Aug 26, 2015 ยท 17 minutes

“You can lie to your LPs, but don’t lie to yourselves.” -- Naval Ravikant, AngelList

Amid the mega-rounds, mega-valuations, and mega-cost of doing business in San Francisco, a new venture capital trend is emerging.

And it’s decidedly mini.

A handful of new funds are in the process of raising money right now, calling themselves “pre-seed funds.” I know what you are thinking if you aren’t in the startup day-to-day: Wait, isn’t a seed round the first money in? It’s named after the tiny little thing that’s planted in the fertile soil of an idea. It hasn’t even started to bloom yet, right? How can you be pre-seed?

And yet, if you have raised money in the last year or so, you know exactly why there’s a new category called “pre-seed.” You knew it the second you pitched a seed fund and they told you you didn’t have enough traction, enough of a lead in your market, early revenues, or the kind of numbers you’d need to close a $2 million funding.

But wait, wasn’t I doing a seed pitch?

Charles Hudson of SoftTech VC wondered that from the other side of the table too. “Wait, weren’t we doing seed investing?”

For six months or so he kept bringing in companies to pitch, and his partners kept saying they were too early. Flummoxed, the entrepreneurs would ask, “If you don’t write the first check, then who does?” Hudson didn’t have a great answer.

Now he’s left SoftTech and is raising a new fund, one of a handful of would-be and just-formed firms hoping “pre-seed” can be a thing, nonsensical as the name might be.  

Welcome to the messy, inevitable collision of four trends: The series A crunch, bigger rounds later in a company’s life demanding higher pro-ratas, the rise and success of institutional seed rounds over the last 5+ years, and the increasing prices of building a company in San Francisco.

Simply put: “Seed” is no longer seed. Pre-seed is seed. And even that’s not the earliest round: There’s friends and family before that. “Series A is actually the fourth round of funding,” says Manu Kumar, of K9 ventures, the best known pre-seed fund. “Before that there is seed, then before that there is pre-seed and then before that there is friends and family. We are the first institution in, but typically we are the second money.”

What does that mean for a Series A, once named because it, too, was the first institutional money into a company? Well those are what we used to call Bs, or maybe Cs.

And all those late stage D or E mega rounds? Those are what we used to call IPOs.

“In the venture industry, we don’t change the names to match what’s actually happening,” Kumar says.

Like some sort of constantly growing stack of Russian nesting dolls, those who write checks to startups hoping to find the next Google, Facebook, Uber have spent the last ten years totally changing what they are doing, but stubbornly keeping the same labels. That means we have to keep coming up with absurd new terms to mean “first money in.”

Why does any of this matter? Because the first money in is always the most important money in Silicon Valley. Six years ago who it was coming from changed dramatically. A handful of pre-seed funds think it’s about to change again.

As Naval Ravikant said at a National Venture Capital Association event earlier in the year: “VCs who say they are doing As, are really doing Bs and Cs. You can lie to your LPs, but don’t lie to yourselves.”

* * * *

Kumar is one of the only people in Silicon Valley I’ve encountered recently who is doing the opposite of the rest of the venture crowd. A rare Valley anti-lemming.

His office is just as atypical. Nestled in an unfashionable part of the currently unfashionable city of Palo Alto, it has a large orange and grey shipping container in the middle that doubles as a conference room so that he didn’t have to deal with permits for putting up a wall. On the back wall of the outside of the shipping container are large carpeted steps that can double as ampitheatre-style seats when he hosts events. “I love this part!” he says opening a Harry Potter like door in the stairs that houses… folding chairs. I was hoping for -- I don’t know-- a speakeasy and I got chairs. “I’m a nerd,” he says.

This office was previously illegally converted into a live-work space by a rogue architect husband-and-wife tenant who made all sorts of changes without permission. “Here’s something you don’t see in every office,” Kumar says, swinging open a door to reveal a shower and freestanding tub. “A master bathroom!”

The landlord was very nervous about renting it again, but Kumar assured him not only was he not going to move in, he wasn’t going anywhere-- metaphorically or literally. Indeed, Kumar may possibly be the most change-averse tenant in all of Silicon Valley.

Kumar is also considered by many people I spoke to as the godfather of the nascent pre-seed movement. But that’s not what makes him so different. That just makes him opportunistic and good at marketing.

No, what’s distinct about Kumar is this: In a funding landscape where everyone is doing a different stage of funding than they were five to ten years ago but still calling it the same thing, he’s doing the precise opposite. He calls himself a pre-seed fund, but he’s changed absolutely nothing about his business, operations, or types of companies he backs. A couple years ago, he was a seed guy. The institutional seed market simply grew into $100 million-plus funds all around him.

To wit: Michael Kim of Cendana Capital backs institutional seed funds and is in many of the better ones: SoftTech, Lerer Ventures, Forerunner and so on. When I called him to talk about the pre-seed trend, he says he has no interest in backing any of the new pre-seed entrants, but then he admits he’s in Kumar’s K9.

