An Open Letter to VCs: Please Get Out of Pre-Seed Investing

Your floundering in pre-seed/seed is hurting startups while losing money for your LPs

Dear VC Fund Friends:

I realize you look down on angel investors as amateurs because you have the luxury of getting paid to invest other people’s money while we have to write checks from our own bank accounts.

Your fund has raised hundreds of millions of dollars and you write big checks. You’ve had a few successes investing in late-stage startups that were already successful. You seem to think that makes you a BSD.

I hate to break it to you, but you’re ill-equipped for early-stage investment and don’t know what you’re doing. Your floundering about, writing big checks to companies that aren’t ready, will not only lose money for your LPs, but will hurt the startups.

I realize you don’t care because you get paid whether they’re successful or not, but it’s corrupting the startup ecosystem in unhealthy ways that will hurt everyone.

Just last week, I was part of an angel group listening to a pitch for an industrial product. Though their market was large, this startup was developing a component of a component of a component. They were still a research project, at least 3–5 years from significant revenue. They had no coherent plan for how they would manufacture or sell their product. But they did have some promising test results. And a patent. In other words, a typical pre-seed hardtech startup.

Our group consisted of scientists and business leaders in their industry. We were intrigued. Though we knew of a few other startups with similar ideas, theirs was different enough to be worth checking into. When we asked the deal terms, they said they were raising $2M on a $20M valuation. We sat with our mouths hanging open.

$20M valuation? After an internal discussion where we unanimously agreed the risk vs reward was completely out of whack, we contacted them said we might be interested if the valuation was closer to $8M.

The founders laughed. They were about to sign a term sheet with a large VC firm to provide $10M on a $30M valuation. For a second time, I sat with my mouth agape. WTF? It turns out they’d invoked the magic word “battery”, and cleantech VCs were lining up to throw money at them.

Unfortunately, this wasn’t an isolated incident. The next day I heard that a startup I knew to be worthless had raised $7M on a $35M valuation. After adding the two magic letters “AI” into their pitch (it was just some off-the-shelf machine vision), impact investors were writing big checks. Aren’t VCs supposed to do diligence?

Why would professional investors like you invest serious money in these companies?

My cynical colleagues insist you’re desperate to invest that $100M sitting in your bank account into anything that will sound good on reports to your LPs. Otherwise, you might have to give all the money back and layoff most of your staff. Please tell me that’s not true.

I’m not so cynical. I like to believe most people are fundamentally honest and that you, my VC friends, simply don’t know what you’re doing. Like a bulldozer in a china shop, you have strength and power where what’s needed at this stage is knowledge and finesse.

I believe you truly want to help startups working on technologies to avert the climate crisis, to enhance equality, to cure disease. You think your expertise investing big dollars in Series A through Z can be applied at smaller scale and you’ll bring your professional expertise to an area run by amateurs.

Unfortunately, it will take a few years for you to realize that what works for investing in companies with significant revenues doesn’t work when they’re just getting started, and what works for investing in software can’t be applied to batteries or green hydrogen.

With all due respect to your amazing success, investing in SaaS startups already generating $2M is easy. You look at growth rates and CAC, and evaluate the team’s ability to execute. You can call a few customers or industry experts and ask them what they think. The tech stack doesn’t matter. Neither does the industry.

SaaS for employee management, SaaS for bowling centers, it’s all pretty much the same. Once the product is built, they just need your money to expand. Will they expand big enough, fast enough to generate a 100x return?— that’s your job to figure out. You’re good at that. You have an MBA from HBS, you’re a whizz at spreadsheets.

But when it comes to battery components, for example, or water purification membranes, or organic waste recycling, new technologies that are years from commercialization (despite what the founders tell you), you’re trying to apply the same process.

Let me offer you some free advice from my 15 years of early-stage startup investing: if you don’t know the difference between an anode and a cathode, you shouldn’t be investing in batteries. If you don’t know the difference between aerobic and anaerobic digestion, stay out of fermentation.

Angel investors learn this lesson early and often: we have to work together in big teams or else we’re doomed to throwing away our money. Early stage investing requires specialized expertise. Not only do we need to evaluate cutting-edge technology, we need to know the complexities of the industry, we need to read the patents, we need to know whether there’s a viable path to market, and whether there are industry giants willing to shell out a huge premium to acquire the business rather than a small multiple of EBITDA.

No one person has all that expertise across hundreds of different technologies, which is why we collaborate in large angel groups of 50 to 500 people who’ve worked in the industry for decades. That one person in your firm with a PhD in astrophysics you hired straight out of school is little help in evaluating perovskite solar panels or carbon nanotube anodes. And you wouldn’t demean yourself to collaborate with amateurs like us.

We watch you invest in things with slick decks that sound good, but don’t make sense if you understood the technology or industry or competitive landscape. Or actually read their patents.

But why does it bother me so much that you’re losing other people’s money investing in no-hope startups or overpaying for very, very early-stage technology? I hear all my founder friends saying, whoa, we’ll be happy to take their money — introduce me!

A little dumb money sloshing around is probably good for the system. Billions of dollars of dumb money makes a mess. A valuation that’s too high sets up the startup for failure in the next round.

Every founder thinks they want as much cash as they can get, but if they haven’t found product-market fit (and by definition, a pre-revenue company hasn’t found PMF) they’re going to need to pivot at least three times before they get rolling. The more they spend now on what will turn out to be a dead end, the harder it will be to pivot. Attempting to fly before you can crawl is a recipe for crashing.

In the end, though, that $5M investment doesn’t matter to you. It’s simply a lottery ticket on the small chance they make it to Series A when you’d get to lead that $20M investment.

But for small investors like me, that $5M at an absurd valuation does matter. You’re chasing us out of the market. With our small checks and thorough diligence, we can’t compete with funds willing to throw big money at anything that sounds good.

When the inevitable shakeout comes and you realize you have to write off your entire portfolio, you’ll poison the industry. Innovation in solar panels in the US was destroyed by the Solyndra debacle that put too much money into untested technology. It took years for companies developing microfluidic diagnostic tools to recovery from your Theranos stupidity. When the shakeout comes, the baby always goes out with the bathwater.

One day the good startups that we’ve found and nurtured through multiple pivots will finally be ready for commercialization. The technology will be proven, the customers primed to purchase. They’ll need your money to build production lines and expand internationally. But by then you’ll have slunk back to the safety of software claiming deeptech is too difficult.

So please do yourselves a favor, support your LPs, and support the startup community by focusing on what you do well — Series A investing and beyond — and leave pre-seed/seed investing to the experts — angel investors.

Your friend, DC Palter

If you want to see the mess venture capitalists can make, read my novel, To Kill a Unicorn, about a startup disrupting the transportation sector with a billion dollars in funding. When the lead scientist goes missing, his hacker friend has to find him.