Seeds of Change: The Advantage of Investing in Companies at Their Earliest Stages

What Exactly Is a Startup?

Traditionally, a startup is defined as a newly established private company that’s designed for rapid growth. That typically means it is supplying a product or service that appeals to a large market, vs. other small businesses which appeal to more focused markets.

Most startups launch as very small operations while they develop their initial idea, and then seek additional funding as they build out their businesses. Often, that funding comes from angel investors or VCs like Alumni Ventures, who fund startups that they think can earn a high return on investment. For this reason, startups need to demonstrate sizable market opportunity, potential, and ability to scale.

By the nature of this business type, startups are typically built with top-end revenue goals and an exit strategy in mind. Exits provide liquidity to investors in a variety of ways, including an initial public offering (or IPO), merger with a special purpose acquisition company (or SPAC), other forms of business acquisition such as an asset purchase, or a direct listing.

Investors should approach seed investing with the understanding that most startups fail, and many others will return only the money you initially put into them. Statistics show that successful small businesses are built over years, not months, according to Forbes. For example, one of the most successful startups, Airbnb, took nine years to become profitable and is now an $82 billion company. This highlights the importance of a long-term portfolio built with patient capital and diversified by stage, sector, and geography.

As Catherine Lu, a Managing Partner for Alumni Ventures’ Seed Fund, put it, “The best companies actually take the longest to return back your money.”

Despite the risks, seed investing offers investors a robust chance of capturing value by backing companies in their early stages when valuations are typically lowest. If you were to wait until a startup goes public to invest, you might be missing out on up to 95% of the gains, which are often accrued by investors before the IPO. For example, some early investors in Uber saw a 4901x return post-IPO.*

In venture capital, returns are thought to follow a rule known the Pareto principle stating that 80% of the wins come from 20% of the deals. Chris Dixon of venture firm Andreessen Horowitz, a CB Insights Smart Money VC, has referred to this as the “Babe Ruth effect,” in reference to the legendary Major League Baseball player. Ruth would strike out a lot, but also made slugging records. Likewise, VCs swing hard, and occasionally hit a home run. Those wins often make up for all the losses and then some — they “return the fund.”

In addition to the potential for significant returns, investors can be attracted to startup investing as part of a portfolio diversification strategy. By supporting a company in its earliest stages, investors can also potentially share their knowledge and expertise, striving to further their chances of success.

For all of those reasons, early-stage funding of startups has exploded in the past decade, according to Crunchbase. Over the course of 12 months in 2021, investors put $329.5 billion into startup investments across all stages, per Crunchbase data. That’s an increase of 92 percent from 2020 levels, which were themselves record-setting.

What Is Seed (and Pre-Seed) Investing?

There are multiple stages of startup funding: Seed, Series A, Series B, Series C, and so forth. Seed funding is a startup’s earliest funding stage.

A recent article on the Finmark blog defined seed-stage funding as “the first formal round of financing for a startup, typically occurring once the company has developed a minimum viable product, demonstrated some traction, and has a clear plan to grow its business.”

Businesses at this stage are typically taking on the costs of salaries, marketing, and product development — and higher costs than revenue alone. The average cost of starting a tech company, for example, is $1 million.

Outside funding amounts in the seed stage can range in the millions of dollars, depending on the startup’s valuation and funding requirements. The median valuation for seed-stage startup funding rounds has grown consecutively year-on-year since 2020 and was $10.9 million as of June 30, 2023, according to a report released by PitchBook and the National Venture Capital Association.

Ron Levin, a Managing Partner who heads the AV Seed investment team, says that seed rounds are typically — but not always — the first round of funding that involves institutional investors, such as venture capitalists or strategic corporate investors.

But what happens before that stage, in the earliest days of a startup’s life, when funding is vital and potentially even harder to raise? In recent years, a new term has emerged to describe this stage: the pre-seed round.

Startups typically seek pre-seed investments to turn an idea into a viable business. Often, they use the funding to assemble a team and build an initial product and prototype.

Entrepreneurs are often surprised at the limited options available for pre-seed money. It is likely that most traditional financial organizations will only invest in companies with demonstrated traction, rather than just an idea.

