There’s Only One Way to Beat the Series A Funding Crunch
Raising seed capital isn’t nearly as hard as raising a Series A, and there’s a good reason why.
According to Crunchbase and the Wall Street Journal, Startupland is currently experiencing a huge Series A funding crunch. While a relatively large number of companies raised seed rounds of $1 million (or more), an overwhelming majority of those companies are struggling to get their Series A.
I won’t go into the details why (you can read the linked articles if you want to understand all that). Instead, I’ll note that the Series A crunch isn’t new. It might be a bit more pronounced at the moment, but, even when more seed stage startups are successfully moving to Series A, the conversion rate is nowhere near 100%. In reality, crossing from seed stage to Series A is really difficult, and most founders can’t pull it off no matter what the macro environment looks like because they don’t focus on the one thing Series A investors actually care about.
A founder struggling to raise his Series A
I was recently meeting with one of these founders struggling to close his Series A. “We’ve only got five months until we reach the end of our runway,” the founder said as we ate burgers at a local lunch spot. His company had raised a $1.5 million seed round 18 months prior, but the A round wasn’t coming together. “We’ve either got to close money soon or drastically cut expenses, otherwise we’re dead in the water.”
“Or?” I asked, prompting him toward a third option.
“Or what?” the founder said with a raised eyebrow.
“There’s a third option you’re missing,” I responded. “What about that third option?”
“I don’t see a third option,” the founder sighed. “Things are getting dire.”
I shook my head. “This is the problem with most seed-stage companies,” I told him. “They get so obsessed thinking about their runways in relation to fundraising that they never see the third option for funding their companies. It also happens to be the most important option!”
Getting stuck on a financial runway
Entrepreneurs often use the phrase “runway” to describe the amount of time their startups can survive. That’s what the founder I was meeting was doing, too. He was telling me he had five months before his startup was going to run out of cash and, presumably, die. It’s a difficult position for any founder because, for startups, five months is a frighteningly short amount of time. The startup might as well be on life support.
The process for calculating a startup’s runway is straightforward enough: Compare monthly expenditures with the amount of money in the company’s bank accounts plus any anticipated revenues. For example, if a company is spending $100,000 per month, has $350,000 in the bank, and is generating $50,000/month in revenues, the company has a seven month runway (i.e. the company is losing $50k/mo, and $350k/$50k is 7 months). True, the math is never that clean, but you get the picture.
Technically, the concept of a startup’s “runway” applies to every new company, but the term is usually reserved for venture-backed companies because it tends to be used in two ways.
The first way is the way the founder used it while I was meeting him for lunch. He used the term to describe how much time his company has left before running out of cash.
The other way the term gets used is during fundraising. It’s a way to explain how much time a particular fundraising round will support a company. For example, if you stand in front of a VC and say, “I’m raising a $4 million round of funding,” that VC might ask, “What kind of runway does that buy you?”
Again, it’s an easily understood concept, but that simplicity is also the danger of the concept and why the founder I was talking with was overlooking the third option for his company. Specifically, once founders start thinking about their startups in terms of “runway,” it means they’re accepting a fundamental principle that their startups should be spending more money than they’re making. But that’s not how businesses should be thinking.
In other words, in case you missed that lesson in business school, companies aren’t supposed to spend more than they make. Yet, somehow, that detail doesn’t always occur to founders who are determined to raise VC, including, of course, the founder I was meeting with. He was so obsessed with fundraising that he forgot he could be increasing his revenues.
The dangers of being on the runway
“When you’re telling me you’re almost out of runway,” I said to the founder between bites of hamburger, “I assume you’re including revenues in your calculation. What do your revenues look like?”
“”They’re not great,” he answered. “We’re generating around $20,000 per month.”
“And what’s your monthly burn?” I asked.
“It’s around $50,000 per month,” he shared.
I did some quick, mental math and then said, “So, if you’re telling me you have five months left of runway, it means you’ve got around $150,000 in the bank, is that right?”
“Yes,” the founder nodded.
“Then your third option,” I told him, “is to get more customers. More customers means more revenue, and more revenue lowers your burn so you last longer.”
I began jotting numbers on my napkin and showed how getting to $40,000 in monthly revenue in the next four months would completely change his company’s trajectory. He’d be close to break-even, and he’d have plenty of extra time to raise his Series A.
“But how do I double my revenue in the next four months?” the founder asked as though he’d discovered some sort of huge flaw in my plan. “If I could do that, I wouldn’t even need VC money.”
“Exactly!” I exclaimed, finally getting to the heart of his problem and the problem I see in most companies that fail to go from seed stage to Series A. “By the time you’re raising any serious amounts of VC, your company shouldn’t need investor money to exist. You should have a viable business model, and the VC money should be used for scaling. But that’s not you. You’re still raising money just to survive, and that’s why VCs don’t want to invest. Simply put, you’re not a good investment unless you can significantly increase revenues.”
I see this same pattern dozens of times every year, and it’s why so many seed stage companies never make it to Series A. When you’re pitching a seed stage company, you’re pitching an unproven vision and asking for money to prove it. In contrast, when you’re pitching a Series A or later, you should have already proven some sort of viable business, and you’re asking for money in order to grow faster.
Keep this in mind as you build your startup. Yes, it’s possible to raise a little seed money based entirely on a compelling vision, but, if you want to beat the Series A funding crunch, you have to prove you know how to acquire customers.