11/02/2015 03:53 EST | Updated 11/02/2016 05:12 EDT

Pre-Seed Funding And Canada's Startup Ecosystem

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Pre-seed, a relatively new stage in the funding process, is becoming more recognized in the Canadian startup ecosystem and in other startup hubs around the world.

The trend is growing for a number of reasons, and Canada would benefit from more capital dedicated to pre-seed from truly value-added investors.

To be clear, the pre-seed round is an initial wave of funding -- usually the first formal round -- and generally involves less than $500,000. It's an enhancement to raising a traditional friends and family round of financing and helps catalyze multiple checks from angel investors to get a startup going.

What's driving the rise of formalized pre-seed rounds? In part, many of the best venture capital funds are moving farther up the chain and are writing larger cheques. This has led to larger institutional seed rounds, increasing the difficulty of securing series A funding.

For certain founders, taking big seed rounds comes at a relatively high cost. This is especially true of digital product companies that don't require much initial capital to build out minimal viable products and test market traction. For these startups, too much cash early on can actually hurt how the business is structured and excessively dilute the founders.

At the same time, top founders know that if they have the ambition to build global category leaders they will need a lot of venture capital at different stages to always exceed target milestones.

Pre-Seed VC rounds allow founders to jump start things, and has a few important benefits including:

Connections and getting out there. For founders seeking significant institutional capital down the road, pre-seed funds provide opportunities to connect with VCs looking to get involved with a startup in its early stages. This is especially relevant to both young or inexperienced startup founders. A premium, curated network is a critical part of the game, and pre-seed allows people get the process started.

The chance to see a team and an idea in action at VC speed. Early stage funding gives founders a better chance to forge and prove customer demand. Relatively small pre-seed rounds and institutional pressure can provide a chance to accelerate tests on a founding team and run more focused, aggressive user acquisition strategies.

Less risk for institutional investors. For VCs connected to pre-seed funds, valuable insights and relationships with the founders can get them better access to higher quality deal flow, critical insights on the founders and an inside track to lead the next investment round

More innovation. The growth of pre-seed backed by institutional capital -- and the presence of more high-quality money at the early stage of the startup ecosystem -- means there's more opportunity for entrepreneurs to test their ideas. In a country like ours that desperately needs to diversify its economy away from natural resources, this is a welcome development. Time will tell, but the growth of pre-seed investment could spur on more innovation and open up new industries and markets.

While Canada has made some positive strides in terms of increases in overall levels of pre-seed money, there are a few things that the ecosystem would benefit from:

Higher quality sources of pre-seed funding. Despite increases in total venture capital funding, we need to higher-quality sources of pre-seed investment. This means dedicated VC funds and similar outfits run by experienced entrepreneurs who have the talent to be leading general partners in this highly risky asset class over those with just traditional private equity backgrounds.

Standardized term sheets. Presently, there is considerable variance in pre-seed term sheets. This is a problem that has been partly resolved in the U.S. via standardized term sheets like "safe," which was developed by the famed Y Combinator accelerator. Having a common template for pre-seed rounds mitigates confusion and is especially helpful to casual angel investors and first-time founders who benefit from a simplified agreement that does not necessitate hordes of lawyers to get a deal done.

Pre-seed's continued growth is important to Canada's economy and competitiveness in the global technology sector. To date, it has come about organically, but now is the time for a broader dialogue.


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