There is a lot of discussion on the web about raising seed and series A rounds, but not much after that. I think there is some false conventional wisdom these days that once a company has achieved “product market fit” the job is done. However, that is far from the truth, and I often hear investors and entrepreneurs lament over is the dreaded “B round”. I’ve heard it often also called the “sucker round”. Some thoughts on this below:
Why Is The Series B the “Sucker Round”
VC’s tend to invest based on major inflection points in a startup. Usually financial metrics are pretty sparse at early stages and investors have a hard time giving companies “credit” for steady, linear progress. Instead, we have an easier time getting over the hump on an investment when we see some sort of major value-accretive milestone achieved.
For seed stage companies, typically, it’s about:
- Compelling founder(s)
- Multi $B market potential
- Something captivating about the product
For series A companies, it’s all of the above, plus usually some evidence of product market fit. Product market fit often looks something like some sub-set of below:
- Exponential user growth (even if total numbers is small) + high user engagement
- Small but accelerating revenue growth (often in the $50K-$100K range monthly).
- 3-5 major partnerships or enterprise customers
I’m sure there are others. But the point is that there are certain milestones that get investors hot and bothered about a series A based on product market fit. But for the series B, it’s much less concrete. A founder may feel like she has made amazing strides in the 18 months since a series A, only to find few investors excited about investing in their business with a meaningful valuation step up. The reason is that the next MAJOR and OBVIOUS value-inflection point is evidence of a repeatable and scaleable business model. It’s usually hard to get to these as a series A company. Common objections entrepreneurs may hear are:
- Yes, users and usage are strong, but you haven’t proven the ability to monetize. You should start testing some low-hanging fruit for revenue to prove willingness to pay
- Yes, you have started to monetize well, but the low-hanging fruit you chose for monetization can’t get that big. You need to show me that the “real” business model can work. By the way, I don’t like bank-shots (to be discussed in a future post).
- Sure, the “real” business model works, but only in one vertical/category/geography. I’d like to see similar growth in 3-4 others
- Everything is working, but it’s not fast enough. I’m worried about incumbent X,Y, or Z now that you are on their radar and they are trying to crush you.
Yes, it sounds pretty crazy. But it’s true. In the seed and series A, you are selling promise and some execution. In growth rounds, you are selling something that already “works”. You are selling a marketing machine, and the ability to “put in 1 dollar and get out 2”. In between, you are selling a hybrid of both, and that isn’t easy.
Interestingly, in recent years, investors have started to subscribe to the thought that once one has product market fit, nothing else matters. We’ve seen high-flying financings on companies that just have traction. More investors have adopted the point of view that there are only a few companies that matter every year, so you should pay up for anything that has “traction” (real or perceived). This means that in some cases, series B’s have looked easy, and we’ve seen a number of successful exits from companies that haven’t had to build a repeatable business model.
These companies get a lot of press, but it isn’t the common experience. Most companies have to become real, scaleable businesses. Some companies may get away with it by raising a series B or C on “traction”. But the music stops eventually. Traction does not inevitably lead to the long-term, sustainable businesses that really matter.
So, what does this mean for entrepreneurs? Let me offer a couple suggestions:
- As always, this means that you have to be very thoughtful about the investors your choose for your series A and B. You don’t want to just go for the highest price. You want a partner that really does have domain experience and can help you think about building the machinery of your business, and has the capacity to support your company if you are executing well but just need more time to attract outside investors.
- You also probably don’t want to have more than one or two very committed VC’s in your A round. The conventional wisdom of “only a few companies matter” means that some funds will basically do anything to get even a small allocation in a really hot company’s series B. However, with capital being concentrated in a few Billion dollar+ funds, I think that in some ways, there will be signaling risk for $3-$5M series A’s that we have seen historically for seeds. It’s still a teeny % of those firms’ funds, after all. So you risk alienating outside investors if one of your insiders decides not to aggressively “buy-up” in your B for a variety of reasons.
- I may be wrong, but I think that your best chance of raising a series B is to really nail one part of the equation. Specifically, either really really nail your business model such that either the economics are extremely compelling or you get to cash flow breakeven. Or, just go for exceptional growth. I think doing both simultaneously it really tough. The high flyers we hear most about do it by exceptional growth of top line revenue or users. But I’ve also seem companies that just really nail their business model early, and then quietly march their way to amazing valuations and outcomes.