Not much different than the famous chasm described in Geoffrey Moore’s book “Crossing the Chasm”, funding your startup venture over time also has a chasm that you want to avoid. This fundraising chasm doesn’t trip up all startups, but that might just be due to luck. Explore this further with me to better navigate the chasm in such a way that it doesn’t suck you into the abyss.
This article explores just one of the topics covered in Chapter 2 of my bestselling book “Startup Success – Funding the Early Stages”.
You can listen to this chapter now and if you’re interested in the book, you can find it on Amazon here.
Typical Funding Cycles
Almost no startup grows into a great company with only a single round of funding. Instead, three and usually more rounds are involved – each providing fuel in the form of both time and resources to reach new and exciting outcomes and milestone accomplishments (see related article titled “How Much Should You Raise”). And it’s those outcomes that provide the foundation of the story you use to fundraising again at a nicely stepped up valuation. This cycle continues until you either reach a sustainable business, experience an exit (acquisition or IPO) or crash and burn.
Investor Evaluation Varies By Funding Stage
There are very few, if any, shortcuts to building a scalable and sustainable business. The graphic below suggests the lifecycle you will go through along the way and the following sections map fundraising attributes to the first few phases of the lifecycle.
Side Note: Sometimes, a viable business becomes sustainable but not scalable and might be referred to as a “lifestyle business”.
In the earliest days you have a developing idea but not even a working prototype. You need funding to build a prototype or crappy, but minimally functional, MVP so that you can prove feasibility (can it be built?) and possibly start to get a sense for desirability (does anyone want it bad enough to pay for it?).
During this funding stage, which probably involves some bootstrapping, some friends & family funding and/or some early angel investors, you are raising money mostly based on hope, vision, promise and potential (let’s call it “HVPP” for short). Investors will also highly evaluate you and your other team members’ skills, experience, drive and passion.
After you’ve built something that minimally works you need to raise money to complete a real v1 of your product, launch it into the market and start to acquire paying customers. You focus a lot of attention on actually proving desirability and starting to test for viability (is there a customer acquisition model that is sufficiently efficient and effective?).
During this funding stage, which probably initially involves angel investors, angel networks or crowdfunding portals and later involves seed-stage VCs, you are raising money based on a fairly developed business plan and, again, your team. The business plan would include important insights from your customer discovery, market size research, plans for customer acquisition and 1-2 year financial projections. But you still have a lot of theories and assumptions that need to be validated. The investors can at least touch and feel your product and get a sense for how smart and driven your team is, but a lot is still HVPP.
After you have a decent batch of paying customers (hopefully approaching $1M per year), you need to raise money to accelerator growth and better support those customers. You probably also have early employees that accepted way below market-rate compensation but that can’t last much longer, so pay raises are in order.
During this funding stage, which mostly involves venture funds, you better have a good understanding of your operating model, unit economics and customer acquisition methods. You should have a functional management system and developing maturity around processes and tool sets. All of these things will still need further improvement and optimization but at least they exist. The other critical thing that exists is a track record of results, otherwise referred to as “Traction”. Investors don’t only get to look at your historical results, they get to see them in nice, pretty graphs. That means they get to see important trends and slopes of curves with which to both imagine and debate future projections.
Note: For a deeper dive into Series A fundraising and a more detailed explanation of how it’s not just a larger version of a seed round, see my articles titled “Your Series A Readiness Scorecard” and “A Series A Isn’t Just a Large Seed Round“.
So Where’s The Chasm?
The chasm I most commonly see exists between the Seed stage and the Series A. If your seed funding enables you to get your product launched but with too few customers or too short of a results track record, the Series A investors will feel like you’re too early for them and they’ll tell you to come back when you have more revenue and the various other things I mentioned above.
In many cases they’ll just say you need more traction for them to get interested. When this happens, don’t just shake their hand and walk away. Instead, ask them a very specific, open-ended question: “What sort of traction would make this an exciting investment opportunity for you?”. At that point, lift your pen and start taking notes because what they tell you becomes the milestones you want to reach. And if multiple investors give you a similar list of traction targets, you’ll really know what you need to shoot for.
Note: Don’t ignore complementary forms of traction that don’t relate to paying customers. I describe a whole host of them in an article titled “Defending Valuation Before Revenue Traction”.
Crossing the Funding Chasm
(Option 1) Bridge the Gap a Small Funding Round
There’s a reason a certain form of funding is referred to as a “bridge round” (see related article titled “Bridging a Gap Using a Convertible Note”). It is intended to bridge the gap between where you are and the next most logical/desirable time to raise money. In this case, raising money to cross the chasm and be better positioned for a Series A. When raising a bridge round, here are some additional considerations to keep in mind
- Shorter time horizon – Hopefully you don’t need a year of funding to cross the chasm but rather a more typical bridge of 3-6 months
- Economics – With progress having been made since your previous round of funding, you should be able to step up the valuation (or valuation cap). How much of a step up depends on the progress you made, the risks that have been removed and/or the incremental upside potential you’ve been able to identify.
- Investor Candidates – If the bridge round is only intended to last 3-6 months, you can’t afford to spend 3-4 months trying to raise the funding. Because of this, it’s likely that a meaningful portion of your bridge funding will come from existing investors. They already know you, are already bought into the original HVPP and are in the best position to recognize and be impressed by the recent progress you’ve made.
- A Series A Nibble – You might get lucky and find a Series A investor that likes what you’re working on but confirms you’re too early for them to lead a Series A round of funding. You might be able to convince them to “take a nibble” by investing any amount in the bridge round. An amount that might seem large to you could be a small nibble for them. The added benefit to them is they get to know the company fairly well over the following months to best decide about leading the Series A. Basically, it gets them a foot in the door.
