providing substantial support to early-stage startups. Similarly, Morgan Stanley’s Inclusive Ventures Lab offers $250k investments to underrepresented founders, aiming to foster diversity and innovation in the startup ecosystem.

These initiatives are vital in bridging funding gaps and fostering inclusivity within the entrepreneurial landscape. At Visible Hands, we have developed pipeline programs like VHNYC and VHBOS-our fellowship programs that offer $10k grants and are prioritized in our deal flow process.

Increased Diligence Standards: The criteria for securing pre-seed funding have become more stringent, making it more difficult for startups to qualify for early-stage investments. Why is this happening? Because VCs are finding it harder to raise their funds. In recent years, raising venture capital funds has become increasingly challenging due to a decline in investments from limited partners (LPs). In the first half of 2024, venture funds globally raised $58.1 billion, a significant drop from the approximately $100 billion raised during the same periods in 2022 and 2021.

As venture capital firms face increased challenges in raising their next funds, they are adopting more rigorous and selective investment strategies. This shift has resulted in a decline in the number of deals compared to the peaks of 2021 and 2022. In the first quarter of 2024, U.S. investors allocated $170.6 billion to startups, marking a nearly 30% decrease from the $242.2 billion invested in 2022.

VCs, including pre-seed investors, should maintain clear standards. While I empathize with the frustrations founders often experience, it’s important to acknowledge that these standards serve a purpose. That said, this does not excuse any explicit discrimination or the frustrating biases that may arise during the diligence process-that’s a topic deserving its discussion. As investors revert to a more narrow pipeline, underrepresented founders, particularly people of color and women, are disproportionately affected. In 2023, companies founded solely by women received just 2.1% of total U.S. venture capital funding, a decline from 2.3% in 2020.

Recognizing these trends underscores the urgent need for a more robust pre-seed ecosystem that supports all founders, with particular attention to those from underrepresented backgrounds. In summary, we have fewer dedicated pre-seed funds, more startups being created, top-tier accelerators facing challenges with diversity, and increased diligence standards.

As I conclude this post, I’ll continue to think through the following questions and welcome ongoing conversation:

• How do we incentivize fund managers to operate pre-seed funds when the economics might not be there operationally? What are other revenue models for pre-seed funds? Can there be philanthropic or strategic sources of capital to help offset the costs of building a lasting fund such as Yale’s Prospect Fellowship?
• How do existing accelerators improve their funnel to underrepresented founders?
• How do we educate and empower founders to build a sustainable business versus relying on venture capital? How do founders leverage new AI tools to pilot their companies more efficiently to get to a point of real traction?
• How do early-stage investors codify and communicate their expectations of their investment parameters? How do founders better understand what is required to raise venture capital?
• How can we make it easier and more efficient to connect with angel investors and not rely on your previous network? How do we train angel investors to properly diligence at pre-seed and to have a broader pipeline than just their immediate community?

I’ll tackle some of these questions in future posts.