Mar 9, 2020

Understanding Baltimore’s Pre-Seed Funding Gap

Diving deep into one of the biggest gaps in Baltimore’s entrepreneurial ecosystem

Read the summary Gaps post here: The Gaps in Baltimore’s Entrepreneurial Ecosystem

Everyone knows how important funding is for starting a venture, whether you are building a small business or high-growth tech startup. The capital needs of a venture change along with the venture’s stage — early-stage ventures might need help with product development costs, while established companies may need funding to expand to a new location or market segment.

Baltimore has no shortage of funding for established ventures — there are over 100 different funding programs in the city alone for startups and small businesses that have revenue and are looking to expand. However, Baltimore has a dearth of one of the most important elements on the funding continuum: Pre-Seed capital.

Having enough Pre-Seed capital can make or break a venture. Unfortunately, not everyone has equal access to these vital funds needed to get a venture off the ground. Here, we’re going to take a look at why Pre-Seed capital is so important, how common sources of Pre-Seed funding can be discriminatory and inaccessible, and examine different ways we can fill the Pre-Seed gap in Baltimore’s innovation ecosystem.

The Importance of Pre-Seed Funding

Note: the following paragraphs focus on Pre-Seed in its conventional sense, with reference to high-growth startups. However, the dearth of pre-Seed funding is equally troublesome for both startup and small business ventures, and the bulk of this article will be addressing Pre-Seed in reference to both venture types.

Pre-Seed, quite literally, means funding before the “Seed” round. The Seed round, a term from Venture Capital, used to be the first funding that a venture received, but over the last decade the Seed has undergone a transformation. Around 2010, the median seed rounds were around $500,000, and only 10% of ventures had revenue at the point of raising. By 2018, the median Seed round is $2.2 million, and well over 50% of ventures have revenue.

The standard for what constitutes a Seed-stage company is higher now than ever before. Years ago, Seed funding was accessible to early-stage ventures who had solid founders, a strong idea, an accessible market, and basic traction. Now, you’re hard pressed to access Seed capital if you don’t have paying customers or significant user growth.

This growth of the Seed round, in turn, has increased the importance of the Pre-Seed round.

Pre-Seed capital, for both startups and small businesses, is typically the money that is used for a venture to build out a minimum viable product, conduct a pilot test, or satisfy initial build costs (materials, development). Sometimes it refers simply to any pre-institutional capital. In essence, it is the money needed to move from a validated idea to the beginnings of a real business.

While costs vary by the type of venture, expenses at the earliest stages easily add up, even if you don’t take into account material or product development costs. There are incorporation, licensing, and registration fees, which can easily run $1,000+ depending on the entity type. There are transportation costs to get too and from workshops, events, or meetings. There’s the cost to launch and host a website, which can set you back hundreds. There’s marketing costs and prototyping costs.There’s also the opportunity cost of working on your venture instead of your day-job or other obligations.

Pre-Seed capital is typically what keeps an entrepreneur afloat as they secure customers and revenue, an obviously vital part of a for-profit venture. Whether they need money to build a prototype, buy the materials to satisfy initial orders, or conduct market tests, having a pillow of capital allows an entrepreneur to bear startup-costs without the venture dying before it gets to live.

Without Pre-Seed funding, most ventures either can’t get customers, or can’t satisfy initial orders even if they secure interested customers (getting customers to pre-order is not a viable option for many ventures). Without customers, you can’t get revenue. Without revenue, you cannot access Seed funding, which is usually venture capital for startups, or debt financing for small businesses.

Herein lies the Pre-Seed Paradox: You often need some sort of capital to get to revenue, but you typically can’t get capital until you have revenue.

Without Pre-Seed capital, a venture cannot take the crucial step towards building a sustainable business or towards accessing larger amounts of capital. Pre-seed funding is thus one of the most important parts of the funding continuum.

The Common Sources of Pre-Seed Funding

The Pre-Seed stage is often too early for Venture Capitalists or Angel Investors. The latter used to be a viable source of Pre-Seed funding, but many Angels are moving closer to seed-stage investing; that is to say, they want to see revenue. This is especially true in emerging ecosystems, where there are less Angels who are accustomed to evaluating risk in the earliest-stage ventures, as you might find in places like Silicon Valley.

Hence, traditional sources of Pre-Seed funding include the (in)famous FFF Round (Friend, Family, and Fools), where you raise money from those in your personal network — rich aunts, rich colleagues, rich friends. For professionals with years of income, Pre-Seed funding can come from personal savings or from putting up assets as collateral to secure debt-financing. For students, who often don’t have savings or assets, Pre-Seed funding is often found in university grants or pitch competitions.

However, these sources of Pre-Seed funding are inherently discriminatory. They assume that an entrepreneur:
a) has a personal network that can cough up $5,000-$50,000, or
b) has personal savings or assets they can risk for a venture, or
c) is attending a university with robust support for student entrepreneurs.