(Option 2) Raise a Larger Seed Round
This obviously doesn’t work once you’re already facing the chasm but if you can see and predict the chasm ahead of time, you could choose to raise a larger seed round to give you enough runway to reach the Series A sweet spot. In fact, I think most companies have this as a goal when they raise their seed round. But what usually happens is things don’t play out as expected. Delays, market changes, team-related issues, distractions of a million varieties and the like cause one or more pivots. That means you didn’t arrive at the expected destination on the funding raised.
“Raise more than you think you’ll need” is a common mantra for early stage ventures. And the people that say it probably got trapped due to what has been described above. It’s true that you will be diluted more by raising more and it’s also possible the demand and interest from investors isn’t sufficient to raise more than you think you’ll need. But at least spend some time thinking this through so as to minimize the odds of dealing with the funding chasm later.
(Option 3) Plan for Multiple Seed Rounds at the Outset
If you could predict that your first seed round would cause you to fall just short of the Series A sweet spot, you could plan for multiple seed rounds in the beginning. In this case, you would raise enough in your first seed round (probably from angels, angel networks or crowdfunding portals) to achieve the milestones that get institutional (VC) investors excited about your second seed round. I will describe more about this strategy in the section below titled “The Long Path to Series A”.
(Option 4) Non-Dilutive Funding Sources
If you are deploying an indirect method of customer acquisition (ie – technology license, OEM or distribution), you might be able to negotiate a pre-payment with your partner. They essentially pay you up-front for a bulk purchase and then draw down that balance as they actually consume your product. In other cases, there might be grants you can apply for with government agencies, non-profit groups or similar. The sources of these types of non-dilutive funding and the way they evaluate the opportunity is so different than traditional venture investors that the reasons for the chasm as described here don’t exist. Use that to your advantage.
The Long Path to Series A
Over the years, Series A investors have positioned themselves later and later in a startup’s evolution. This means that it has gotten harder and harder to reach their sweet spot after only a single seed round of funding. More and more startups need to raise at least two rounds of funding during their seed stage.
Rather than guess at the need to raise multiple seed rounds, follow this process to implement an informed approach:
- Meet with some Series A venture funds that like to invest in your category of startup. But instead of asking them for an investment, ask what you will need to accomplish to be a highly interesting investment opportunity for them in the future.
- Determine the combination of time (runway) and resources (people, marketing spend, etc) that will be needed to accomplish the things that should cause the Series A investors to get excited.
- Determine the amount of seed funding that will be needed to achieve the needed time and resources from #2.
- If the needed funding is $1.5M or more (likely for most startups), you’ll need a lead VC to invest half or more of the target amount and probably additional VC’s to fill in the rest. In other words, it’s not a round made up of only angel investors.
- Meet with some seed-stage venture funds to determine if your current level of accomplishments is sufficient to get them interested in leading the desired round of funding. These meetings are more test drives for information gathering and relationship building than full-blown fundraising campaign meetings.
- If you’re not ready for the seed-stage venture funds, then you’ll need to split your seed stage into two rounds of funding. The first will likely need to be of a size that’s appropriate to raise from angel investors (typically $750K or less) and also enough for you to accomplish the things that will get the seed-stage VC’s excited. The second seed round might be another angel round or, more likely, an institutional seed round.
While splitting the seed stage into two rounds of funding, just make sure to avoid falling into the fundraising chasm. Accomplishing so much from the first seed round to get close to the Series A sweet spot might cause your second seed round valuation expectations to be out of reach for the institutional seed investors. You want the first seed round to get you safely into the sweet spot of the institutional seed investors, but not a lot more than that.
Listen to my 5 minute podcast recording on this topic:
What’s in a Name?
Shakespeare famously wrote “a rose by any other name would smell as sweet”. But that’s not exactly the case for the seed stage of a startup. As described previously, it’s pretty common to require more than one round of funding during the seed stage, in order to reach the Series A sweet spot. But the name you give to each seed round also describes where you are in that seed stage, from an evolutionary and maturity standpoint.
There no right or wrong way to name your seed rounds. In fact, I did a survey of a bunch of investors on Twitter and 54% responded with “who cares?” when asked what they prefer to call the larger, institutional, priced round of funding that happens before the Series A. Nonetheless, since you’ll probably need to come up with some strategy, below are some options to consider, assuming two such rounds:
- Seed 1 and Seed 2
- Seed and Seed Plus (or Seed+)
- Seed and Seed Prime
- Angel Seed and Institutional Seed
- Early Seed and Late Seed
Notable Variations to the Chasm Model
Certain types of companies need to raise more money earlier and/or have a much longer timeline to get their product launched and their first paying customers. The best examples are hardware, biotech and life sciences companies. These companies still have fundraising chasms to deal with but they occur at a different point in the company’s evolution.
- Hardware – The chasm commonly exists after a couple of generations of prototypes have been completed but before the product has been launched into the market. Hardware companies often have to go through 4-5 different prototype generations before finally having a design that 1) works 2) can be manufactured 3) carries an acceptable cost (bill of materials). It is sometimes hard to find a category of investors that are excited about funding the final couple of prototypes and subsequent launch.
- Biotech & Life Sciences – The chasm commonly exists after some basic feasibility study has been completed and provisional patents filed but before regulatory approval (ie – FDA) and way before paying customers. The challenge finding investors at this stage is similar to what’s described above for hardware companies.
Hopefully you’ve concluded that the fundraising chasm is at least something to include in your seed fundraising strategy. Things won’t play out like you plan and you almost certainly should raise more than you think you’ll need for your seed round if the investor demand is there. But even if you decide not to or try but aren’t able to, at least you know there’s some chance you’ll be facing the chasm in the future and can have some backup plans to successfully cross it.