Still, there are several popular options for securing a pre-seed investment:

• Family and Friends: Sometimes thought of as a separate category occurring before pre-seed, this type of funding can be a good option for companies just getting started that may not yet have gained credibility with professional investors. Friends and family invest the most money in startups in aggregate, committing over $60 billion per year. In fact, 38% of startup founders report raising money from their friends and family. The average individual investment amount is $23,000.
• Angel Investors: It’s no coincidence that pre-seed is also commonly referred to as an “angel round” — it’s at this stage that angel investors can make the biggest impact. An angel investor is typically a high-net-worth individual ($1+ million in liquid assets) who invests their own money directly in early-stage (and sometimes later-stage) businesses. These investors are often accredited and may have a background as current or former entrepreneurs themselves.
• Crowdfunding: This is a technique of soliciting money from a large number of individuals using permitted internet platforms to sponsor a project. According to Crunchbase, there are 1,300+ crowdfunding groups in the U.S.
• Startup Incubators and Accelerators: These collaborative programs provide both support and resources such as training courses, office space, and access to active investors. Y Combinator is among the best-known startup accelerators, investing in nearly 3,000 companies since 2005.
• Venture Capitalists: VC firms are generally known for keeping their powder dry until a startup’s Seed or Series A round. However, that has changed in recent years. By one count, over 80 active VCs and funds have invested at the pre-seed stage, with rounds of ~$1 million. One reason VCs invest in pre-seed funding is to gain better access to successful startups in the later rounds. At the same time, a startup’s founders have to effectively pitch their product idea to potential VC investors and convince them that it has a high potential for growth and profit.

Pre-Seed vs. Seed Funding: What’s the Difference?

Is Early-Stage Investing Right for You?

To answer that question, Lu said it’s important to consider whether you want to go it alone as an angel investor or decide it is better to invest in seed-stage startups through a venture firm like Alumni Ventures.

It comes back to that risk-reward equation mentioned earlier. Approximately 10% of startups fail within the first year, according to the U.S. Bureau of Labor Statistics, which means as an individual investor you should consider “cutting at least 50 to 60 checks to have a diversified enough portfolio to [potentially] start seeing some good returns,” says Lu.

“You should have a large amount of capital at your disposal that, if you lost it, you would be personally fine,” Lu recommends. “So, say you wanted to do 50 deals and you wanted to put $25,000 to work in each, then you need $1.25 million. And if you multiply that by two to get $2.5 million, that would provide about half in reserve for follow-on investing. I would want to put more money into the best-performing companies in order to increase the returns that I might ultimately have.”

Also worth considering is the considerable time commitment involved in sourcing and then evaluating companies. Lu speaks as the full-time manager of the AV Seed Fund, who dedicates her resources and that of her team to this extensive evaluation process. An individual who may also be busy with full-time employment, family, and other obligations might not have the time to properly research a deal, let alone create a portfolio.

For instance, an academic study that looked at 1,137 exits from 539 angels concluded, “More hours of due diligence positively relate to greater returns.” This translates into an overall return multiple of 1.1x in 3.4 years for angels who spent fewer than 20 hours in diligence vs. 7.1x for those who spent more than 40 hours.

In general, Levin says investors should also consider diversification. “I would be thinking in terms of a portfolio of investments, with seed or angel representing a percentage  of my total investments.”

In addition to dealing with the complexities of mastering diverse sectors for portfolio diversification, raising and managing the required funds, and navigating initial investment risks, there’s also the significant hurdle of accessing the best deals.

However, for individuals eager to roll up their sleeves to find, evaluate, track, and diversify deals, seed and angel investing might be right for you. But Lu believes others who have a keen interest — but not the time, expertise, or access — might wish to consider Alumni Ventures as an alternative. Writing one check for a diversified portfolio is much more accessible to an accredited investor compared to finding the time, resources, and capital to build a portfolio on their own.

^{* CB Insights, “From Alibaba to Zynga: 45 of the Best VC Bets of All Time,” June 9, 2021. NOTE: Uber was founded in 2010, before Alumni Ventures existed. Only investors holding all their shares from the initial investment through the entire period would have experienced these gains. This is an outsized example of the potential of venture investments, but it should not be expected. Venture investments involve a substantial risk of loss, including the loss of all capital invested.}

^{IMPORTANT INFORMATION: The information presented is not investment or other professional advice for any person. All venture capital investing involves substantial risk, including risk of loss of all capital invested.}

^{These materials are not an offer to sell, or a solicitation of an offer to purchase, any security. Opportunities to invest in any Alumni Ventures fund are extended only to eligible investors pursuant to the terms of applicable offering documents. Alumni Ventures funds provide eligible investors with indirect exposure to startups and venture companies, but are not mechanisms by which investors can invest directly in such startups and venture companies.}