Likewise, any funding source with a full-time requirement (where, in order to access the capital, at least one person has to be working on the venture full-time) assumes that a person has enough savings to pay their bills while working on a pre-revenue venture. Pitch Competitions, while a good way to earn some extra capital, often require that founders pay their way to the final rounds, which can be cost-prohibitive for many.

Now if you are working to foster entrepreneurship in a city such as Baltimore, these wealth & income assumptions pose a big problem. Baltimore is 63% African American, and as of 2016, the median accumulated wealth for African-Americans was around $13,500, compared to $142,000 for whites. The median income in the city for working African Americans is $39,000, whereas it is $77,000 for working whites. Founders of color are also less likely to know a large enough group of high-net-worth individuals who can contribute to a Friends & Family round.

If the ability to successfully grow a startup or small business depends on whether or not someone has a high-worth network, savings or assets to put up as collateral, or a university education, it is quite easy to understand why we have a persistent racial gap in entrepreneurship.

This isn’t even taking into account blatant discrimination against African Americans in equity and debt markets, which is rampant. African American businesses are more likely to be denied lines of credit and pay higher interest rates on loans, after accounting for collateral and credit history.Even for ventures with that cherished revenue goal of $500k+ in gross annual receipts, African American-led firms receive only half of the equity and debt investment that white-led firms do.

These assumptions to not discriminate on race alone. They also disadvantage young founders, who are unlikely to have significant enough assets to get debt financing, to have non-familial networks of wealth, and to have years of accumulated savings to use to start their ventures. Veterans and returning citizens also face similar challenges.

If you wan’t to build an equitable funding ecosystem, you cannot assume that an entrepreneur has existing pools of wealth to draw from to kick-start their venture. While the idealistic take has the founder putting up substantial sums of their own capital to make their business work, operating under this assumption will only perpetuate inequalities already pervasive in entrepreneurship.

Non-Discriminatory Sources of Pre-Seed Financing

First, let’s preface this by clarifying that even if financing sources are not structured in a discriminatory way, there will still be discrimination when it comes to their access and utilization. Studies have shown that African American founders are less likely to seek funding sources, due to a lack of knowledge of available opportunities, a lack of personal connections to capital sources, and a justified fear of rejection.

However, there are ways that Pre-Seed funding can be structured to be more accessible to diverse and low-income founders. Here’s a non-exhaustive list of some possibilities, and the way they must be structured to be accessible.

1) Non-Collateralized Loans

Since the majority of small businesses cannot take on equity capital (typically reserved for high-growth startups), debt capital is extremely important for helping entrepreneurs get their ventures off the ground. However, to avoid implicit discrimination, these loans shouldn’t come with collateral requirements, and they should take a holistic approach to analyzing creditworthiness.

Baltimore Business Lending is a great example of this. A subsidiary of Baltimore Community Lending, a local CDFI, BBL provides capital to early-stage startups and small business that cannot access traditional capital markets. Likewise, the Latino Economic Development Corporation (LEDC), another local CFDI, offers a Seed Loan to help new ventures get off the ground. While LEDC and BBL are a great start, there needs to be more CDFI institutions willing to fund ventures at their earliest stages, and many of the CDFI’s in Baltimore still have collateral and credit requirements.

2) Micro (and Macro) Grants

Grants are an entrepreneur’s best friend — they don’t come with the ownership stake that equity investments carry, nor the burden of having to pay them back with interest. While understandably, this “free-money” source is in short supply, it’s still a vital source of financing for early stage ventures.

Grants do not come with a financial return on investment, so they are typically provided to fulfill some impact goal. Thus many grants are only available to nonprofit organizations, and cannot be used as Pre-Seed capital for profit-focused ventures, especially those without a social-impact goal.

However, offering grants is a great way to help entrepreneurs get their business ventures off the ground without taking on the risk of other capital sources. The more business ventures that are able to launch and sustain, the better the local economy. In a roundabout way, providing grants to for-profit ventures can thus fulfill many social goals.

Baltimore Corp’s Elevation Awards and CLLCTIVLY’s Black Future’s Micro-Grant program are two great examples. Both provide grants to any venture type and are targeted towards populations that are underserved by traditional capital markets. While the Elevation Awards offer $10,000 per venture, many grant programs only offer a few thousand. Thus, in order to be a viable Pre-Seed funding source, there either needs to be more institutions offering these grants, or they need to come with higher dollar amounts.

3) Direct Investments from Philanthropies

In recent years, some philanthropies have been directly investing in startup ventures (while most of their support for small businesses goes through CDFIs). Direct Investments are similar to Venture Capital (VC) investments, where the philanthropy provides capital in exchange for equity, hoping for a larger return some years down the line.

