How Pre-Seed VCs Make Money (and Why It Matters to Founders)

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Tina Hrabak

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For many founders, preparation for the fundraising process centers on building their pitch, identifying target investors, and making sure they know all of the numbers behind their business. With so much work going into impressing the investor on the other side of the table (or Zoom!), it’s easy to view venture capital with intimidation because they hold the power to fund game-changing growth for your business.

We’re hoping to pull back the curtain a bit on the business (yes, VCs are running a business just like you, and most had to fundraise too!) of pre-seed venture and how those business dynamics affect how they view your investment potential.

How a Pre-Seed Venture Capital Firm Makes Money

Venture capital operates in a world where risk and reward are closely linked, particularly in the pre-seed stage. VC funds usually raise the money they invest from Limited Partners (LPs), which can be financial institutions, wealthy families and individuals, pension funds, and universities. Just as you would expect returns from a stock you own, LPs expect funds to return their investment (and more). Pre-seed VC is a particularly risky and long-term investment where most of the portfolio companies fail and it often takes years to reach a viable venture exit.

Since returns are deferred for VC teams and LPs, VCs traditionally operate on management fees, which usually represent 2% each year of active investment (so, if a fund is $100M, their management fees are $2M annually). VCs start making real money when their companies exit, but first, they have to “return the fund”: the initial dollars their LPs invested (in the previous case, this would be the first $100M). Once the fund is returned, typically 20% of any additional returns go back to the VC, with 80% to the LPs.

This math and timeline are important for founders to note: most of the VC investors you are talking to aren’t actively making money on their portfolio unless they’ve been investing for years. A million things can go wrong for their companies and your job is to convince them that you can be the company that can go through the gauntlet and return the fund.

Three Questions Pre-Seeds VCs Ask Themselves (and YOU!) When Evaluating a Deal

With so many unknowns in the earliest stages, how can you convince the VC you’re pitching that you can be a winner in their portfolio? Let’s examine the things generally running through our minds while founders are pitching:

  1. Is there Founder Market Fit (FMF)?: At the most basic level, FMF may come from industry or expertise, but founders that go beyond industry experience, can communicate why this problem must be solved, and why they are the ones to solve it will excel here. Is this problem all you can think about? Good. Do you know that your customers, contacts, and/or former colleagues are also losing sleep about this and are willing to pay for a solution? Even better.

    Beyond your work experience, what are your superpowers? Troy Henikoff, Managing Director of MATH Venture Partners (and LongJump LP!), says all successful companies have one thing in common: sales. Are you an exceptional salesperson in your field? That’s a great demonstration of FMF. When LongJump invested in Cuentologia, we were impressed by the founders' complementary skill sets. Ursula had a creative background in advertising, while Fiorella had years of experience in business and finance, specifically marketing major CPG brands. What set them apart was the intentionality behind their marketing experiments, the sourcing of their storytellers, and their unique insights and understandings around their customer behavior.
  2. How has this company learned lessons and turned them into actions?: At the pre-seed stage, the goal is to achieve Product Market Fit (PMF). To attain this, most companies will have some form of traction: a little revenue, some users, Letters of Intent, etc. However, pre-seed funding is highly competitive, and just having some traction isn't enough to demonstrate that you know how to turn an idea into a full-fledged business.

    VCs will want to know how you gained your traction, what you learned from it, and what it will take to get more. Often, founders will start answers with the words “we think”: “We think that apartment dwellers will be early adopters of our product based on our initial customer discovery.” Instead, work toward “we know”: “We know urban apartment dwellers are primed for this solution based on our initial pilots that compared waitlist conversions in downtown Chicago apartment buildings to locations in Naperville.” It’s your job to build confidence in the investor that you’re going to use their funding to build in an informed and efficient way.
  3. How does this get BIG?: Returning to that original pressure funds have to generate returns in one of the riskiest asset classes, you have to sell investors on the potential for this idea to get massive. This is a major challenge in the earliest stages: there are so many unknowns, you don’t want to seem too detached from the now, and pivots are certainly to come.

    One of the first things to ask yourself before you gear up for a pre-seed raise: is this VC-fundable? The unfortunate truth is that the answer for many companies, based on their market potential alone, is no. Depending on the level of investment, companies need to have the potential to go public or be acquired for hundreds of millions, if not billions of dollars.

    If VC is a path for you, given your market potential, you have to communicate a delicate balance between what you’re doing now to capture your initial market and if all goes right, how you expand your market. Our portfolio company, OrdrSmart, adopted an “expand/contract” approach when building their business for a large, venture-returnable market. The founders identified a problem (ingredient sampling) affecting a specific set of customers, before zooming out to determine if this problem was applicable in the larger food and beverage industry, as well as in other industries such as manufacturing. They then zoomed back in on their initial targets. If they can successfully address the problem with their early adopters, they can use that experience, product, and roadmap to tackle the larger industry and new markets. This is an example of communicating how the now can lead to the big future while staying tethered to reality.

How LongJump (or another VC) Should Help You

What’s the difference between pre-seed and seed? Courtesy Alumni Ventures.

All of LongJump’s partners come from a founder background and know what it’s like to strive for that first sale, scour networks for introductions, and be told “no” by investors who didn’t get it. Every company we invest in gets a deal lead, a partner that is by their side to meet and discuss strategy, talk through the challenges, and celebrate the wins.

Our support doesn’t stop with deal leads: our team’s networks (including our LP network) are open to our founders and we’ll do whatever we can to open the right doors for your progress. We believe that we can support beyond the capital we provide and do that through our connections and the community around us.

Any VC’s success is tied to the performance of their portfolio companies. They will have different approaches to how they can help and it’s up to the founders to communicate their needs. At the bare minimum, keep your investors in the loop. We don’t just want to hear about the wins, we need to know about the losses so we can help you get through them before it’s too late (seriously, Jason Calacanis says, “If your startup isn’t sending you monthly updates, it’s going out of business.”).

If you think you’re building the next big thing and LongJump’s founder-led approach appeals to you, we want to hear from you. Anyone can apply for our funding, no warm intro is needed, and we can’t wait to hear about what you’re working on.

Resources for Pre-Seed Founders