Crossing the Chasm - from Seed to Series A

17th January 2022

The startup world has changed out of all recognition over the past 10 years. The explosive growth in venture capital and the ecosystem that it supports has been a major driving force. Capital deployed globally last year was up more than 10x over what it was a decade earlier.

VC has become the funding mechanism of choice for ambitious entrepreneurs that aspire to build global category leaders of real scale and enduring success. As the 2021 State of European Tech Report revealed, "..the number of companies that have raised venture capital to fund their journey far exceeds those that take alternative paths." 

On the face of it, with funding at record levels, there has never been a better time to be a startup founder.

But not all boats have risen on this tide. The 10-year spending boom has not resulted in a similar increase in the number of startups being funded, up just over 2x for the same period. In fact, for the past 3 years, the number of new startups closing rounds at the formative Seed stage has actually been in decline.

And whilst the graduation rate of Seed stage businesses to Series A did see some improvement in 2021, making this critical transition remains one of the biggest hurdles for founders (and a major focus for Duet Partners). Usually associated with attaining product/market fit and the beginning of early scaling, many other stars must also align.

Founders seeking to lead their startups through this phase must better understand the changing needs and aspirations of the VC asset class. For example, they must not fall into the trap of thinking that frothy market conditions have made the funding process any easier, or by hitting a few key metrics they will 'qualify' for funding.

Even on the back of a record year of investment in 2021, almost one-fifth of founders say it has become harder to raise capital.

The sacrifice of growth potential - the 'missing 6%'

The road to startup success has never been easy. Research by McKinsey has shown that in both the US and Asia, only around 20% of all startups that successfully secure Seed funding eventually go on to exit or reach Series C.

Across Europe, this figure is even lower - only 14%.

This lower level of advancement doesn't mean that European companies are more likely to fail. Failure rates with the US are actually comparable. In fact these companies may actually be growing and profitable, and thus self-funding. But there is a 'missing 6%' that could be sacrificing a real growth opportunity and the potential to become a global category leader, where the biggest exit returns can then be realised.

There are clearly many different factors at play across these 3 major geographies. For example, market fragmentation in Europe is greater. For a European startup to address a market that is similar in size to that of the United States, it would need to enter 28 heterogeneous countries. And access to capital, especially at later stage, has always been more limited in Europe.

But with startups now driving global growth ambitions from ever earlier stages and the increasing amount of cross-border investment by the big international funds, these particular differences are gradually diminishing.

Even so, there still is a tough road ahead. Europe represents just 7% of global public tech market cap, compared to 70% in the US. But with 98 new European Unicorns being formed in 2021 alone, the level of ambition and optimism has never been so high.

Support for founders in the formative stages of the journey is also increasing. More money is being recycled back into the ecosystem by founders with successful exits. Numerous incubators and accelerators are helping startups take early shape. Entrepreneur First, an accelerator for future founders from all backgrounds, has become a major force for good.

At Duet, we have our own role to play. Our primary focus is helping UK founders successfully lead their businesses through the critical Seed to Series A transition. According to the McKinsey data, this is where a disproportionate number (77%) of startups fail or fall off the high-growth funding pathway.

The potential to drive higher graduation rates from Seed to Series A is definitely there. But there are some particular challenges that founders must wrestle with before Europe can reach parity with the US or Asia. Some are inevitably tied to macro market factors, but others are within the direct control of startup founders and their early investors.

Crossing the Chasm

In Geoffrey Moore's classic work, Crossing the Chasm, he reveals that the journey through the product adoption lifecycle is neither smooth nor gradual. Moore challenges classic lifecycle theory by introducing the idea that between the Early Adopters and the Early Majority there is in fact a major discontinuity - "The Chasm".

In simple terms, what the early adopters or 'Visionaries' are searching for is significantly different to what the early majority or 'Pragmatists' seek. The Visionaries see the new product as a change agent, a disruptive force that can be used to enable immediate competitive advantage - even if incomplete. By contrast, the Pragmatists are looking for something that is proven, complete, and dependable.

As a result, transitioning from the early adopters to the mainstream market calls for a fundamentally different approach. For example, Moore tells us that the first step is to focus resolutely on a specific segment or niche of the market and dominate this first - to secure a "beachhead" from where word of mouth becomes the initial marketing strategy. In this way, the Visionaries are used (perhaps unwittingly) to give confidence to the Pragmatists.

We can see how this concept has influenced lean startup thinking in the mainstream markets of today - especially for high growth businesses with category-leading aspirations. For example, the creation of the Minimum Viable Product to establish early traction in the beachhead with the early adopters.

But just as a chasm exists between the expectations of the Visionaries and the Pragmatists, so a similar chasm exists between what makes a Seed stage business investible and what makes a Series A business investible.

The transition might appear linear and gradual, but it is not. If it were, then far more startups would graduate.

To understand this nonlinearity more clearly we first need to understand one of the core tenets of the VC world.

