Pre-revenue funding 101

So you’ve got an idea for a business. Now you need funding.

Many early-stage founders may not be ready for venture capital. Some may never want to take outside funding. But it takes bucks to build, and there are several funding pathways, depending on a founder’s goals.

But first

Before deciding on a pre-revenue funding option, early-stage founders should ask themselves a few questions: What problem are they trying to solve? Why would customers pay for their solution? And who should be on their team?

“These are the things that you have to have super clear,” Aidan Madigan-Curtis, partner at VC firm Eclipse, told Morning Brew. “The capital will follow getting those things right, whether it’s venture capital, early accelerator capital, angel capital, or…non-dilutives.”

From there, she suggested that founders look within their networks for people with entrepreneurial experience, including potential angel investors—and they shouldn’t be shy about asking them to write a check.

Pre-seed funding

The average startup receives about $500,000 in pre-seed capital, according to Crunchbase. Initial funding can come from:

• Angel investors
• Family and friends
• Incubators and accelerators
• Crowdfunding
• Venture capital

Whether a founder has enough traction to do a pre-seed round can come down to factors like their previous experience in their chosen market, how quickly they’re prepared to get their product out, and whether they have a prototype ready. Common steps to prepare include developing a strong, concise pitch deck and assembling a list of investors.

Melissa Bradley—a serial entrepreneur, angel investor, general partner for BEA Venture Fund, and Georgetown University professor—told us there are three questions founders should ask themselves to guide their funding decisions: What is your risk tolerance? What is your intention with the business? And what role do you want to play in the business in the long run?

Venture capital vs. bootstrapping

Bootstrapping is the practice of raising capital on your own; venture capital brings in institutional investors.

Benefits of the first approach include forcing founders to be disciplined and focused on generating a profit, and it can allow them to maintain more control of their company. Bootstrapping generally has a slower growth trajectory; venture capital supports faster growth and carries less personal financial risk.

Some businesses simply aren’t a good fit for venture capital. Unless you can demonstrate your ability to enter a big market and deliver a high rate of return, you might be better served by other funding paths, according to Madigan-Curtis.

Bootstrapping makes sense for founders in industries that don’t require a lot of inventory or up-front capital, like service-based businesses, according to experts at JPMorgan.

An important consideration at the outset of any founder’s funding journey is what level of control they want to end up with, which requires meticulous cap table management.

“If you think there is a remote possibility that you’re going to take venture, then whether you do or not, you want to make sure that you are managing your cap table as if you are going to get venture,” Bradley said, “which means that when you issue the shares at the onset and you start to give them out to friends and family…you’re mindful of your dilution right off the bat.”

Friends and family

Raising money from family and friends is a less formal approach, and gives founders greater control over their product and go-to-market strategy. However, accepting loans from your nearest and dearest can put stress on relationships.

Two common ways of raising money from family and friends are business loans, where you agree on a timeline and an interest rate, and equity funding, which cuts the investor in on the company’s future profits.

Bradley tells founders to think carefully about how this arrangement might change the relationship dynamic—and remember that once someone becomes an investor, you have a fiduciary responsibility to them.

“Nothing should be done on a napkin. Nothing should be done in a Word doc that you created,” she added. “As soon as you take an investment—whether it’s from a friend or someone you don’t know—you need to engage legal counsel to protect both of you.”

SAFE notes vs. convertible notes

One of the most common ways to raise money from angel investors or friends and family is via a convertible note, which is a short-term debt instrument that converts into equity when certain conditions are met, per The Startup Law Blog.

Another option is a SAFE (Simple Agreement for Future Equity), which gives investors the right to buy shares in the company later. One big difference between the two is the timeline: Convertible notes have a predetermined end point; SAFE notes do not have a set interest rate or maturity date.

No matter which route makes the most sense for the business, the critical first step, Bradley stressed, is taking the time to make the right call.

“Never feel rushed in making a financing decision,” she said. “Be patient and make sure you carve out the time to think through the financial implications, the economic implications, the emotional implications, and the ownership implications.”