Guide to Venture Fund Economics: Pre-Seed and Seed Funds

As the startup ecosystem continues to evolve, one of the key drivers of its success has been the availability of funding to entrepreneurs. Investors have played a critical role in supporting early-stage companies through pre-seed and seed funding rounds, providing the necessary capital to turn innovative ideas into successful businesses. However, the economics of fund returns for pre-seed and seed funds are complex, and understanding them is essential for both entrepreneurs and investors.

Pre-seed and seed funds are typically smaller than later-stage funds, with target fund sizes ranging from $5 million to $50 million. The smaller fund sizes reflect the fact that pre-seed and seed investments are riskier and more speculative than later-stage investments. Investors in pre-seed and seed funds are typically looking for high-risk, high-reward opportunities, with the expectation that a small number of successful investments will generate outsized returns for the fund.

The average check size for pre-seed and seed investments is typically in the range of $100,000 to $2 million and above. This reflects the fact that early-stage companies generally have lower capital needs than later-stage companies. However, the average check size can vary significantly depending on the fund's investment thesis and the stage of the companies it is targeting.

Ownership at exit is a critical factor in determining the returns for pre-seed and seed funds. At the pre-seed and seed stages, investors typically acquire a significant ownership stake in the company in exchange for their investment. This reflects the fact that the company is still in its early stages and has yet to establish a track record of success.

As the company grows and attracts additional funding, the ownership stake of pre-seed and seed investors will typically be diluted. However, if the company is successful and is ultimately acquired or goes public, the pre-seed and seed investors can still realize significant returns on their investment.

Pre-seed and seed funds typically invest in a large number of companies to diversify their risk. The exact number of companies in the portfolio will vary depending on the size of the fund and the investment thesis. However, most pre-seed and seed funds will invest in at least 20-30 companies.

Pre-seed and seed funds typically have a specific investment thesis that guides their investment decisions. This investment thesis will typically focus on a particular sector or stage of company development. For example, a pre-seed and seed fund may focus on investing in early-stage fintech companies or in companies that are developing new technologies for the healthcare industry.

The investment horizon for pre-seed and seed funds is typically longer than for later-stage funds. This reflects the fact that early-stage companies take longer to mature and generate returns for investors. Pre-seed and seed funds will typically have an investment horizon of 5-7 years or longer.

Pre-seed and seed funds are inherently risky investments. To manage this risk, pre-seed and seed investors will typically invest in companies with strong management teams, innovative products or services, and clear growth prospects. They will also look for companies that have a clear path to profitability and a plan for scaling their business.

Pre-seed and seed funds will typically charge management fees to cover the costs of running the fund. These fees will vary depending on the size of the fund and the investment thesis. Management fees can range from 1% to 2.5% of the total fund size per year.

Pre-seed and seed funds will typically exit their investments through a merger or acquisition or an initial public offering (IPO). The timing and method of exit will depend on the company's growth and market conditions. Successful exits can generate significant returns for pre-seed and seed investors and can also attract additional capital to the fund for future investments.

The "2 and 20" rule is a commonly used fee structure in the venture capital industry that is also used by many pre-seed and seed stage funds.

It refers to a compensation model where the VC fund charges its investors two types of fees:

1. Management fee - A fixed percentage of the total amount of capital committed to the fund, typically 2% per year. This fee is paid annually to cover the fund's operating expenses, such as salaries, office rent, legal fees, and other administrative costs.
2. Performance fee - Also known as the "carried interest," this fee is a percentage of the fund's profits. Typically, it is set at 20% of the returns generated by the fund after the investors have received their initial investment back.

For example, if a VC fund raised $100 million from investors, it would receive a $2 million management fee each year to cover its operating costs. If the fund generates $150 million in profits, the VC fund would keep $30 million (20%) as a performance fee, and the remaining $120 million would be distributed among the investors.

The 2 and 20 rule is attractive to VC fund managers because it aligns their interests with those of the investors. Since the management fee is a fixed percentage of the committed capital, the fund managers are incentivized to raise as much capital as possible. The performance fee, on the other hand, is only paid if the fund generates profits, which means the fund managers are motivated to invest in companies that are likely to succeed and provide a significant return on investment.

