More and more startups are getting seed funding these days and have for a number of years. That’s a good thing. Below we’ll discuss some of the reasons for this phenomenon. But at least partially as a result of this good fortune for software, SaaS and other startups, a second phenomenon has occurred along with it. In this article we’re calling it the “Series A funding squeeze”. What I mean by the is the inability of the majority of those seed-funded startups to raise a series A round. Recent statistics indicate that only roughly 15% of seed-funded companies are able to raise their series A round. As a startup founder or early employee, that number should get your attention. And in my opinion, it should probably modify your behavior as a result. So let’s take a quick look at what’s going on in the startup funding ecosystem, as well as offer some ideas on how to raise your odds of avoiding “crib death” of your company, given the current funding realities:
What’s Going On
The Economy has been good for a while
Let’s face it, good economies lead to more money for EVERYTHING, and capital for startup companies is no exception. A good stock market leads to more IPOs and M&A, which frees up capital for reinvestment in startups. It also stimulates the greed motivation to create more companies that will lead to IPOs and M&A. So this isn’t complicated; a good economy leads to a virtuous cycle of good things, including more money for investment. The tech startup economy is a primary beneficiary of good economic times. In particular, this has driven a comparatively large amount of seed investing by Angels and newer, smaller seed-oriented funds.
The lowering of tech startup costs
It’s never been easier or cheaper to start up a company, particularly a tech company such as a SaaS or mobile software business. The costs of creating a website have plunged to practically nothing, and while software development is still expensive, development tools and pre-built libraries have improved greatly over time. This allows much more cost-efficient development than in years past. Lastly, while developers are never an inexpensive resource, the ability to source and manage them remotely as a result of modern Internet technology has enabled a worldwide perspective to software development – for those without a fear of utilizing “non-local” resources. All of this adds up to being able to realistically start a software-based business for a fraction of what it took a decade or two ago. This has naturally led to an increase in software startups and seed investment.
VCs awash in money
Venture Capital firms have been swimming in money for a long time. While they of course have to answer to their own investors and create returns that enable them to raise their own new funds, a good economy definitely makes all of this easier. Plus the fact that since there is more money around, there is a greater need to find places to invest it beyond a boring, simple bond return. As the stock market thrives and appears more expensive, alternative investments such as VC funds become more and more attractive to high net work individuals and institutional investors such as pension funds and insurance companies, all of who are seeking high returns.. Even as existing, successful VCs raise larger and larger funds, all of this additional money also causes a paradox. Even though they theoretically have much more money available for the startup ecosystem, with a constrained number of partners they feel that to manage this larger pot of money efficiently they need to write checks in much larger chunks. This naturally leads them to focus on later stage investments in more mature companies, effectively reducing the amount of funds available to earlier rounds (such as a Series A funding).
Typical VC-backed business models can lead to premature death
Traditionally, institutionally-funded startups have taken a fairly short term view of their businesses, often based on the typical “Seed, Series A, Series B, Series C, etc” funding cycle. They plan on every round of money lasting them for roughly 12-18 months. Then it’s on to the next round.
This can cause a lot of “over aggressive” spending decisions, especially if the amount of money you’ve raised in a round is quite large. Ok, said another way, money can make you stupid! There, I said it. Funded startups often spend money on things and at a level that a boot-strapped startup would NEVER even consider. It’s human nature, like giving a starving man unlimited food. He’s likely to overindulge. Sometimes, of course, this is a good thing and leads to very fast growth. And generally the VC backers of a company are “strongly encouraging” the startup management team to “go fast”. Don’t worry about profitability; grow that top line as fast as you can. This is the VC-backed game; they only fund companies that they believe have very large potential valuations. They aren’t interested in “singles and doubles”, virtually every funding of a startup is aimed at hitting a home run. The VCs know they won’t all turn out to be home runs, but their model is to try with a bunch of companies and hit a few. They believe that this is the best way to get the growth on THEIR investors money which required to raise their own next fund and stay in business. So they push their portfolio companies to “go big or go home”.
You can question whether or not this is a sound approach to portfolio management (and I do). But make no mistake; that is how the VC game is played. So to a certain extent, once you take money from a VC investor, your are on this boom or bust path whether you like it or not.
And it can all work out great in the end. As long as you are able to hit on all of those aggressive milestones and keep getting to your next funding round.
But what if you DON’T continue to meet those milestones? Unfortunately, a large percentage of companies don’t. Do you want to just fold the tents and “go home”? If not, let’s take a look at some alternate strategies to avoid a strictly 1 or 0 result:
What To Do About It
Raise another seed round instead of Series A funding
About 40% of seed-funded startups end up raising a second seed round. This is a realistic alternative because there are many more seen investors around these days. Maybe you’ve fallen off that super fast track, but still have the story to raise more money. Just not in the quantity and from the sources you’re previously planned. There’s no shame here.
Treat every funding round like it could be your last
Another way of saying this is “become capital-efficient long before your investors are demanding it”. Though your investors are likely going to continue to push you to grow as fast as possible, you are still running the company (I hope!). It’s important to seriously listen to your investor’s advice, but once you become simply a robot implementing their preferences, you might as well go home anyway. Because you had BETTER have a better idea of how to run your business than they do. So evaluate continuously and objectively as you go along, what’s changed and where your business is at. You may have raised money based upon a huge market potential, but what if it turns out that it’s a good sized market, but not as gigantic as previously thought. Or it’s a slower developing segment than you expected, and the competition isn’t as fierce as you once thought. There’s nothing like being in business for a while to tell you the truth about a market and specific company’s potential that’s often unknowable when you raised that seed round. Adjusting to reality is a best practice for any business.
The common thread in these circumstances is that it may make sense above all to lower your burn rate – BEFORE you actually hit the skids. Or, god forbid, even become profitable! Because it may take longer to hit those Series A milestones; or you may not be able to make them at all in the timeframe required for a real Series A funding round. But you still might have a very nice business on your hands! Don’t blow through money just to “stay on the VC track” if it isn’t justified. Slow down that rapid hiring, when you really just need to solve a specific business problem and you can due it by hiring a consultant or deploy existing resources. Stop spending money on that expensive marketing program that isn’t generating a profitable return, even though it’s growing the top line. Don’t sign that lease for outrageously expensive offices which could house 5 times your current staff.
Manage the business PROPERLY for it’s stage and ultimate potential. Even if you don’t hit a home run, a singe or double is ALWAYS preferable to a strikeout. I believe that striving to become capital efficient at an early stage is a best practice for nearly any business. Yes, there are a few exceptions of companies in fast growing markets with huge potential and fierce competition, where it makes sense to throw caution to the wind and worry little about the burn rate. If your company fits into that category, go for it! But I caution you to make sure that you really do fit into that category at every stage of your development and that above all, that next round of funding is practically guaranteed. If that funding doesn’t appear absolutely guaranteed, why not step back and try to see what the future could realistically hold. Neil Young famously sang “It’s better to burn out than to fade away”. That may be true for some, but I personally prefer a third option: profitably running and eventually selling a nice stable business, even if it hasn’t turned out to be the rocket ship initially envisioned. Even your investors will thank you for it.
The funding of startups, particularly by institutional investors such as VCs has been written about quite a bit. There is a lot of advice out there. Some what you read is pretty consistent and makes a lot of sense, but some of it contradictory as well. What’s been your own experience in trying to fund a startup? Especially as it relates to the Series A funding squeeze? We all learn together, so please use the comment field below to share your opinion or a bit of your own startup funding story.
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