Both are true: When he backed them, K9 was called a seed fund because what Kumar does now-- this new innovative class of investing-- was still called seed five years ago.

Pre-seed (or in the past, just seed) is intended to fill the gap between the $50,000 you can get from your past successes or friends and family and a $2 million …. well, we would have said a $2 million Series A five years ago, now we’d say a $2 million seed round.

Pre-seed guys describe themselves as willing to back a couple founders and a PowerPoint to the tune of a couple hundred thousand. The logic is that it’s so easy to throw a product out there these days thanks to so many open platforms for distribution, why not gamble a small amount of money to see if you have something before you go big?

Makes sense. And sounds familiar. When I ask both Kumar and Hudson-- who is raising his pre-seed fund now-- how that is different than what seed funds-- or so-called “MicroVCs”-- said five or six years ago they give the same answer: “It’s not.”

Says Hudson, “When I started five years ago, we most often were the company’s first institutional round. They didn’t have any traction. They had a good team and we were convinced enough about the intersection of the team and the market that it warranted a bet. There wasn’t an expectation of traction. I call it ‘classic seed.’”

“Nothing has changed,” Kumar says. “I just relabeled it.”

* * * *

Why do a few funds investing relatively small amounts of money matter, in an age of sexy mega deals? Because Silicon Valley was built on being the first money in. Things can get weird in frothy times when early investors lose pro-ratas to mega rounds and hot money swarms in and out, but historically the first money in does best. This is one reason Ravikant has dubbed “First Round Capital” the smartest named venture firm in the universe. (Actually making sure they are the First Round is of course another matter. It’s newest fund is now north of $100 million in size, and has migrated to larger deal sizes along with a lot of seed funds.)

It’s also important, because that is the only capital that is really taking a risk. The company has the least data to show, and it’s really just promise and hope and salesmanship. The willingness to shrug and write a check, knowing full well that odds are nothing will come of it, is what separates the Valley from the world.

And lately, the amounts of seed rounds have increased, while the absolute number of them has been on the decline. According to a June CB Insights report, the average seed round has been above $1 million for eight of the last nine months. The research group further found that 2015 -- a banner year for fundraising when it comes to dollars-- is on pace to be the worst year for deals between $150,000 and $1 million in four years. Four years ago, the MicroVC trend was in full bloom.

Continually filling the funnel with new ideas is a vital chunk of the ecosystem that someone has to be doing. And most investors would acknowledge that the lower you can make that barrier, the more good companies we’ll get. The more bad ones too, but those will typically die a quick death and -- especially in a time like now-- the talent will get rapidly reabsorbed into the tech ecosystem.

And that set of investors just like in the early days, who can invest purely off gut and watch a company go from idea to IPO? That’s a rawness hard to find in a serial entrepreneurial, unicorned-up, sophisticated ecosystem like the Valley. A harkening to the days when Robert Noyce and Bob Moore got a few million bucks at a $5 million pre to do their next act-- no matter what it would be. (It wound up being Intel.)

As the cost of building a company has plummeted over the last 15 years, the need for seed funding became even greater: You could get a product out there for less than $1 million, so why dick around with Series A term sheets? Enter uncapped notes, AngelLists, incubators and accelerators and all sorts of ways to see what entrepreneurs have as quickly and cheaply as possible. Series As got pushed so late, that VCs started building out seed arms of their funds. It was an asset division born out of an ability to do more with less.

And many of those seed funds have done extraordinarily well. FitBit’s IPO alone has returned several times the money of the $50 million or so SoftTech fund it was funded out of, changing the firm’s ability to raise cash for at least the next few funds.

“In 2008 and 2009, we had all these new people starting micro-VC funds, and people who start venture funds are entrepreneurs,” Kumar says. “Entrepreneurs can’t help but grow their businesses and the way you do that is to increase the assets under management.”

And with so many seed funds doing well, they could raise bigger funds. And they did. Forerunner, Lerer, SoftTech and many others are all currently raising or expected to raise new funds in the $100 million level. First Round and others are already north of it.

It frustrates LPs like Kim, who argues it’s much harder to get a 3x return on a $100 million fund. He started out investing in seed funds, and suddenly he’s found himself betting on what we would have considered Series A deals five years ago. “We have a cut-off at $100 million, so we won’t back funds that go beyond that,” he says. “I’ve been pounding my GPs on the head about it all summer.”

That said, there are also very prudent reasons these seed funds have started to become…. well, Series A funds, if you will. As Jeff Clavier said to me at lunch recently, “You can argue we are writing bigger checks because we have bigger funds. Or we have bigger funds because we have to write bigger checks.”

The biggest factor has been the so-called Series A crunch. The worry was that so many companies were getting created thanks to accelerators, seed funds, and a lower cost of starting up. And there weren’t meaningfully more VCs to do Series As. It was musical chairs and something had to give. The math seemed irrefutable.  