However, some critics of the 2 and 20 rule argue that it creates a misalignment of incentives between the fund managers and the investors. They suggest that the VC fund managers are guaranteed a steady income through the management fee, regardless of the fund's performance, which could lead to a lack of urgency in making profitable investments. Additionally, the high fees can eat into the investors' returns, reducing the overall benefits of investing in a VC fund.

While pre-seed and seed funds offer investors the potential for high returns, they also face a number of challenges. One of the biggest challenges is the high failure rate of early-stage companies. Many pre-seed and seed investments will not succeed, and investors must be prepared to accept this risk as part of their investment strategy.

Another challenge for pre-seed and seed funds is the increasing competition for investment opportunities. As more investors enter the market, it can become more difficult to find high-quality investment opportunities at attractive valuations.

Despite these challenges, pre-seed and seed funds also offer significant opportunities. The early-stage ecosystem is constantly evolving, with new technologies, business models, and investment theses emerging all the time. Investors who can identify and capitalize on these trends can generate significant returns for their funds.

While pre-seed and seed funds typically have smaller fund sizes and average check sizes, there are also larger seed funds that have fund sizes of $200 million or more. These larger funds play a critical role in the startup ecosystem, providing significant capital to help early-stage companies achieve their growth objectives.

One example of a larger seed fund is Foundry Group, which has a target fund size of $350 million and focuses on early-stage investments in the technology sector. The fund has a strong track record of identifying and investing in high-growth companies, including Fitbit, SendGrid, and Zynga.

Another example is First Round Capital, which has a target fund size of $300 million and invests in companies across a range of sectors, including healthcare, consumer products, and software. The fund has a broad portfolio of successful companies, including Uber, Square, and Blue Apron.

These larger seed funds typically have more resources and expertise than smaller pre-seed and seed funds, which allows them to make larger investments and provide more support to their portfolio companies. They also tend to have more established networks and relationships within the startup ecosystem, which can provide valuable resources and opportunities for their portfolio companies.

While the role of larger seed funds in the startup ecosystem is somewhat different from that of pre-seed and seed funds, they all play a critical role in supporting the growth of early-stage companies and driving innovation and entrepreneurship forward. By understanding the economics of fund returns and the unique challenges and opportunities facing each type of fund, investors can make informed decisions and support the development of the startup ecosystem as a whole.

When deciding whether to raise money from seed-stage specific funds or multi-stage, larger VC funds, there are several factors that startup founders should consider.

Firstly, seed-stage specific funds often have a more narrow investment focus and expertise, which can be helpful for startups looking for specialized support and guidance. These funds may have a deeper understanding of the particular industry, market or technology that the startup is operating in, which can lead to more effective mentorship and connections to relevant partners.

On the other hand, larger multi-stage VC funds often have more resources and can provide more significant follow-on investments as the company grows. This can be particularly advantageous for startups with ambitious growth plans, as they may need more substantial amounts of capital in later rounds.

In terms of alignment of incentives, seed-stage specific funds may have a greater interest in the success of the startup as they typically have a more significant equity stake and are invested in the early stages of the company's development. Larger multi-stage funds may have a more diversified portfolio, which can lead to less intense focus on any particular startup. However, larger funds can also bring significant resources and networks to the table, which can be helpful in supporting the startup's success.

Pre-seed and seed funds play a critical role in the startup ecosystem, providing the necessary capital to turn innovative ideas into successful businesses. Understanding the economics of fund returns for pre-seed and seed funds is essential for both entrepreneurs and investors. Key factors to consider include target fund size, average check size, ownership at exit, portfolio construction, investment thesis, investment horizon, risk management, fund management fees, performance fees, exit strategies, and the challenges and opportunities facing pre-seed and seed funds.

Despite the challenges facing pre-seed and seed funds, the potential for high returns remains strong. By focusing on companies with strong management teams, innovative products or services, and clear growth prospects, and by staying abreast of emerging trends and investment theses, pre-seed and seed investors can continue to generate significant returns for their funds and support the growth of the startup ecosystem as a whole.