I heard from an entrepreneur I know that a very prominent institutional investor turned down their request for Seed Round funding because the company is pre-revenue. There is no way this company can get to revenue without a reasonably large amount of funding and it made me realize that this is the Catch 22 of Canadian Seed Funding. Now many of you have heard similar statements in the past from VCs,  but I’ve been thinking about this because of the problem it creates for companies.

When companies hear that VCs won’t invest pre-revenue they translate this to mean that when you have some revenue, funding may be available so whatever you do, it should be focussed on getting a product launched so you can get some revenue. What will an entrepreneur do in a situation like this? They will prioritize product development over customer discovery. With limited funding from pre-seed money there typically isn’t enough money to do both customer discovery/product marketing and product development. So, they put almost all their money in product development and little in product marketing.

As a result, companies that I meet typically have done very little and in some cases no customer discovery before they bring a product to market. They have also not typically spent much time on market sizing, competitor discovery, customer market research and a whole host of pre-revenue activities. And why are they doing this? It’s because this is what investors are telling them to do when they inform them that they won’t invest until they have some revenue.

The end result is companies that rush products to market, find a customer if they are lucky, raise some funding once they have revenue and then they have money to do customer discovery. But at this stage the customer discovery often tells them that the market they thought might be there, isn’t there for the same product they developed. So, they go back to the drawing board and rejig the product so that it meets the market needs that they discovered too late.

Now they are using Seed funding for customer discovery and to recreate their product, frequently having to pivot into something entirely different. But having to relaunch or pivot slows down growth so when they come to look for a Series A Round, their growth is low and investors are not interested. Now they are dead in the water. And why is this? It is often because they couldn’t raise funds to do proper customer discovery before they launch.

I wanted to look at what stage a company needs to be in to get financing in the US because rumours abound that US venture capitalists will fund a company earlier than a Canadian VC will. To do that research I looked at 132 companies that had received Seed Capital In one month, checking that same month as to whether they had a live product available to ship or did not have a live product and were thus pre-revenue. Here are the stats.

What this implies is that 45% of the companies in this test were able to get seed capital financing without revenue. Oddly enough, these companies had a higher level of pre-seed funding (averaging $673 thousand) and the Seed funding they did get was marginally higher ($2.9 million). In the US then, being pre-revenue isn’t a big impediment to getting funding and a firm like the one I was talking to wouldn’t hear the pre-revenue response so often.

I understand that there will always be some seed stage funders who want to see revenue before considering funding but I think this is a typically Canadian problem. The problem is the small size of our market. With fewer firms seeking funding, a Canadian VC that funds entirely or mostly Canadian companies will see companies in a variety of markets and will not be able to specialize and get to know particular markets in the same depth as US VCs who see more companies will. With less market knowledge, Canadian VCs will have to rely on other signals as to whether a company has potential. The easiest route is to rely on the market thus the requirement that a company have revenue before a VC will consider investing.

This results in the Catch 22 of Canadian seed funding that requires that a company have revenue before investing. It’s sad for the companies that need more money to launch a product. What are they to do? What they have to do is go down to the US to get funding. Find a US or foreign VC which will support them pre-revenue.

This blog is part of what we discuss in a workshop series hosted by Communitech. You can find out more about it by clicking here. If you want to receive more blogs like this, you can subscribe by filling in the space on the right.