Clavier has proudly said the Series A crunch was a myth, and that his firm never saw it. But in actuality, if his companies never saw it, it was because SoftTech basically started doing seed + half a series A rounds to make sure companies would be able to get enough traction to get into that elite 30% or so that graduate from seed to Series A.

“Everyone got paranoid about the Series A crunch and instead of funding a company for twelve months, we started funding them for eighteen to 24 months,” Hudson says. When rounds get into the millions, investors need to see a lot more to feel good about that kind of gamble.

And these firms also had to reserve funds for bridges if those Series As were taking longer. And as deal sizes across the board got larger, seed funds needed bigger reserves if they wanted to keep doing their pro-rata shares to keep stakes in their winners. Kim cites examples where hot companies raise a $10 million series A and a seed fund may have to choke down another $2 million payment to keep its stake. That’s one less company it can fund.

And, lastly, Clavier and others have made the point that it’s just more expensive to build a company in San Francisco than it used to be. “You used to be able to build a company and get it to Series A on $1 million,” he said. “You can’t today.”

* * * *

If the migration upstream is understandable, and the CB Insights numbers show a clear gap in the a result, what does that mean for the venture landscape? Are we destined to keep growing each category, then adding a new one in the first position with an escalating series of absurd names?

Yes and no. And this may get to some of the uniquenesses of the new class of pre-seed deals.

LPs are skeptical-- although it bears noting they were skeptical of seed funds too. Kim was the only one I reached out to who spoke on the record, but the concern is that the bets are just too speculative, that the check sizes won’t buy enough ownership of the company, and that some of the people raising pre-seed funds just don’t have enough of a track record to raise a bigger fund -- so they’re the ones embracing the label.

And the fear of adverse selection doesn’t just end at the fund managers. Even Charles Hudson admits adverse selection among entrepreneurs is what worries him. Are the people flocking to little known pre-seed funds the ones who just can’t raise money elsewhere? Put another way: Is pre-seed the new incubator? The place that lowers the bar of entrepreneurship slightly too low?

“Adverse selection is the biggest existential risk to us because of exactly what you describe,” Hudson says. “Pre-seed becomes a backwater for those who can’t.”

That’s the bear case for Hudson’s fund, which is still in process. The bull case is he takes a risk on first time founders who just don’t have the connections that others do. “First time founders are going to be my sweet spot,” he says. “They are the ones that struggle the most and I’ve done much better investing in people who are not already wealthy.”

There are some other minor differences from MicroVC wave of funds too, in truth. Kumar for instance only does eight to ten deals a year, still more than a VC, but less than a lot of the early seed funds which were very pray-and-spray heavy. Kumar does in depth mentoring, housing those founders in his office until they raise a seed round and get their own space. And every once in a while, he does a deal in which he recruits a founder to build something he wants to see in the world. So in those, he’s more like a cofounder.

In that sense, some of these funds are also a throwback to the days before the institutional seed deals when angels did a handful of deals they could really work with. That type of angel investing gave way to a Ron Conway-portfolio approach, an admission that with more seed funding out there, the odds of survival would be that much slimmer.

And both Kumar and Hudson think there are ways to do pro-ratas without raising fund sizes, whether it’s using AngelList to spin up Special Purpose Vehicles, or raising a side opportunistic growth fund.

As fund managers who were part of the early MicroVC wave start a new wave, there are surreal moments for them. The frustrations they all felt about VCs, some of the pre-seed guys now feel towards the seed crew. That they don’t take enough risk. That they expect too much of an early stage founder. That they just want to sit back and cherry pick the good deals.

One of the most surreal conversations I’ve had over the recent weeks I’ve been working on this story was about “signaling risk.” Seed funds for years have argued that VCs operating their own mini-seed funds can dramatically help startups or be deadly to them. When it works, it provides an on ramp to a Series A. When a startup doesn’t go as planned, and a VC doesn’t re-up, the “signal” sent to other VCs can be fatal, classic MicroVCs have argued. To some, it’s a talking point for why entrepreneurs should stick with seed funds early on, and VCs only when they are ready for an A.

At lunch with Jeff Clavier weeks ago, he told me about a company he’d just met with that he loved but wasn’t quite far enough along for him. He said he was thinking about putting a small amount in as part of a pre-seed round, just to stay close to the company and get the first look.

“Wait a minute!” I screeched. “Doesn’t that create the same potential for signaling risk that you guys have complained against with VCs for years?”

He considered it and granted the point, adding maybe he shouldn’t do the deal after all.

There are plenty of reasons to be skeptical-- and LPs I’ve spoken to are. And there are plenty of unintended cultural ramifications to any new category of funding coming into the mix.

But if institutional seed funds were a good idea six years ago, one could argue they still are… whether those original MicroVCs still do “real” seed rounds or not.

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