One of the first major steps to getting on track is to raise a seed financing round. Entrepreneurs typically have between 18 and 24 months of runway after their initial seed round. This means that the capital raised should be sufficient to cover the expenses for the next year and a half to two years, giving the company time to advance its technology to a minimum Technology Readiness Level (TRL) of 6-7, if not higher. TRL levels from 6 to 9 mean that the technology is pretty much ready to be deployed.

Pre-order agreements as an attractive de-risking tactic

So the first thing entrepreneurs need to do is focus on de-risking the company for the next round of funding, as later-stage investors will want to see certain levels of de-risking before writing checks. Apart from building a strong team and hitting key milestones in the development of the technology, this involves demonstrating commercial traction in a measurable way.

Traction or sales are measurable, and can mean booked revenues, contracted revenues, pre-order agreements, advance market commitments (AMC), and/or letters of intent (LOIs). Demonstrating significant traction to prospective investors is always a very good idea. Pre-order agreements in particular can work very well for climate tech startups that have not fully advanced to serial production of their plants/products but are already experiencing a solid amount of inbound customer interest. So here are my thoughts on how they work, and how founders can use them to build an order book that will make them valuable for later-stage investors and avoid the dreaded “Funding Valley of Death”.

4 things to know about pre-order agreements for startups

Pre-order agreements are a lightweight legal document between two parties, where the purchaser: 1) secures the option to purchase one (or more) of the startup’s units/plants in the future; and 2) agrees to make a fractional down payment of e.g 1% of the expected price today. Either party can back out at any point in time and the down payment is fully refundable. Simple as that.

These potential customers are essentially reserving their place in line for manufacturing. Especially for manufacturing-heavy, deep-tech companies, this is an excellent way to demonstrate a very real market pull and demand for this type of technology. It is important to highlight that pre-order customers are taking significant risks in wiring five-digit amounts to a party they know to be a pre-revenue startup, signalling a strong need for the product.

There are four important details in this type of contract:

1. There is no hard commitment to deliver the product after the contract is signed. The true value of this type of agreement is the customer giving a reinforced commitment to buy the product once it is available — a proof point of traction from the market.
2. There is no purchase price in the pre-order contract. This is done intentionally as there might be changes in production or on the supply-chain side. However, the basic technical parameters of the unit/plant should be mentioned in a fact sheet, which is often attached as an annexe.
3. This is not a financial instrument for startups. Meaning, the down payments are not to be seen as comparable to proceeds from an equity round or grants that could be deployed in product development. The best practice is to put the down payments aside in a separate bank account and not use them.
4. Startups need to consider their realistic mid-term manufacturing capacities. While both parties are aware that delivery might take a while, entrepreneurs should already have a solid plan to enter small series production and work towards actually delivering the signed pre-orders.

Pre-orders alone will not automatically close the next round

Pre-order agreements can be seen as an instrument to mitigate the “chicken-or-egg” dilemma of showing sales traction before a substantial ramp-up of manufacturing capacity has taken place. Investors acknowledge and value an order book of several (dozen) signed and wired pre-orders. It is an entirely different story to show a stack of signed agreements with money in the bank to investors - compared to just talking their way through a theoretical sales pipeline that is unconverted.

While commercial traction is undoubtedly a key indicator for prospecting investors, it is important to acknowledge that even proper success in closing pre-orders alone will not automatically close a startup’s next round. Without parallel progress in product maturity, VCs are unlikely to put up a term sheet. Entrepreneurs need to clock in as many operational hours of the plant, that is for pre-order, prior to raising the next round as well. Look at commercial traction as a catalyst to help them achieve their funding targets.

In addition to that, keep in mind that institutional investors are investing into a company. Most VCs are not investing into an idea alone and neither are they looking to invest into a company that is essentially a sales department and not much else. Conviction in the market is key, but so is market-readiness of the product and the team in charge of delivering it.