The Power Law of VC

In his acclaimed book, 'Zero to One', legendary founder and investor, Peter Thiel, explains what all VCs know but few founders truly appreciate: "..venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined."

He adds: "This implies two very strange rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. This is a scary rule, because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more humble scale.) This leads to rule number two: because rule number one is so restrictive, there can’t be any other rules."

As a result, VCs are on a quest to back future category leaders, where rapid and sustained growth is essential to delivering a winner takes most outcome.  Without the outsize returns that these leaders provide, VC fund economics simply don't work.

When the realisation bites it's often too late

Ambitious founders that are seeking to maximise growth potential will very likely end up pitching to VCs, either during the Seed phase or at Series A. In the current market this includes not just mainstream VC funds but potentially certain Private Equity funds, Hedge Funds, Mutual Funds, and Corporate (CVC) funds that are increasingly active in the VC asset class.

Seed stage pitches will typically focus on the market need, the innovation that will fill this need, early customer traction and the team.

VCs looking to invest at Seed will also be asking another key question. "Is there a serious prospect of this company being able to secure Series A investment down the line?" If they have real doubts they will step back from the Seed round. Founders must anticipate this early scrutiny of future Series A capability and deal with it proactively.

Series A pitches will focus much more on customer traction, clear confirmation of product/market fit, a go to market strategy that is working and a business model that shows real scaling potential. The evidence must show that the chasm has been crossed.

But we know from the analysis of graduation rates that few of these VC pitches will be successful. They may cover the right topics, but they just won't be sufficiently convincing. Of course, not every startup can be a category leader. Some will fall well short of the mark, but some will get very close.

These marginal cases are of particular interest. They are part of the 'missing 6%' that, with some rework in the underlying proposition, could graduate.

Unfortunately, for these founders, this realisation often comes too late. Investor feedback suddenly makes them see there is a just too big a gap to fill given the cash runway they have left. There is just not enough time to properly rework the proposition. They thought they had a good read on the criteria that investors would employ, but there were gaps in this understanding.

“A year from now you will wish you had started today”

Karen Lamb

The biggest mistake is to hang too much on commercial momentum alone. For example, startups that think because they have crossed the $1M in ARR threshold they should automatically be Series A material, can be setting themselves up for a shock. We hear and read about such stories with increasing regularity. Recent comments from Asheem Chandna, Partner at Series A specialist Greylock Partners are typical:

"I recently met with an ambitious entrepreneur whose new company had a solid roster of customers. Their billings during the first few quarters were impressive. But I passed on the investment because, while I admired the individuals and liked their idea, I couldn’t envision a path beyond $20 million in revenue."

The 'metric' for winning Series A isn't a pat formula

A core part of the mission for the best incubators, accelerators and early stage advisors, is to ensure founders understand the bigger picture of what VC investors are looking for and how each topic will be examined. This must be set in place at the earliest opportunity. At Duet we seek to do this during the early phases of Seed stage if possible, and at least 9-12 months ahead of the Series A.

Time must not become the enemy.

In our view, the general framework for this early self-evaluation should be that of a gap analysis - 'This is where we need to be (for Series A) and this is where we are now.' In other words, the outcome should be: 'Here are the clear priorities we must work on to become investment ready.' Some of these will be specific to the particular sector and some will be more generic, but all should be consistent with the critical success factors for category leadership.

Such a framework for ensuring investment readiness is also invaluable in helping develop the future funding strategy. This is especially useful for startups that are exclusively backed by private investors. Here there may be particular interest in trying to evaluate the implications of bringing in VC investors versus other funding pathways.

Founders that can secure early alignment between themselves, their current investors and the likely needs and aspirations of VC investors, will have a much easier passage through both the late Seed and Series A funding cycles.

Beyond investment preparation

The rubber ultimately hits the road when the funding strategy is finally put into action. Many incubators and startup accelerators will facilitate introductions to investors at the culmination of a group programme. But most startups forge a lonely path in their formative stages and founders must rely on their own self-education and connections to prepare and conduct a funding campaign.

But this can be a tricky and complex process to navigate. For first-time founders in particular, this is often a period of great uncertainty, consisting of much trial and error. Hence the second major role we undertake at Duet: Ambitious founders can receive 1/1 guidance through a live funding campaign, from investor target list creation and pitch deck development, right through to deal completion.

The startup ecosystem has developed significantly in recent years fuelled by an avalanche of venture capital. We are in an era where tech entrepreneurship has moved centre stage. Starting a business is now a 'career path' all of its own. But starting is always a lot easier than finishing.

By ensuring founders become increasingly savvy at crossing the Seed to Series A chasm, our aim is to help more of the 'missing 6%' graduate and maximise their true growth potential.

John Hall is CEO and Co-Founder of Duet Partners Ltd. Duet is a startup to scaleup advisor that supports ambitious founders in the development and execution of funding campaigns at Seed and Series A. We've worked with some of the UK's most exciting startups over the past 12 years, helping raise £100M's. Our client list is here.

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