I have been a pre-seed software investor for 25 years, investing in over 250 companies.
Chat GPT would be a terrible Pre-Seed Software investor; here is why.
I asked Chat GPT “How do you evaluate Pre-Seed software companies”? Here is their 7-part framework and how it is off base versus my experience in the industry.
1. Analyze the Team: Examine the team members’ experience and track record. Do they have the skills and experience to succeed? Are they well-respected in the industry? Have they had success in the past? What can you learn about them?
My Take: Team is the #1 thing in pre-seed, sometimes the only thing you have. IMO having the perfect Founder/Market fit is much more important than specific “skills” or being “well-respected in the industry”. It is much more important to me that the founders have demonstrated insight into the problem area and reasonable connections in the industry to get the first customer requirements and early customers than any “credentials” you could hang on the wall. Also you need a “complete” founding team. There are four key skills the founding team must have. These can all be in one person but typically require 2-3 founders who have worked together before. These include 1. sell customers (know the industry), 2. raise money from investors, 3. Build the product technically, 4. Manage the operations of the company.
2. Understand the Business Model: Make sure that the pre-seed software company has a viable business model. What is the company’s competitive advantage? How is the company planning to generate revenue? What is the company’s value proposition?
MY Take: Nearly every pre-seed company I have ever invested in has changed it’s business model over the first year or so. The business model is rarely the key to the market. ChatGPT gets closer when talking about “value proposition,” but the key is more what is the Problem and what is your Solution? I want to focus more on the problem you have identified, how well you understand it and your unique solution to it. The ROI, etc.
3. Analyze the Market Opportunity: Evaluate the size and potential of the market the pre-seed software company is targeting. Is the market large enough to support the company’s growth? What type of competition is the company up against? What are the barriers to entry?
MY Take. IMO the market size slide in every deck is the least interesting. Everyone quotes huge market sizes at a macro level. And everyone has competition. The MORE IMPORTANT thing to focus on is your specific THIN EDGE OF THE WEDGE. What is your market entry? What is your distribution trick? How will you get your first 100 customers? Don’t tell me about barriers of entry, tell me about HOW YOU WILL ENTER.
4. Assess the Product: Evaluate the quality of the product. Does it solve a real problem? Is it user friendly? Does it have features that give it an advantage over competitors?
MY Take. The product at Pre-Seed is usually barely an MVP and certainly does not have Product Market Fit yet. Assessing the product at this stage is not very helpful. Rather than focusing on the features of the product at this stage, I prefer to focus on “Does it propose to solve a real problem and does the team understand the problem?” If you get the problem right the product should follow. I also don’t care much about competitors other than the existing ways customers solve the problem. That could be competitive products, or spreadsheets, or manual processes, whatever. The core question is: “Is the proposed product solution to the problem 10X better than the current way people are solving it?” That is a high bar but the right bar for Pre-seed. The real competition is Doing nothing.
5. Consider the Financing: Examine the pre-seed software company’s financing. How much capital has the company raised? What is the timeline for raising the next round of funding? Does the company have enough cash to survive until it can become profitable?
My Take. ChatGPT is really hallucinating if it assumes a pre-seed company will get profitable on the pre-seed financing. That is not the expectation nor the norm. ChatGPT would never invest pre-seed if they only look for potentially profitable companies in this funding round. In Pre-Seed, I expect to fund 18-24 months of runway to get enough product market fit traction to raise a Seed or Series A round. You are a success in Pre-Seed if you raise the next round.
6. Assess the Financials: Analyze the company’s financials. Does the company have enough cash to survive until it can become profitable? What is the company’s burn rate? Are there any red flags in the financials?
My Take. Again, expectations of profitability in Pre-seed is not realistic. And the burn rate is likely very low but will go up after the financing, especially for bootstrapped companies not paying themselves, etc. There are rarely historical financials that are useful. The financial projections are also very suspect. For me, the key to analyzing financials in pre-seed is to figure out if the founders are capital efficient by nature and if they have reasonable assumptions in the model. They should have realistically optimistic projections, based on some insight into the market. This is more of a feeling than a science. In pre-seed you want teams that are very capital efficient and under promise and over deliver future projections. In terms of red-flags, look for crazy expenses early (too high salaries, offices, etc.) and for weird things on the cap table like excessive advisor grants or warrants.
7. Examine the Legal Structure: Make sure the pre-seed software company has established the legal structure necessary to protect its investors and customers. Are all of the necessary documents in place? Are there any potential legal issues that could arise?
My Take. This is also a little overly optimistic on ChatGPT’s part. Many times, the companies are not even incorporated yet, and the financings are on SAFE notes. What you want to look for is that the company uses standard hopefully US Delaware C corp documents (like the NVCA docs) and is NOT an LLC or foreign entity. Many times the legal formations can come at the same time as the financing. Also ensure that the founding team has their shares on a vesting schedule and there is an option pool created. You should do a google search for any legal actions, but I would not expect any in pre-seed. If you have some, or do a background check on the founder (which you should do) and find weird stuff, run away.
8. Understand the Exit Strategy: Evaluate the company’s exit strategy. What are the company’s plans for the future? How will the investors exit their investment? Is the exit strategy realistic?
MY Take. One of the biggest red flags for me in a pre-seed deck is an “Exit” slide. Pre-seed founds need to have such a huge opportunity in front of them that they can’t see the exit. Even talking about an exit at pre-seed signals to me that the founders may be more mercenary than missionary and will run for the exits at the first sign of any trouble. If ChatGPT focuses on Exit at Pre-seed, they will pick the wrong founders.
Summary
ChatGPT does not yet have enough intelligence to understand the creative process involved in three guys and a dog creating a new company. It applies big company metrics to measuring something that requires much more nuance and understand of how small companies identify gaps, build products, and grow over time. In Pre-seed the primary decision point rests around the founding team, their experience, their market and product insight and ability to execute. Not things that can easily be measured or tracked in financials.
The bottom line is that Pre-Seed investing is the lowest information form of investing. ChatGPT is very good at pattern matching in a high-information environment. Pre-Seed is not that. There is just too much judgement involved.
