This week on the startup to scaleup journey:

• Crossing the chasm from Seed to Series A
• Valuation trend analysis offer ends

Crossing the chasm from Seed to Series A

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 life-cycle theory by introducing the idea that between the Early Adopters and the Early Majority there is, in fact, a major discontinuity - "The Chasm".

The chasm exists because the needs and expectations of these two adjacent cohorts are fundamentally different. Founders that understand this discontinuity accrue a powerful advantage. Not only does this help them navigate the early stages of customer engagement but it is the key to unlocking investment at Seed and Series A.

Find your niche
In Moore's depiction, what the early adopters or "Visionaries" are searching for is very different to what the early majority or "Pragmatists" seek. The Visionaries (the main occupiers of the "Early Market") see the new product as an agent of change, a disruptive force that can be used to enable immediate competitive advantage - even if incomplete.

By contrast, the "Pragmatists" (the first port of call in the "Mainstream Market") are looking for something that is proven. Their needs are typically associated with incremental improvement rather than disruption. They are willing to adopt new technologies, but they are more risk averse than the Visionaries.

As a result, transitioning from the early market to the mainstream market calls for a very different approach, not least because the mainstream market should also dwarf the early market in scale. To start with, Moore tells us that to cross the chasm we must focus on a specific segment or niche of the mainstream market and dominate this first - to secure a "beachhead".

Elusive Beachhead
Simply launching a full scale assault into the mainstream market would be too risky. Resources would be diluted and competitors would find it easier to repel the advance. A measured incursion allows for a rapid opportunity/risk assessment. If this turns out to be good landing spot then more resources can be applied. If not, a quick withdrawal can be made and a new beachhead scoped. In the startup, this is the journey to product/market fit.

But the hard reality for most startups is that, despite resolute effort, the beachhead remains elusive. There are 2 primary reasons:

- They find the right landing place but then either lack the strategy, the capability, or the resources to conquer the beachhead quickly without suffering heavy losses.

- They land in the wrong place. It is a beachhead of sorts but it is a landing spot that only leads to a small, slowly-growing market. This can still be a place worthy of building a business, but it will not have the scale potential that most founders (and investors) seek.

If multiple beachhead forays are unsuccessful then either a revised product or a different market must be found. This would be a classic, early-stage 'pivot'. But pivots of any scale are expensive. If a startup can't efficiently find a beachhead from which it can scale and doesn't have the means to pivot, it is destined to either languish or fail.

Startup to Scaleup graduation
Research by McKinsey has shown that only around 14% of all startups that successfully secure Seed funding eventually go on to exit or reach Series C. The biggest drop-off has always been in the Seed to Series A transition. In mainstream venture markets (e.g. B2B SaaS) this maps almost exactly onto Moore's chasm.

In McKinsey's analysis, undertaken before the market slowdown of the past 18-24 months, only 14% of companies graduate from Seed to Series A and continue on a funded growth path. In other words, only 1 in 7 cross the chasm. There always was a clear step function in investment criteria between these two funding stages, but the gap has widened and become much more nuanced as markets have slowed.

For the mainstream venture market, Seed investors not only need to be convinced that the startup is a hot Seed-stage proposition, but that it is on a clear path to also hitting Series A criteria. In particular, by Series A it should be operating firmly within the beachhead from which it will ultimately grow.

To be clear, if Seed investors are not convinced that the startup has a very good probability of raising capital at Series A (from new, bigger investors), they will be very unlikely to invest. The only 'workaround' is to sufficiently capitalise the startup at Seed such that it will not need further funding prior to becoming self-sustaining. This is not unheard of but brings a different set of issues (for a later article). 

Investment Criteria
One of the biggest mistakes founders make in trying to predict investment criteria for the next round is to hang too much on commercial traction alone. For example, by crossing a particular ARR threshold they should somehow automatically be a Seed or Series A candidate. Revenue attainment and momentum are of course key factors, but in any investor scorecard there are many others that can quickly derail a campaign, irrespective of revenues. For example:

Right beachhead: Founders may have a convincing story that they are headed towards or are already in the right beachhead, but if they don't demonstrably have the strategy, capability, or resources (excepting the capital they now seek) to conquer and secure the beachhead quickly and without heavy loss, they will struggle to raise.

Wrong beachhead: Recent comments from Asheem Chandna, Partner at Series A specialist Greylock Partners hammers this point home:"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.

Bridge rounds increasing
A clear sign that more startups are floundering in the chasm is the rising incidence of bridge rounds. In last year’s State of European Tech report, a clear uptick in bridge rounds was already becoming evident by 2Q22. Today, in the 2023 report, that uptick has developed into a clear trend, with 2023 seeing the highest share of bridge rounds across all stages globally since 2019.

Bridge rounds are more common at the earliest stages of a startup's fundraising journey, when they serve to buy more time to find product-market fit. This is also reflected in the latest data, with 38% of Seed-stage rounds being bridge rounds. Even more worrying, 39% of Series A rounds are similarly classed. This indicates real trouble in expanding successfully though the chosen beachhead and into the mainstream market.

Helping founders navigate the funding chasm
Our own approach is rooted in the belief that you must understand the needs of two audiences before you prepare your funding strategy (and well before you write your deck): The customer audience and the investor audience. They both have particular needs that change as markets change, and you must solve for both.

Founders are constantly talking to customers, whether they be (in Moore's terminology) innovators, visionaries, or pragmatists. This enables a process of discovery that provides them with critical insights. But regular dialogue with investors is much harder. The old adage, "when you're talking to an investor, you're pitching", means that investor discussions are rarely 'discovery' meetings.

Our approach, enabled by deep investment research, is to first analyse how investors are responding to a particular industry, vertical, and emerging market segment. We want to know: What types of investor are active here? Who might become active as the market evolves? What are the latest deal trends? (e.g. investment themes, valuations, deal sizes, syndication strategies, etc.). What are the hot investment criteria? (e.g. strategy, capability, resources, right beachhead, etc.). Then the big question; How well does the investment proposition measure up to what investors are looking for? (We discuss this part in more detail here.)

Crossing the Chasm
In mainstream venture markets, the journey through Seed to Series A requires ever more diligent preparation. Founders raising Seed rounds must have at least half an eye on the Series A objective. They must be efficient in finding the right beachhead even though this journey has much uncertainty. They must try and raise sufficient capital to ensure they can cross the chasm successfully, without multiple bridge rounds. The good news is that Seed VCs are demonstrating their awareness of this with round sizes rising to all time highs in 3Q23 and valuations trending up strongly alongside.

Building a convincing investment story at early stage is truly hard and far fewer have been rewarded through 2023. But for those that are now able to create the right proposition, 2024 holds great promise.

Valuation trend analysis offer ends

2 weeks ago we announced that we were making available our extensive investment research capability to provide a free, no obligation, peer group valuation trend analysis for companies looking to raise capital at Seed or Series A in 2024.

Our aim with this initiative was to provide founders with the very latest market data, customised for their specific sector and funding stage. This is the hard evidence that boards seek but is often so difficult to obtain.

We made 25 slots available for this exercise and all these have now gone. We still have a handful of results to deliver to founders before the end of December. We will share our overall findings early in the New Year.

Thank you to all those that reached out. We have enjoyed some remarkable discussions and hopefully provided some fresh insights into the current funding market.

Happy reading!