For a few reasons, philanthropies are better suited than other institutional investors to take on the increased uncertainty that comes with investing at the Pre-Seed level. VCs must produce a return relatively rapidly (before their 10 year fund expires), so they tend to only invest in companies that they are reasonably certain can achieve 10–50x return within 3–6 years. For this reason, investing before revenue tends to not only be too risky, but too far from return to make it worth it.

Philanthropies, however, aren’t usually bound by a 10-year lifecycles, meaning they can bear to wait longer for a return. Since most philanthropies can only invest a small amount of their total capital in this way, the failure of their startup-investment arm won’t mean ruin for the organization as a whole. Finally, they typically have a mission to support their community, and successful local startups bolster the talent ecosystem and economy.

For these reasons, direct investments from philanthropies should be a good source of Pre-Seed financing for startups. Unfortunately, relatively few philanthropies in Baltimore have robust direct-investment arms, and the few that do have adopted a VC-esque style, meaning they look for revenue first. If philanthropies want to support their communities through enterprise, their approach must be re-examined.

4) In-Kind Solutions

Of course, the purpose of Pre-Seed funding is to get a business to revenue, and this process doesn’t have to require capital. One of the big pre-revenue costs is often product development, either in the sense of actual products or software. If you can provide a way for the entrepreneur to develop their product without needing capital, you have addressed the Pre-Seed Paradox.

An example of this, although not a perfect one, is smartlogic’s SmartVentures. From their website:

SmartVentures is a new program designed to provide an alternative path to scale for startups. The SmartVentures program will provide selected companies with $400K of product development and mentorship to help them take their product to scale.

Let’s assume an entrepreneur has a validated idea for an enterprise software company. Often, to secure large client contracts, you’ll need a workable platform, but building a workable platform either requires the founder know how to code (and spend a substantial time doing it) or pay $100,000+ for someone else to build it. Instead of giving the founder funding directly, SmartVentures builds the product instead.

The glaring issue with this example is that SmartVentures still looks for revenue-generating companies, so even though this model has the potential to fill the Pre-Seed gap, it’s not a perfect fit.

You see other In-Kind solutions in things like AWS credits (for hosting websites free of charge), and pro-bono legal and accounting services. They key to making these solutions work is ensuring that there are enough of them to fill all of the gaps that an entrepreneur might otherwise need capital for.

5) Accelerators that include Investment

Perhaps the best sources of Pre-Seed funding are those that come with education, mentorship programs, and connections to both customers and further funding sources. This is, of course, the role of accelerators in an entrepreneurial ecosystem.

By providing support along with early capital, accelerators better manage the risks of early-stage business ventures, making them a fantastic source of Pre-Seed funds. Unfortunately, there are relatively few accelerators that accept small businesses, since many (but not all) accelerators take an equity stake, the returns of which typically go towards funding the future accelerator.

Baltimore has two fantastic accelerator programs, Conscious Venture Lab and Accelerate Baltimore (now defunct). Conscious Venture Lab invests up to $100,000 for 8% equity, and Accelerate Baltimore invests $25,000 on a convertible note with the chance for one team in the cohort to win $100,000. Both of these accelerators provide enough capital to be meaningful for ventures, and they are at least willing to entertain ventures at the pre-revenue stage.

While these programs are fantastic, there are not nearly enough of them in the city. Which is, of course, the topic of Gaps Part 2: The State of Acceleration in Baltimore(coming soon!)

What This Means For Baltimore

As outlined above, Baltimore does have a few fantastic sources of Pre-Seed financing for both startup and small business ventures. However, for all of the entrepreneurial potential that we have in our city, there are not nearly enough Pre-Seed financing sources that are not discriminatory or otherwise inaccessible to founders of all social and financial backgrounds.

Unlike other sources of capital, Pre-Seed capital is not very mobile, meaning that while a startup can easily raise a Seed or Series A round from another ecosystems while remaining in Baltimore, they will be hard pressed to get their first $5,000-$50,000 in funding from a source outside of their home ecosystem (barring the rich uncle in New York).

It is thus of the upmost importance that Baltimore’s ecosystem developers focus on creating more accessible, equitable sources of Pre-Seed funding. This can be done through removing discriminatory lending requirements, providing more grant funding to for-profit ventures, shifting institutional investment to earlier stages, or coming up with creative solutions to help entrepreneurs get to revenue without capital.

Until this gap is filled, we will struggle to create the thriving pipeline of small business and startup ventures needed to revitalize Baltimore’s economy.

The good news? Pre-Seed capital is, by nature, a small amount — maybe between $500-$50,000 per venture. Compared to Seed or Series A financing, which requires many millions of dollars, creating Pre-Seed opportunities takes relatively little capital. And as mentioned above, addressing the Pre-Seed paradox need not come in the form of capital. There are hundreds of creative solutions that can be applied here.

So who will step up to the plate? Many organizations can, and we hope that many will. And when they do, EcoMap Baltimore will be here to cover the news.

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